The ongoing trade skirmish continues to weigh on market sentiment, for good reason. Strategas Research Partners estimates that GDP will take a direct 0.1% point hit for every two months that the existing tariffs remain in place. While that may not seem like a lot, it could subtract up to 0.6% points from growth over the course of a year. In addition, there are indirect effects that come from decreasing business confidence, which has already been quickly eroding. In fact, the Conference Board’s CEO Confidence Index fell -20 points from December 2017 through December 2018. For context, that’s the largest one-year decline in CEO confidence since late 2000. Though it eventually bottomed at a much lower level than today, not even during the Financial Crisis did CEO confidence erode so quickly.
For investors, the subsequent slowdown in growth may mean the difference between positive and negative earnings growth over the next year. Therefore, trade tensions remain news, and something we will certainly be tracking.
However, there is another piece of news that you are unlikely to read about on the front page. Labor productivity has been improving. Economic theory postulates that long-run potential GDP is made up of two components – the growth in the labor force, and the growth in productivity of those workers. All else equal, stronger productivity pushes up the long-term growth rate. Additionally, more productive workers help keep costs contained and profit margins elevated, despite rising real wages, a fortuitous cycle indeed.
Why is productivity rising? Simple, companies have been investing heavily in intellectual property (IP), even during volatility in the economic cycle. There’s evidence that such investment provides an outsize benefit to profit margins relative to investment in traditional brick and mortar capacity. Executives have certainly caught on as non-IP investment has tended to be quite volatile, while growth in IP has remained steady.
Bringing the news together, the trade issues are certainly providing a weight on market sentiment. However, if a deal can be reached and at least a portion of the tariffs rolled back, it is possible that the economic cycle is not as “late” cycle as it would appear. Interest rates are low, inflation is well anchored, and rising productivity can potentially help extend the expansion.