Perspective. Economic and Market. Is U.S. economic growth understated?

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1 Wells Capital Management Economic and Market Perspective May 5, 2016 Bringing you national and global economic trends for more than 30 years Is U.S. economic growth understated? James W. Paulsen, Ph.D Chief Investment Strategist, Wells Capital Management, Inc. The current economic recovery has been the slowest of the post-war era. Indeed, throughout this recovery, U.S. real GDP has hovered near the stall speed of about 2% growth (the Mendoza Line for economic recoveries) constantly fueling fears that another recession was imminent. Chronic consternation surrounding this recovery has produced persistent liquidations from equity mutual funds even though the stock market has mostly risen, has made borrowing money almost taboo, has prevented the emergence of CEO animal spirits who possess considerable capabilities to drive a capital spending cycle but lack the confidence, has pushed fiscal and monetary authorities to respond with the most incredible, unconventional, massive, and ongoing package of economic stimulus ever employed in our history, and finally has produced a highly combative political climate with both sides suggesting the other is responsible. What if the pace of real GDP growth during this recovery was actually closer to 3% rather than sustaining near the Mendoza Line? How much would the rhetoric surrounding the aftermath of the worst crisis since the Great Depression be altered? Would economic policies still (or ever) be so outsized? After seven years of persistent economic recovery would CEO, household, and investor behaviors still remain so conservative? And, if most perceived a slower but reasonably growing recovery, would voter backlash against establishment candidates be so virulent? Official reports suggest U.S. productivity has grown at its slowest pace of any economic recovery in the post-war era. Indeed, U.S. productivity has increased at the paltry annualized pace of only 1% in the current recovery compared to a post-war recovery average of 2.4%. However, the real wage rate has been climbing steadily throughout this recovery suggesting much stronger productivity performance and thereby stronger real GDP growth. Moreover, the growth of investment, consumer spending, and job creation also imply the pace of economic growth in this recovery has been stronger than officially reported. This note focuses on the long-standing and close relationship between real wages and productivity performance. Using a forecasting model based on the real wage rate, productivity is estimated to have grown much faster than reported suggesting average real GDP growth during this recovery may actually be closer to 3%. If the economic recovery has actually only been subpar rather than almost comatose, what are the implications for policy officials and investors if eventually a consensus comes to embrace this reality? Productivity and the real wage rate As shown in Chart 1, since 1964, U.S. productivity (i.e., U.S. business sector output per hour worked) has increased about 2.1% per annum. However, during the current recovery, productivity has increased only 1% per year. Experiencing the weakest productivity performance of any economic recovery in the post-war era is curious, however, since as shown in Chart 2, the real U.S. wage rate has risen significantly in this recovery. The real wage rate has risen by about 7.5% since the end of the last recovery or about 0.86% per annum. This is one of the strongest gains in real wages during any recovery since the 1960s! Does it make sense that companies would raise real hourly labor compensation rates by one of the fastest paces in more than 40 years if the real productivity of laborers was weaker than any recovery in the post-war era?

2 Chart 1 U.S. Productivity Index vs. trendline average Natural log scale Solid U.S. Productivity Index U.S. business sector output per hour of all persons Dotted Trendline average since 1964 of U.S. Productivity Index Chart 2 U.S. real wage rate* *Average hourly earnings index divided by consumer price index The oddity of this conundrum is illustrated in Chart 3 which overlays the detrended U.S. Productivity Index (i.e., shows the level of the productivity index in Chart 1 as a percent above or below its trendline average) with the real wage rate. When the detrended productivity index rises, productivity is growing faster than average and when the solid line in Chart 3 declines, productivity is subpar. Clearly, there has been a strong historical relationship between the real wage rate and productivity. Until recently, during the last 50 years, the direction and pace of real wage gains have been closely related to the performance of labor productivity. Indeed, real wages have rarely advanced without a commensurate rise in productivity. Chart 3 U.S. Productivity Index vs. U.S. real wage rate Percent above / below long-term trendline average Solid Detrended U.S. Productivity Index Dotted Detrended U.S. real wage rate The divergence between productivity and real wages since early in the contemporary recovery is dramatic, historic, persistent, and inexplicable. If accurate, it suggests companies have been constantly paying up for a resource which has been chronically delivering subpar performance. Assuming companies are not irrational, either wages are overstated or productivity is understated. Our guess is productivity has been perennially underreported throughout this recovery. Perhaps this reflects measurement difficulties associated with the aftermath of the Great 2008 Crisis, the aging demographic profile of the U.S. economy, the ongoing decay of manufacturing relative to a service-based economy, or maybe by the increasing importance of new-era products and services. 2

