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Technology might be one of the most underrated storylines in the economy right now.

These days, we’re marveling over new-age innovations like blockchain, artificial intelligence and the metaverse. We’re also dwelling on the consequences of historic inflation.

But few are talking about the role innovation could play in this business cycle. COVID has been tragic, but there’s been one silver lining: We’ve had to re-think how we live, work and interact with each other. And that collective re-thinking has led to a renaissance era of sorts, one that could potentially lead to big productivity gains for U.S. companies and an extra boost for the economy and markets.

Graph titled The Power of Productivity tracks year-over-year change in productivity (four-quarter rolling average) with periods of recession marked between 1950 and 2020. With a few exceptions, periods of recession tend to come with a drop in productivity followed by a spike in productivity. However, there have also been many ups and downs between period of recession, although productivity rarely dips below 0%. Source: Ally Invest, Bureau of Labor Statistics

The Power of Productivity

Productivity, in an economic sense, is a simple, yet powerful concept. It’s the measure of how much companies are producing per hour of work. If companies can operate more efficiently (or produce more per hour), they can potentially produce more and keep costs low. Zoom out, and higher productivity could be a catalyst for strong, yet sustainable growth with manageable inflation.

Gains in productivity can be fleeting, though. Companies need to be focused on long-term growth over short-term returns, and sometimes, it takes a crisis to jolt society into an innovative era. If you look at the data, you’ll notice that productivity tends to spike when companies rebuild after a recession, and when society goes through seismic shifts. After all, necessity is the mother of invention.

The 1950s and 1960s were the golden eras for productivity as professional careers blossomed and world trade opened up in the post-World War II economy. Productivity gains were notoriously dim in the last cycle, though, as the Great Financial Crisis forced many businesses into cost-cutting mode.

Inspiring, Yet Challenging

Today, we live in equally inspiring and challenging times.

On one hand, we’re innovating at warp speed. Business applications have surged. Crypto and the blockchain are changing the way we transact. Tech companies are building the metaverse. The government is spending $1 trillion to improve roads, public transit and internet connectivity. Intellectual property spending as a percentage of gross domestic product spiked to a 21-year high last quarter. Technology is a textbook driver of economic growth, and it’s tough to conceptualize the impact this COVID-era renaissance could have on society.

At the same time, business owners are getting desperate. Consumers are spending the most in years, but companies can’t keep up with demand. We’re in the midst of a historic labor shortage, with 1.4 times more open jobs than unemployed people at the moment. Prices are growing at the fastest pace in 30 years, and inflation looks like it’ll stick around for longer than anticipated. Oh, and there’s the whole supply chain crisis, too.

Graph titled Demand > Supply for the First Time in Decades tracks retail sales against retail inventories from 1992 to 2021. Inventories have always been well above the sales line (by about $50 billion, at least) until recently, in 2021, when the lines cross. Retail inventories are now below retail sales. Source: Ally Invest, U.S. Census Bureau

Operating conditions may be painful now, but they could force companies to invest in more efficient, long-term solutions. Luckily, many companies are in a position to spend as they face these logistical nightmares. S&P 500 companies are sitting on a mountain of cash, thanks to double-digit profit growth for the past three quarters.

The Early Stages

Be patient, though. While we may be in the early stages of a productivity boom, it could take a while to manifest. Businesses may have plans to spend, but data shows capital spending hasn’t materially picked up. Productivity was one of Wall Street’s big predictions in the last business cycle, and it never really materialized (even though an 11-year economic expansion is nothing to complain about).

And despite all the catalysts, productivity data has been all over the place recently. Productivity jumped early on in the recovery, but it’s sputtered out since then. Last quarter, productivity declined 5% quarter over quarter – the worst reading since 1981 – as employee hours rose faster than output. Productivity can be a little uneven at the start of a new business cycle.

It’s also important to point out that innovation alone doesn’t shield the economy from rough periods. Productivity surged in the late 1990s in the dot-com era, right before the economy overheated and tech stocks plunged. The internet may have radically changed society, but it wasn’t fully appreciated until years after the tech bubble burst. The world may be more open to new ideas these days, but that doesn’t mean technology will save us from economic obstacles.

The Bottom Line

Don’t underestimate the power of innovation. It may be difficult to conceptualize just how far technology has come in this past year and a half, and companies are searching for efficiency. We may be in the middle of one of those seismic societal shifts, and history has shown it’s tough to fight the technological tides.

If you’re thinking long-term, you might want to pay attention to companies embracing new technology and investing back into their businesses. While short-term measures like dividends and buybacks can benefit shareholders (and may be enticing in an inflationary environment), a long-term growth plan could help you find the next big business.

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Headshot of Callie CoxAs senior investment strategist for Ally Invest, Callie Cox helps educate Ally Invest customers about the financial markets through engaging content and strategic initiatives. Callie has worked in financial research for her entire career, with stints at LPL Research, TABB Group and Bloomberg. Her work has been featured in Bloomberg, the Financial Times, Yahoo Finance, and Barron’s (among other publications). You can also find her on Twitter at @callieabost.