Eye of the Tiger

By HENRY H. MCVEY Feb 09, 2023

We have been suggesting since the onset of the pandemic that we are experiencing a macro 'regime change,' driven this cycle by a variety of unique supply side shocks, including a more challenging market for attracting and retaining workers. Generational demographics, less cross border mobility, and rapid technological change represent structural forces in the developed markets that, we believe, will make labor the 'eye of the tiger' for governments, employers, and investors for the foreseeable future. If we are right, it will likely necessitate enhanced spending on worker retraining while process automation will continue to gain in importance. However, the greatest opportunity is likely for employers to find new ways to align their interests with those of their workers - creating potential for employees to become more engaged across multiple aspects of their jobs. In addition, greater access to and investment in childcare and elder care will be needed for working parents and primary caregivers generally; at the same time, employers should adapt positions to be more attractive for workers aged 55 or older. No doubt, the aforementioned convergence of factors will drive significant macroeconomic and societal challenges. However tremendous opportunity for greater prosperity lies within those challenges.

As part of explaining our regime change thesis this economic cycle, we published a detailed note last year outlining our thoughts on how the ongoing tightness in the labor market was not an aberration, but instead the beginning of an important trend (see Labor in Transition). In particular, our research uncovered several important shifts in the large labor markets, including (among others) COVID 'absences', weakening immigration, a dearth of worker retraining, and a rash of early retirements. All of this was also occurring against the backdrop of a structural acceleration in baby boomer retirements.

We posited then that persistent structural tightness in the labor market would likely lead to some combination of higher wages as well as worker shortages across multiple industries on a sustained basis, and that as a result, corporate margins and growth rates were at risk of being adversely affected. This scenario of ongoing sticky worker costs and worker shortages has played out faster and more furiously than many were expecting over the last 12 months ― and to the surprise of many global CEOs and investors. It has also been a conundrum for central bankers, and especially for the Federal Reserve. Indeed, despite the Fed raising rates at a record clip over the last 10 months, the employment to population ratio has actually increased.

So, while we do acknowledge that there are likely to be cyclical challenges to the labor market at some point this cycle (for example, we forecast that the full-year average U.S. unemployment rate ticks up to a peak of around 4.5% in the mild recession scenario we model as a base case, vs. 3.6% in 2022), we continue to think - even as we move past the most acute phase of the current labor shortage - that there is a high likelihood that structural factors will put downward pressure on unemployment levels as well as inspire more upward pressure on wages through the course of the normal business cycle. See below for more detail, but in our view, these structural factors include:

Demographic Headwinds: In most of the developed world, as well as in China, demographics are not keeping pace with the demand for workers. In the U.S., for example, roughly as many people are aging out of their working years (16-64) as are entering them, while the working-age populations of Europe and Japan have started to shrink. ¹ One can see this in Exhibit 1. While its urban population is still growing, China's total working-age population actually contracted by about three million people last year. Meanwhile, in the United States the stock of available workers in the workforce since COVID increased by only one million people, while overall demand (employment + job openings) is now about seven million jobs higher. This mismatch between available workers and demand for labor in the U.S. is one of the key reasons the unemployment rate is now so low, despite the aggressive Fed tightening cycle.

Low Rates of Participation: Higher labor force participation typically can help offset stagnating population growth. However, the participation rate in the United States has declined, from a peak of 67.1% in 2000 to just 62.2% (Exhibit 16). Meanwhile, although Europe and Japan have managed to increase labor force participation rates (LFPR) in recent years by about 50 basis points and 230 basis points, respectively, they will need to do more going forward in order to offset the effects of an aging population (think of the ongoing battle to raise the retirement age in France from 62 to 64). One can see this in Exhibit 18, which shows that participation rates in absolute terms are actually quite low, especially in Europe (which has a participation rate of just 6.1% for those over 65).

A Smaller Tailwind from Globalization: As my colleague Vance Serchuk often reminds us, we are transitioning from an era of 'benign globalization' (where economics drove geopolitics) to one of 'great power competition' (where geopolitics often constrain economic considerations). All else equal, this new era will require more local workers in developed markets, armed with the requisite skills, to generate the same level of output, as the logic of 'competitive advantage' and greater global trade is replaced by one of 'security', trading within like-minded blocs and greater domestic production. Moreover, slowing population growth and rising wages in developing markets have meaningfully changed the calculus of offshoring manufacturing, making for a less attractive labor-cost arbitrage. Just consider that the ratio of China manufacturing wages to U.S. wages has fallen to just 4:1 today from about 40:1 in the 1990s (Exhibit 19).

A Pull-Back in Immigration: In 2020-2021, U.S. immigration fell to about 50% of the 2000-2019 average (i.e., to 620,000 from 1.3 million), which we think translates in aggregate to roughly 1.1 million 'missing' workers. Meanwhile, Europe and Japan saw similar decreases during COVID, with immigration falling to about 70% and 60%, respectively, of pre-COVID levels. While immigration flows showed signs of recovering in late 2021-2022, we think that most developed markets will need to focus on increasing immigration - particularly skilled immigration - in order to keep their economies in equilibrium going forward. Unfortunately, this need is occurring at a time of intensifying geopolitical tensions as well as more political division within democratic systems. For example, stagnating immigration rates have now emerged as a structural concern for the United States, especially in light of our expectation for the births/deaths ratio to turn negative in coming years. At the same time, we think that given Japan's domestic politics, current levels of immigration are not high enough to offset the impact of an aging population, despite immigration reforms gaining traction over the last ten years. A similar story is playing out in Europe too.

Key to our thinking are the following considerations:

COVID Policy Responses, Especially in the U.S.: In hindsight, the U.S. decision not to more consistently align financial support with employment during the pandemic (as in Germany, for example) was probably misguided. All told, U.S. unemployment surged by +920 basis points from trough to peak during COVID. By contrast, Europe's unemployment ticked up by just +110 basis points and Japan's by just +80 basis points (Exhibit 22). Our work suggests that the U.S. decision to shed workers rather than cut hours (tying relief to companies who maintained their workforces) during the early days of the pandemic may have led to some 1.2 million people permanently leaving the workforce after their initial dislocation. All told, the 'hangover' effect from COVID has contributed to a 110 basis point drop in U.S. participation from 2019 levels (Exhibit 18). Meanwhile, on a quarterly basis, participation has increased by +60 basis points in Japan and +30 basis points in Europe since the onset of COVID.

So, where does the structural change in the labor market take us in 2023 and beyond?