Download Is U.S. economic growth understated?

Wells Capital Management
Perspective
Economic and Market
Bringing you national and global economic trends for more than 30 years
May 5, 2016
Is U.S. economic growth understated?
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.
However, the real wage rate has been climbing steadily
throughout this recovery suggesting much stronger productivity
performance and thereby stronger real GDP growth. Moreover,
the growth of investment, consumer spending, and job creation
also imply the pace of economic growth in this recovery has
been stronger than officially reported.
The current economic recovery has been the slowest of the
post-war era. Indeed, throughout this recovery, U.S. real GDP
has hovered near the “stall speed” of about 2% growth (the
Mendoza Line for economic recoveries) constantly fueling fears
that another recession was imminent. Chronic consternation
surrounding this recovery has produced persistent liquidations
from equity mutual funds even though the stock market has
mostly risen, has made borrowing money almost taboo, has
prevented the emergence of CEO animal spirits who possess
considerable capabilities to drive a capital spending cycle but
lack the confidence, has pushed fiscal and monetary authorities
to respond with the most incredible, unconventional, massive,
and ongoing package of economic stimulus ever employed in
our history, and finally has produced a highly combative political
climate with both sides suggesting the other is responsible.
This note focuses on the long-standing and close relationship
between real wages and productivity performance. Using a
forecasting model based on the real wage rate, productivity
is estimated to have grown much faster than reported
suggesting average real GDP growth during this recovery
may actually be closer to 3%. If the economic recovery has
actually only been subpar rather than almost comatose,
what are the implications for policy officials and investors if
eventually a consensus comes to embrace this reality?
What if the pace of real GDP growth during this recovery
was actually closer to 3% rather than sustaining near the
Mendoza Line? How much would the rhetoric surrounding
the aftermath of the “worst crisis since the Great Depression”
be altered? Would economic policies still (or ever) be so
outsized? After seven years of persistent economic recovery
would CEO, household, and investor behaviors still remain
so conservative? And, if most perceived a slower but
reasonably growing recovery, would voter backlash against
establishment candidates be so virulent?
Experiencing the weakest productivity performance of any
economic recovery in the post-war era is curious, however,
since as shown in Chart 2, the real U.S. wage rate has risen
significantly in this recovery. The real wage rate has risen by
about 7.5% since the end of the last recovery or about 0.86%
per annum. This is one of the strongest gains in real wages
during any recovery since the 1960s! Does it make sense that
companies would raise real hourly labor compensation rates
by one of the fastest paces in more than 40 years if the real
productivity of laborers was weaker than any recovery in the
post-war era?
Official reports suggest U.S. productivity has grown at its
slowest pace of any economic recovery in the post-war
era. Indeed, U.S. productivity has increased at the paltry
annualized pace of only 1% in the current recovery compared
to a post-war recovery average of 2.4%.
Productivity and the real wage rate
As shown in Chart 1, since 1964, U.S. productivity (i.e., U.S.
business sector output per hour worked) has increased about
2.1% per annum. However, during the current recovery,
productivity has increased only 1% per year.
Economic and Market Perspective | May 5, 2016
Chart 1
Chart 2
U.S. Productivity Index vs. trendline average
U.S. real wage rate*
Natural log scale
Solid — U.S. Productivity Index — U.S. business sector output per
hour of all persons
Dotted — Trendline average since 1964 of U.S. Productivity Index
*Average hourly earnings index divided by consumer price index
Chart 3
The oddity of this conundrum is illustrated in Chart 3 which
overlays the detrended U.S. Productivity Index (i.e., shows the
level of the productivity index in Chart 1 as a percent above
or below its trendline average) with the real wage rate. When
the detrended productivity index rises, productivity is growing
faster than average and when the solid line in Chart 3 declines,
productivity is subpar. Clearly, there has been a strong historical
relationship between the real wage rate and productivity. Until
recently, during the last 50 years, the direction and pace of real
wage gains have been closely related to the performance of
labor productivity. Indeed, real wages have rarely advanced
without a commensurate rise in productivity.
U.S. Productivity Index vs. U.S. real wage rate
Percent above / below long-term trendline average
Solid — Detrended U.S. Productivity Index
Dotted — Detrended U.S. real wage rate
The divergence between productivity and real wages since early
in the contemporary recovery is dramatic, historic, persistent,
and inexplicable. If accurate, it suggests companies have been
constantly paying up for a resource which has been chronically
delivering subpar performance. Assuming companies are
not irrational, either wages are overstated or productivity is
understated. Our guess is productivity has been perennially
underreported throughout this recovery. Perhaps this reflects
measurement difficulties associated with the aftermath of the
Great 2008 Crisis, the aging demographic profile of the U.S.
economy, the ongoing decay of manufacturing relative to a
service-based economy, or maybe by the increasing importance
of new-era products and services.
| 2 |
Economic and Market Perspective | May 5, 2016
Based on its historical relationship, what does the current real
wage rate suggest about productivity? Chart 4 shows the result
of a regression model which forecasts detrended productivity
based on the real wage rate. Although officially reported
productivity is about 4% below its long-term trendline average,
based on the current real wage rate, productivity should be
about 4% above its trendline average. That is, based on its
historical relationship to the real wage rate, the current level of
productivity may be underestimated by about 8% or by a little
more than about 1% annually during this recovery.
