A Conference Board survey released yesterday revealed that CEOs are becoming significantly less positive about the outlook for the economy, and for their businesses. Why such sad lads? The survey does not contain details,but reasons to temper expectations are not hard to find. Softening real estate markets, rising interest rates, and hikes in energy prices are clobbering the consumer; nearly all forecasts show a falloff in demand growth.

All these concerns, however, pale in comparison to a possible shrinkage in productivity gains. The best hope for avoiding a fall-off in productivity is for corporations to step up capital spending, which may not happen if managements are gloomy about the outlook. A vicious circle, indeed.

Without a doubt — the driving force behind the current expansion — and the stock market, has been booming corporate earnings. And the major driver of earnings has been rising productivity. Ken Goldstein, economist at the Conference Board, thinks this underpinning may be evaporating.

“The days of record profit growth have passed” Mr. Goldstein says, citing an expected cooling in economic expansion and a continued lid on pricing flexibility. Productivity gains, in his view, can not be counted on to prop up profit growth going forward.

“We can’t sustain 4%–6% increases in productivity,” Mr. Goldstein says. “If we see a big push in non-residential investment later this year, that might move productivity back up in late 2007 or 2008.”

Mr. Goldstein’s theory is that productivity growth has simply been too good for too long, a view shared by many economists. Just how strong the increases have been is indicated by the revised data for the first quarter of this year, released by the Bureau of Labor Statistics in June. In the first quarter, nonfinancial corporations reported a 3.7% rise in productivity, up from 2.4% in the fourth quarter of 2005. Productivity for all of 2005 was up 4.9%.

Gains from 2002 through 2004 were impressive too — ranging from 3.9% to 4.2% each year. This has not been the norm historically. In the early 1990s, productivity rose at less than 2.5% annually; it wasn’t until 1996 that output per hour worked began to take off, presumably reflecting the increases in technology spending which fueled the dotcom boom.

Why is productivity so important today? Because corporations find themselves unable to raise prices, and because in recent quarters wage and other cost increases have been more that offset by rising output per hour worked. In the absence of strong increases in productivity, earnings will likely come under pressure.

That pronouncement assumes that wages will rise. In fact, wages have been increasing, though certainly at a modest rate for this far into a recovery. Though the press has latched onto the notion that this has been a “jobless recovery,” an economist with ISI Group, Stan Shipley, says that is an overstatement. In reality, steady increases to the national payroll have led to unemployment levels typically associated with upward pressure on wages. In June, hourly wages rose 0.5%, alarming those who viewed the implied 3.9% annualized gain as evidence of a tightening labor market.

Mr. Shipley cautions that recent increases are inflated by a shift from lowpaying to high-paying jobs, which has accounted for about 1% of that increase. He says that there has been an increase of 2.3% in high-quality jobs,or those that pay more than $19 a hour, over the past year. At the same time, low paying jobs (paying below $15/hour) are up only 0.3%.

Mr. Goldstein agrees that there has been an improvement in the mix of jobs over the past few months, but sees it as the result of job losses in low-paying sectors as opposed to gains in highpaying areas. He cites the retailing sector, which has lost 86,000 jobs over the past three months, as an example. He admits, though, that an upturn in health care hiring (78,000 jobs in the past quarter) and in professional and technical services (up 63,000) have boosted average wages.

Overall, employment has grown slowly. Mr. Shipley thinks part of the reluctance to add workers comes from pressures brought to bear on corporate managers in the late 1980s to produce steady, sustainable earnings growth.

Notwithstanding the tepid pace of hiring, wage gains do appear to be accelerating. Interestingly, while wage hikes are moving higher, increases in benefits are falling behind. This suggests that corporations are becoming more mindful of the possibility that such promises will turn out more crippling than current wage increases.

More moderate gains in benefits will help keep a lid on labor costs, as will continued layoffs in the auto sector and eventually in construction. The ISI team also notes that frantic merger and acquisition activity will lead to downsizing in affected industries.

Nonetheless, wage increases will likely accelerate moderately, driven by continued increases in jobs. Hiring indicators are mixed. The Conference Board Help Wanted Index trailed down in May, while that organization’s survey of online job advertising showed a gain. Similarly, the Monster employment index rose in June. A recent Business Roundtable report suggests that major corporations are expecting to continue hiring at a steady pace.

To cover increased wage costs, corporations will look to higher prices and increased productivity. On both counts, they may face challenges. Pricing flexibility remains elusive, mainly because of global competition. Productivity will be key, and may depend on another round of business capital spending, which has lagged in this cycle. Not only is capital investment critical at this stage to compensate for a fall-off in the growth of consumer spending, it may also determine profit growth in 2007 and beyond.

The economy, and the stock market, may ultimately prove the real victims of that declining confidence level.

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