Baby boomers have traditionally thought it was all about them, so it will not be surprising that the retirement of the baby boomers is having a large impact on life in the U.S. The surprising part is that much of the impact is positive, and many of the benefits of it will be felt by the younger generation.
Recent market developments suggest:
Wage growth and the outlook for economic welfare for Americans younger than the boomers are much more robust than conventional wisdom believes.
Interest rates and inflation are likely to remain low by the standards of the past several decades for many more years.
Although economic growth and corporate earnings growth are likely to be slower, on average, than they have been in the post-World War II period, this economic expansion and equity bull market might last much longer than usual.
Being an informed investor is sometimes a bit like being a detective. In making asset allocation decisions, it is wise to consider various macroeconomic factors to be key drivers of expected returns, especially if it is to be believed that the economy is likely to perform differently than the consensus expects. As we look at the macroeconomic situation in early 2015, we face several “mysteries”:
The U.S. unemployment rate fell to 5.6% at the end of 2014. The economy added nearly 3 million jobs in 2014. A recent Job Openings and Labor Turnover Survey (JOLTS) report found that there are more job openings today than there have been since 2002. Yet the labor force participation rate continued to fall in 2014, reaching 62.7%, down more than 3 percentage points in 10 years to the lowest level in many decades. With strong demand for labor and a shrinking supply, general economic theory would suggest that wages should be rising robustly. Yet the December JOLTS labor report showed average hourly wages falling that month, and rising just 1.7% for 2014 as a whole. If wage growth was weak or negative, we would expect consumer confidence to be weak despite lower gas prices. Yet the latest surveys show confidence hitting multiyear highs. We would expect consumption spending to be weak, but the Q4 GDP report showed consumption growing at a robust 4.3%. How is this growth possible?
- With aggressive monetary policy in the U.S. and much of the developed world since the financial crisis, many have expected that inflation would rise, especially if economic growth started to recover. Growth did pick up in 2014 after a weak Q1 due to bad weather, reaching 5% real GDP growth at an annual rate in Q3. But rather than rise, inflation plunged to under 1% as measured by the Consumer Price Index (CPI) at year's end. Of course, the drop in oil and commodity prices bears much of the responsibility, but other measures like core Personal Consumption Expenditures (PCE) are falling and remain well under the Fed’s target of 2%. Isn’t inflation, as renowned American economist Milton Friedman told us, always and everywhere a monetary phenomenon
Some believe that market anomalies can be explained by market manipulation by central bankers. Others believe that the underlying economic picture is much worse than official statistics indicate--that low rates and falling commodity prices are a signal that we are about to enter another possible recession. We offer a different perspective.
Changing The Hourly Wage Growth
According to the Bureau of Labor Statistics (BLS), average hourly wages fell by 5 cents (0.2%) in December, and rose just 1.7% for 2014 overall, despite strong job growth of about 3 million.
There has been a persistent drag on the average hourly earnings calculation recently due to the retirement of boomers and their replacement with a larger number of lower-paid workers.
The U.S. labor force is quite dynamic; every month there are many exits and entrants. There have always been many retirements every month and many new workers. But the substantial increase in boomer retirements, combined with the surge in new jobs, makes the influence on average hourly earnings interpretation trickier than normal.
BLS calculations are quite complex, but the basic math is that average hourly earnings are total wages divided by total hours worked. There are fewer than 145 million civilian employees in the U.S. The average non-farm work week is just under 35 hours (the average is pulled down by part-time jobs), and the average wage is a bit under $25 per hour. That’s roughly a $125 billion weekly payroll for roughly 5 billion hours worked.
In December 2014, BLS data demonstrates that 250,000 net jobs were added. Let’s make the simplifying assumption that the basic dynamics of the labor market that month were 250,000 folks retired, and that 500,000 people were hired to replace them and grow the work force as the economy expanded. We know that new entrants to the labor force make less than experienced persons. Also, we can assume that the retirees were earning $40 per hour ($15/hour above the overall average), and that the new hires are earning $15 per hour. Let’s assume both groups work 35 hours per week. How might that influence the calculation of average hourly wages?
According to current Bureau of Labor Statistics calculations, if 99% or more of those in the workforce that are not entering or retiring in a given month have flat wages for the year, the average hourly wage would drop by about 3%. In other words, if it is estimated that the hourly wage drag from retirements/new entrants is close to correct, then the wages of those in the labor force continuously might be rising much faster than 1.7% per year.
There are a lot of caveats that must accompany this analysis. The U.S. labor force is much more dynamic than that and must account for more than just new entrants and retirees. Not all retirees earn premium wages, and not all new entrants start at a lower wage. This work says nothing about the distribution of wage gains, which other research suggests might be concentrated among those already earning higher incomes. Furthermore, the phenomenon of higher wage earners retiring and lower earners coming in is by no means new--but it matters more to the calculation today than it has in the past because the number of retirees seems to have jumped by about 50% above what it was about eight years ago, and the number of new jobs has finally accelerated sharply in the past couple of years. However, for investors and others trying to make sense of economic data, numbers that correctly show weak average hourly wage growth might need more intense analysis and interpretation to glean the truth of the underlying health of the labor market.
And if the wages for most individuals are growing, does this suggest that the Fed is behind the curve, and that inflation and interest rates will soon accelerate? This probably won’t occur, although time will tell.
Indicators For The Future
In short, the average hourly wage is a good indicator of the hourly labor costs experienced by business, which are growing quite slowly. The level of productivity might face some pressure, but the potential future growth of productivity is likely enhanced as new entrants to the labor force enter the steepest slope of the learning curve.
One of the main reasons for low interest rates in developed markets worldwide, besides central bank policies, is supply and demand. In other words, older individuals are less likely to go into debt and more likely to want to buy fixed-income products. This keeps demand for fixed-income high and the growth of debt low, driving prices up and yields down.
The investment implications of all this from our perspective are that inflation and both short- and long-term interest rates might stay lower for longer, despite solid real economic growth of 2%-3.5% over the next couple of years. We have not seen, and might not see, in this cycle the sort of rapid credit growth that usually fuels rapid recoveries from severe recessions: An older population doesn’t want to borrow and constrained financial institutions are reluctant to lend. Yet if much of the current labor force is starting to see real wage growth accompanied by higher potential productivity growth, this might be an unusually long, slow economic cycle, and the long bull market might have a ways to run.
Edward F. Keon, Jr. is a managing director and portfolio manager for Quantitative Management Associates (QMA), as well as a member of the asset allocation team. In addition to portfolio management, Keon contributes to investment strategy, research and portfolio construction. Keon has also served as chief investment strategist and director of Quantitative Research at Prudential Equity Group, LLC, where he was a member of the firm’s investment policy committee and research recommendation committee.