Chart 4
Regression model estimating detrended U.S. Productivity
Index from the detrended U.S. real wage rate
Solid — Detrended U.S. Productivity Index
Dotted — Regression model extimate based on U.S. real wage rate
Mendoza Growth or just slow growth?
The current economic recovery is almost seven years old.
Officially, real GDP has averaged just 2.1% annualized growth,
just above the Mendoza Line! However, what would this
recovery look like if productivity had actually performed as
suggested by the movement in the real wage rate?
Chart 5 compares officially reported annual real GDP growth
(solid line) with an estimate based on actual total hours
worked times estimated productivity (based on the forecasted
regression model illustrated in Chart 4). As shown, although this
estimate has not perfectly predicted actual real GDP growth, it
has provided a reasonably accurate assessment of economic
growth at least until the contemporary recovery. Admittedly,
this model has seemingly overstated real GDP growth since
the 1990s or perhaps productivity has simply been increasingly
underreported since the 1990s? Conceding the less-than-perfect
historic efficacy of this GDP forecasting model, it does suggest
that real GDP growth has been sizably underreported in this
recovery. Based on the officially reported total number of labor
hours worked during this recovery and estimated productivity
(from a regression model based on the actual real wage rate),
average annualized real GDP growth during this recovery would
have been 4.2%. While we do not believe the pace of actual
economic growth has been more than twice as great as officially
reported (i.e., 4.2% estimated versus 2.1% officially reported), we
do think it is likely the economy’s performance has been greatly
underreported in this recovery.
Chart 5
U.S. real GDP annual growth
Reported (solid) vs. estimated (dotted) from real wages
Solid — Actual (reported) annual real GDP growth
Dotted — Estimated annual real GDP growth. It is the annual growth
in actual total hours worked and estimated productivity growth
(based on real wage rate)
This is reinforced by other measurements of the recovery as
illustrated in Chart 6. The average annualized growth during
this recovery in real investment spending, real consumption
spending, and total job creation suggest average annualized
real GDP growth has actually been about 0.5% to about 1.25%
faster than officially reported. The solid bars in this chart
show the average annualized excess growth rate during this
recovery of real GDP above three important components of
the economy, investment, consumption, and employment. The
gray bars show what the average growth differential was in
every recovery since 1950.
| 3 |
Economic and Market Perspective | May 5, 2016
Chart 6
Summary & conclusions?
Certainly, the contemporary recovery has been subpar.
We are not suggesting the recovery has been massively
understated and therefore in reality has been very solid. Even
if the official reports of real GDP growth are underreported,
the pace of economic growth in this recovery is still below
average compared to post-war norms.
Annualized growth in real GDP above recovery growth in
real investment, real consumption, and real job creation
However, evidence does suggest the annualized pace of
real GDP growth during this recovery is probably faster
than widely perceived. The behavior of the real wage rate (a
reliable indicator of labor productivity in the past) signifies
U.S. productivity has been significantly underestimated.
Moreover, the pace of growth during this recovery among the
major segments of the economy (e.g., investment spending,
consumption spending, and job creation) also hints that
overall real GDP growth is stronger than suggested by the
official numbers.
It is not our intent to argue that this subpar recovery is
actually pretty good. But, we do think it is instructive for
investors to consider just how materially different the
mindsets and behaviors of policy officials, businesses,
consumers, investors, and voters might have been if
economic growth in this recovery were in fact just a bit better.
And, what would a sudden change of reality toward slightly
faster economic growth mean for stock and bond markets?
For example, since 1950 ,during recoveries, annualized real GDP
growth has been about 1.68% faster than the pace of job creation.
That is, the jobs multiplier (the amount by which job creation
produces additional real GDP growth) is about 1.68%. By contrast,
on average in post-war recoveries, annualized real investment
spending has typically risen about 3.72% faster than real GDP
growth. As shown, during this recovery, the GDP multiplier for
each of these three major components of the U.S. economy have
been less than their respective historical norms. The pace of real
investment spending during this recovery has produced about
1.25% less real GDP growth than it has over the post-war era (i.e.,
-5.02% less -3.72%). Similarly, the consumption GDP multiplier has
been about 0.5% less in this recovery compared to its historic norm
(i.e., -0.11% versus +0.27%) and the jobs GDP multiplier has been
about 1% less (i.e., 0.77% versus 1.68%).
