For centuries, economists have extolled the almost magical properties of competitive markets. In the 1770s, Adam Smith wrote about an “invisible hand” by which individuals end up promoting the common good even though they only ever intended to do themselves a bit of good. In the 1970s, Milton Friedman spoke passionately of the virtues of a free-enterprise system in boosting innovation and productive activity. Such voices are quieter now and much of modern economic commentary is devoted to how to fix an economy when markets fail or how governments and central banks should seek to manipulate it. However, the U.S. economy in the wake of the pandemic should serve as a reminder of the power of simple economics. No matter how abnormal the starting point, an economy will, if sufficiently neglected by the government, tend towards balanced growth.
This appears to be the case with the U.S. labor market today, which continues to normalize following the mass unemployment and then huge labor shortages of the start of this decade. Data released this week will provide fresh perspective on labor demand, in the JOLTS release on Tuesday and on labor supply and wages, in the employment report on Friday. These reports should provide further evidence of the ability of competitive markets to pave a wider and longer runway for the current soft-landing expansion. This is, on its face, positive news for both fixed income and equity markets. However, investors should focus ever more closely on valuations, as stable, non-inflationary growth, while positive for workers and consumers, is also an ideal environment for the growth of asset bubbles.
A Message of Moderation
Labor market data this week should provide a message of moderation.
First, we estimate job openings ticked down modestly from 8.488 million at the end of March to 8.377 million at the end of April. Job openings have been falling very steadily since peaking at almost 12.2 million in March of 2022. However, even with this decline, job openings remain well above their 7.6 million pre-pandemic peak, set back in 2018.
Second, we estimate that non-farm payrolls grew by 164,000 jobs in May, down slightly from 175,000 in April, with both the unemployment rate and year-over-year wage growth coming in at 3.9%. While this would leave both of these numbers unchanged from April, it is worth noting that the unemployment rate was 3.7% a year ago, while year-over-year wage growth was 4.7%. Overall, even a slight easing in a super-strong labor market appears to be compatible with moderation in wage growth.
The Outlook for Labor Demand, Labor Supply and Wages
Going forward, we expect a further slowdown in the growth in labor demand, reflecting slower momentum in the economy overall. Last week saw a downward revision to first-quarter real GDP growth from 1.6% to 1.3%. Equally importantly, April data on consumer spending, inventories and international trade suggest a slower-than-expected start to second-quarter growth. The biggest areas of weakness appear to be consumer spending on the basics, such as food and clothing, and investment spending on equipment and structures. This, in turn, could reflect the lagged impact of higher rents squeezing discretionary income for lower and middle-income consumers and the effect of higher interest rates on capital spending outside of AI. Whatever the reason, we now see real GDP growth tracking 2.1% for the second quarter, in a slightly disappointing bounce-back from first-quarter weakness, with year-over-year gains in real GDP falling to 2.2% in the third quarter and just 1.9% by the fourth.
This diminished pace of economic growth should lead to more moderate payroll gains. It should also be noted that, while the overall labor market is still experiencing excess job openings, there are now areas, including the construction and retail sectors, where job openings are below their average levels from 2019. While historical relationships suggest that 2.0% real GDP growth should roughly equate to 175,000 to 200,000 new jobs per month, we do expect that tight labor supply, falling job openings and solid productivity gains will reduce this number in the months ahead towards an average increase of roughly 150,000 per month.
Looking at labor supply, if this Friday’s report aligns with our expectations, the unemployment rate will have been at or below 4% for 30 straight months. Over that two and a half year stretch, the economy has created over 9.2 million new jobs and somehow managed to find the workers to fill them.
A deeper dive into the data shows a significant uptick in labor force participation among working age individuals. Indeed of the 200 million American civilians aged 18 and 64, the seasonally-adjusted labor force participation rate climbed from 75.9% in November 2021 to 77.4% in April 2024 – a 15-year record high. This, on its own, would have supplied an extra 3 million workers to the U.S. economy. In addition, there has been a strong bounce-back in U.S. immigration visas issued overseas and a surge in immigrants streaming across the southern border, claiming asylum and obtaining permission to work while their cases are pending. The most recent monthly data do show a slowing of this wave of immigration. However, given lags in how these workers are integrated into the economy, the recent surge in immigration should allow employment to grow at a solid clip going forward.
The surge in labor supply has been remarkable. However, even more remarkable has been the gradual decline in year-over-year wage growth, which has fallen from a peak of 5.9% in March of 2022 to 3.9% in April 2024. Part of this slowdown is due to a surge of low-wage immigrant workers into low-wage occupations such as retail.
But another part of it is surely just the success that firms have had in holding the line against wage increases. Just 6% of private sector workers were members of a trade union in 2023. While the 33 major strikes in 2023, (that is strikes involving more than 1,000 workers), is high by the standards of recent history, it is far below the 200+ strikes that occurred in the United States every year between 1964 and 1979. Moreover, even as nominal wage growth has slipped, real wage gains have risen due to lower consumer inflation. We expect that, with next week’s CPI report, the Bureau of Labor Statistics will be able to announce the 12th consecutive monthly gain in year-over-year real wage growth. While we don’t expect wage growth to collapse, we do expect it to gradually ease further in the next few months, reducing Fed concerns about labor market tightness contributing to resurgent consumer inflation.
Investment Implications
Despite alternating fears about overheating and recession, it appears that the U.S. labor market remains on a soft-landing path. This makes any early Fed easing unlikely. We believe the Fed will have enough “good news” on inflation to cut rates at least once this year, at the December FOMC meeting and they may also be willing to cut in September. However, the evidence suggests that the economy is slowing to a continued soft-landing pace and not stalling out. Consequently, it is appropriate to think of a normalizing economy justifying more normal interest rates – not a sharply-slowing economy justifying outright monetary stimulus. This could imply four one-quarter point cuts in the federal funds rate in 2025, with the rate stabilizing at close to 4% until the Fed feels the urge to actively warm or cool the economy.
For investors, this continued normalization onto a soft-landing growth path is the best possible scenario from a fundamental perspective. However, this very stable economic environment could encourage a further flow of capital into investments that have outperformed in recent years but now look expensive, such as mega-cap growth stocks, and away from underperformers, such as non-U.S. equities. It could also undercut the appeal of broad diversification – who needs bonds or alternatives in an economy that always works for equity markets?
However, both economic and market history underscore the value of that diversification. The remarkable normalization of an abnormal labor market is testament to the ability of the economy to heal itself following a shock. However, it provides no protection against the impact of another shock. For that protection, investors should continue to focus on the diversification of their portfolios overall and the valuations of the assets from which they are constructed.