Covenant Weekly Market Synopsis for July 20, 2018

July 23, 2018

Last Week Today: Federal Reserve Chair Jerome Powell gave his semiannual testimony to Congress, which can be summed up as: economy strong, interest rates to move higher. | In a CNBC interview and subsequent Tweets, President Trump expressed his view that the Fed should not raise interest rates. The President’s comments were notable for two reasons: recent administrations have adhered to a policy maintaining the Central Bank’s independence, and, in 2016, he said the Fed should be “ashamed” of creating a “false stock market” by keeping interest rates low. | The Chinese Yuan declined 1.2% to a one-year low, prompting speculation the Chinese government is weakening the currency to maintain the competitiveness of Chinese companies despite US tariffs.

For the most part, strong corporate earnings announcements last week offset trade concerns, resulting in a draw for domestic equity indices. Indeed, the S&P 500 ended the week almost exactly where it began, while the Nasdaq Index declined by 0.1%. The scoreboard overseas wasn’t a whole lot more exciting, as international developed stocks (as measured by the MSCI EAFE Index) fell 0.1%, and Chinese shares rose 0.8%. The yield curve flattened further intraweek, before steepening a tad, and the spread between 2-year and 10-year bonds ended the week at 0.3%. Commodities don’t issue earnings announcements, and the ongoing protectionist trade rhetoric was negative for the complex even as the US Dollar weakened by 0.2%: gold -1.2%, silver -1.9%, copper -0.9%, WTI Crude -0.8%. 

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Labor Market Demography – The June labor market report confirmed ongoing strength in this critical economic sector. Non-farm payrolls increased by 213,000 jobs in June, and April/May payrolls were adjusted higher by 37,000 jobs, closing out an impressive second quarter in which new hires counted 632,000.

The Labor Force Participation rate increased from 62.7% to 62.9% as a booming job market continues to pull idle laborers from the sidelines. As the number of labor market entrants exceeded the number of newly created jobs, the headline unemployment rate increased from 3.8% in May to 4% in June. Regardless of the apparent contradiction, a shift higher in the unemployment rate resulting from an expanding workforce is a good thing for the economy.

The participation rate is well below the levels seen before the Great Financial Crisis (“GFC”), implying (all else being equal) there is still an abundant labor pool to tap. However, all else is not equal, and the available labor pool may not be as large as it once was owing to changing demographics. Before discussing that point, it is worth looking at how a previous demographic shift dramatically altered the labor market and increased U.S. economic output.

From a historical perspective, the current Labor Force Participation Rate appears rather impressive compared to the levels seen in the two decades from 1950 – 1970. Nevertheless, one should not take too much comfort in the comparison. Those decades reflect a different era – an era in which women were beginning to enter the labor force. Indeed, from 1950 until 1970, the female labor participation rate increased from 33% to 37%. Female employment would continue to grow, and by 2007 the women’s participation rate nearly doubled to 59% from 33% in 1950. This significant demographic shift helped push the total Labor Force Participation Rate from an average of 57% to a peak of 67%, boosting economic output in the process.

 

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Sources: Bureau of Labor Statistics, Bloomberg, and Covenant Investment Research.

The Labor Force Participation rate remained between 66% and 67% until the GFC. Massive job losses impacted employees of both genders, and while the female participation rate deteriorated, the decline was not meaningfully different than that of the male population. Since the GFC, the total participation rate has bounced between 62% and 64%, unable to recover to its pre-crisis level. Part of the reason for the continued low participation rate is the relatively slow economic recovery from the GFC and the number of discouraged workers it engendered. Yet, the recession ended nine years ago, and the estimated 8.7 million jobs lost as a result of the GFC have been replaced (Source: Center on Budget and Policy Priorities). Even if there is some conflicting data around the exact number of jobs lost vs. jobs gained throughout and since the GFC, there is little doubt that the labor market is markedly improved. Indeed, the labor market appears tight by a variety of metrics and labor surveys (e.g., the Job Openings and Labor Turnover Survey).

If the labor market is so good, why then has the participation rate mostly remained below 63% since 2013?

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Source: FTN Financial

While there are several contributing factors to this puzzle, the demographic shift represented by retiring Baby Boomers is a major force holding down the participation rate. It’s also worth noting that the demographic turnover is depressing measures of wage growth because as the Boomers retire, they are generally replaced by less experienced (and cheaper) labor.

The first members of this aging generation first entered the “55-years and older” cohort seventeen years ago in 2001. While the GFC delayed retirement for many of the Boomers, the strong performance of risky assets over the last nine years has made retirement achievable for many. For others, though they may not feel financially comfortable retiring, Father Time has caught up physically, forcing them into retirement. The aging of the Baby Boomer generation is expected to put downward pressure on the Labor Force Participation rate, which the Bureau of Labor Statistics forecasts will decline to 61% by 2026.

The economic implications of the aging population in the U.S. are important. In simple terms, if one thinks of the economy as a boat, the economic boat can move faster in one of two ways:

  • More people rowing (i.e., a growing labor force), or
  • Fewer people rowing faster (i.e., higher productivity)

On the first point, the accelerating rate of Baby Boomers leaving the workforce is reducing the number of people available to row. Moreover, tighter immigration laws are preventing the U.S. from importing workers to replace retiring Baby Boomers. To the second point, labor productivity has remained stubbornly low since the GFC. While productivity has shown brief signs of accelerating, this volatile data series has, heretofore, not exhibited consistent improvement. Perhaps robots will solve the productivity problem, but that remains to be seen.

The Bottom Line: The demographic shift of women entering the workforce provided a boost to the Labor Force Participation Rate and economic growth in the United States. We are currently in the midst of another seismic demographic change, but this one is a headwind to economic growth. Absent improvements in productivity, economic growth in the United States will be hard pressed to remain above 3% per annum on a sustainable basis (higher growth in 2018, spurred by fiscal stimulus, notwithstanding) as there are simply fewer people to employ. Slower economic growth, combined with average (if not high) current valuations, should temper investors return expectations for risky assets in the coming decade.

Be well,

Jp.