3 Based on its historical relationship, what does the current real wage rate suggest about productivity? Chart 4 shows the result of a regression model which forecasts detrended productivity based on the real wage rate. Although officially reported productivity is about 4% below its long-term trendline average, based on the current real wage rate, productivity should be about 4% above its trendline average. That is, based on its historical relationship to the real wage rate, the current level of productivity may be underestimated by about 8% or by a little more than about 1% annually during this recovery. Mendoza Growth or just slow growth? The current economic recovery is almost seven years old. Officially, real GDP has averaged just 2.1% annualized growth, just above the Mendoza Line! However, what would this recovery look like if productivity had actually performed as suggested by the movement in the real wage rate? Chart 5 compares officially reported annual real GDP growth (solid line) with an estimate based on actual total hours worked times estimated productivity (based on the forecasted regression model illustrated in Chart 4). As shown, although this estimate has not perfectly predicted actual real GDP growth, it has provided a reasonably accurate assessment of economic growth at least until the contemporary recovery. Admittedly, this model has seemingly overstated real GDP growth since the 1990s or perhaps productivity has simply been increasingly underreported since the 1990s? Conceding the less-than-perfect historic efficacy of this GDP forecasting model, it does suggest that real GDP growth has been sizably underreported in this recovery. Based on the officially reported total number of labor hours worked during this recovery and estimated productivity (from a regression model based on the actual real wage rate), average annualized real GDP growth during this recovery would have been 4.2%. While we do not believe the pace of actual economic growth has been more than twice as great as officially reported (i.e., 4.2% estimated versus 2.1% officially reported), we do think it is likely the economy s performance has been greatly underreported in this recovery. Chart 4 Regression model estimating detrended U.S. Productivity Index from the detrended U.S. real wage rate Solid Detrended U.S. Productivity Index Dotted Regression model extimate based on U.S. real wage rate Chart 5 U.S. real GDP annual growth Reported (solid) vs. estimated (dotted) from real wages Solid Actual (reported) annual real GDP growth Dotted Estimated annual real GDP growth. It is the annual growth in actual total hours worked and estimated productivity growth (based on real wage rate) This is reinforced by other measurements of the recovery as illustrated in Chart 6. The average annualized growth during this recovery in real investment spending, real consumption spending, and total job creation suggest average annualized real GDP growth has actually been about 0.5% to about 1.25% faster than officially reported. The solid bars in this chart show the average annualized excess growth rate during this recovery of real GDP above three important components of the economy, investment, consumption, and employment. The gray bars show what the average growth differential was in every recovery since

4 Chart 6 Annualized growth in real GDP above recovery growth in real investment, real consumption, and real job creation Summary & conclusions? Certainly, the contemporary recovery has been subpar. We are not suggesting the recovery has been massively understated and therefore in reality has been very solid. Even if the official reports of real GDP growth are underreported, the pace of economic growth in this recovery is still below average compared to post-war norms. However, evidence does suggest the annualized pace of real GDP growth during this recovery is probably faster than widely perceived. The behavior of the real wage rate (a reliable indicator of labor productivity in the past) signifies U.S. productivity has been significantly underestimated. Moreover, the pace of growth during this recovery among the major segments of the economy (e.g., investment spending, consumption spending, and job creation) also hints that overall real GDP growth is stronger than suggested by the official numbers. For example, since 1950,during recoveries, annualized real GDP growth has been about 1.68% faster than the pace of job creation. That is, the jobs multiplier (the amount by which job creation produces additional real GDP growth) is about 1.68%. By contrast, on average in post-war recoveries, annualized real investment spending has typically risen about 3.72% faster than real GDP growth. As shown, during this recovery, the GDP multiplier for each of these three major components of the U.S. economy have been less than their respective historical norms. The pace of real investment spending during this recovery has produced about 1.25% less real GDP growth than it has over the post-war era (i.e., -5.02% less -3.72%). Similarly, the consumption GDP multiplier has been about 0.5% less in this recovery compared to its historic norm (i.e., -0.11% versus +0.27%) and the jobs GDP multiplier has been about 1% less (i.e., 0.77% versus 1.68%). Overall, there appears to be a fair amount of evidence to suggest that economic growth may be significantly underreported in this recovery. A poor measurement of productivity may be understating actual real GDP growth by as much as 2%, and the performance during this recovery of real investment spending, real consumption, and job creation suggest real GDP growth may actually be anywhere from 0.5% to 1.25% faster than officially reported. It is not our intent to argue that this subpar recovery is actually pretty good. But, we do think it is instructive for investors to consider just how materially different the mindsets and behaviors of policy officials, businesses, consumers, investors, and voters might have been if economic growth in this recovery were in fact just a bit better. And, what would a sudden change of reality toward slightly faster economic growth mean for stock and bond markets? What if the average annualized pace of real GDP growth during this recovery was actually closer to 3% rather than hovering about the Mendoza Line as suggested by the official numbers? How different would the character of this recovery have been had the official numbers been closer to 3% than 2%? Although the economy s performance would still be considered subpar, it would not chronically be considered near death as it has throughout this recovery. How many times (including currently) have most market participants feared the economy was near the stall speed of 2% growth and feared a recession was imminent? Could the reason the economy has never stalled even though it has reportedly hovered about the Mendoza Line frequently is because in reality it has always been growing at a subpar but still sustainable pace? Without the primary hallmark which made this bull market great climbing a perpetual wall of worry would the stock market have done as well? Would leadership in the stock market still mostly be centered among defensive sectors, dividend payers, large capitalization stocks, and domestic stocks? 4

