The Labor Market Conundrum: The Cyclical and the Secular

Back in 2005, then Federal Reserve (Fed) Chairman Alan Greenspan mused on the failure of long-term yields to rise, famously calling it a conundrum. Today, we face another mindboggling conundrum with equally significant investment implications: Why are wages still stagnant, when jobs are being created at the fastest pace since the late 1990s? To answer this question, it is helpful to separate the cyclical from the secular.

The U.S. labor market is the strongest it’s been in more than 15 years. Last year, on average the economy created more than 250,000 jobs per month. The acceleration in job growth has pushed the unemployment rate down to 5.5%, the lowest since the spring of 2008 and close to what most economists would consider ‘full-employment’.

Yet, despite the market’s apparent strengthening, two long-term trends persist: fewer working age Americans are engaged in the labor market than at any point since the late 1970s, and for those who are working, wage growth is modest, at best. Although there are a few anecdotal examples of companies raising wages—Walmart and TJX being two of the more recent—wages are not responding as expected to the acceleration in job growth (although there are indications that overall compensation, including benefits, is rising much faster).

While cyclical factors are supporting job creation, the drop in participation and slow wage growth are a multi-decade phenomenon. Workforce participation has been in a downtrend since 2000. A significant portion of the drop can be traced back to an aging population, but participation has also fallen for working age Americans. The problem is: Once you leave the workforce, it’s proving difficult to re-enter. There are several explanations for this, ranging from a mismatch of skills to the disincentives associated with loosening the criteria for long-term unemployment insurance. What is clear is that very few of these individuals are being lured back to work despite the stellar pace of job growth.

On the wage front, there are many different factors at work. Although we’re creating lots of jobs, more of them are now part-time. The greater mix of part-time workers, most of whom receive lower wages, is dampening average hourly wages. But by far, the biggest factors are long-term. A combination of disruptive technology, global wage arbitrage (moving jobs overseas) and slower productivity growth has doggedly held wages back, not just in the United States, but also in most developed countries. U.S. real wage growth has been stagnant at the household level since the 1990s—for men, real wages peaked back in the mid-1970s.

This is part of the reason why this economy feels so different from the boom times of the late 1990s. Between 1995 and 2000, the last time the labor market was this strong, real wage growth averaged nearly 4%. This time around, the average is less than 2%. The disappointing difference has a lot to do with today’s sluggish productivity growth. Back then, U.S. output per hour for the nonfarm business sector was growing at an average annualized rate of roughly 2.50%. Over the past three years, the average has dwindled to less than 1%. Put simply, without faster productivity, companies are not motivated to raise pay.

Surely, faster wage growth is still possible, as demonstrated by the 1990s. But to overcome secular headwinds, productivity needs to rise. So far, despite a stronger labor market, that trend has yet to emerge.

While this is a longer term story about decades-long trends in the economy, it does lead to some implications for investors in the shorter term. First, softness in income growth implies less inflationary pressure, while lower household spending could slow overall economic growth. If these conditions take hold, interest rates would likely remain at low levels for a long time, despite the Fed’s likely increase in rates later this year. Second, slow wage growth is partly behind the lackluster household spending we’ve seen. If that continues, caution may be warranted around consumer discretionary stocks. These have performed well year-to-date, but it makes sense to pick your spots carefully going forward. Be wary of companies whose valuations are counting on a surge in consumer spending and focus instead on those with potential to take market share from their competitors.

Source: Bloomberg.

This material represents an assessment of the market environment as of the date indicated and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any security in particular.

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