How Should Investors Weigh the Strong Labor Market?

If investors were once mostly worried about inflation, their main concern now appears to be recession. With growth stocks appreciating at more than twice the rate of value equities, investors seem to be anticipating a broad, traditional economic slowdown that would bring higher unemployment but stable corporate earnings.

With a host of headwinds—higher interest rates, tightening global financial conditions, war in Europe and a stalled recovery in China—slower economic growth is likely. But our base-case forecast is for an economic soft landing that comes with a “profits recession,” or negative year-over-year change in corporate earnings growth.

At the heart of this view is the health of the U.S. labor market. If it can stay resilient for longer, it would sustain wages and personal incomes, and thus consumption, while pressuring company margins and, thus, equity prices. We see at least three factors helping the labor market stay robust:

• Its current strength and tightness: We just saw a better-than-expected job report for July, with employers adding 528,000 jobs in the month. And certain data, such as the number of job openings per applicant, quit rates and wage differentials between job switchers vs. stayers, suggest the market is the tightest it’s been in decades. This is supported by the highest-ever reading on the Atlanta Fed’s wage tracker, which indicates a 7.2% annual growth rate.

• Structural changes: Our analysis suggests that the pandemic has imposed structural shocks to labor supply that will be slow to subside. While the total U.S. workforce is poised to return to its February 2020 peak of 164.6 million workers, it remains about 6 million to 7 million smaller than it should be relative to long-run growth trends. Factors such as high rates of retirement during the height of the pandemic, as well as COVID-related deaths and disabilities, likely account for a significant part of the shortfall, not to mention loss of immigrants and other labor-force detachments driven by gig work and entrepreneurship.
  

• Room for demand to fall: A labor market gauge known as the Beveridge Curve suggests that the supply of workers is constrained, as a soaring number of job openings, relative to the unemployment rate, is failing to attract re-entry into the job market. This means we could conceivably have a reduction in job vacancies but still see only a modest increase in unemployment—a dynamic that could support further wage growth and consumption.

Admittedly, some recent data have been mixed, and some indications—such as higher unemployment claims and a dip in job openings in June—may suggest a marginal weakening in the jobs market. Nonetheless, we are hyper-focused on the labor market in determining our investment direction. When it comes to growth vs. value, we are neutral and await further clarity on the labor market before shifting that position.

In the meantime, investors should watch the labor market carefully and avoid the temptation to chase opportunities that are too deeply rooted in certain economic or policy outcomes. Our best advice right now: Stay patient, and use cash only opportunistically.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from August 8, 2022, “Labor Market Holds the Key.” Ask your Morgan Stanley Financial Advisor for a copy. Listen tothe audiocastbased on this report.