Are We All Just Getting Lazy?
Slowing productivity growth is the stock market's new worry
By Tara Kalwarski

(MONEY Magazine) – As if oil prices and the weak dollar weren't making investors nervous enough, now comes word that the vaunted upsurge in U.S. labor productivity may be waning. Estimates show a sharp drop in growth for the last two quarters of 2004. Here's why that's a concern.

Nonfarm business productivity is a stew of stats that include private-sector output, hours worked and number of employees. What matters to investors is the relationship among productivity, employment and inflation. To grow, companies want to get more out of more workers. In the Goldilocks economy of the late '90s, productivity stayed at a rate that made hiring possible yet kept wage pressures in check. If productivity growth slows too much or declines, labor costs rise. Companies then take a hit to profits or pass the costs along to customers. Fed chairman Alan Greenspan roiled the markets a bit in mid-February when he indicated that slowing productivity growth could spark higher inflation.

But there may not be much spark here, at least not yet, given where we are in the economic cycle. "As an economic expansion matures, productivity slows down," explains J.P. Morgan senior economist Anthony Chan. It's too early, Chan says, to conclude that productivity growth is in free fall. At an average 4.1% in 2004, it remained nearly double the 20-year average. Also, there may be upward adjustments to the preliminary 0.8% fourth-quarter growth-rate number.

The soaring rate of productivity increases in 2002 and 2003 was unnaturally high, says Wells Capital Management chief investment strategist James Paulsen. During the recession and early in the recovery, companies fired hundreds of thousands of workers while maintaining output. Last year, those labor cuts, combined with strong sales growth, sent S&P 500 earnings up 24%. Cost-cutting pressures abated and payrolls increased by 2 million. If productivity growth stays below 2% for long, that's a worry, say Chan and Paulsen. For now, take it easy.