The stock market has defied expectations in 2024, shrugging off rising interest rates that typically dampen investor enthusiasm. Many fear a brewing bubble, particularly in the red-hot world of artificial intelligence (AI). But what if there's another explanation? Enter the unsung hero: productivity.
Increased productivity, meaning getting more output from the same amount of work, fuels economic growth without sparking inflation. This shift in the market's perspective explains the curious phenomenon of equities welcoming a strong economy, a stark contrast to past anxieties. However, some experts remain cautiously optimistic, questioning whether the recent productivity gains are a sustainable trend.
The economic picture is a tale of two halves. While the initial inflation surge was a consequence of pandemic-disrupted supply chains mending themselves, a more productive economy kept inflation at bay. Investors who braced for a growth slowdown under the Federal Reserve's interest rate hikes were pleasantly surprised. The economy, bolstered by unexpected strength, pushed back expectations of Fed rate cuts, consequently pushing up bond yields. Yet, for shareholders, this was a minor inconvenience overshadowed by the potential for higher profits.
This investor confidence stems from a fundamental belief: the economy has more growth potential than anticipated. This translates to higher growth – and consequently, higher profits – before inflation rears its ugly head. The long-term vision? Many investors are banking on advancements in technology, particularly AI, to usher in a productivity boom reminiscent of the 1960s or late 1990s. Higher productivity paves the way for higher interest rates, but the stock market anticipates that increased growth will offset this.
This narrative permeates across various market segments. Previously, stock prices and Treasury yields moved in opposite directions. However, in the latter half of 2023, both mirrored each other – even as 10-year Treasury yields soared to 5% and then came crashing down. Today, they exhibit a slight tendency to rise and fall in tandem.
Furthermore, cyclical sectors, those most sensitive to economic health, are outperforming their defensive counterparts as rate expectations and bond yields have climbed this year. This stands in stark contrast to the past few years, when higher Treasury yields signified economic headwinds, hindering cyclical stocks and bolstering defensive ones. Investors are betting on the "right kind" of growth – one fueled by productivity.
The credit market also reflects this narrative. Investors are more open to purchasing riskier corporate bonds, evident in the narrowing spread between Treasury yields and those of low-rated junk bonds. This defies the trend of the past two years, where higher Treasury yields signaled bad news for companies due to increased interest costs and a sluggish economy. Today, a robust economy translates to lower default risks for even the riskiest companies, rendering higher Treasury yields less of a deterrent.
However, the AI-driven productivity boom might be wishful thinking. While generative AI has showcased impressive capabilities, and government subsidies have spurred significant corporate investment in the U.S., the technology's inherent problems are becoming increasingly apparent. Its application might be more limited than company executives anticipate. Without sustained productivity gains, the Fed will have to intervene by further tightening interest rates to curb inflation.
It's important to acknowledge that productivity doesn't benefit everyone equally. The widening economic disparity leaves smaller companies struggling as they grapple with higher financing costs. This is also the case for highly leveraged areas like real estate and renewable energy projects. As rates rose, the Russell 2000 index, which tracks smaller companies, lagged behind larger stocks, echoing the pattern witnessed last autumn.
The productivity gains witnessed in 2023 were, to an extent, a one-off event driven by the reversal of pandemic-induced supply chain disruptions. While the possibility of an AI-powered productivity boom holds promise, accurately gauging the impact of new technologies – even on individual companies, let alone the entire economy – is a complex task. Investors might be getting a little ahead of themselves, but that's demonstrably better than a full-blown bubble.
