×

Here's the one data point that could be bad news for corporate profits

Cash dollars
Moodboard | Moodboard / 360 | Getty Images

Non-farm labor productivity was down for a third straight quarter, according to Wednesday's numbers. Such consecutive drops in productivity have not been seen since 1979, the Wall Street Journal reported. In fact, this is a pattern we would normally see only during economic recessions. So, what is behind the recent weakness in productivity and should we be concerned about this key driver of income growth and living-standard improvements?

First of all, the weakness shouldn't come as a huge surprise given the sluggish pace of economic growth we've been enduring. GDP growth has averaged less than 1 percent over the past three quarters, with relative strength in personal consumption (consumer spending) more than offsetting weakness in other areas.

Private investment, which accounts for only about 17 percent of total GDP, has been the biggest drag. This category includes business investment in things like facilities, equipment, software and inventories. Companies, in the aggregate, have largely been foregoing, or at least deferring, capital investments even as they have been hiring new workers at a pretty solid pace.

The improvement in the labor market, in turn, has provided consumers with the means and willingness to spend more. In fact, the Personal Consumption component of GDP has grown at an average pace of 2.7 percent over the past three quarters – well above the average of 1 percent for the economy overall. Fortunately for us (for the time being), consumer spending, at nearly 70 percent of GDP, is a much larger component of GDP than private investment.

So, we have dodged a recessionary bullet thanks to the consumer's continued willingness to spend. But, second quarter the spending growth was fueled by raiding the cookie jar. Spending growth well outpaced income growth in the quarter, leading to a drop in the savings rate to 5.5 percent in the second quarter from 6.1 percent in the first quarter. This is quite a dramatic drop in one quarter. In any case, as long as the consumer keeps spending at a pretty good clip and offsetting the weakness in business investment, we shouldn't be at risk of recession, right? Not so fast.

What, if anything, does the recent weakness in labor productivity portend for the future pace of consumer spending and economic growth? First let's look at how productivity is measured. Productivity is simply aggregate economic output dividend by aggregate hours worked. This metric simply tracks how much the average worker contributes to the economy per hour of work.

Changes in productivity can be driven by a variety of factors. According to the web site Investopedia, growth in labor productivity "is directly attributable to fluctuations in physical capital, new technology and human capital. If labor productivity is growing, it can be traced back to growth in one of these three areas." So, growth in labor productivity would generally be associated with increases in business capital investment, improvements in technology and innovation, and improvements in education. Intuitively, this makes sense. Each of these factors should help workers produce more goods and service in the same amount of time.

Alternatively, decreases in labor productivity can be attributable to corporate America's unwillingness to invest in the things that improve worker productivity, like new facilities, equipment, software, training, and research and development. The drop in business investment we've been seeing within the private investment sector of recent quarterly GDP reports is proof that companies are not investing in productivity-enhancing initiatives.

Instead, it appears as though companies have opted to add more workers rather than investing in the productivity of the ones they already have. They have done so, in part, because the supply of labor had been abundant and cheap in the wake of the biggest recession in decades. But they have also done so because they have not seen enough demand for their products and services to justify major investment outlays.

And finally, many companies have foregone capital investments because investors have been rewarding stock buybacks, dividend increases and, in some cases, acquisitions more highly than anything else. When it's all said and done, corporate management teams do whatever makes their stock price go up.

Undoubtedly, the lack of corporate investment since the end of the Great Recession has been a factor contributing to the decline in labor productivity growth. From 2000 through the beginning of the Great Recession (December, 2007), labor productivity grew at an average annual rate of 2.6 percent. But since the end of the recession in June, 2009, productivity growth has averaged just 0.9 percent. That is a pretty stunning statistic.

Obviously, the next presidential administration and Congress will need to think of ways to incentivize corporate America to increase their growth investments rather than engaging in financial engineering (stock buybacks, dividend increases) and/or generating earnings through cost-cutting and restructuring. Without new investments in the future, incomes and living standards are unlikely to improve at anywhere close to the rates of decades past.

Why is the labor productivity problem important for investors? Because it will affect not only the economy, but also corporate profitability. Over the past seven years, corporate margins and profitability have benefited enormously from both cheap labor and the deferral of investment spending (among with other factors). From 2009 through 2015, S&P 500 operating earnings per share rose 93 percent on just a 24 percent increase in revenue per share.

Now, however, much of the slack has been wrung out of the labor market. The unemployment rate has decreased from a financial-crisis high of 10 percent to below 5 percent in recent months, and the sharp reduction in labor supply has started to put upward pressure on wages. Coupled with the weakness in productivity growth, unit labor costs have risen 12 percent since the first quarter of 2010 (See chart below). Optimists will say that rising labor costs should eventually incentivize companies to invest more heavily in labor-saving equipment.

And both higher wages and increases in investment spending will undoubtedly be good for the long-term health of the economy. However, the concern for the Fed and the new administration will be that rather than sacrifice margins and profits (and still faced with lackluster demand), corporate management teams will hire less workers or even implement layoffs.

This could threaten to unwind a lot of the progress we have made in the labor market. The technical term for this is a "Catch 22". In either case, the era of rising margins driven by low labor costs and deferred investments may be coming to a close. Companies will be more heavily dependent on revenue growth for future earnings growth.

So, the issue of productivity is not insignificant as we assess the short- and long-term outlooks for corporate profitability and stock prices. For stocks to continue to perform well following one of the longest bull markets in history, we need to start seeing evidence that prospects for revenue growth are improving. This will require some degree of fiscal stimulus, such as infrastructure improvements, further incentives for businesses to make capital investments and hire new workers, and improvements in the quality of education, to offset the effects of Fed monetary-policy normalization. All of these initiatives would pay off in the form of more robust growth in labor productivity in the future.

As stock valuations plow farther into historically high levels, our proclivity is to remain defensive. A sizable portion of the earnings growth we¹ve seen since the end of the recession has been fueled by unsustainable cost-cutting, low labor costs, the deferral of growth investments, and financial engineering such as stock buybacks and debt refinancings. We have yet to transition to an environment of better top-line growth fueled by productivity-enhancing investments.

Current valuations reflect optimistic assumptions with regard to Fed policy normalizing, the transition to a new presidential administration, and a renewed spirit of collegiality on Capitol Hill. We just don¹t see enough evidence for these Pollyannaish forecasts. As such, we continue to favor sectors and companies that should provide downside protection if things go wrong while also providing for upside participation. This is no time to swing for the fences.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.

For more insight from CNBC contributors, follow @CNBCOpinion on Twitter.