Topics: "Labor shortages", "Taiwan", and "Highly-indebted states"
“Help Wanted”. We expect semiconductor, vehicle and other goods bottlenecks to resolve themselves in the months ahead, and interpret declining business surveys as the result of a temporary supply shock and not a sign of inadequate demand. As a result, growth should rebound in 2022, and positions that benefit from reflation should benefit (energy, value and cyclicals). However, while goods bottlenecks will dissipate, the US will still face tight labor markets and rising wages that are at odds with current Fed policy
Our prior note looked at semiconductor, vehicle, goods, shipping and other physical bottlenecks that are leading to lower growth forecasts for the next 2 quarters. We’re starting to see signs of improvement: a small decline in anchored LA/Long Beach containerships, freight rates falling from peak levels, a decline in commercial rail delays from 14 days in August to 3.5 days and a 20% increase in Taiwanese production of 8-inch wafers typically used in automotive systems since January of this year. Bottlenecks should continue to gradually improve over the next few months. As a reminder, the fundamental catalyst for the current situation is the surge in goods spending in the US and Europe relative to services, an abnormal pandemic-related change that supply chains were not ready for. Combine the semiconductor intensity of Western goods imports with high levels of COVID restrictions in Asia, and you have the ingredients for a massive supply shock. As mRNA vaccination rates rise in Asia and community spread declines, a relaxation in worker density and other COVID protocols should follow.
In the US, in-person spending on pandemic-sensitive services is recovering alongside oil and airline spending; the outlier is white collar office utilization rates, the most vaccine-resistant variable of all. All things considered, we expect normalization of US and European goods spending relative to services in the months ahead, which should reduce physical bottlenecks further.
US labor markets, however, may not normalize so quickly. Company surveys show all-time peaks regarding plans to raise worker compensation since they’re having trouble filling jobs, and regarding plans to raise prices. Wage increases are now eating into overall business optimism; historically, the chart on the lower right tends to track changes in S&P margins reasonably well, although not all the time.
Where have all the workers gone? That’s a good question. Let’s use estimates to add up all the workers missing from the labor force since the pandemic began1.
- The impact of COVID unemployment (UI) benefits on labor force participation is still unclear. While benefit expiration in July and August led to an increased job finding rate among unemployed workers, it did not lead to higher labor force participation. In any case, let’s start with the estimated number of people receiving UI benefits as of September 1 that exceeded their prior salaries (2.7 million out of 5.3 million UI recipients)
- During the pandemic, 1.5 million more people retired than usual compared to what was a steady linear trend beforehand. There’s some research indicating that rising stock markets and housing prices boost retirement rates, but the sudden spike in retirements starting in March 2020 suggests that COVID is the main catalyst here
- Visas granted to immigrants and non-immigrant temporary workers collapsed during the pandemic. While visas are starting to recover, the pandemic decline resulted in ~700,000 people missing from the labor supply. Visa shortfalls during the pandemic add to a backlog of around 1 million people waiting to receive employment-based visas. More immigration data: highly educated immigrants who qualify for green cards wait an average of 16 years before receiving them. Also: Trump cut the number of family preference green cards, which increased availability of employment-based green cards by 122k. But only 40k were granted by the September 30 deadline; the rest may be lost for good absent Congressional action
- An increase in self-employment also plays a role. While such individuals are still in the labor force, self-employment spiked by 800,000 once the pandemic hit. The largest job switching categories: people leaving manufacturing and agriculture for construction and transportation (i.e., ride-hailing). So, the shortages you read about regarding goods and food production are in part attributable to this trend
Everyone else. Another 1.7 million people left the labor force during the pandemic for reasons other than those stated above. This category includes:
- Some of the 3 million respondents to a September Census household survey saying that concerns about getting or spreading COVID are why they’re not working (this is around half the pre-vaccine level from late 2020, but still a large number)
- Some of the 4 million people citing child care constraints in the same survey, even after the reopening of schools (i.e., people not working due to providing care for children not in school or daycare). This figure declined by roughly half once schools opened in September
According to BLS surveys and our estimates, ~2 million people out of the 7.5 million missing workers intend to search for work again at some point, and we do expect increased labor supply by year-end. But it might not be enough to restore the pre-COVID balance of supply and demand in the labor market, which was already pretty tight. As a result, wage pressures and labor shortages may be an endemic feature of the post-COVID US economy and put pressure on the Fed by the middle of next year. Note: on the issue of job mismatches, the latest data suggest that this is more of a geographical problem than an industry problem right now, with the largest worker shortfalls relative to vacancies in North Carolina, Georgia, Indiana and Wisconsin.
