The COVID-19 pandemic of 2020 is now starting to fade from memory. Four years after the sudden outbreak of the disease sparked mass economic shutdowns, mask wearing, and millions of deaths, it’s tempting to think the crisis is becoming just another episode of history. However, the pandemic clearly led to changes in the global economy. For example, it helped usher in an era in which governments and companies worry a lot about potential supply chain disruptions.[1]
In this report, we discuss how the pandemic changed the United States labor supply. We focus on two key developments during the pandemic: 1) the mass excess retirements and deaths of baby boomers,[2] and 2) the generous income support programs implemented by the federal government. Considering these developments as a package, we show how they essentially amount to a labor market reform — perhaps the most significant US labor market reform in decades. We then examine how these labor market changes could help spur outsized US economic growth in the coming years, albeit with additional upward pressure on consumer price inflation and interest rates. We wrap up by examining the implications for investors.
[1] This would not be the first time a pandemic affected the labor markets. The “Black Death” in the 1300s killed so many workers that the lucky survivors saw a jump in real wages. After the Spanish Flu epidemic of 1918, something similar occurred.
[2] The baby boomer generation is conventionally considered to be all those born from 1946 to 1964.
There will be no accompanying podcast for this report.
Throughout history, immigration has been a politically charged issue, creating a rift between capital and labor. Employers have advocated for looser immigration policies to fill job vacancies, particularly for positions that don’t offer high pay. Conversely, labor unions often push for stricter policies to prevent an influx of workers that could suppress wages. This long-standing divide presents a complex challenge for policymakers seeking a middle ground that satisfies both sides.
The recent surge in immigration has reignited tensions between populists and technocrats. While populists often worry about immigration’s impact on national security, technocrats highlight its potential economic benefits. Research by the nonpartisan Congressional Budget Office estimates that immigrants could contribute $7 trillion to the economy over the next decade. At the same time, there is hope that immigration could help the Federal Reserve achieve its dual mandate of price stability and full employment. According to Fed Chair Powell, the influx of new workers has allowed the country to add new jobs without triggering significant wage pressures.
Nevertheless, there is a growing push for stricter immigration policies, even as additional workers are needed for the economy. A Harris Poll survey indicates that more than half of Americans favor tighter controls on illegal immigration. Interestingly, 42% of Democrats — a demographic typically associated with looser immigration restrictions — endorse such measures. This shift in public opinion briefly spurred bipartisan support for the most restrictive immigration bill in recent history. However, the legislation ultimately crumbled as politicians pushed for even stricter measures.
Despite public opposition, rising immigration has demonstrably helped the Fed limit price inflation while keeping employment high. Over the past four years, the influx of foreign workers has helped firms keep a lid on wage rates, thereby reducing cost-push inflation. The hiring of non-natives has also expanded the labor supply without boosting the unemployment rate. For example, the recent surge of foreign workers into the labor force coincided with a fall in the non-seasonally adjusted unemployment rate, from 4.2% in February to 3.9% in March.
Going forward, the rising pushback against immigration may complicate the Fed’s efforts to do its job. Since one of the Fed’s preferred inflation gauges, the Core PCE index for services, is closely linked to wages, a decrease in wage growth is likely necessary in order for the Fed to achieve its inflation target in a reasonable time frame. However, strict measures to limit foreign workers could support wage growth and constrain the Fed’s ability to cut interest rates. A tighter labor market due to fewer foreign workers could put upward pressure on wages, making it harder to control inflation.
Although immigration has helped temper inflation recently, political resistance makes it an unreliable long-term solution for the Fed. Absent significant productivity gains, a more limited labor force could exacerbate inflationary pressures, which could then necessitate restrictive monetary policy to keep price pressures contained. This could lead to a period of underperformance for long-term Treasurys as investors seek higher returns to offset inflation. Of course, the labor market has historically adjusted slowly to immigration changes, so the disinflationary effects of today’s immigration will probably continue for the foreseeable future. Nevertheless, a crackdown on immigration would likely contribute to a less positive environment for bonds in the longer term.
Conflict in the Middle East is one of the most persistent themes in current events. Not only is this true today, but Middle Eastern discord has dominated the news flow throughout most of our lives. At Confluence, we recognize that this enduring pattern of strife reveals the presence of many major fault lines that run through Middle Eastern society, politics, economics, and relations with the rest of the world.
