Is the labor market softening?

The labor market has been the last hold in what is a series of contracting macroeconomic data. This has been a primary reason that the transmission of monetary tightening policy in the US has relatively slow.

We just received the updated Summary of Economic Projections from the Fed after yesterday’s FOMC June 14 rate announcement. Not surprisingly, the Fed has revised the expected unemployment number down from 4.5% to 4.1% by the end of 2023. The last reading for the unemployment rate from the Jobs Report on June 2, was 3.7%.

What’s interesting about this situation is that the Unemployment Rate has historically almost always fallen during a Fed Hiking cycle. The only exception was the period between 1980 and 1990. Not only that, but the rate has usually been the lowest right before a recession.

Now recessions are called in hindsight, so it’s tough to say what happens first. Do people start to lose their jobs because of recessionary conditions within the economy? Or does the increase in unemployment actually bring on a recession because of a reduction in consumption?

We like to think that it’s the former, and that’s what most economic theory says. But, we’re not here to debate economics. We’re here to discuss what the data is telling us.

The Unemployment Rate and Non-Farm Payroll report are both the Fed’s preferred measures for the labor market and they still suggest a very tight labor market. We are however, seeing signs of softening. We heard Chair Powell discuss yesterday as well. This could potentially give way to a full-blown economic contraction.

The last Jobs Report in June showed 339,000 of jobs being created according to the non-farm report indicating the job market still remains tight. But, there were some discrepancies there as the unemployment number went up. We cover this in detail below. We’ve also been covering various data points such as the JOLTs reports, initial claims reports and non-farm payroll reports on an ongoing basis in our Macro Morsels section.

This is a good time to to tie it all together to to see where the data is heading.

What’s the overall picture?

• The Labor Market continues to remain tight due to wealth effects, self-employment and job openings in various sectors where there was a shortage of labor.

• What did the last jobs report tell us? Well, contrasting stories. The discrepancy between the Non-Farm Payroll going up and the Unemployment rate going up is mainly because what the two sets of data is measuring. That’s as well the case for the ADP employment report.

• Average hours worked, quit rates, temporary work, levels of self employment and small business employment show us that this is changing and the data is beginning to show signs of a crack. However, we hear about layoffs in tech and finance, in particular, but none of that seems to have moved the needle.

• Wage data shows some sign of easing as well but, by no means fast enough to bring down core services inflation.

• We will need to see meaningful declines in the services data - measured through ISM services1 - to see unemployment start to increase and inflation start to decrease. This may ultimately be the last straw that pulls consumption down and therefore, GDP growth leading to a recession.

Let’s take a look at these in more detail.

Why is the labor market so tight?

It’s no secret that the pandemic actually made people wealthy. Stimulus checks and easier measures in terms of SNAP payments, Medical Insurance Coverage, the Student loan moratorium and PPP loans actually helped people far more than anticipated. Housing, stock portfolios, retirement accounts - all increased to unprecedented levels creating the great wealth effect. Much of that reversed in 2022 after the Fed started hiking and is still reversing. People have had no choice but to go back to work. People thought that their retirement portfolios were going to help them quit early. And for a while it did but, that trend has changed.

There were shortages in many sectors in the labor market - nursing, healthcare, leisure, restaurants. If you remember, Domino’s had a big problem getting drivers to deliver pizzas. Medtronic says that medical procedures had come to a halt because there were no healthcare technicians to do pre-operative scans. Those shortages are now easing and it’s no surprise that every month that’s where we see the most jobs being filled.

Then you have the situation that people are hoarding workers. As weird as it sounds, after the shortages many companies experienced, they don’t want to let staff go because filling these positions later may become much too difficult. We also have a whole faction of companies who are of the idea that the economy remains strong and earnings will start to improve in the 2H 2023 and they want to be prepared for that. This is a bit of a Catch-22 because the economy remains strong due to the low levels of unemployment and people still spending. But that’s a discussion for another day.

We see this not only in the actual numbers but also the Labor Force Participation rate that remains at historic lows. The labor force participation rates is calculated as the labor force divided by the total working-age population. The working age population refers to people aged 15 to 64.

What did the latest data tell us? - NFP vs. HH Survey vs. ADP

The Jobs Report comes out on the first Friday of every month. This is the Non-Farm Payroll (NFP) and the HH Survey.

This month - Jun 2 - the May data showed a higher discrepancy than usual. This is because of what each of these items measure.

• The Non-Farm Payroll (NFP) report is from the Establishment Survey and it directly samples from about 150,000 non-farm businesses (700,000 establishments) to estimate jobs, wages and hours. NFP provides estimates of jobs. May’s showed an addition of 339k jobs.

• The Household Survey is also called the Current Population Survey. This directly samples from about 60,000 US households to estimate unemployment, job market status and and other measures. The scope is wider and includes paid and unpaid employment, self-employment, farm workers, and those on unpaid leave. The Household Survey provides estimates of employment status. May’s report showed a decline in jobs of 310k, increasing the unemployment rate to 3.7% from 3.4%.

While it’s not a fair comparison between the two, if we try to reconcile the differences for the May report the major issues are:

• 369k decline in self-employed

• 123k decline in workers on unpaid leave

• 180k increase in multiple jobholders

Historically, the household estimate usually corrects towards the NFP data, which means the Household Survey numbers and therefore, the unemployment rate is overstated. However, what’s important is what these changes tell us. We explore this below.

