Productivity, Okun's Law and Cash Flow Suggest Positive Employment Surprises

Labor productivity and cash flow have been surging. These factors are key for the employment outlook. Here is why:

   1. Productivity tends to accelerate above trend at the trough of a recession and especially in the first phase of the growth cycle. The reason is that companies fire people in a recession and when production picks back up people are working to the max of their capacity. But that type of productivity uptick is not sustainable. It is merely a cyclical phenomenon typical in the early phase of recovery.

      A glance at the empirical data supports this view. In 2009 unemployment rose by double the amount implied by Okun’s Law. Okun’s law states that there should be a 1% increase in the unemployment rate for every 2% that GDP falls below trend. Okun’s law would have predicted a 1.5% increase in the unemployment rate in 2009 but it turned out to be a 3.0% increase. The Okun’s Law relationship has held remarkably steady for over 60 years. Unless one believes that there has been some sort of remarkable advance in productivity, this unusual rise in the unemployment rate will not be sustainable and will soon revert.

      Productivity grew 5.1% for all of 2009 and surged to 6.2% in the fourth quarter of 2010. There can be no question that in 1Q 2010, productivity will again be extremely high as jobs have been shed and the economy has been growing nicely. The fact that productivity is surging so strongly is a great sign. Why? Because it means that companies probably overdid it on layoffs. In other words, employment levels are unsustainably low relative to the level of sustainable structural demand. That means that companies may need to pick up the pace of hiring soon as the payroll is unsustainably low.

   2. The strong growth in free cash flow that companies are reporting certainly confirms this hypothesis. If companies were not generating above trend free cash flow (relative to sales), it would suggest that their payrolls are about where they need to be. But the strong cash flows they are generating (relative to sales) could be indicating not only that companies have the financial capacity to hire, it is also probably indicating that they will need to start hiring soon. In other words, they are enjoying a surge in cash flow that is paralleled by the unsustainable uptick in productivity growth. It indicates that headcount may be unsustainably low.

Given the low head count at companies, strong free cash flow, the pick-up in consumption and relatively low inventory levels, positive surprises in employment could be coming down the pipeline in the not too distant future.

If so, look out above on the S&P, because if there is one thing that most economists seem to agree on these days is that there will be either a “jobless recovery” such as the one in the early stage of the last cycle, or that the recovery in employment will be slow. A vocal but influential minority actually think that there will be no reductions in unemployment at all.