Even before the pandemic, our macro forecasts had been signaling that a structural shift in the U.S. employment market was taking place. Indeed, despite significant progress in key areas such as automation and digitalization, the United States still remains short qualified workers to satisfy its growth demands. Now, under the cloud of COVID, a perfect storm has been brewing: Lack of worker retraining, weakening immigration trends, early retirement, and shifting priorities based on health and well-being, have all come together to accelerate this worker shortage, changing the narrative on not only the recovery but also the resting rate of inflation this cycle. For global allocators of capital, we believe we have entered a new investment regime. Specifically, we think that most allocators of capital will need not only to shorten the duration of traditional fixed income portfolios but also to lean into more products that provide inflation protection, including Real Estate and Infrastructure. We also think that CIOs should be adding more opportunistic strategies (both liquid and illiquid) to their portfolios. Across all asset classes, a greater focus on productivity, and perhaps even more importantly, pricing power, will be required to succeed in the new, more employee-driven environment that we envision, particularly in the United States.
While my international travel schedule has slowed dramatically since the fall, I actually have been able to make quite a few trips up and down the East Coast of late, including stops in Delaware, Virginia, South Carolina, and the District of Columbia. I highly value the time I spend outside of Gotham, as it allows me to better understand through person-to-person interactions the direct impact that COVID is having on both the economy and society at large. Without question, what is increasingly clear from my day-to day encounters with small business owners as well as in talking to CEOs across multiple industries where KKR does business – including healthcare, technology, and leisure – is that there appears to be a structural labor shortage, leading to an increased difficulty in hiring.
This phenomenon, though, is not just an East Coast one. Rather, like Omicron, it is widespread across the United States. Indeed, we do not view the current labor shortage as an aberration. Rather, we believe that ongoing tightness in the labor market will lead to higher wages across multiple industries on a sustained basis. If we are right, then we believe that not only will corporate margins be adversely impacted but also inflation could settle at a higher resting ‘heart rate’ in the United States, particularly relative to past cyclesֿ.
- The U.S. labor market is now nearly the tightest it has been in 50 years. There are four key areas on which to focus to help explain the post-pandemic employment shortfall:
- Retirements: 1.4 million of excess retirements as a result of the pandemic. Most of these 55+ age workers are likely not to seek re-employment
- Family Responsibilities: 0.7 million labor force dropouts due to child and elder care responsibilities. Skill erosion or lifestyle changes could deter a full return to the workforce
- Discouraged Workers: 0.5 million increase in the shadow labor force, after netting out a 0.7 million drop in school enrollments. Strong demand should lead most to eventually return to the workforce
- Immigration Decline: 900,000 ‘missing’ immigrants due to the pandemic, of which we think only half will eventually be recouped as surplus immigration relative to longer term trends
Investment Conclusion: Alongside higher rent inflation and stronger commodity prices, we believe upward wage pressure supports our view of a higher resting heart rate for inflation this cycle
Key to our thinking, which we describe below in more detail, are the following points:
- Our research suggests that the U.S. labor market is the tightest it has been in many decades. The aging population and antiquated immigration system were already putting substantial pressure on labor availability before the pandemic. Importantly, though, COVID-19 shook previously dormant fault lines in the workforce via a sudden wave of retirements and a pause in immigration flows. In addition, the pandemic created new challenges around family care and the integration of discouraged workers back into the labor pool. As such, we believe that 2.1 million of the 3.9 million current labor shortfall in the United States may be more permanent in nature.
- The workforce participation rate, which over the last three months has averaged 62.0% versus 63.4% pre-pandemic (down 1.4 percentage points), is unlikely to increase, we believe, as much as the Fed and employers hope. We do see room for some further cyclical improvement, which began to play out in the January jobs report. However, workers over the age of 55, Black Americans, and workers without college degrees all represent important categories where the participation rate continues to lag badly.
- Digging into the wage trends we track, low-wage workers are now seeing the fastest increases in wages. We are also seeing workers incentivized to change jobs frequently, as they often command hefty pay increases when they do. This likely means worker retention is going to get harder, not easier. All told, the current quit rate suggests a ‘true’ unemployment rate closer to 1.0-2.0%, not the reported level of 4.0%.
- Despite the historic tightness of the labor market, because of inflation U.S. workers actually did not receive a real wage increase in 2021. However, we do think that they will get one in coming years, following what largely has been two decades of wage stagnation. Despite surging employee pay in 2021, real incomes actually fell – on average – 50 basis points in aggregate last year, dragged down by energy, shelter, autos, and food, among other factors.
- In hindsight, the decision to lay-off employees in the U.S. so abruptly early in the pandemic may have been a mistake relative to other parts of the world. Our work shows that the European approach of furloughing employees (cutting hours worked instead) has – thus far – yielded much better results than in the U.S. Also, we must all be cognizant that the global labor arbitrage has evaporated. U.S. manufacturing wages are now less than four times as expensive as those in China today, compared to more than 26x when China joined the WTO in 2001.
Bottom line: These employment trends represent the cornerstone of our thesis about a higher resting heart rate for inflation. In fact, our deeper dive on the structural labor market issues has firmed our conviction in the magnitude and persistence of the inflationary impulses.