A change that explains higher markets: the economy becomes more productive

Productivity gains—that is, more output for the same amount of work—allow for more growth without inflation, helping to explain the market's shift from seeing a strong economy as bad for stocks to seeing it as good (though stock prices are still bullish to me). The risk is that the market sees last year's undeniable short-term productivity gains as evidence that long-term gains are to come.

In the short run, inflation has fallen because the economy has become more productive (often because the pandemic's damage to supply chains has been reversed), not because the economy has slowed.

Investors who thought the Federal Reserve's higher interest rates would hurt growth found that much of the economy was unaffected. Stronger-than-expected growth this year has led economists to push back the date of the first central bank rate cut, pushing up bond yields. But that doesn't matter to shareholders because the hit from rates being higher for longer is offset by the gains they now expect from higher profits.

At an economic level, investor confidence is that there is more potential for growth than expected, so more growth—and thus profits—can be made before the economy overheats and leads to inflation.

In the long run, many investors believe that the gains of new technologies, especially AI, will lead to a sustained productivity boom similar to that of the 1960s or late 1990s. Higher productivity means higher interest rates than otherwise, but for the stock market that growth should be offset by higher profits.

This story plays out in many areas of the market. More fundamentally, stocks have moved in the opposite direction to Treasury yields in the second half of last year, with yields on the 10-year benchmark rising to 5% and then falling again. There is a slight tendency to rise and fall with yield.

Cyclical sectors, which are more sensitive to a strong economy, outperformed statically defensive sectors. This is different from the past two years, when higher Treasury yields were often interpreted as a headwind for the economy, hurting the cycle and helping the defense. Investors are looking forward to the right growth.

In credit markets, the story shows a preference for buying risky corporate bonds. The spread on Treasurys—a measure of how risky investors think they are—despite higher yields overall, while yields on junk-bonds, the two lowest categories rated single-B or CCC, have fallen this year.

Again, this is the opposite of what happened in the past two years, when higher Treasury yields were interpreted as bad news for companies, as they raise interest costs and slow the economy. This year, higher Treasury yields have been interpreted as good news for riskier companies, as a stronger economy means less default risk despite higher interest costs.

Investors may be wrong about immediate productivity improvements. Generative AI has done impressive things, and it's true that there is a lot of corporate investment within the US thanks to government subsidies. But the problems with generative AI are becoming more apparent, and its applications are less likely than company executives believe. If productivity gains don't change, the central bank will need to taper a strong economy to prevent inflation from rising again.

Productivity isn't for everyone. The two-speed economy has left small companies behind, with high financing costs coupled with highly leveraged areas of business such as real estate and wind farms. The Russell 2000 index of small companies continued a pattern from last fall as rates rose, while large stocks underperformed, and rates fell slightly in the past few weeks.

Last year's gains in productivity are unlikely to be repeated as they are driven by the reversal of pandemic-period supply shocks. Betting that the AI ​​productivity boom will continue has a good story behind it, but quantifying the impact of new technologies even on individual companies, let alone the economy as a whole, is difficult. Investors can be deceived. But it's still better than a bubble.

Write to James Mackintosh at [email protected]