The August jobs report released yesterday saw unemployment rise to 3.8%, the highest level in a year and a half. This reflects progress in rebalancing the labour market, which Fed Chairman Jay Powell said “remains incomplete” at the annual Jackson Hole Economic Symposium late last month.
Here I take a closer look at the report to assess how much further rebalancing has taken place, if at all. The idea really is to gauge what it means for inflation and interest rates, based on what the handy Phillips Curve theory indicates. Finally, I look at the opportunities presented by both the latest and evolving labour market trends for stock market investments.
A look at the jobs numbers
While the labour market report does show an increase in the unemployment rate, a single month’s data can’t be taken at face value. The number has fluctuated in a range over the past year (see chart below). If this trend were to continue, we might just see a return to lower rates in the next reading.
Also, the latest increase is due to a rise in the numbers entering the workforce as the participation rate rose to 62.8%, up from 62.6% last month. So it’s really not a genuine cooling off in the economy, but a reflection of more people entering the job market. The employment-to-population ratio has actually stayed static at 60.4%.
Next, let’s look at the non-farm payroll data. Some 187,000 non-farm jobs were created during the month, which is less than the past 12 months’ average of 271,000. This too, on the face of it, indicates a cooling off in hiring. But not so fast, like unemployment numbers, it needs to be looked at more closely too.
Besides a pullback in employment in temporary help services, the biggest declines were seen in industries like transport and warehousing as well as the information sector.
The transport and warehousing sector was affected by trucking company Yellow Corp’s bankruptcy, and the trucking transportation segment in particular saw a decline of 37,000. The Hollywood writers’ strike resulted in a fall of 17,000 in the motion picture and sound recording industries sub-segment of the information sector.
Coming to average hourly earnings shows that they rose by just 0.2%. But as the White House Council of Economic Advisors notes, nominal average hourly earnings remain fairly elevated on an annualised basis at 4.6% (see chart below).
The key takeaway here is that while there are some signs of a come-off in the labour market, they can’t be taken for granted because of the specificities of the data points.
The Phillips Curve
If the cooling off labour market turns out to be temporary, there could yet be an upward pressure on inflation. The relationship between unemployment and inflation is most popularly captured in the Phillips curve. It’s quite intuitive, in that lower unemployment implies higher wages, which can be passed on to consumer prices, driving up inflation and vice-versa.
While there’s a robust debate out there as to whether the Phillips curve framework actually works practically, it’s worth noting a recent San Francisco Fed study on it. It looks at the relationship between core PCE inflation on the one hand and the unemployment-to-vacancy ratio on the other, acknowledging that unemployment rates and vacancy rates need to change for inflation to decline.
Specifically, the unemployment rate would need to rise to 4.6% by 2025 and vacancy rates would need to fall to 3.6%, from the present 5.3%, for inflation to be at around 2%.
The Fed’s own forecasts don’t see inflation coming off to its target level anytime soon either, expecting it to average at 2.1% only in 2025. At the same time, it has said that its decisions will be data dependent and has also acknowledged the potential of lagged effects of interest rate increases.
Added to this is the fact that the latest jobs report really doesn’t give a clear picture, despite what the headline figures show. In fact, what we do know for certain is that the unemployment rate is not compatible right now with the target inflation rate. The Fed projects it to rise to 4.5% by 2025, along with inflation being around its target rate.
The S&P 500’s response
With this as the background, it’s little wonder that the S&P 500 (SP500) barely responded to yesterday’s news. Note that so far this year, the average absolute change in the index on the date of this release has been 1%, which is higher than the 0.67% daily change in 2023 so far. In fact, the maximum daily rise that the index has seen this year has in fact coincided with the jobs report release in January of 2.28%.
There’s a likelihood that the employment report can continue to influence the index in the coming months as well, particularly since the interest rate story hasn’t played out fully yet. In fact, going by the latest numbers, it appears that the Fed is unlikely to be done with the rate hike cycle yet. So from a trading perspective, there might be opportunities when the report is released through interest rate sensitive sectors like financials and real estate.
It hasn’t exactly been the best past year for either of them, but real estate in particular can start making gains as interest rates subside and the will-it-happen-will-it-not concerns over the recession are behind us. The likes of Vanguard Real Estate Index Fund ETF Shares (VNQ), with AUM of USD 32 billion are worth considering, as any of its peers.
Over the long term, the labour market story gets more complicated. The labour force participation rate, which is the proportion of the population over 16 that’s employed or wants to work, is expected to decline from 61.7% in 2020 to 60.4% in 2030 as per projections by the US Bureau of Labour Statistics.
Let me put this in perspective. In the past 25 years, this rate has never been at the projected lows (see chart below), except during the pandemic. A fast ageing population is really the cause of this, which can come with its own benefits (see point 3 on Ageing Population under the heading of Three Big Inflation Impacting Changes in the link), but for now, it does create an inflation risk.
While it’s unlikely that inflation will rise to the highs we’ve seen in recent years, caused by a readjustment of demand and supply conditions post-pandemic, it wouldn’t be surprising to expect inflation to be sticky downwards. I think defensives would look attractive from the perspective of a higher inflation scenario. Healthcare, in particular, is interesting since it’s also likely to see growing demand from an older population. ETFs like VanEck Vectors Pharmaceutical ETF (PPH), which have seen a good performance over the past year or some of its peers might be worth considering.
Labour market trends are critical right now, in so far as they reflect on how inflationary conditions are likely to evolve. The latest numbers only give a partial indication of a cooling off in the tight jobs market, which means that further interest rate hikes are still possible. The responsiveness of the S&P 500 to the jobs report indicates that as a result there may still be trading opportunities in interest rate sensitive sectors around the release dates.
Over the longer term too, though there is a likelihood of inflation staying sticky downwards going by the ageing population. Labour force participation rates are projected to drop to levels not seen in 25 years. This makes a stronger case for defensives than would otherwise be, particularly in the healthcare sector.