Robert F. DeLucia, CFA, Consulting Economist, Prudential Financial To learn about Prudential Capital Group and its financing capabilities, attend the session Finding Alternative Capital in the Private Markets at the Financial Leadership Summit on Monday, May 23, 2016 Presented by: Matt Douglass, Managing Director - 212.626.2068 - [email protected]
I have argued for some time that employment is the most important factor necessary to bring about a healthy and sustained recovery from the Great Recession. In principle, the manifold economic benefits of a healthy labor market can be best summarized as follows:
- Job creation is the primary driver for personal consumption expenditures, which comprise nearly 70% of US GDP
- Rising employment, falling unemployment, and rising incomes provide a powerful foundation for a healthy and sustained housing market expansion
- A healthy labor market supports the banking system because of the tight relationship between unemployment and bank credit quality
- There is a high correlation between job creation and capital formation, implying a favorable spillover effect on business investment spending
- Strong growth in employment boosts the demand for office space and is supportive of market rents and ultimately commercial construction
- Strong job creation and rising wages are supportive of public finances, because of the heavy reliance of government revenues on personal tax payments
- As the main engine of world economic growth, US consumer spending is a vital catalyst for the global economy and world trade
Current Business Cycle: US labor market performance has been excellent over the past five years, as measured by rapidly declining unemployment and robust job creation. Nonfarm payrolls have increased by a cumulative 14 million workers since the labor market trough in 2010, while the unemployment rate has declined by 50% from its peak that same year, to a current rate of 5%.
- Highly Consistent: Consistency in growth has been extraordinary: Nonfarm payrolls have increased for an unprecedented 65 months. The cumulative average monthly job growth over this entire five-year period was 205,000. Moreover, there is evidence of strengthening in recent months: The average monthly increase in net payrolls has accelerated to 245,000 during the past six months. Full-time employment has increased at an even faster monthly pace of 262,000 over this same period.
Cycle Shortcomings: At the same time, there have been several areas of weakness in the current labor market cycle:
- Zero growth in the overall labor market
- Multi-year lows in the labor participation rate
- Sluggish growth in wages, salaries, and benefits
- Disproportionate demand for part-time workers versus full-time workers
- Record duration of unemployment
In short, the labor market recovery of the past five years has been robust, but mainly in terms of hiring, ultra-low layoffs, and net job creation. The labor market has underperformed in other important respects, undermining job security and confidence. However, many of these lagging areas are beginning to show preliminary signs of catch-up.
JOB CYCLE PHASE TWO
Encouraging new data suggest that the US labor market cycle may be entering a new phase, which should bolster prospects for aggregate output, income, and spending in future years. What are the critical qualities of phase two? Recently emerging labor market developments of a positive nature include the following:
1. Accelerating growth in the overall labor force
2. A steadily rising trend in the labor participation rate
3. Broader employment opportunities that enhance job security
4. Much improved prospects for full-time employment
5. Increased worker confidence to voluntarily leave current jobs
Expanding Labor Market: Following many years of stagnation, labor market growth has begun to accelerate, with cumulative growth of 2.4 million workers in the past six months alone. For reference purposes, the labor force typically expands by only 2.2 million in an average year. The explanation for this break-out is that so-called “discouraged workers” are finally beginning to return to the workforce after many years of sitting on the sidelines.
- Success Rate: Growth in the labor force surged again in the most recent monthly employment report, with more than 70% of new entrants finding a job. This is the highest success ratio for any month in nearly a decade.
Labor Participation Rate: The conceptual companion of a growing labor force is a rising trend in labor participation, which had also stagnated since the Great Recession. This measure has increased in the past six months at the fastest pace in a quarter century (see Chart 1).
The broad economic significance of an expanding labor force and reversal in the labor participation rate is as follows:
- Evidence of a healthy underlying labor market
- An increase in worker confidence that should boost spending
- Increases in the pool of available workers to spur economic growth
- Downward pressure on wage inflation because of increased labor supply
- Most importantly, increased availability of new workers is necessary to extend the longevity of the expansion cycle
Record Low Layoffs: Another important feature of the current labor market is a record low pace of layoffs. Initial claims for unemployment insurance have declined to the lowest level in decades. In addition, initial jobless claims have remained below the pivotal 300,000 level for the 59th week, the longest such streak since 1973. As one of the ten Leading Economic Indicators as tracked by the Conference Board, initial jobless claims is arguably the most reliable measure of labor market strength (see Chart 2).
