U.S. nonfarm employers in May added a seasonally-adjusted 138,000 jobs. This was the 80th consecutive month of positive job gains. The unemployment rate also dropped to 4.3%, which was the lowest level in 16 years. Strong employment, as evident by the long streak of job gains and low unemployment, may suggest to some investors that the economic future is bright. The opposite is more likely to be true. If you are confused, then please continue reading.
Recession Odds Rise
Low levels of unemployment have normally occurred at economic turning points resulting in economic recessions. If you count the “twin recessions” of the early-1980s as one recession, then there were 10 recessions in the past 70 years. The unemployment rate was on average 4.5% when the United States entered those 10 recessions. In other words, the odds of a recession are now rising.
Like an engine, strong employment is an indication that an economy is revving high on all cylinders. That sounds like a good situation to be in but the future typically proves less favorable. Engines that operate at a high output for too long need downtime for maintenance. Economies are not too different. A tight labor market is a lot less likely to further grow output for too much longer. Economic growth requires an ample and flexible labor force ready to work. That is not the case right now.
The unemployment rate decreased to 4.3% last month partly because more people have exited the labor force. Approximately 608,000 more Americans decided to either stop working or looking for work in May. That makes it more challenging for the economy grow, particularly in times of full employment. You don’t need to take my word for it. A highly esteemed economist and former central banker last month said in reference to the U.S. economy (emphasis added):
“We have already approached the limits of our capacity and unemployment is pretty much about as low as it can go, so we don’t have that extra capacity to create growth.” – Ben Bernanke, former Federal Reserve Chairman (May 17, 2017)
Little Slack Remains
People like Donald Trump have asserted that the labor participation rate is abnormally low, which is true. People are discouraged, so the solution is for policy makers to come up with ways motivate them back to work. That’s the argument. As a data driven investor, I am not so sure about that. People exit the labor force for various reasons. One of them is retirement, which is on the rise.
The Washington Post did some fact checking three years ago during the height of the economic recovery about the rate at which Baby Boomers (born between 1946 and 1964) were retiring. It confirmed 10,000 Baby Boomers indeed retire every day. This equates to almost 4 million people permanently exiting the labor force annually. Baby Boomers make up a big part of the demographic landscape so their exit from the labor force in large numbers can only hold back economic growth.
Whatever the reasons to exit the labor force, economic data also shows that less and less Americans are interested in returning to work. As shown in the graph below, only 5.9% (yellow line) of Americans not in the labor force want a job now. This is a very low number. How low? It equates to the 1st percentile looking back 20+ years.
The 5.9% level from last month is not too different from the levels experienced immediately before the past two recessions. In the 12 months before the last recession started in December 2007 (Subprime Mortgage Bubble), an average of only 5.9% Americans not in the labor force wanted jobs immediately. As for the 12 months before the recession previous began in March 2001 (Tech Bubble), an average of only 6.3% Americans not in the labor force wanted jobs immediately. Looks familiar, doesn’t it?
In the face of déjà vu, does this mean a recession is now imminent? Not necessarily but it certainly increases the odds. The highly esteemed economist and former central banker also said in reference to the U.S. economy last month (emphasis added):
“We’ve got basically a 2 percent economy here and that means it doesn’t take that much to knock you off track.” – Ben Bernanke, former Federal Reserve Chairman (May 17, 2017)
Makes me wonder: what could knock the economy off track?
Negative Productivity Growth
Economic growth is also a function of productivity growth. Multi-factor (or overall) productivity growth is the degree in which labor and machine efficiency improve. When overall productivity growth turns negative, it is usually a harbinger for recessions. This commonly happens when the economy operates at full employment. That’s when it becomes harder to find good help, which contributes to higher wages. Companies begin to find it harder to stretch that dollar. Some begin rethinking their spending. Others tighten their belts. At the tipping point, recessions occur.
Not every recession is caused by negative multi-factor productivity growth per se. As illustrated in the graph above, the recession that began in 2001 (Tech Bubble) did not experience negative growth in overall productivity. It did though drop by a fairly large margin of 110 bps that year.
Multi-factor productivity growth turned negative (red bars) less than 18% of the of times (before 2016) since the Bureau of Labor Statistics began collecting and calculating this data almost 30 years ago. It happened in the 1991 recession and in 1993 and 1995 as the economy slowly recovered. It happened again in 2008 when the economy plunged from the global recession, and in 2009 when the economy recovered from the financial crisis.
After 5 consecutive years of low overall productivity growth of less than +1.0%, it turned negative again in 2016. Real GDP increased that year but by only +1.6%. That was driven by companies hiring more people and buying more machines and software. The negative productivity growth though indicates they were not getting bang for their bucks. I imagine companies are re-evaluating their hiring and spending plans.
With the labor market now at full employment, there are much less people to hire. This means the economy is much less likely to grow. Combined with negative overall productivity growth, the economy is more likely to get knocked off track and tip into a recession. Although the stock market recently rose to an all-time high, investors should curb their enthusiasm.
Whether or not you believe the labor market and productivity drive economic growth, please consult an investment fiduciary before making any investment decisions. Should you be in search of an investment fiduciary, Meritocracy Capital Partners Inc. would welcome the opportunity to serve as your partner.
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