Slower Productivity Creates Risk for Stock Bulls

The rally in the stock market is not incompatible with the modest recovery in the U.S. labor markets. Indeed, a company’s efforts to hold down labor costs is usually rewarded with a higher stock price.

That has been the case through most of the recovery. Instead of hiring new workers, U.S. companies got more output out of their existing workforce. But the strategy may no longer work in 2013.

Since the recession ended in mid-2009, output in the nonfarm sector has risen 10.5%. Of that gain, about half came from rising productivity, and another fifth came from longer hours. Employment gains accounted for less than a third. The level of productivity, as measured by the Labor Department, has surpassed its prerecession high, but employment is still 4% below.

Productivity’s contribution to output held the line on unit labor costs and improved company profit margins. As measured by the Commerce Department, margins economywide stood at a record 16.1% in the third quarter of last year, after margins fell to as low as 10.0% in mid-2009.

After depending on productivity to fuel growth, however, companies have nearing the end of doing more with less.

Businesses are recognizing their existing staff are hitting their limits. According to a survey of manufacturers done by the New York Fed, 40% of respondents who plan in hire this year said the first or second most important reason was that their current employees are overworked.

As long as demand holds up, smaller productivity gains will help the jobs outlook. Companies will have to meet rising output by adding more workers.

But that scenario raises two risks to the expectations underlying stock prices.

First, Federal Reserve officials will have to adjust policy sooner than now expected if job growth strengthens significantly.

Second, an efficiency slowdown puts downward pressure on margins. Stock prices are supposed to based on profit expectations. If demand were to accelerate–possibly because new jobs generate a jump in incomes–then an increase in revenue volumes will offset the drop in margins.

If–as it seems more likely–demand continues to expand at a modest 2% or so pace, squeezed margins could throw a curve in the current running of the stock bulls.