Euro-zone: The Revival of Productivity edit
One thing has escaped analysts' attention about euro area GDP data so far this year - labour productivity. This key ingredient of economic welfare and catalyst of stock market performance has accelerated significantly. The reason for this oversight, unfortunately, is the poor performance of the European statistical system: very few countries produce timely and reliable data on productivity per worker, not to mention productivity per hour. Don't blame Eurostat for this woeful situation: this small EU Directorate cannot invent data that do not even exist at the national level of several large European economies. However, just because productivity is measured poorly, doesn't mean it should be overlooked. According to our tentative measurements, productivity per worker in the business sector, which grew on average by 0.7% from 1999 to 2005 on OECD estimates, reached 2.0% (annualised rate) in the first half of this year, peaking at 2.4% in the second quarter.
-->More importantly, productivity per hour accelerated from 1.3% on average in the first six years of EMU to 2.4% in the last six months. There is certainly a cyclical and therefore temporary dimension to the resurgence of European productivity.
However, I am firmly convinced that cyclical developments do not explain everything. A combination of accelerating corporate restructuring due to globalisation and consistent investment in information technology by European companies is the other and more fundamental reason for the acceleration in productivity. This should have important consequences for investors.
In order to measure productivity trends, we start from the OECD series on productivity per worker in the business sector for the euro area. Since several labour market reforms - such as the 35-hour working week in France or the regularisation of illegal immigrants in Spain and Italy - have seriously distorted the data, some corrections must be made, as we explained in an earlier note (Productivity Revival, Eric Chaney and Anna Grimaldi, August 18, 2004). In addition, the secular trend of part-time employment is reducing the aggregate number of hours worked per worker, even if in Germany, Belgium, the Netherlands and, to some extent, France, the number of hours worked by full-time employees is probably on the rise, as 'Siemens-type' agreements with unions (working longer hours without full compensation) spread progressively across the continent.
There is also a cyclical dimension to part-time jobs, which are more flexible than full-time jobs: in bad times, companies first lay off temporary workers, then those on short-term contracts and then re-negotiate part-time agreements. In good times, things work in reverse. Consequently, the share of part-time workers is probably increasing faster than trend at present. Add up these various corrections and discount a slowdown in top-line growth in the third and fourth quarter of this year, and you are left with a 2.1% growth rate for hourly productivity in the business sector, to be compared with 2.2% in the 2000 boom year, when GDP growth reached 4.0% in the euro area. A similar performance for productivity, with much slower growth (around 2.5%), is a clear sign in my view that the improvement is not only cyclical.
Interestingly, while European productivity seems to be on the mend, US productivity is showing signs of deceleration. From an equity standpoint, this should favour European stocks on a relative basis since productivity acceleration typically implies a rise in the profit share (witness the stunning rise of the profit share in Germany over the last three years) in the first stage, and the opposite in the event of deceleration. In fact, this change in relative trends has not escaped investors' attention: from January 2003 (2003 was the turning point for productivity per worker in the euro area) to date, euro area share prices, as measured by the broad Euro Stoxx index, have outperformed US stocks (as measured by the S&P500 index) by 42%, in same currency terms. If, as I suspect, we are only at the beginning of a structural productivity revival in Europe, this is a trade that long-term investors should continue to consider.
There are also important consequences for policy makers: faster productivity growth provides a welcome shield against inflationary risks, since it raises the speed limit of the economy, or the growth rate above which it would be overheating. As the European Central Bank ponders both the pace of its monetary normalisation and the level at which short term interest rates would be neutral for the real economy, a faster productivity growth would have two implications. In the short term, cyclical inflationary pressures are probably less threatening than they would be if productivity continued to grow at a snail pace. Hence, the risk for the ECB of falling "behind the curve", i.e. to have raised rates too slowly so far to prevent inflation from accelerating, is very limited. Currently, the markets are anticipating two more 0.25% rate hikes this year, which would bring the refinancing rate to 3.5%, or 1.5% in inflation-adjusted terms. With still significant slack in the economy, monetary policy would remain expansionary, although much less than one year ago, without fuelling inflation, which is the right compromise the ECB should seek. Given the strong headwinds the eurozone economy will face next year, such as, for instance, a large scale fiscal tightening in Italy and Germany, GDP growth is likely to drop significantly below trend next year. Therefore, I take the bet that the ECB will prove pragmatic and cut interest rates in the course of 2007.
However, in the long term, faster potential GDP growth also implies a higher return on assets, other things being equal and, consequently, a higher neutral rate of interest, i.e. the level at which monetary policy neither stimulates nor bridles economic growth. There is no free lunch.