A fault line is defined as a “divisive issue or difference of opinion that is likely to have serious consequences.” A major fault line is one in which the competing forces have both deeply embedded positions and the resources to support those positions. Many issues of this type characterize those in the Middle East, which explains why conflict in the region is so common despite repeated attempts at resolution. Investors must be prepared for this trend to endure for the foreseeable future, which will continue to meaningfully impact global affairs.
This report briefly reviews the main fault lines that define the Middle East from a geopolitical standpoint. This is not a complete list, but rather it is a selection of those we consider most enduring and impactful. Confluence does not take positions on these issues, but we will summarize and show how they produce complexity. We arrange these prominent fault lines in three layers: the ancient fault lines, the more modern ones, and the present-day issues that are currently causing “geopolitical earthquakes.” While these earthquakes do raise the risk of escalation into a broader regional war, we remind readers that the region has often witnessed this increased level of risk before without necessarily leading to further escalation. Rather than trying to predict the outcome, we recommend that investors pay attention to key implications, which we will highlight at the end of the report.
Danish Prime Minister Mette Frederiksen recently castigated the European governments that slashed their defense spending at the end of the Cold War and then remained far too complacent about the growing threat from Russia in recent years. According to Frederiksen, hiking their defense budgets as is now necessary will require countries to reverse the tax cuts and welfare spending hikes they have been funding with their post-Cold War defense reductions. The United States may be in the same position since it also spent its post-Cold War “peace dividend” on civilian programs. This report looks at these fiscal dynamics and what future fiscal and monetary policy might really look like.
As our regular readers know, we at Confluence believe the intensifying rivalry between the US geopolitical bloc and the China/Russia bloc will lead to bigger future defense budgets in many countries. Western nations that cut their defense spending dramatically after the Cold War and spent the resulting peace dividend on civilian programs will soon be under great pressure to reverse course. We have also argued that growing geopolitical tensions will likely lead to stronger government intervention in Western economies. Frederiksen is one of the first Western leaders to state the trade-offs so clearly: Hiking defense budgets as required now may well require tax hikes and/or civilian spending cuts.
To scope out the prospects, we compared today’s US federal budget to the budgets of the late years of the Cold War. In the chart below, we show the Office of Management and Budget’s estimated fiscal year 2023 federal receipts and outlays as a share of gross domestic product and compare them to their average shares from 1985 to 1989. The chart shows the US has cut its defense spending by about 2.7% of GDP since the late Cold War. However, it also boosted its outlays on Medicare, Medicaid, other healthcare, and Social Security retirement benefits by a total of 5.1% of GDP. (In large part, those spending hikes probably reflect the aging of the US population and rampant healthcare price inflation.) The excess of new spending over the peace dividend is mostly explained by a small rise in tax receipts and a major expansion in the budget deficit.
Comparable data for European countries is hard to come by, likely because of relatively bigger economic, financial, and political changes after the Cold War. Nevertheless, a review of government outlays in the United Kingdom suggests European countries spent their peace dividend in roughly the same way that the US did. As shown in the chart below, the UK cut its defense spending by 1.9% of GDP and then hiked healthcare, social security, and other civilian spending by a total of about 8.1% of GDP. It would not be a surprise if other Western nations shifted their budget spending in similar ways.
This reorientation of the West’s public spending will have enormous political and financial implications in the coming years. Of course, much of the increased social security and healthcare spending has benefited politically powerful senior citizens. We think those seniors would thwart any substantial cuts to that spending to fund higher defense budgets. For example, if US leaders now wanted to boost the defense budget back to the late-Cold War average of 5.8% of GDP from today’s 3.1% of GDP, not much of the required $708 billion in new military spending would likely come from cuts to Social Security, Medicare, and Medicaid outlays. Other civilian outlays today are not much higher (as a share of GDP) than they were in President Reagan’s second term. Therefore, even if those programs were cut to their share of GDP in 1985-1989, the savings would cover less than half of the targeted boost in defense spending. The shortfall could theoretically be made up with new revenues, but we think today’s strong political opposition to taxes means the required tax hike of about $400 billion would be a nonstarter in Congress.