5 Would bond yields have declined as far as they have? Would the Federal Reserve have implemented, and persistently maintained the unprecedented, massive, and crisis-like policies they still mostly employ? Would deflationary mindsets be so dominant? Would a significant capital spending cycle still be AWOL this late in the economic cycle? If the U.S. economy was hovering near a 3% real GDP growth rate, would there be as much concern here in the U.S. about the economic performance in Europe, Japan, or even in China? Finally, if most agreed the economy was growing at about 3% in this recovery rather than near 2%, would there be as much debate about the haves and have nots, as much political turmoil between the left and right, and as much disgust with establishment politicians? Is it possible the character surrounding this economic recovery, and financial market performance has been primarily based on a premise (i.e., the economy is barely growing fast enough to avoid an imminent relapse into another recession) which is significantly exaggerated? Perhaps, more importantly, if the economy is growing faster than advertised, what are the implications during the balance of this recovery? Until the economy recently returned to some semblance of full employment (e.g., around a 5% unemployment rate), whether the economy was growing at 2% or 3% was not as obvious nor as important. Earlier, many may have been baffled, based on a belief the economy was hovering about stall speed, by why the unemployment rate declined back toward 5%, why housing activity did lift again, why bank lending has returned to about 8% growth in the last year, and why auto sales spiked back near-record highs. However, all of these results could be easily explained by an economy perhaps averaging closer to 3% real growth. Moreover, if actual economic growth is persisting at a pace faster than appreciated, because the economy is now back near full employment, this also will likely push bond yields higher, and force the Fed to quicken its exit strategy. The premise shaping the character of this entire economic recovery has been a widespread belief, supported by the official numbers, that the pace of economic growth has persistently hovered near the Mendoza Line. This has produced a recovery dominated by fears surrounding recession/deflation risk. However, could the balance of this economic recovery be increasingly dominated by escalating overheat/inflation/rising interest rate fears predicated on a growing realization that economic growth has been, and continues to sustain at a pace faster than officially reported? Written by James W. Paulsen, Ph.D. An investment management industry professional since 1983, Jim is nationally recognized for his views on the economy and frequently appears on several CNBC and Bloomberg Television programs, including regular appearances as a guest host on CNBC. BusinessWeek named him Top Economic Forecaster, and BondWeek twice named him Interest Rate Forecaster of the Year. For more than 30 years, Jim has published his own commentary assessing economic and market trends through his newsletter, Economic and Market Perspective, which was named one of 101 Things Every Investor Should Know by Money magazine. Now though, with the economy closer to full employment, if there has been an understatement in the pace of economic growth, it will likely become more significant. The difference between an economy growing at 2% versus 3% at less than full employment might simply explain why the unemployment rate declined faster than most anticipated. However, at full employment, if the economy is actually growing closer to 3% rather than the official 2% pace, cost-push pressures, commodity price hikes, and overall inflation rates should accelerate faster than the consensus expects. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; Nelson Capital Management; Peregrine Capital Management; and The Rock Creek Group); Wells Capital Management, Inc. (Metropolitan West Capital Management, LLC; First International Advisors, LLC; and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. 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