08 Aug 2003 Productivity – The Double-edged Sword

Yesterday, the Labor Department reported that productivity grew more than twice as fast in the second quarter than in the previous three months as the economy accelerated.  The increase of 5.7% was considerably over analysts’ estimates of 4.1% and the fastest since the third quarter of last year. 

Productivity measures the amount of production accomplished by an employee in one hour’s work.  Increasing productivity enables businesses to cut labor costs while producing equal or greater amounts of goods.  In the long-run the gains typically lead to higher corporate profits, business investment, and hiring.  But in the short-run if an economy fails to grow as fast as productivity increases, new jobs are not created to offset those lost.  Costs are cut, but so are jobs.

The latest report from the government showed that the economy grew by 2.45% in the second quarter, less than half the rate that productivity grew.  The fear is that after three years of stagnant growth, businesses will be eager to cut costs and reluctant to hire more workers, further slowing the recovery.  Also of concern is that a stubborn and relatively high unemployment number will further dampen consumer confidence and slow spending.

Another factor exacerbating the unemployment problem is that this country is losing its manufacturing base.  After WWII theU.S.economy was comprised of 75% manufacturing and 25% services companies.  A dramatic reversal has occurred over the last 55 years as latest figures show that our economy is now almost 85% services and 15% manufacturing.

All those computers purchased in 2000, new software applications, and novel ideas spawned by the dot com era are being better utilized by businesses (and government) to improve production while cutting costs. America’s best and brightest technology and communications companies are making the world marketplace more productive, while ironically enabling foreign manufacturing and service workers to effectively displace more expensive American workers.

Here in North Carolina we are painfully aware of this reality as the textile and furniture industries are disappearing before our eyes.  Last week, the large, high-end textile manufacturer, Pillowtex announced that they were closing 16 manufacturing and distribution facilities while terminating 6,450 salaried and hourly workers.  They also announced plans to reorganize under protection of Chapter 11 bankruptcy laws.  It is doubtful that any of the manufacturing jobs lost last week will return to this state or to this country.

Pillowtex could not compete with cheaper competition and had to take drastic measures.  When all other factors such as quality, delivery, raw materials, etc. can be assured, business managers will seek out the cheapest labor they can find to produce their goods less expensively than their competition.  Consumers ultimately win as prices fall.  They win, that is, if they have a job to pay for their consumption.

As long-term investors we are excited by the prospect of future economic improvement brought on by dramatically increasing productivity.  Indeed, we concentrate our holdings in companies that deliver productivity enhancing technologies or in companies that employ those technologies better than their competitors.  But it’s in the short-run where jobs are lost, perhaps permanently, that is of concern.  Will this economy create new jobs fast enough to offset those lost to rapidly rising productivity and cheap foreign labor?

The answers will not come as quickly as we would like.  Previous economic recoveries started from lower levels of employment, capacity utilization, and economic growth than this economy now demonstrates.  Furthermore, the length of the slowdown makes managers more cautious than in previous recoveries, so they are more reluctant to invest, hire, and take business risks.

But there are signs and voices in the haze of uncertainty.  Cisco CEO John Chambers said in his Wednesday afternoon conference call to investors that Cisco would continue to take prudent business risks to grow their business.  Cisco represents 65% of the world’s network router and switch market.  Similar statements have come from companies like Microsoft, Dell, WalMart, Chicos, Ebay, and Amazon.

Government reports also hint of continued improvement.  As you can see in the chart below, most of the reports are highlighted in green and show improvement, some significant.  Factory Orders were up substantially in June, well over May’s .4% growth.  The ISM Non-Manufacturing index o fU.S. service industries staged the broadest expansion in six years as orders flowed at an unprecedented rate. Readingsabove 50 indicate expansion.  The index started in July of 1997.

Both government and corporate reports show that we are in recovery.  The Administration, Congress and Fed continue to demonstrate their willingness to do whatever it takes to keep this ‘fragile’ recovery on track.   Until the next round of corporate earnings we only have company guidance and government reporting to hint at our progress.  The market will likely wander somewhat aimlessly for a couple of months.   But for now, investors and business leaders seem to be reaching for their swords in increasing numbers as they feel a bit more confident in their knowledge of where the handle is.