Hamish McRae: Who will benefit most from higher productivity?

Let's assume the recovery is secure – yes, I know there are doubts but let's for the moment set those aside. This will be the first post-New Economy recovery, that is to say, the first recovery that embodies the gains in efficiency from the great investment in information technology. Now consider what that should do for profits.

In the past few days there have been two particularly interesting papers from investment analysts, interesting because they come to rather different conclusions. In New York, the economics team of Credit Suisse First Boston, led by Neil Soss, reckons that the tremendous surge in productivity that has taken place as a result of this investment will indeed feed through into profits. However, a few days earlier in London the team at HSBC, led by Stephen King, concluded that consumers, rather than profits, would reap the benefit.

Mr King explained this thesis in his Monday column here 10 days ago so let me just summarise it very briefly. He argued, using US data, that there used to be a steady relationship between productivity growth and profits but this had broken down. This was because the same changes that boosted productivity also changed the competitive position of industries. Yes, these changes made companies more efficient but they also created a more competitive marketplace, eroding companies' ability to make profits. You can catch a glimpse of this process in the first graph, which shows how the relationship seems to have changed in the past five years compared with the previous 20.

The CSFB team have taken a slightly different approach, separating gains in manufacturing productivity from the rest and then looking at what this might mean for profits for the companies in the sector.

Certainly the gains look impressive. The second graph shows the five-year moving average gains since 1950 for two industries: the motor vehicles and the industrial machinery manufacturers. In both cases there has been a sharp rise in the late 1990s. The gain in industrial machinery is more remarkable, but then this includes computers so you might expect sharp increases. The motor increases are pretty extraordinary, though, given a product that has changed only incrementally. Suddenly these companies seem to have broken out of the zero to 5 per cent range and reached 7 to 8 per cent a year.

So what does this mean for profits? The CSFB team have looked at particular categories of manufacturing (such as industrial machinery) and linked changes in productivity to growth of profits in the past. On this evidence, the two do fit together: as you get a surge in productivity you also get a surge in profit share.

So who is right? Well, it is actually possible that both might be right. Some industries have certainly seen their pricing power devastated by the new technology revolution and it may be very difficult to make decent profits in these despite a recovery in demand. But that has happened many times before, particularly through international trade, when new lower-cost entrants from abroad enter a hitherto stable market and bring about a step change down in prices that domestic companies are hard pressed to match.

It is certainly true that the ultimate beneficiaries from almost all technical revolutions are the customers, though in the intermediate stage both company profits and wages for workers in the sector tend to be bid up. But the New Economy has not changed market conditions in all industries. There will be some where companies can manage to add features to products (or add service to products) and so manage to maintain margins. As demand rises, so will profits. The CSFB team does acknowledge that the data is mixed and that the rebound will be more moderate than in previous cycles.

The problem this raises, of course, is that the markets may have priced in a sharper rise in profits than companies can deliver. The London economic advisers GFC have shown this rather starkly in the bottom graph. Market capitalisation has come back some way since the peak but there would have to be either a very sharp fall in the market or a tremendous surge in profits to get back to anything like the relationship of 1995. Yes, profits did rise in the US during the first quarter, but only by a meagre 0.5 per cent, compared with the 5.6 per cent annual rate growth in real GDP.

So what will give? There will be a summer and autumn when the markets will avidly watch two things. They will naturally watch the trend in final demand and any faltering in that will worry them a lot. But they will also watch the ability of companies to deliver real profits. During the past few months it has been socially acceptable to produce lousy profits provided they could point to better times ahead. It was a slightly exceptional case because it was generated by capital write-downs but Vodafone's record loss this week was received with remarkable calm.

But companies can only do that once. The mood will shift in the months ahead and if it becomes clear that the remarkable gains in productivity are being largely passed on to consumers in lower prices, then the markets will have to adjust to that.

They will have to do this against a background of even lower inflation expectations. The other side of the "profitless recovery" coin is that consumers will benefit hugely from lower prices. Those of us who are still in jobs will be able to carry on increasing our living standards. But the increase will come in the form of lower prices rather than higher wages, just as has happened in Japan.

The market implications would be that the widely expected global rise in interest rates will be very modest. Not only do we not need much higher rates but the world economy could not stand them. Still, even a modest rise in rates will trouble the markets and I suppose there is now a serious danger of a W-shaped bear market. Many people were expecting a W-shaped recession and now looks as though that was wrong. Not so many people had expected the W to show itself in share prices. But unless profits improve soon, that is the danger.