Growth Over the Long Run

From Wall Street to Washington, pundits and politicians looking for a worst-case scenario on stocks and the economy think they have found it.

Bond rates have skyrocketed over the past seven weeks, so the negativist narrowband is saying the stock market rally is over. Meanwhile, jobs continue to decline and the unemployment rate is mired above 6 percent, hence there will be no economic recovery. So goes the thinking of our Cassandra commentators.

These views are wrong. Dead wrong.

It is quite true that jobs are slumping even as the economy gains momentum. Why the divergence? The answer is tremendous productivity growth, which is a very profitable thing.

Advanced technology innovations continue to be applied to every nook and cranny of corporate America, and this affords businesses new opportunities to reduce labor and operating costs across-the-board.

Following a three-year business slump, firms have been doing more with less wherever they can. CEOs are literally squeezing water out of rocks. In the seven-quarter recovery so far, 2.6 percent annual economic growth has occurred, while non-farm payrolls have lost 1.7 million jobs and hours worked have decreased by nearly 2 percent annually. This is a testament to productivity, or output-per-hour, which has increased an unbelievable 4.5 percent yearly during this period. As a result, corporate profits are up nearly 30 percent — about the same as the stock market.

As for future growth, order backlogs for non-defense capital goods (excluding aircraft) have increased six consecutive months at a 9 percent annual rate, according to the U.S. Commerce Department. This is a classic leading indicator of corporate capital spending and job creation.

And this is exactly what too many pundits and politicians don’t understand, or refuse to admit: When businesses put their profits to work in the next round of capital-goods investment, the jobless recovery will give way to a new job-creating cycle. (The Bush tax cuts, including faster expensing write-offs, will only help this new “capex” modernization wave, making businesses even more efficient.) While higher productivity may depress job creation in the short run, it is a powerful stimulant for higher profits and more rapid economic growth — including job creation — in the longer term.

Productivity-driven profits are exactly why investors should not panic over the recent interest-rate rise in the bond market. Instead, the new investor class must recognize that market rates are being driven higher by rising real rates — not inflationary fears. And these upward-moving real rates tell us that the economy is heating up.

Not coincidentally, the jump in real interest rates occurred within days of the final passage of across-the-board tax-rate reduction on individual incomes, corporate profits paid out as dividends and capital gains. The dividend piece has been a quick winner: Citigroup, as one example, recently raised its dividend by 75 percent, providing $7 billion of new cash to investors. That’s just one company. Hundreds of other companies are following suit, many with 50 percent dividend increases.

Lower tax rates on invested capital always raise asset values. So do dividend increases. This fiscal recipe for wealth creation and strong economic growth is the real driver behind the recent bond-market interest-rate rise.

It is quite true that higher interest rates do in fact reduce the present value of future corporate earnings. But if lower tax rates and higher productivity returns have raised real interest rates on one side of the stock market ledger, these very same factors will raise corporate profits and economic growth on the other side. In short, the bond-market yield rally will not detract from stock market valuations.

Stocks, by the way, are still roughly 30 percent undervalued in relation to higher Treasury bond rates. And the value of stocks benefit enormously from profitable growth, while Treasury bonds do not. This is all the more reason to stay invested in the stock market.

Too many in the media and in Washington substantially underestimate the growth value of supply-side tax cuts. And most do not understand the growth effect of rising productivity. But tax cuts and productivity are precisely what will boost jobs, wages, wealth and the economy’s potential to grow over the long run.

Borrowing a phrase from the great economist Milton Friedman, the long run begins right now.