If political realities mean defense rebuilding can’t be fully funded by cutting civilian spending or hiking taxes, what will Western governments do? We think the likely answer would be even bigger budget deficits coupled with financial repression. In other words, Western governments would likely fund higher defense spending largely by borrowing. To limit the resulting interest costs, agencies such as the US Treasury and central banks such as the Federal Reserve would probably adopt policies to keep bond yields artificially low, such as by forcing banks to buy and hold more Treasury bonds. The central banks could also adopt yield curve control, in which a central bank, such as the Fed, caps long-term yields by buying up Treasurys. While this may seem implausible to many investors, it’s important to remember that there is a precedent for this policy. Indeed, financial repression was used in the decades right after World War II to help the US government weather the debt overhang left after the war ended. The implication for bond investors is that the yields on their future government bonds may not keep up with consumer price inflation, and their purchasing power may slowly erode over time.
Note: there will not be an accompanying podcast for this report.
Our forecast does not include a recession during the three-year period.
The US economy is expected to be relatively strong throughout the forecast period.
We expect heightened geopolitical tensions to persist as the deglobalization trend continues.
Inflation is likely to remain higher due to structural forces such as tight labor market conditions and shortened supply chains caused by deglobalization.
Monetary policy is expected to remain tighter for longer given elevated inflation and low unemployment rates. While hikes are unlikely, monetary easing may be pushed out further and the terminal rate will likely be higher than observed in previous easing cycles.
Our fixed income focus is on the intermediate segment in expectation of a positively sloped yield curve, albeit one that is relatively flat compared to recent cycles.
Our sector and industry outlook favor a Value bias as well as quality factors.
International developed equities present an attractive risk/return opportunity.
Gold and silver exposures were maintained.
ECONOMIC VIEWPOINTS
The US presidential election season is starting to take over the airwaves and usually brings concern over the general direction of politics and the economy. Given that this important part of the democratic process involves intense emotions among voters, one might expect the election’s outcome to significantly influence market sentiment and performance. Yet, historical data contradicts this statement. Instead, markets have typically shown a tendency to remain flat in the first half of the election year and rally in the months just before the election. Importantly, markets are good at discounting expected outcomes, but they do not handle uncertainty and rapid change well. Congress is expected to remain divided with slim margins, thus major changes in overall legislative action is unlikely.
We will focus more on the election in the coming quarters, but for now, we continue to closely watch inflation, labor markets, and fundamental valuations of each asset class. Inflation remains front of mind as the Federal Reserve’s communication moves from “transitory” to “speed bump” inflation. As we’ve written before, we see structural forces positioned to keep inflation higher than pre-pandemic levels. Factors contributing to higher inflation include supply chain rearrangement with reshoring and friend-shoring of industrial capacity, elevated geopolitical tensions, and developed world aging demographics.
Labor markets have remained surprisingly strong with the unemployment rate currently at 3.8%. While wage growth rate has slowed, the most recent median wage level grew 4.7% year-over-year. Technological advancements, most notably AI, could change labor’s significance, but we believe there will be minimal impact during our forecast period. On the other hand, the aging workforce and uncertainty of immigration numbers will have more impact on whether the labor markets remain tight.
Inflation, labor markets, and economic growth are important indicators in their own right, but their combined effect is amplified by the monetary policy response. As higher-than-expected inflation and the strong labor market continues, our expectation is for the fed funds rate to stay higher for longer. While our forecast does not include policy tightening, we believe that the easing timeline and magnitude have been delayed. We don’t expect the FOMC to lower rates to the levels seen in recent easing cycles. We also expect the Fed to hold policy steady through the election cycle.
STOCK MARKET OUTLOOK
We anticipate a compelling economic backdrop over the forecast period. In turn, this will be supportive for risk assets. Our expectation is for the domestic market rally to broaden across market capitalizations. The large cap rally is already widening beyond the Magnificent 7, whose stocks are off their recent highs. We are not forecasting a breakdown in the largest stocks, but rather a measured and sustainable broadening of valuations that more accurately reflect business fundamentals. This glide-path should be supported by the high levels of cash currently held on the sidelines.
We continue to favor a Value style bias across all market capitalizations. Value equities still offer appealing fundamental valuations compared to historical averages, stable earnings growth, and less exposure to sectors we consider overvalued. Independent of whether an ETF is categorized as Value or Growth, our analysis focuses on the ETF’s underlying holdings to determine which ETF we anticipate will perform in line with our forecast. Within large caps, we maintain an overweight position in Energy due to geopolitical tensions in the Middle East and sustainable energy transition policies, thereby creating an opportunity within the sector. Additionally, we maintain our factor exposure to the military-industrial complex through two positions in military hardware and cyber defense. The deglobalization seismic shift continues to fuel additional conflicts that had been controlled through soft power over the past few decades of global economic growth and collaboration.
