I've called US growth anemic, but I'm an optimist compared with Northwestern Economics Professor Robert Gordon. If he's right in his provocative new paper "Is US Growth Over? Faltering Innovation Confronts Six Headwinds," investors may be grossly overestimating how fast the United States is likely to grow in the coming decades.
While the United States has been stuck in a slow growth mode since the end of the recession - and arguably even going back to 2000 - Gordon argues that that this period of slow growth could last much longer, and actually get worse. His basic thesis is that consumption growth, which is the primary driver of US economic growth, could fall below 0.5% annually for the bottom 99% of the income distribution. More frightening, he believes that this period of essentially no growth could last for decades. The part that I found the most interesting was his assertion that productivity growth will slowly grind to a halt.
The crux of his argument is that we are now in the aftermath of the third industrial revolution - the information technology revolution. While we may marvel at the seemingly constant stream of new tech devices springing from this latest revolution (iPad Mini, anyone?), these new innovations tend to enhance entertainment, not productivity, he asserts.
Gordon argues that the first two industrial revolutions - steam and railroads in the 19th century, and electricity and petroleum in the early 20th century - had a much more profound impact on productive capabilities. As the benefits of these revolutions are now fully diffused in most developed countries, the productivity surge that followed them will evaporate. Unfortunately, Gordon argues that this latest technology revolution, while dazzling, will not have the same type of fundamental impact on human productivity.
I'm not sure I buy all of his arguments, but Gordon raises some very interesting questions. One is the fact that most investors anchor their investment assumptions on the recent past. But if past growth was a function of one-off events that cannot be replicated, is this a reliable guide to the future?
While I agree that changing demographics and excessive debt will act as a drag on growth, I think the professor's assumption that income growth goes to 0.5% or less for the vast majority of Americans is overly pessimistic. In addition, even in the 1970s - not our best period - productivity growth still averaged nearly 2%. While the iPhone may not be as useful as indoor plumbing, I still believe technology gains will produce productivity growth in the 1% to 2% range.
Given that we do expect US growth to be slower, although perhaps not as slow as Gordon suggests, here are some things for an investor to consider. In a slow growth world, financial markets are likely to be more volatile, real rates lower and US equity valuations lower. One place to be particularly careful is with US small caps. This is the market segment most sensitive to US growth. We would prefer mega cap stocks that, hopefully, are exposed to faster international growth. We'd also want to increase exposure to emerging markets.