Before we move on, let’s have a quick look at the ADP numbers. The ADP Report for may showed a lower number of 278,000 jobs added.

The ADP National Employment Report (NER) presents independent measures of the U.S. labor market based on ADP payroll data covering more than half a million companies with more than 25 million employees.2 

The ADP measure is based on actual payroll data and therefore, doesn’t cover self-employed and people on unpaid leave. In that sense, it’s closer to the NFP Report. The discrepancy between the ADP and NFP report then, is the fact that the ADP only takes into account active workers and therefore, temporary changes such as seasonal adjustments and worker strikes are not accounted for by the ADP.

What are the other Data Points telling us? 

Average Hours Worked

Average hours worked is declining. This is a telltale sign of the labor market softening. Average Hours Worked decline when there are more part-time workers - when companies don’t want to make a major commitment to a full-time employee. It could also mean that companies are cutting hours for existing workers, to pay them less.

One argument could be that hours worked is declining because more people joining the workforce, only want to do part-time work. After the pandemic, many people have decided not to go back work full time. But this also means that more people are having to go back to work, even if it’s part time, because disposable income is declining.

Temporary Work 

Temporary work goes hand in hand with the average hours worked. As you can see from the chart above, as the economy goes into a recession, temp work increases. We’re gradually starting to see temp work increase now as well.

Productivity

Productivity is decreasing. The BLS reported on Thursday, mentioned that productivity had decreased by -2.1% during Q1, 2023 on a quarterly basis. YoY change still remains negative, as we can see in the chart below.

When labor productivity decreases, higher wages cannot be sustained for long. Higher productivity almost always commands better wages and we're seeing the opposite now. This is a sign of softening.

Unpaid Leave

There were quite a few people who were put on unpaid leave during the pandemic. Companies couldn’t afford to pay them or perhaps they didn’t want to increase costs. But, they also didn’t necessarily want to let people go, should business activity pick up again. This data is on a downtrend now. So either these people are being let go because people want to lower their headcount or, these people are going back to work.

Many of these people would have had their benefits. now that Medicaid determinations will start to come through, people will start to go back to work to maintain their healthcare insurance benefits. And employers will want to get rid of this cost. I wish there was more detail in this data to determine what exactly is happening. We will keep an eye out for more incoming data on this topic.

Quits Rates

Next up we have quit rates. We see this dropping. not surprisingly, we had a lot of people quit during the pandemic primarily because of the wealth effect. There was also fear, particularly in the healthcare sector. And other reasons, such as having to take care of their kids at home.

A lot of people enjoyed working from home and spinning up their own companies. The side gigs became full-time work. But, this is now changing and we see also in the next section on self-employment.

Self Employment

The levels of self-employed workers dropped drastically last month. This is not a great sign. Unfortunately, it would seem that the rise in the gig economy that happened during the pandemic is waning. People are having to go back to work. It’s never easy to get full-time employment once you are out of the job market. So, these people would likely have to settle for temporary or part-time work. Some may have to even take drastic pay cuts and jobs not in line with their profile. It goes back to bringing down average hours worked and would definitely mean a decline in wages.

News of Layoffs

The Challenger Job cuts data for the last 2 years shows a clear acceleration. We know much of it is coming out of the tech and finance sector. But, this isn’t exactly moving the needle on the unemployment rate. There are a few reasons for that:

• Many of these layoffs are announced but done in stages with a long runway.

• There’s still hiring in many sectors of the economy where there were labor shortages previously. We discussed this above.

• People may not be reporting their unemployment status just yet because they may have a good severance package to live off of.

Wage Data

However, wages still remain considerably high (rightfully so) to attract employees and compensate for inflation.

While Chair Powell doesn’t think there is a wage spiral pushing up inflation, the extremely tight labor market can be a contributing factor to inflation. However, as inflation starts to decline, companies will be faced with a situation of lower corporate profits - something we’re already seeing with earnings. Given this situation, companies will be forced to cut costs and that too, in terms of labor. Also something we’re seeing in various parts of the market.

The Employment Cost Index, which is a measure that the Fed watches, has been showing some softening. It is currently at 4.86% YoY. However, as you can see from the chart below, we are still far above pre-pandemic levels and the long run average of 2.62% YoY. This remains very troubling for the Fed.

Closing Thoughts - What we need to see

As I wrote this article and started putting in the data to tie is at all in, I realized that we’re nowhere close to where we need to be in terms of the data softening, even though some of the numbers are rolling over.

The truth is the labor market still remains exceptionally tight with an imbalance in labor supply and demands. As we said in the beginning, we will need labor metrics in the services sector rollover before we can see a meaningful change.

The key takeaways:

• Unemployment at 3.7% is not commensurate with the 2% inflation target. We need to see unemployment levels of at least 5% to reach the inflation target.

• We need wage growth to decline to the long-run average of 2.5% to 2.6%.

• To achieve this, we would need profit margins to decline. According to Bridgewater, profits margins need to decline about 20% to produce wage growth below nominal GDP growth to achieve these targets.

Fed Chair Powell was right, we still have some ways to go.