Where Are the Workers?

by Gene Podkaminer, CFA, Franklin Templeton Investments

by Franklin Templeton Investment Solutions

Where Are We Now?

In order to estimate the path forward for the Federal Reserve (Fed), risk assets, and the continued expansion of the United States (US) economy, it is first important to understand the path forward for labour force participation. Looking over the coming months, the number of workers returning to the labour force will determine how many job openings can be filled and how quickly wage growth will retreat from its lofty levels. Wage inflation, a symptom of an otherwise tight labour market, bleeds into corporate earnings and our outlook for risk assets. Here, we’ll explore the various contributing factors to the participation rate, what we can expect going forward, and implications for both the Fed and risk assets.

As the US workforce continues its path towards recovery from the COVID-19 pandemic, we find ourselves in an economy with spiking wage inflation, an abundance of unfilled jobs, and a Fed that is still noticeably accommodative. These metrics are all at least partially caused by slack in the labour force participation rate (the percent of the population neither currently employed nor actively seeking work). Though the US unemployment rate has improved to 4.2% as of November 2021, we have often seen the participation rate’s recovery lag that of the unemployment rate over previous cycles.

Even prior to the COVID-19 outbreak in early 2020, the labour force participation rate in the United States had been in a structural downtrend for decades. However, the pandemic brought about a significant drop below the historic trend, with limited signs of recovery over the past 20 months (see Exhibit 1).

Exhibit 1: Labour Force Participation Remains Subdued

The decline in US labour force participation has been driven by many factors, including:

• Early retirement
• COVID-related exits
• Childcare prioritisation
• A shift towards younger workers leaving the workforce and moving back in with their families
• Workers deterred from accepting jobs requiring an in-office presence (preferring to stay remote)
• Increased household savings and government stimulus packages

Even as wages climb, job openings spike (see Exhibit 2), and unemployment rates fall, incentivising people to reenter the workforce has thus far proved difficult, and the participation rate remains suppressed.

Exhibit 2: Job Openings Hit Historic Highs

Where Are We Headed?

While we don’t expect many early retirees to reconsider their job prospects, there is reason to believe that a large swath of prime-age workers (aged 25-54) who have exited the job market over the past two years could be poised to reenter as wages climb higher. For context, we have 3.6 million less workers today than we did in February 2020, according to the US Bureau of Labor Statistics—1.5 million of which still fall into the prime-age camp (see Exhibit 3). However, the outlook for the remaining two million workers is foggier. Early retirees are highly unlikely to return to the workforce. Childcare and COVID-19 concerns will force longer-term exits for some segments of the prime-age working group. We don’t expect a full return to 63.3% participation rate over the near term.

Exhibit 3: Prime-Age Workforce Drawdown

Looking forward, we expect a particularly exaggerated rebound in participation for low-educated, prime-age workers, as upward wage pressure continues to be strongest among lower-paying and leisure/hospitality jobs. As the US private sector broadly prepares to set aside more capital over the coming year for continued wage gains, and we learn to grapple with the likely endemic state of COVID, the opportunity cost for prime-aged workers to sit on the sidelines will only grow.

Implications for the Fed

We’ve increasingly heard over the past few Federal Open Market Committee press conferences that the Fed’s tightening criteria boxes are being checked. Wages are rising across all demographics, with many low-income sectors seeing the largest percent increases. During the last cycle in 2017-2018, when we were at comparable levels of unemployment and wage growth, the Fed had already finished its taper, begun tightening its balance sheet, and was multiple hikes into its tightening cycle—all against the backdrop of lower growth levels than we’re seeing today.

In our base-case expectations for the Fed, we will likely need another nine+ months for us to be in a similar monetary policy position (see Exhibit 4). Should the Fed continue to view a 4% unemployment level as consistent with its interpretation of “full employment”, we expect that an increase in the labour force participation rate within the range of 62.2%-62.6% will be consistent with these levels.

As the labour force participation rate likely recovers over the coming months, we expect the Fed will have ample flexibility to conclude its taper and eventually raise interest rates multiple times over the coming year.

Exhibit 4: Months to 4% Unemployment Rate for a Given Labour Force Participation Rate

Implications for Multi-Asset Markets

Many of the inflationary pressures currently facing the US economy can be attributed to the surge in durable goods demand that resulted from COVID-19 lockdowns. Inflation driven by high demand has unique implications for a multi-asset portfolio—namely, a moderately supportive environment to take risk in assets like equities and high yield credit.

As we expect the Fed to accelerate its taper and hike rates over the next 6-12 months on the back of further labour market tightening, longer-duration assets are likely to suffer. As such, within fixed income we disfavor longer-dated sovereign debt, while we prefer sectors including bank loans and high yield corporate credit that pair strong fundamentals with minimal duration risk.

Likewise, not all industries are created equal within the US equity market, and companies across all sectors are having a difficult time attracting new talent. Should we see labour force participation rates fail to materially improve over the coming months, corporate margins could be meaningfully squeezed. Nonetheless, to this point, we have seen corporates broadly pass through rising input costs with ease to their consumers. Within a cross-asset portfolio, we favour equities as rising wage pressures are, to this point, not enough of a threat to offset a healthy profit margin backdrop.

What Are the Risks?

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