[A-List] New economy bull

["Keaney Michael" <Michael.Keaney@xxxxxx>]

Stephen King: Don't expect productivity gains to benefit the bottom line
Consumers cannot enjoy strong income gains and strong capital gains.
It's one or the other
The Independent, 13 May 2002

We know that strong productivity growth is a good thing. Politicians the
world over are always promising to raise productivity growth. Those
countries that manage to do so are seen as paragons of economic success.
Others are seen as relative failures.

Most people also like to believe that those economies with faster
productivity growth will also see strong growth in profits and,
therefore, substantial increases in stock prices. Based on this belief,
it made sense to pour all your money into US equities at the end of the
Nineties.

Or did it? Over the last five years, total returns on US equities have
averaged just 7.4 per cent per year. Better than government bonds (6.6
per cent) and cash (5.2 per cent), but only just. Given the greater
volatility and inherent riskiness of equities, it might have been better
to have put your money in these other forms of saving.

Over shorter periods, the situation is even less encouraging. In the
last three years, equities have fallen in value (on a total return
basis) by an average of 5.5 per cent per year, compared with gains of
4.4 per cent on bonds and 5.0 per cent on cash. In other words, an
American investor was better off putting his or her money in the bank.

This is a fairly remarkable result. After all, US productivity growth
over the last three years - or, indeed, the last five years - has been
persistently strong, suggesting that at least some parts of the New
Economy have been more reality than myth.

Productivity performance, therefore, has been delivered. According to
latest HSBC research, however, the beneficiaries have been a bit of a
surprise. Shareholders have not done very well. Nor, for that matter,
have companies. My first chart shows that, during this period of very
strong productivity growth, profits growth in the US has been unusually
weak. In contrast to earlier periods, strong productivity growth has not
been accompanied by strong profits growth.

The main beneficiaries have, in fact, been workers and, more generally,
consumers. Productivity has been strong in recent years but so too have
been wages, particularly adjusted for inflation (see second chart). In
other words, income gains have been the main source of reward for
productivity improvements, not capital gains.

In my view, the skewed nature of the benefits stemming from the new
technologies reflects their impact on the competitive environment facing
individual companies. In the late 1990s, companies correctly worked out
that the introduction of new technologies would lead to much lower
costs. Armed with that information, they invested aggressively, hoping
to deliver much higher profits than in the past. They were aided and
abetted by investors who willingly surrendered their safe, but boring,
holdings of cash in exchange for shares in dynamic, new economy,
enterprises.

There was, however, a major problem. Productivity gains certainly
implied lower costs. But they also implied changes in the demand
environment facing individual companies. In effect, companies lost
pricing power in a major way. Lower costs meant lower barriers to entry,
implying greater competition. Higher expected profits meant
over-investment, leading to excess capacity in many industries. The new
technologies increased price transparency, reducing the extent to which
companies could indulge in discriminatory price tactics. And,
importantly, the communications revolution opened up domestic players -
suppliers of both goods and services - to foreign competition, part of
more general moves towards greater globalisation.

The result has been a considerable erosion of profitability. Pricing
power has gone down. Worse still - from a shareholder perspective - the
higher levels of demand generated by all the investment and spending in
the late 1990s meant both lower unemployment and higher wages. The
conclusion is simple. Consumers won, producers and shareholders lost.

Should this come as any big surprise? Earlier technological revolutions
suggest not. The railway mania in the 1840s and 1850s provides a very
good example of earlier excess. An initial period of rapidly rising
railway share prices and investment was accompanied by a boom in GDP
growth. Then, profit reality turned out to be a lot more miserable than
earlier expectations, in part because of excessive investment.

Rail share prices collapsed, investment fell back and economic growth
went from boom to persistent disappointment. The real winners were those
would-be passengers who, faced with the introduction of third class rail
tickets, suddenly discovered travel had suddenly come within their
relatively limited budgets.

The same has been true in recent years. Technology producers have, for
the most part lost out. True, the volume of technology sales has
increased dramatically but, for the most part, only because of a
collapse in prices. Other industries have also been affected. Without
technology, it would have been a lot more difficult for Ryanair and
easyJet to enter the fray against British Airways and other giants of
the airline industry. The net result, however, has been a major collapse
in air fares over recent years.

What does all this mean? For companies, their strategies may have to
change. They will need to reduce their costs. That may mean swapping
expensive Western labour for cheaper labour elsewhere. Some may exit
their industries altogether, brought down by the burden of debt
associated with earlier, excessive, investment. Others may carry on
investing, hoping that further increases in capacity will eventually
drive other companies to ruin.

To date, consumers have done very well. Even for them, however, there
may be problems. In the late Nineties, they really did have their cake
and eat it. They benefited from higher incomes, a genuine response to
faster productivity growth. They also, however, benefited from the
capital gains associated with inflated profit expectations. So they
could spend with abandon, fuelled by strong incomes and a false
confidence in the returns that could be generated in capital markets.

If my arguments are right, however, consumers have suffered from a
serious dose of double counting. They cannot enjoy both strong income
gains and strong capital gains. It's either one or the other. Assuming
that income growth remains reasonably robust, the implication must be
that consumers will simply have to save more to meet their future
obligations for their retirement. That, in turn, could act as a
constraint on the pace of economic growth in coming years.

As things have turned out, the New Economy has delivered a lot more than
I had expected. That has been demonstrated by the continued strength of
productivity growth, even through the downswing. The financial
implications, however, have been very different from the wild optimism
that permeated markets in the late Nineties. The new technologies have
led to a much more competitive world. That means more output, lower
prices but also lower profits. The capital returns seen in the late
1990s will not be seen again for many a long year.

Stephen King is managing director of economics at HSBC.