By the way, the Fed staff and FOMC participants revised up their near-term inflation forecasts but continue to expect inflation to moderate in 2022. The staff forecasts that inflation will fall back below 2% in 2022 and only return to 2% in 2024. I disagree with them. As a reminder, Fed forecasts for policy rates ended up being wrong for most of the last decade:
Help Wanted, Part 2: The era of a possible US defense umbrella over Taiwan has long since passed
The market cap of the World Semiconductor Index finally surpassed the market cap of the World Energy Index in 2020, an indication of a world that’s more reliant each year on technology. Taiwan has the largest global share of semiconductor capacity at 21%, including a 50% share of higher value added logic chip capacity; and Taiwan’s TSMC has a market cap that is more than double Intel. The likely US response to any actions by China that constrict Taiwanese semiconductor supply would be a lengthy and expensive effort to rebuild US semiconductor production capacity (now just a 12% share), rather than a defense of Taiwan itself.
A lot of clients have asked about Taiwan given increased sabre-rattling by China. The latest: China sent a record number of jets into Taiwanese air space, President Xi said that complete reunification of the motherland “must and will be fulfilled”, and also warned that the Chinese people have a glorious tradition in opposing separatism. Taiwan’s defense minister said that tensions with China are at their worst in 40 years.
To be clear, the US is not obligated by treaty to defend Taiwan from attack. A Sino-American Mutual Defense Treaty was put in place in 1955 and did obligate the US to defend Taiwan, but this treaty was abrogated permanently by the US in 1979 in exchange for China establishing diplomatic relations with the US, and Chinese support for American actions in Communist Afghanistan (when the US was arming the Afghan mujahideen). The Sino-US mutual defense treaty was replaced by the Taiwan Relations Act of 1979, which instead obligates the US to provide Taiwan with “sufficient defense capabilities”. While US arms sales to Taiwan of $11 billion in 2019 were the highest on record, this may not amount to much if a military conflict occurs.
After normalizing for wage differences and purchasing power, China’s military spending is ~90% of US levels. As part of a special section in this year’s Outlook, I spoke with the author of a RAND Corporation report on Chinese military capabilities. The RAND analysis indicates that China has changed the balance of power in the region, substantially eroding the ability of the US military to defend Taiwan even if it chose to.
The second chart below shows the evolution of US air superiority against Chinese surface to air missile systems. The area above and to the left of each curve represents RAND estimates of how often US forces would prevail as a function of US aircraft missile range and detectability. For example, in 1996, only highly detectable US aircraft with shorter range missiles would lose in battle. By 2017, US aircraft needed to be much less detectable and more weaponized due to improvements in Chinese air defense systems. Similar findings: the share of Chinese ships destroyed by US submarines in a 7 day campaign scenario fell from 100% in 1996 to 40% by 2017, and the estimated US air force fighter wing capacity required to defeat China in an attrition battle rose by 7x.Since the RAND publication was released, China has added more destroyers, cruisers, aircraft carriers and assault ships; hypersonic and intermediate range missiles; anti-submarine warfare; and long range bombers.
See Appendix for additional semiconductor facts and figures
Help Wanted, Part 3: Highly indebted states are still going to need help, even with improved solvency ratios
COVID has not turned into the municipal disaster that many feared a year ago. State revenues have been more resilient than expected, and according to the National Association of State Budget Officers, 38 states reported FY2021 general fund revenues above initial forecasts. The March 2020 CARES Act provided $150 billion to state and local governments; another $125 billion was authorized in December 2020; and in March 2021, Biden’s American Rescue Plan made another $350 billion available to states and local entities. From a big picture perspective, a lot of state and local financial burdens were shifted onto the Federal government. While less explicit than a Federal bailout of underfunded pensions, the 2020/2021 acts were still wealth transfers from citizens of less indebted states to citizens of highly indebted states.
That said, we wanted to take a look at the most indebted states right before COVID began (which is the latest data available from state consolidated annual financial reports). As a reminder, our IPOD ratio looks at the share of state revenues required to service bonded debt and to amortize all unfunded pension and retiree healthcare obligations over the next 30 years assuming a discount rate/investment return of 6%. As you can see below, most ratios improved since our last analysis in 2017, some substantially.