What if the average annualized pace of real GDP growth during
this recovery was actually closer to 3% rather than hovering
about the Mendoza Line as suggested by the official numbers?
How different would the character of this recovery have been
had the official numbers been closer to 3% than 2%?
Although the economy’s performance would still be
considered subpar, it would not chronically be considered
near death as it has throughout this recovery. How many times
(including currently) have most market participants feared the
economy was near the stall speed of 2% growth and feared a
recession was imminent? Could the reason the economy has
never stalled even though it has “reportedly” hovered about
the Mendoza Line frequently is because in reality it has always
been growing at a subpar but still sustainable pace? Without
the primary hallmark which made this bull market great —
climbing a perpetual wall of worry — would the stock market
have done as well? Would leadership in the stock market still
mostly be centered among defensive sectors, dividend payers,
large capitalization stocks, and domestic stocks?
Overall, there appears to be a fair amount of evidence
to suggest that economic growth may be significantly
underreported in this recovery. A poor measurement of
productivity may be understating actual real GDP growth by
as much as 2%, and the performance during this recovery of
real investment spending, real consumption, and job creation
suggest real GDP growth may actually be anywhere from 0.5%
to 1.25% faster than officially reported.
| 4 |
Economic and Market Perspective | May 5, 2016
Would bond yields have declined as far as they have? Would
the Federal Reserve have implemented, and persistently
maintained the unprecedented, massive, and crisis-like policies
they still mostly employ? Would deflationary mindsets be so
dominant? Would a significant capital spending cycle still be
AWOL this late in the economic cycle? If the U.S. economy
was hovering near a 3% real GDP growth rate, would there
be as much concern here in the U.S. about the economic
performance in Europe, Japan, or even in China? Finally, if most
agreed the economy was growing at about 3% in this recovery
rather than near 2%, would there be as much debate about the
haves and have nots, as much political turmoil between the left
and right, and as much disgust with establishment politicians?
Moreover, if actual economic growth is persisting at a pace
faster than appreciated, because the economy is now back near
full employment, this also will likely push bond yields higher,
and force the Fed to quicken its exit strategy.
The premise shaping the character of this entire economic
recovery has been a widespread belief, supported by the official
numbers, that the pace of economic growth has persistently
hovered near the Mendoza Line. This has produced a recovery
dominated by fears surrounding recession/deflation risk.
However, could the balance of this economic recovery be
increasingly dominated by escalating overheat/inflation/rising
interest rate fears predicated on a growing realization that
economic growth has been, and continues to sustain at a pace
faster than officially reported?
Is it possible the character surrounding this economic recovery,
and financial market performance has been primarily based on a
premise (i.e., the economy is barely growing fast enough to avoid
an imminent relapse into another recession) which is significantly
exaggerated? Perhaps, more importantly, if the economy is
growing faster than advertised, what are the implications during
the balance of this recovery?
Until the economy recently returned to some semblance of full
employment (e.g., around a 5% unemployment rate), whether
the economy was growing at 2% or 3% was not as obvious nor
as important. Earlier, many may have been baffled, based on a
belief the economy was hovering about stall speed, by why the
unemployment rate declined back toward 5%, why housing
activity did lift again, why bank lending has returned to about 8%
growth in the last year, and why auto sales spiked back near-record
highs. However, all of these results could be easily explained by an
economy perhaps averaging closer to 3% real growth.
Written by James W. Paulsen, Ph.D.
An investment management industry professional since 1983, Jim is
nationally recognized for his views on the economy and frequently
appears on several CNBC and Bloomberg Television programs, including
regular appearances as a guest host on CNBC. BusinessWeek named him
Top Economic Forecaster, and BondWeek twice named him Interest Rate
Forecaster of the Year. For more than 30 years, Jim has published his
own commentary assessing economic and market trends through his
newsletter, Economic and Market Perspective, which was named one of
“101 Things Every Investor Should Know” by Money magazine.
Now though, with the economy closer to full employment, if there
has been an understatement in the pace of economic growth, it
will likely become more significant. The difference between an
economy growing at 2% versus 3% at less than full employment
might simply explain why the unemployment rate declined
faster than most anticipated. However, at full employment, if the
economy is actually growing closer to 3% rather than the official
2% pace, cost-push pressures, commodity price hikes, and overall
inflation rates should accelerate faster than the consensus expects.
Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital
Management, LLC; Nelson Capital Management; Peregrine Capital Management; and The Rock Creek Group); Wells Capital Management, Inc. (Metropolitan West Capital Management, LLC; First International
Advisors, LLC; and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC.
Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions.
The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as
investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be
guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital
Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000.
| 5 |