In early 2005 I argued in this column that the eurozone productivity growth deficit on the US was smaller than the consensus believed and that it would narrow. I reckoned that US labour productivity had received an outsized cyclical boost from asset-price bubbles. This boost would not last.
It seems that my prediction is being borne out. The US-eurozone productivity growth differential has narrowed significantly in the past two years. In the past quarter, eurozone labour productivity (based on output per hours worked) grew by 1.5% year on year compared with 2% in the US.
Moreover, GDP data in the eurozone and in the US for the past few years have recently been revised. As a result, the starting gap in the level of labour productivity between the US and the eurozone, which had widened from five percentage points in 1995 to 15 points in 2004 on the old data, has been halved.
After 17 consecutive months of interest rate increases from the Federal Reserve, the US economy is running out of steam. Property price growth has ground to a halt. Consumers will have to tighten their purse stings from now on. US real GDP growth is set to grow at a below-trend 1% to 2% annual rate. And simply put, less output growth means lower productivity.
In contrast, in the core of Europe employment is now expanding and the recent turn-up in German job vacancies suggests that this story has further to run. Once Germany’s consumption engine kicks in, eurozone growth will be boosted.
A bigger share for profits
In the past few years, the share of wages in national output in both the US and Germany has fallen. However, I reckon the boost to the share taken by profits in the US has been mainly a cyclical phenomenon, whereas eurozone corporate restructuring has delivered a secular rise in the profit share. The share of profits in Germany has risen to an all-time high, with the gain in the past six years much sharper than in the US.
Germany Inc has continued to cut more jobs even as the economy and employment began to expand. So a lean and mean eurozone corporate sector is well capable of sustaining annual productivity growth of 2.5% or so. Indeed, the superiority of US productivity growth over the eurozone might well disappear entirely this year.
The trade-off from this is becoming clear. The US is more susceptible to higher inflation. US annual CPI inflation is now more than 1.5 percentage points more than in the eurozone, and rising. This inflation premium is forcing up the cost of capital in the US. For an economy driven by credit, that matters. Rising long-term interest rates are hurting consumers in the pocket by driving up mortgage rates and pushing down asset prices to boot.
Higher returns
Back in early 2005, my investment conclusion from the prediction of a narrowing productivity gap was that eurozone equities would outperform those in the US. And since the Fed moved into rate increase mode on June 30 2004, eurozone equities have risen more than US stocks. When converted into dollar terms, the returns are even higher, as the euro appreciated 5% against the greenback in that time. A dollar investor in eurozone equities and bonds would have made annualized returns that were respectively 13 and 5 percentage points larger than the corresponding US assets.
| Europe starts winning the productivity race |
| US-eurozone productivity growth differential (% yoy), on a four-quarter moving average |
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| Source: Datastream |
From here, I still expect eurozone equities to outperform those in the US. First, valuations suggest that much of the good news has not yet been discounted by eurozone equities. Eurozone equities also remain cheap relative to bonds.
The equity earnings yield gap over bonds has widened to nearly two percentage points. The earnings yield gap for US equities is not as compelling as in the eurozone.
Eurozone economic growth is accelerating, just as it is slowing in the US. Moreover, as the sustainable growth differential turns to the eurozone’s favour, more investment flows will flood into European equities or exit American stocks. That will increase the risk of further depreciation of the dollar against the euro.
David Roche is president of Independent Strategy Ltd, a London-based research firm.www.instrategy.com