The reasons for improved ratios differ by state and include rising asset values, tax increases, reductions in retiree healthcare plan coverage, a cap on salaries used for pension accruals and contributions to underfunded plans (see Appendix for more details). The Illinois improvement is impressive; but how many times can you increase state taxes on companies and individuals? In 2020, Illinois recorded its 7th straight year of population loss, the most since World War II and the second largest of any state in raw numbers or % of population. Illinois is the only state whose population loss accelerated each year for the past seven years.
The bottom line: highly indebted states (most of which are controlled by DEM legislatures and governors) still have to dedicate almost a third of state revenues to unfunded pension and retiree healthcare obligations2, despite the best of all possible market environments to drive asset values higher. While financial repression and Federal transfers have given these states a reprieve, a diversified municipal portfolio is still recommended for residents of these states, even at the expense of paying state taxes on out-of-state bonds.
Appendix
Semiconductor facts and figures [SIA Semiconductor Factbook, IC Semiconductor Research, TrendForce]
- Semiconductor categories include microprocessor and logic devices (42% of sales); memory storage devices (25% of sales); devices that translate light, voice and touch analog signals into digital signals (13% of sales); and discrete optoelectronics and sensors generally used to generate or detect light
- While the US has 47% market share of global semiconductor revenues, only ~40% of US production capacity is located in the US. The rest is located in Singapore, Taiwan, China, Europe and Japan
- Taiwan has the highest share of semiconductor capacity at 21%, followed by Korea at 20%, Japan and China at 15% and the US at 12%. Taiwan also a 50% share of higher value added logic chip capacity
- Taiwan also controls 60% of the semiconductor foundry market by revenue, which refers to outsourced semiconductor production (for companies like AMD, Apple, Qualcomm, Nvidia and Huawei)
State specific catalysts for changes in municipal IPOD ratios, FY2017 to FY2020
- Illinois: a state personal tax increase from 3.75% to 4.95% and a corporate tax increase from 5.25% to 7.00% helped propel revenues higher by 44%. Furthermore, pension service costs declined due to a cap on the salary used for state pension accruals
- New Jersey: large decline in current pension service costs due to changes in benefit terms (interest credited for first two years of time period from termination to retirement instead of the entire period); reduced health care plan coverage terms
- Hawaii: Revenues increased by 10% annually, more than the median state and much faster than pension payments growth
- Kentucky: Large decline in current period service costs for the Kentucky Teachers Plan (for reasons that are not entirely clear)
- Pennsylvania: Faster revenue growth than pension payments growth, and reductions in OPEB plan coverage
- West Virginia: A State Senate bill now requires the state to make a large annual contribution to the state retiree healthcare plan (which boosted the funding ratio from 21% to 38%)
2 While unfunded pensions are not explicitly cross-defaulted with general obligation bonds, our research indicates that in almost every case when pensions or retiree healthcare obligations were restructured by cities, bondholders suffered writedowns that were just as large or even greater. Examples include Central Falls RI, Harrisburg PA, Vallejo CA, Jefferson County AL, San Bernardino CA, Stockton CA and Detroit MI.
Help Wanted
“Help Wanted”. We expect semiconductor, vehicle and other goods bottlenecks to resolve themselves in the months ahead, and interpret declining business surveys as the result of a temporary supply shock and not a sign of inadequate demand. As a result, growth should rebound in 2022, and positions that benefit from reflation should benefit (energy, value and cyclicals). However, while goods bottlenecks will dissipate, the US will still face tight labor markets and rising wages that are at odds with current Fed policy
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FEMALE VOICE 1: This podcast has been prepared exclusively for institutional, wholesale, professional clients and qualified investors only, as defined by local laws and regulations. Please read other important information, which can be found on the link at the end of the podcast episode.
MR. MICHAEL CEMBALEST: Good morning, everyone, and welcome to the Eye on the Market podcast for October. Last time, we looked at the semiconductor vehicle and other goods' bottlenecks, which we expect to resolve themselves in the month ahead. We interpret declining business surveys that we're seeing right now as the result of a temporary supply shock and not a sign of inadequate demand. As a result, we think growth will pick up next year, and a bunch of cyclical and energy positions should benefit from that.
However, while the goods' bottlenecks will probably dissipate, we're looking at extremely tight labor markets and rising wages that I don't think are going to clear up so quickly and that are also at odds with current fed policy.
So, on the first page of today's note, we take a look at really the fundamental catalyst for the weird situation that we're in right now, which is the surge in goods' spending relative to services in both the U.S. and Europe. In other words, once the pandemic hit, people started buying a lot more stuff than services. That stuff tends to be very semiconductor intensive, and then you've got a massive supply shock, given the degree to which goods spending is highly reliant on imports from Asia, where the lower vaccination rates and lower efficacy of the Chinese vaccines have led to more severe worker density protocols and things like that. But, again, over the next few months, we expect those things to dissipate.
