Common sense says productivity growth should affect equity prices. If companies can increase output and revenue without taking on more staff and increasing labour costs, then profits should rise. If labour costs don't increase, the Bank of England won't expect inflation and so will hold down interest rates. And if productivity grows quickly, economic conditions will feel good and so positive sentiment will boost shares. On all three counts, high productivity growth should raise price-earnings ratios, as investors become more optimistic, anticipate rising profits or enjoy easy money conditions - or all three.
History shows that common sense is correct. Since 1988 there has been a high correlation (0.71) between labour productivity growth over a three-year period and the PE ratio on non-financial stocks. For example, strong productivity growth in the early 1990s was accompanied by high PE ratios. The mid-90s productivity slowdown saw equities de-rated. The tech bubble of the late 90s coincided with fast productivity growth. And, since then, productivity growth and valuations have both trended downwards.
This suggests that a big reason why equity valuations are low now is that productivity has stagnated. In the last three years, GDP per hour worked has grown at an annualised rate of less than 0.5 per cent. This is less than at any time in the 1970s, when militant unions and restrictive practices were, supposedly, strangling the economy.
In turn, this implies that if productivity growth does pick up, shares will enjoy a re-rating. And it could be a big one. If productivity were to return to its average of the last 40 years, of 2 per cent per year, then post-1988 relationships predict that the non-financial PE ratio would rise to just over 17. This implies a 75 per cent rise in prices, even without any rise in profits.
And there's one powerful reason to think that productivity growth could recover.
When demand growth falters, companies tend to hang on to workers in the hope that things will get better. This labour hoarding should diminish in the next few years. If we're lucky, this will be because the economy recovers and so workers who are presently under-employed will become more productive. If we're unlucky, it will be because companies abandon hope of an upturn and so trim their staff numbers. Either way, productivity growth should rise.
Labour hoarding, however, is not the only story. Productivity growth was slowing down long before the recession of 2008. This suggests there are some longer-term forces holding down productivity, which mean that we might not see a strong rebound any time soon.
One of these forces lies in another fact that predates the recession - that business investment as a share of GDP has fallen. This reduces productivity growth directly, because it means workers have to use outdated equipment; they spend their time cussing malfunctioning servers and software rather than doing productive work. But it also matters for productivity indirectly. The lack of investment is a sign of a lack of monetisable growth opportunities. This means we have fewer high-productivity innovative start-ups than usual. And it means older companies employ staff on only marginally monetisable projects, such as supermarkets employing delivery drivers.
This problem is amplified by the fact that some of the minority of companies that do have good ideas are unable to attract financing. This matters, because research shows that a large chunk of productivity growth comes not from existing companies increasing their efficiency but from new establishments entering the market and older inefficient ones exiting. The lack of credit is slowing this "external restructuring" and so retarding productivity growth.
And herein lies our problem. There's little reason to suppose that the dearth of investment opportunities will disappear any time soon. Nor is it obvious that the National Loans Guarantee Scheme or the Bank of England's more generous lending to banks will be sufficient to get credit flowing again. This means that, aside from a brief boost caused by an unwinding of labour hoarding, productivity growth could stay low by historical standards, which in turn would hold down equity valuations.
But what if I'm wrong and productivity does bounce back strongly? Even this would not necessarily be a wholly good thing. Stronger productivity growth would give us a jobless recovery, which means that if share prices do rise a lot, it will be at the same time as unemployment stays high. And this might cause a stronger political backlash against rising inequality, which investors might find uncomfortable.