Breadth of Employment: According to research by Moody’s Analytics, the intrinsic demand for labor has begun to broaden to the full spectrum of the work force. Hiring is strong across most industries, occupations, pay scales, and regions of the country. Small, medium-sized, and large companies are expanding their workforces at a solid pace. There are three obvious laggards: Oil and gas firms, mining and resource companies, and select exporters of manufactured goods. Each of these sectors should stabilize later in the year. 
Voluntary Job Separations: Perceptions of a healthier labor market have emboldened workers to voluntarily leave jobs at a faster rate in search of higher-paying employment. The propensity of workers to leave work in search of better jobs is measured by the quit rate, which tracks voluntary worker separations as a percent of the workforce. Currently at 2.3, this is the highest rate since 2007, and a manifestation of both a more dynamic job market and increased job security (see Chart 3).
Full Employment: An important implication of these trends is that the US labor market is rapidly approaching full employment. As a generalization, monthly growth in net payrolls of 200,000 is more than double the amount needed to absorb workers into the workforce. The implication is that the US economy could be at full employment — defined as 4.5% — by the middle of next year (see Chart 4).
Social Versus Economic: However, from a broader business cycle perspective, full employment should be viewed as a double-edged sword. While extremely desirable in a social and political context, full employment has mixed economic ramifications. Simply put, an economy at full employment is vulnerable in two crucial respects:
- A tight labor market implies upward pressure on wages, which would compel the Federal Reserve to adopt a more restrictive credit posture.
- Full employment implies an increasing scarcity of the resources necessary to support further growth, which suggests that the end of the expansion phase of the cycle could be just beyond the horizon.
Labor Participation: The crucial independent variable with respect to these two issues pertains to labor force growth and trends involving the labor participation rate. Potential late-cycle pressures could be alleviated by an expanding labor force and a steadily rising participation rate.
- Labor Market Slack: More specifically, a growing number of workers re-entering the labor force would increase the pool of available workers, thereby maintaining slack in the labor force and effectively deferring the arrival of a fully employed market. Conversely, a stagnant labor force would have the opposite effect, resulting in an effective shortage of workers. I will be monitoring monthly trends in this area very closely because of its direct influence on labor compensation, monetary policy, and the potential duration of the expansion cycle.
LABOR MARKET FORECAST
The outlook for the US labor market over the next two years can be summarized as follows:
Net Job Creation: Nonfarm payrolls are expected to expand by 2.5 million workers for all of this year and in 2017.
Unemployment: The unemployment rate is expected to decline to 4.5% — the level generally assumed to be full employment — as early as the first half of 2017. The timing is totally dependent upon the growth in the labor force.
Labor Compensation: Wages should begin to rise at a faster rate later this year and continue to rise through all of 2017. Wage rates should be rising at a 2.5% annual rate by yearend, by 3% by the middle of next year, and by 3.5% around yearend 2017 (see Chart 5).
Labor Composition: In addition to escalating wage rates, worker income should benefit from faster turnover of the labor force — churning — as employees voluntarily transition from current jobs to higher-paying employment. 
BROAD ECONOMIC IMPLICATIONS
As discussed previously, the economic outlook heavily depends upon labor market trends. In particular, resumed growth in the labor force and a reversal in the labor participation rate would have significant implications for the economic outlook:
- An expanding workforce, rising wages, and broadening job opportunities should enhance job security and consumer confidence.
- Household income should be bolstered by rising employment, compensation, and a transition to higher-paying jobs, all of which would support healthy growth in consumer spending.
- By expanding the pool of available workers, a growing labor force should extend the life of the expansion by postponing full employment and maintaining adequate labor market slack to support further growth in output and spending.
- While US corporate profitability has benefitted enormously from the ability of firms to maintain tight control over labor costs, reduced labor market slack could shift bargaining power from employers to employees. The result could be an end to the corporate profit cycle, as rising labor costs exert downward pressure on company profit margins.
Robert F. DeLucia, CFA, was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that role, he spent 25 years at CIGNA Investment Management, most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as the Consulting Economist for Prudential Retirement. Bob has more than 40 years of investment experience.
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