What is not going to dissipate so quickly, however, are the tightness in U.S. labor markets. Some of the surveys are off the charts in terms of difficulty filling jobs, plans to raise worker compensation, wages, wage increases eating in to overall business optimism.
In today's note, we walk through where all the workers have gone, or a list of the categories, with respect to workers that have left the labor force. So, let's take you through them. The first big category is a controversial one, but it's the universe of workers who, at least as of early December, had been receiving, for some period of time, benefits that were higher than their prior salaries. So, this number is estimated to be between 2.5 to 3 million people. Now, those excess benefits are coming to an end right now, but it may take some time before those people feel a full economic incentive to go back to work. And, remember, as we discussed last time, the foreclosure and eviction moratoria are still in place in a lot of cities and states around the country.
You've also got about 1.5 million people, more than usual, that retired during the pandemic. It was a pretty steady linear trend beforehand. But, about 1.5 million people left the labor force and retired. There's some research that rising stock markets and housing prices allowed them to do that. But, when you look at the timing of when those retirements occurred, COVID was the primary catalyst for making them quit in the first place, or retire in the first place.
Then, you've got about several hundred thousand people, at least, maybe almost a million, of missing immigrants and non-immigrant temporary workers. VISAs granted to them collapsed during the pandemic, and while some of those VISAs are starting to recover, there's a huge hole in the labor force from all of those VISAs that weren't given for such a long period of time.
There's a lot of strange things going on in the immigration system. Trump had cut the number of family preference green cards, and that simply increased the availability of something called employment-based green cards, but only around a third of them were granted by the September 30th deadline, and the rest may be lost for good, if Congress doesn't act.
Another category is an increase in self-employment. While these people are still in the labor force, around 800,000 people left things like manufacturing and agricultural jobs for individual construction jobs and ride hailing. So, when you read about shortages in goods and food production, part of it's attributable to this increase in self-employment.
Then, the last category is a hodgepodge of 1.5 million people that left the labor force for all sorts of other reasons. Some of them because they can't get childcare, even with schools reopening, some of them because they're concerned about getting COVID. 3 or 4 million people each have cited in some census surveys that those two things are affecting their ability and/or inclination to go back to work.
Now, about 1 to 2 million—if you add up all those categories, it's about 7 million. 1 to 2 million of those people are indicating that they plan to re-enter the labor force fairly quickly. But, that said, you're still missing a few million people, and so we do expect an increased labor supply over the next few months, but it might not be enough to restore the pre-COVID balance of supply and demand in the labor market, which was already pretty tight.
So, wage pressures and labor shortages may be an endemic feature of the post-COVID economy and put a lot of pressure on the fed by the middle of next year, if we're looking at still a 0% funds rate and a 4-5% consistent wage inflation.
Now, by the way, the fed and both the staff and the FOMC participants expect inflation to moderate in 2022, and the staff is actually thinking that inflation will fall below 2% next year. I disagree with them, for all of the obvious reasons.
The second topic this week is Taiwan. It fits in the Help Wanted scheme, because there's a lot of presumption that the U.S. would help Taiwan in any kind of military conflict with China. I don't think that's the case, but let's go through the details. The reason everyone's so focused on this, the market cap of the world's semiconductor index is now higher than the market cap of the world energy index, in indication that the world's becoming a lot more reliant on technology than traditional energy, notwithstanding the energy supply issues that we're having right now, which we'll discuss in a future Eye on the Market.
Taiwan's TSMC has a market cap that's double, more than double, that of Intel. So, there's a lot of focus right now on what happens to global semiconductor supply chains, with respect to this whole China-Taiwan issue. My perception is any developments, whether now or in the future, that constrict Taiwanese semiconductor supply would end up with a multi-pronged and costly and lengthy effort by the U.S. to rebuild its own semiconductor production capacity, rather than to defend Taiwan itself.
So, what's going on? Well, China has been sending a couple hundred jets in to Taiwanese air space. President Xi said that complete reunification of the motherland must and will be fulfilled, and he also warned the Chinese people have a glorious tradition in opposing separatism. Taiwan's defense minister said tensions with China are at their worst level in 40 years.
To be clear about this, the U.S. is not obligated by treaty to defend Taiwan. There was, past tense, a Sino-American mutual defense treaty that was put in place in 1955, which obligated the U.S. to defend Taiwan. But, this treaty was abrogated permanently by the U.S. in 1979, in exchange for China establishing relations with the U.S. and also, believe it or not, in exchange for Chinese support for what the U.S. was doing in Afghanistan, where the U.S. was arming the Afghan Mujahidin.
