A Tale of Two Economies
All eyes will be on the Federal Reserve this week as it gets set to raise its policy rate, the Federal Funds Rate, yet again. Inflation remains a persisting threat and one the Fed has made clear it intends to defeat. Investors should not doubt the Fed’s resolve. The recent rallies have often come on the back of bursts of optimism that sees the Fed raising rates by less, stopping sooner rather than later, or even cutting rates in mid-2023, as indicated in the futures market. We see these hopes as misplaced, but even so, there is room for optimism for investors. Underneath the ongoing inflation forces lies one driver that makes our current situation quite unlike any the U.S. has seen in the past. Labor shortages are the key problem right now and it has led to some areas of the U.S. economy remaining in recovery mode even while others are contracting because demand for some goods has fallen sharply. This disparity in the economic prospects of different sectors can guide investment decisions.
Labor is in short supply. By contrasting the Congressional Budget Office’s January 2020 outlook for the potential U.S. labor force, we can see just how severe the shortage has remained over the last two years:
Sources: Congressional Budget Office, Bureau of Labor Statistics.
The U.S. is “missing” at least two million workers, all while job openings continue to run well ahead of the number of people unemployed. Not only have more Americans chosen to retire early, but many continue to be sidelined from ongoing Covid illness, while others are reportedly out of the workforce because of Long Covid. In addition, several years’ worth of restrictions on both legal and illegal immigration have reduced the inflow of labor which historically feeds the U.S. labor supply. None of those factors is likely to ease anytime soon. The missing will likely stay missing for some time. And while wage growth has slowed since peaking at 5.6% in March, at 5.1%, it is still running a couple percentage points above its pre-pandemic level. Eventually, wages will reach a level sufficiently high to reduce demand for them by firms and perhaps, eventually, to draw enough workers back. We’re not there yet, however, as evidenced by the excess of job openings relative to those seeking work. And wages are rising because employers need to chase the few remaining workers on the sidelines and attempt to lure others away from competitors. The Fed will have to raise rates further to get this under control.
That labor shortage, in addition to the wage growth it is prompting, is also continuing to constrain the recovery in supply triggered by the initial shutdowns from the pandemic. Companies in sectors ranging from travel and leisure to medical devices and to technology have been unable to increase output enough to meet pent-up demand. Last week saw one such company, Ciena Corp., report that it finally received enough components from its suppliers to satisfy a large chunk of demand from its customers in telecommunications services, data centers, and a wide set of enterprises. The stock surged 20%. Another company, Broadcom, reported that it has so many (non-cancellable) orders on its books that it has visibility to its sales for at least the next twelve months. It, too, serves data center and telecom equipment providers, and also sells critical components for high-end iPhones. Some areas of the economy will continue to expand as those supply constraints ease.
Other areas of the U.S. economy, however, are clearly in contraction: PCs, printers, most smartphones, some retail, and other consumer electronics are seeing sales fall, and suppliers are reducing headcount. Demand has shifted away from these products because consumers loaded up during the depths of the pandemic and because consumers have shifted spending towards services and away from goods, more broadly. Those employees will flow to areas of the economy that are still trying to catch up to strong demand. Unfortunately, there will be a mismatch of skills between workers displaced from one area and the jobs available in others, so this reallocation will take time and goods and services shortages will take a while to resolve. In those areas, expansion will continue as labor moves, even as other areas contract.
And while this reallocation plays through, we should expect wages to keep rising above historical rates and so to keep the upward pressure on inflation. Don’t expect the Fed to quit raising rates until those pressures noticeably ease. And in the meantime, we are focused on investing opportunities in the areas of the economy still in recovery mode and in companies that are well positioned to ride out the contraction underway elsewhere.
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