AI is Boosting Productivity. Why That Matters for Your Portfolio.

Companies' heavy investment in artificial intelligence (AI) is driving up overall tech spending, potentially igniting a boom in worker productivity as firms harness AI's potential. For investors, this trend is significant, especially given the economy's surprising resilience.

The US economy and job growth have defied expectations in 2024, showing remarkable resilience. Real GDP rose around 3% year-over-year during the first half of the year, catching many forecasters off guard.

This strength is expected to continue, with the Atlanta Fed’s GDPNow model projecting that real GDP will likely rise at an annual rate of 3.2% during Q3. The pessimistic “hard-landing” predictions have largely faded, and with the Federal Reserve initiating a new stimulative monetary policy loosening cycle in September, the US economy appears on track to accomplish the much-desired soft landing.

An often-overlooked positive surprise in the US economy is the strength of labor productivity.  This important economic metric, which measures the efficiency of producing economic output, has grown an impressive 3% year-over-year during the first half of 2024. This marks a strong improvement from the reported -2.5% decline in productivity growth during early 2022.

Why This Matters

The recent strength in productivity matters for several reasons. One is that increasing productivity, all else equal, is disinflationary. Until September of this year, the Fed had been in restrictive mode, necessarily focused on taming inflation pressures seen over the past two years. The decline in inflation has been thanks in part to rising productivity growth.

Consider the recent boost from technology companies pursuing the promise of AI’s potential. Tech firms have invested heavily in software and R&D, some $80 billion more than a year ago. The investments have been productivity boons for tech companies that can scale rapidly.

Eventually, the productivity improvement will spill over to non-tech companies, which are now beginning to reap the benefits of these new technologies. As non-tech companies start to deploy AI, robotics and automation, they will be better equipped to address a deficiency in the availability of skilled labor in the US while simultaneously enabling a continued boost in productivity. This investment, in turn, should support improved efficiency, thus lowering the cost of producing goods and services and helping to tamp down inflation pressures.

The recent gains in productivity growth, should they prove sustainable, matter a lot for companies and the overall economy. Higher productivity increases profit margins by increasing output and containing labor costs. It also helps support consumption growth and might even help to slow the burden of rising federal debt to GDP, another pressing issue, and one that is far too often brushed aside by politicians.

Investment Implications

So, what are the implications for investors? Taken together, stronger-than-expected economic growth, stable labor markets, softening inflation, and improving productivity growth combine for a potentially robust outlook for markets and the economy over the next few years.

Ed Yardeni of Yardeni Research expects profit margins on the S&P 500 to expand to 14% next year, which is higher than the current consensus of around 13%. Yardeni’s view is that the so-called mega-caps, along with the broader S&P 500, will continue to improve their margins over the next year. The companies best able to use AI, humanoid robotics and other technologies will have the most to gain.

Should above-trend productivity growth in the coming quarters be realized, this would support the expected improvement in companies’ margins. It could also provide the underpinnings for continued strength in the overall market as well as support improvement in stock market breadth beyond the Magnificent Seven technology companies.

This suggests that mid-cap and small-cap companies, which had been lagging their mega-cap counterparts until very recently, could continue to outperform on a relative basis as their price/earnings (p/e) ratios close the gap on the much higher valuation levels seen among the mega-caps. The forward p/e for the S&P 500 currently stands at around 21, the Magnificent Seven at 28, and the S&P 500 ex-Magnificent Seven at 19, an unusually wide gap versus the past decade.

Risks to the Outlook

There are, of course, many risks to this outlook. One is that the Fed has declared “mission accomplished” too soon in the battle against inflation and the 0.50 percent cut was overly aggressive thus jeopardizing the progress made on inflation.

The recently released September consumer price index (CPI) increased at an annual rate of 2.4%. When excluding food and energy, the annual rate was 3.3%. Both figures came in slightly higher than economists had expected. Improvements in productivity growth may not be able to subdue inflation pressures. The bond market also appears to have some concerns, with the 5-year Treasury yield rising to 3.9%, up 45bps from a month ago.

Another concerning factor is geopolitical uncertainty. China’s economy has been slowing over the past year or so, providing a tailwind to disinflation driven by lower import costs on goods from China. The slowdown in the world’s second-largest economy has also led to lower energy prices. To counteract the economic weakness, China recently launched aggressive stimulus plans, which could reinvigorate its economy and stoke demand.

This, along with flareups in the Middle East, has put upward pressure on oil prices. Should the conflict between Israel and Iran escalate further, production facilities could suddenly be taken offline, causing a spike in oil prices.

Another risk is the upcoming US election and the potential impact on fiscal policy. A sweep by either party, where both chambers of the Congress and the White House are controlled by a single party, will almost certainly lead to a wider federal deficit.

The recent Committee for a Responsible Federal Budget report indicates that fiscal policy plans put forth by both presidential candidates, if implemented, would lead to significant increases in the national debt. The total US public debt as a percentage of GDP has been rising steadily over the past decade, now at 120%, near its 50-year high.

For these reasons, we could see further progress on disinflation stall into 2025, causing the Fed to react. This could mean “higher for longer” Fed Funds rates, where the Fed leaves rates unchanged rather than cutting further this year as the market has been expecting. Though it seems unlikely, another scenario could be that the Fed feels compelled to change course, leaving rates unchanged well into 2025 until it sees the desired progress towards its 2% inflation target.

Some combination of the recent Fed rate cut alongside aggressive China stimulus and Middle East tensions may stall the progress made on inflation. However, the US economy remains resilient, and the possibility of continued productivity gains driven by investments in AI provide structural tailwinds that support a continued resilient economy and corporate profit margins.