Anyway, this Sino-U.S. mutual defense treaty was replaced by the Taiwan Relations Act of 1979, and all that does is obligate the U.S. to provide Taiwan with "sufficient defense capabilities." Arms sales from the U.S. to Taiwan last year of $11 billion were the highest on record, but I don't think that's going to amount to very much, if a military conflict were ever to occur.
If you look at the data for China, and you adjust their military spending for wage and purchasing power, it's around 90% of U.S. levels. Earlier this year, I spoke with the team at the Rand Corporation that specializes in analyzing the balance of power in the region, specifically China, Taiwan, and the U.S., and since 1996, China has radically changed the balance of power in the region. We have a couple of charts in here that show that, and we've written about this before. Essentially, China has been investing in destroyers, cruisers, aircraft carriers, intermediate range missiles, antisubmarine warfare, long-range bombers, and what was in 1986 an almost impossible task for China to impose its will in a 7-14 day campaign to take Taiwan was, as of 2017, all of a sudden a 50-50 proposition, and the gap between China and Taiwan and the U.S. just continues to grow.
As one example, in 1996, around 100% of Chinese ships were estimated to be destroyed by U.S. submarines in a 7-day campaign, and that number is now less than 40%. So, that's why, as far as I can tell, at least in my opinion, the most likely response that the U.S. would ever mount here would be some maybe military aid to Taiwan, but the more practical response would be to try to increase its current 12% manufacturing capacity for semiconductors up to some higher number.
The last topic for this week on Help Wanted refers to some of the highly indebted states in the United States that have not just a lot of bonds outstanding, but a large pile of unfunded retiree healthcare and pension obligations. These states got a lot of help from the federal government. So, COVID hasn't turned in to the municipal disaster that many people, including me, feared that it might. Around 40 states are now reporting general fund revenues for 2021 above their initial forecast. And, if you add up the March 2020 CARES Act, an extension authorization of December 2020, and then the American Rescue Plan, there's something like $600-700 billion were transferred from the federal government to the states. While less explicit than a federal bailout of underfunded pensions, the Acts from the last couple of years were essentially still wealth transfers from citizens of less indebted states to citizens of highly indebted states.
So, we wanted to at least take a look at the most indebted states right up until COVID began, which is he last data that's available from a lot of the state consolidated annual financial reports. Again, I think the data, as of right before COVID began, is probably a good proxy for where they are now, given all the aid that's been channeled to the states. And, we have this iPod ratio, where we look at the share of state revenues required to service debt and amortize all the unfunded pension retiree healthcare obligations over the next 30 years, using our assumed investment return of 6% on diversified defined benefit plan portfolio.
So, as shown in the chart, almost all the ratios have improved substantially since our last analysis. Why wouldn't they have? Asset values for public and private equity have gone up a ton. And, as everybody knows, a lot of the municipal, state, and local plants are huge investors in private equity. There have been some tax increases. There have been reductions in retiree healthcare plan coverages, salary accrual caps, contributions to underfunded plans, etc., etc.
Now, the big, big mover here is Illinois. But, even after the tax increase that they passed, they're still looking at something like a third of all government revenue having to go to pensions. I don't think that's very sustainable, and Illinois also has just recorded its seventh straight year of population loss, and a population loss that's accelerating each year.
So, the bottom line for us is that the most indebted states, many of which, by the way, are controlled by democratic legislatures and governors, still have to dedicate almost a third of their revenues to unfunded pension and retiree healthcare obligations in order to service them, despite this very favorable market environment. I think financial repression and federal transfers have given these states a reprieve, but for residents of these states, a diversified municipal portfolio is still highly recommended here, even at the expense of having to pay state taxes on out-of-state funds.
So, that is the end of this week's Eye on the Market. Our next piece will be our Thanksgiving Eye on the Market, sometime in mid-November. Thanks for listening. See you soon. Bye.
FEMALE VOICE 1: Michael Cembalest, Eye on the Market, offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JP Morgan Asset and Wealth Management. Michael Cembalest is the chairman of Market and Investment Strategy for JP Morgan asset management, and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market by contacting your JP Morgan representative. If you'd like to hear more, please explore episodes on iTunes or on our website. This podcast is intended for information purposes only and is a communication on behalf of JP Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or as solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information, which can be found at www.jpmorgan.com/disclaimer-eotm.
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