Facing Reality on Growth and Inflation

Today, I have the privilege of running the Boston Marathon for a third time on behalf of the Dana Farber Cancer Institute.? I love being part of the team – despite many difficult personal stories, the volunteers, organizers and runners are a very warm and positive bunch to train with.? Moreover, the research conducted by Dana Farber is critical to winning more of the millions of individual battles which constitute the war on cancer.?

Running for Dana Farber also gives me a way to participate in the Boston Marathon since, perhaps not surprisingly, I lack the athletic ability to qualify on the basis of past performance.?

This is sad, but it is reality.?

In my imagination, my running is as cool and strong as the Kenyans and Ethiopians who will undoubtedly lead the field.? But the spectators who will cheer me on, as I stagger up the Newton hills, will see the truth, which is something a good deal hotter and weaker than I would like.

The same could be said of the American labor market, as portrayed in last Friday’s jobs report.

The weakness was evidenced in the headline job gain of 194,000, well short of the consensus expectation of 475,000, as well as a 183,000 decline in the labor force.? These shortfalls were mitigated, to some extent, by a 169,000 upward revision in payroll gains for the prior two months, a decline in the unemployment rate from 5.2% to 4.8% and a modest increase in the average workweek.

Still, the economy has 5 million fewer payroll jobs and 3.1 million fewer people in the labor force than before the pandemic.? Moreover, this is clearly a supply problem rather than one of demand.? Tuesday’s JOLTs report is likely to show that there are still well over 10 million unfilled jobs in America, compared to now just 7.7 million unemployed workers.? As confirmation of this problem, last week the National Federation of Independent Business reported that 51% of small businesses had positions they could not fill in September, a 48-year high.

Part of the problem may still be an industry-worker mismatch as many jobs require skills that laid-off workers don’t have.? There are also issues related to the pandemic and childcare which are likely keeping some potential workers out of the labor force.? Finally, while enhanced unemployment benefits have ended, some workers may be able to postpone a job search for a while due to savings accumulated from government programs over the past two years.

However, we should also recognize the real limits to U.S. labor force growth.? The labor force participation rate measures the percentage of the entire civilian population aged 16 and older that is working or actively looking for a job.? As the baby boom continues to turn 65 in huge numbers, the measured labor force participation rate will tend to decline based on demographics alone.? Indeed it is notable that while the overall labor force participation rate has fallen by 1.70 percentage points since February 2020, (from 63.34% to 61.64%) the same statistic for those aged 25 to 54 has only fallen by 1.29 percentage points (from 82.89% to 81.60%).? The problem is that this prime working-age population has actually declined in the last two years.

A second related problem, is that the pandemic and changes in U.S. regulations have combined to reduce immigration from a peak over one million people per year in 2015 and 2016 to, we estimate, roughly 250,000 in the past year.? While roughly 61% of the overall U.S. population is between the ages of 18 and 64, according to the Center for Immigration Studies, 73% of new immigrants fit into this age category.? A lack of new immigrants is limiting the pool of potential workers.?

However, even as job growth remains weaker than we would like, a tightening labor market is contributing to a general heating up of inflation.? Over the past two years, the average hourly earnings of production and non-supervisory workers have increased by 10.4%, the strongest two-year gain (apart from pandemic distortions last year) since 1983.?

Faster-growing wages are clearly contributing to higher inflation overall.? However, this is not the only issue as supply bottlenecks are increasing prices for a wide swath of consumer goods.?

Rising energy prices have more recently become a problem, with WTI oil prices rising above $80/barrel last week and natural gas prices climbing above $6 per million BTU.? The oil price surge reflects a global recovery in demand as pandemic effects fade and some discipline on the part of the OPEC+ group as it only slowly ramps up production in response. The natural gas spike, at least in the U.S., has partly been caused by hurricane disruptions to production although rising demand is also a factor. Finally, rents have started to rise very sharply across the country reflecting soaring home prices and, perhaps, the effect of the end of the eviction moratorium.

Some of these inflationary pressures will show up in Wednesday’s CPI report, which we expect to show a fourth consecutive month of greater than 5% year-over-year gains in consumer prices.?

It should be recognized that most of the recent inflation increase is likely transitory as the Federal Reserve has argued.? High prices themselves provide a powerful incentive to producers and distributors to get goods to market thus relieving price pressures.? However, it is looking increasingly likely that some of this higher inflation will linger.? In particular, the effects of fast-rising wages, fast-rising rents and, most of all, higher inflation expectations should keep inflation well above the Fed’s long-run 2% target through 2022 and into 2023.

Policy makers would undoubtedly like to see stronger growth and cooler inflation.? However, this is simply not the economy we have and we expect the Federal Reserve to bow to this reality by announcing a plan to taper bond purchases at its meeting next month and to start raising short-term interest rates before the end of next year.

For investors, it is also important to recognize reality.? While there are many great American companies which will be able to flourish even in a slower-growing U.S. economy, it makes sense to be globally diversified to benefit from markets which are more attractively priced today and economies which have a better potential for strong growth with low inflation going forward.

Disclosure

Any performance quoted is past performance and is not a guarantee of future results.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.