The Shift That Explains Lofty Markets: The Economy Got More Productive

At an economic level, the investor belief is that there is more capacity for growth than expected, so more growth—and thus profits—can be had before the economy overheats and leads to inflation. Image: Pixabay
At an economic level, the investor belief is that there is more capacity for growth than expected, so more growth—and thus profits—can be had before the economy overheats and leads to inflation. Image: Pixabay

Summary

There is a lot of bubble talk lately, but it’s easy to tell a story of how recent market gains could be largely justified.

Stocks have proved remarkably resilient to rising bond yields this year. Many think this is because a bubble is inflating, especially in stocks linked to artificial intelligence. Here’s the alternative, in one word: productivity.

Productivity gains—that is, more output for the same amount of work—allow more growth without inflation, helping explain the market’s switcheroo from treating a strong economy as bad for shares to treating it as good (although stock prices still look optimistic to me). The risk is that the market is treating the undeniable short-term productivity gains of the past year as evidence that long-term gains are on the way.

In the short term, inflation has come down because the economy has been more productive (in large part as pandemic damage to supply chains was reversed), not because the economy slowed.

Investors who thought the Federal Reserve’s high interest rates would hurt growth discovered that much of the economy was unaffected. Stronger than expected growth this year led economists to push back the date of the first Fed rate cut, pushing up bond yields. But it didn’t matter to shareholders because the hit from rates staying higher for longer was more than offset by the gains they now expect from higher profits.

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

In the long term, many investors hope that gains from new technologies, particularly AI, will lead to a sustained productivity boom akin to that in the 1960s or late 1990s. Higher productivity means higher interest rates than otherwise, but for the stock market that should be offset by the higher profits that growth brings.

This story shows up in lots of areas of the market. At the most basic, stocks have switched from moving in the exact opposite direction to Treasury yields in the second half of last year, both as yields soared to a peak of 5% on the 10-year note and as they came back down, to having a slight tendency to rise and fall in line with yields.

Cyclical sectors most sensitive to a strong economy have also outperformed steady defensive sectors as rate expectations and bond yields rose this year. This is different from the past couple of years, when higher Treasury yields were mostly interpreted as a headwind for the economy, hurting cyclicals and helping defensives. Investors are betting on the right sort of growth ahead.

In the credit markets, the story shows up as a willingness to buy the riskiest corporate bonds. The spread over Treasurys—a gauge of how risky investors think they are—of junk-bond yields rated single-B or CCC, two of the lowest categories, have come down this year, despite higher yields overall.

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

Investors might be wrong about imminent productivity improvements. Generative AI has done impressive things, and it’s true that there is a lot of corporate investment going into the U.S. thanks to fat government subsidies. But problems with generative AI are becoming more obvious, and its uses might turn out to be more limited than company executives hope. If productivity gains don’t turn up, the strong economy would have to be slowed by the Fed to prevent inflation from taking off again.

Productivity doesn’t help everyone either. The two-speed economy has left smaller companies behind as they are hit harder by higher financing costs—along with other highly leveraged areas of business, such as real estate and wind farms. The Russell 2000 index of smaller companies underperformed larger stocks as rates rose, and outperformed in the past few weeks as rates came down a little, continuing the pattern that held last autumn.

For sure the gain in productivity last year isn’t repeatable, since it was driven by the reversal of pandemic-era supply shocks. Betting on its being followed by an AI productivity boom has a good story behind it, but working out the impact of new technologies even on individual companies, let alone the economy as a whole, is tough. Investors might be getting carried away. But that’s still better than a bubble.

Write to James Mackintosh at james.mackintosh@wsj.com

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