We still view valuations of small and mid-cap stocks as attractive, coupled with respectable earnings power. However, the recent mid-cap price appreciation has led us to dampen our prior overweight to the asset class. Separately, with our expectation for monetary policy to remain tighter for longer, small cap equities might face steeper financing conditions, introducing further volatility in the asset class that we do not view as appropriate for the more conservatively oriented portfolios. For the more risk-accepting portfolios, to mitigate this risk, we maintain our quality factor exposures within the mid-cap and small cap allocations, which screen for indicators such as profitability, leverage, and cash flow.
We maintain our allocation to Uranium Miners, bolstered by ongoing global initiatives to develop and utilize nuclear energy. The evolving landscape of baseload energy production, coupled with policy shifts, have highlighted nuclear energy as a key player in the energy transition. Ambitious green energy policies are driving substantial goals for reducing fossil fuel usage, yet the current green energy technologies face challenges in generating energy at the required scale and consistency. Furthermore, a persistent supply constraint of uranium over the last decade underscores a compelling supply/demand imbalance. This scenario presents a significant opportunity for strategic exposure to the uranium sector, aligning with our long-term investment outlook.
International developed equities remain constructive given relative valuations. Most equities in the developed world ETF are large global market leaders that possess competitive advantages, yet these companies are trading at valuation discounts to domestic large cap companies. Given the attractive valuations and high dividend yields, we have added international developed in the lower-risk portfolios. We maintain a country-specific exposure to Japan as shareholder-friendly reforms continue to take effect and as capital flows continue moving into Japan, which could potentially lead to multiple expansion.
BOND MARKET OUTLOOK
We anticipate that the path to a positively sloped, though relatively flat, Treasury curve by the end of the forecast period may be uneven given our expectations of heightened inflation volatility. In the near term, with inflation above the Fed’s preferred 2% level, tight labor markets, a data-dependent Fed, upcoming domestic elections, and the US Treasury’s need for heavy issuance of debt, we concur with the market’s assessment that the Fed will be content to leave its fed funds rate higher for longer. These influences alone portend a volatile period for bonds, especially among longer maturities.
As with last quarter, an inverted yield curve leads us to emphasize the intermediate segment of the curve due to its modest rate stability and resultant limited market risk and opportunity costs.
(Source: Federal Reserve Economic Data)
Among sectors, we find advantages in mortgage-backed securities (MBS), particularly highly seasoned pools with lower coupons, relative to Treasurys. Extension risk is more limited in these pools and recent spreads are attractive from a historical perspective. By contrast, investment-grade corporates are currently trading at historically tight spreads of less than 100 bps to Treasurys, approaching the record from 1998. Accordingly, we employ corporate bonds more liberally in the short-term segment and maintain our overweight to MBS in the intermediate-term bond sleeve of the strategies.
Looking at speculative-grade bonds, while spreads have tightened post-COVID, they remain above historically tight levels and still offer attractive yields. Although caution is appropriate in the broader speculative bond segment, we find continued advantage in the higher-rated BB segment given that credit fundamentals remain relatively healthy and the vast majority of bonds in this segment are trading at discounts to par.
OTHER MARKETS
Among commodities, we retain the position in gold as both a hedge against elevated geopolitical risks and an opportunity given increased price-insensitive purchasing by international central banks. In the current deglobalization environment, international central banks are seeking to buy gold as a reserve asset in fear of the weaponization of the dollar. Silver is maintained in the more risk-tolerant portfolios for its low price relative to gold. Real estate remains absent in all strategies as demand is still in flux and REITs continue to face a difficult financing environment.
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
The Confluence Diffusion Index receded from the previous month, in a sign that the economy is still fragile. The March report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index slipped from -0.0909 to -0.1515, slightly below the recovery signal of -0.1000.
Investors’ dimming hopes for a June rate cut have caused a mild tightening of financial conditions.
Sinking housing starts signal a potential slowdown in construction activity.
Payroll data appears positive, but pockets of weakness remain in the job market.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.
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