2Q Productivity Falls 1.8%

Non-Farm Business Productivity in the second quarter was revised down to a decline of 1.8% from the previous estimate of a 0.9% drop (seasonally adjusted annual rate). This is a very significant slowdown from the 3.9% rate in the first quarter. That, in turn, was down from a 6.0% growth rate in the fourth quarter.

In fact, the rate of productivity growth has slowed in each quarter since the second quarter of 2009, when it was running at 8.4%. The string of increases from the second quarter of 2009 through the first quarter of 2010 had resulted in the highest rate of productivity growth in over 50 years.

Productivity is the output per hour, and thus depends on two things: output, which roughly corresponds to GDP growth; and hours, which roughly corresponds to employment (and the average workweek). The surge in productivity in 2009 was mostly due to a rebound in output, with first falling, and then slowly rising employment.

Relative to a year ago, productivity is up 3.7%, which is still a pretty good showing, but that is due to a 3.7% increase in output, while hours worked are unchanged. Relative to the first quarter, output is up 1.6% while hours worked are up 3.5%.

The downward revision was all from the output side, which was revised down from 2.6% growth, while hours were revised down slightly from 3.6% growth. The decline in the output numbers was not a surprise coming as it did after the second quarter GDP numbers were revised down.

Decline in Services

The decline in productivity appears to be coming all from the service side of the economy, which is not measured directly. However, the numbers are presented for manufacturing. Manufacturing productivity actually accelerated to 4.1% growth from 1.6% growth in the first quarter. While that was revised down from the initial read of 4.6% growth it is still pretty impressive, especially in the context of overall productivity falling at a 1.8% rate.

Alternatively, one could surmise that the drop in service sector productivity was particularly nasty. In the second quarter, manufacturing output rose 8.4% while hours increased only 4.1%. The downward revision came from the hours-worked side, which had previously been estimated at 3.6% growth; output was revised slightly higher from 8.3% growth.

In the first quarter, output rose by 7.0%, which was also a very solid showing (still coming off a very depressed base) but it took a 5.3% increase in hours worked to generate that increase. On a year-over-year basis, manufacturing productivity is up 7.5% based on an 8.4% increase in output and a 0.8% rise in hours worked.

Durable Goods Productivity Increasing

The increase in productivity has been particularly impressive in the Durable Goods side of manufacturing. Companies like Ford (F) and Whirlpool (WHR) were able to increase output in the second quarter by 13.6% but were able to do so with only a 3.4% increase in hours worked. That resulted in a 9.9% increase in productivity.

While the durable goods productivity was revised down from the previous estimate of 11.2% growth, it is still a very impressive showing, and far better than the 2.4% increase in durable goods manufacturing productivity in the first quarter. The acceleration in productivity came from both an acceleration in output — it climbed at an annual rate of 13.6% in the second quarter, up from an already impressive 9.3% gain in the first quarter. It also came because they were able to generate that gain in output with only a 3.4% increase in hours worked (a.k.a. employment) rather than the 6.8% increase in employment (annual rate) in the first quarter.

Relative to the first read, output was revised down from 14.1% growth while hours worked were revised up from 2.7% growth. Year over year, durable goods manufacturing productivity is up at a staggering 11.4% rate.

Non-Durables Not So Good

The news was not nearly as good on the non-durable goods manufacturing side, which is about twice the size of the durable goods side as a share of the economy and employment. Firms like Altria (MO) and Heinz (HNZ) were able to increase output in the second quarter by 2.8%, which was actually revised up from a 2.2% increase in the first read on the numbers. However, it took a 5.3% increase in hours (revised from 5.1%) worked to generate that increase.

As a result, non-durable manufacturing productivity growth fell at an annual pace of 2.4% in the second quarter, although that is better than the 2.8% decline in the original report. It is down from the first quarter productivity growth of 1.4% on a 4.6% increase in output and a 3.1% increase in hours. Year over year, non-durable manufacturing growth is 3.2% on a 4.5% increase in output and a 1.2% increase in hours worked.

Importance of Productivity Growth

Over the long term, productivity growth is probably the single most important economic statistic there is. It is productivity growth that governs the rise in GDP per capita. GDP per capita is the best shorthand measure around for determining how wealthy a country is (yes, I know that there are serious flaws with GDP as the be-all and end-all of economic happiness, but for a single number it does a pretty good job). After all, the GDP of China under Mao was significantly larger than the GDP of Sweden at the time, but nobody (other than perhaps some extremely delusional Marxists) thought that the Chinese were better off that the time economically than were the Swedes.

In the short term, particularly as the country suffers from high levels of unemployment, the matter is not nearly that simple. You can have a rise in productivity if output is falling, but businesses are laying off people faster than they are cutting output, and that clearly does not lead to higher GDP per capita or a wealthier society. Rising productivity can also lead to large disparities in incomes, particularly if it is being caused by an increase in unemployment due to fewer hours worked.

The tie between a rise in productivity and a rise in national wealth is conditional upon reasonably full employment. With unemployment at 9.5% (in July, we will see tomorrow where it was in August) and there only by grace of a falling participation rate (people dropping out of the workforce altogether so they are neither employed nor unemployed) a fall in productivity is not necessarily a bad thing. We need to put people back to work, even if the rise in hours worked is not quite matched by a gain in output.

From the Investor’s Viewpoint

From the point of view of an investor, rather than that of a citizen who is interested in the overall health of the economy, the fall in productivity is bad news. Gains in output are going to roughly correspond with increases in revenue. Since for most firms wages are one of the biggest expense line-items, having to hire more people (or have existing workers work more hours) that does not generate a corresponding increase in output is going to put downward pressure on margins.

We have seen a remarkable rise in margins over the last year. For the S&P 500 as a whole in the second quarter, net income was up 37.2% while revenues were up just 10.7% (with a significant part of revenues and net income coming from overseas, so there is not a one-to-one correlation with the productivity numbers, which are for the US only).

Wages tend to be a bigger part of total expenses for service sector firms than they are for manufacturing firms. The apparent drop in productivity in the service sector should be a yellow flag for further profit growth in that part of the economy. On the other hand, the sharp surge in productivity in durable goods manufacturing, coming as it does through both higher output, and higher but not as high numbers of people working indicates that those firms should still have the wind blowing strongly at their backs for continued earnings growth.

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About Dirk van Dijk 112 Articles

Affiliation: Zacks Investment Research

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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