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You Can’t Outrun A Bear (Market), But You Can Be Prepared To Lie Flat

“The Great Resignation.” “The Big Quit.” “Antiwork.” “Tang Ping.” Whatever one wants to call it, there is no doubt that we are witnessing a labor market phenomenon today. Starting in early 2021, large numbers of workers have been quitting their jobs at a historic pace. From April to September, more than 24 million Americans voluntarily left the workforce. And this is not just happening here in the United States. Around the same time, China also experienced a well-publicized backlash to a culture of long hours and hard work. We expect it is only a matter of time before we see similar reports from across the globe, complete with a plethora of new terms for this labor market.

However, whatever one thinks of the branding, the circumstances it aims to describe are incontrovertible: the labor supply is strained. Generally, labor markets have a cyclicality to them, which roughly correlates with the economy and who holds more sway in the power dynamic between employers and employees at a given point in time. For example, when the economy is strong and employers need to hire to keep up, workers tend to get multiple job offers, leading to a bidding war for their services. Meanwhile, when the economy is struggling, employers tend to lay off employees, resulting in a disadvantageous ratio of multiple job seekers for a given available job.

It does seem to appear that the labor power dynamic has recently shifted in favor of the workers. The rate at which Americans have been quitting their jobs over the last 20 years can be seen in Figure 1. The spike in the last year is unmistakable. Even when compared to the exuberant job markets just before the 2008 financial crisis and the COVID-19 pandemic, workers are voluntarily leaving their jobs at much higher rates. The most obvious takeaways from this observation will not come as a surprise to our readers. After all, much has already been written about the prevailing theory on what is causing people to quit their jobs in such large numbers.

 

Figure 1

Figure 1: 20-year history of the monthly US Quits Rate, which tracks voluntary job separations initiated by employees in the United States per month as a percentage of total employment. (Source: Bloomberg Finance LP, US Bureau of Labor Statistics)

 

First, it should be noted that approximately 40% of the resignations in the workforce are in hospitality, leisure, healthcare and industrial/manufacturing jobs, where workers have long complained about pay, benefits, hours and general working conditions dating back to before the pandemic even began. It would seem that people who once felt they had to put up with these conditions are finally saying they have had enough. In part, a reorienting of priorities took place as the global community faced a threat which cut across social, political and financial boundaries – “family first” and “gratitude for what we have” became steadier mantras for many.

But it probably didn’t help that the period immediately following the initial shutdown in 2020 resulted in a widening gap between haves and have-nots. Some people benefited from the opportunity to work from home; had savings which increased substantially in the Fed-fueled financial markets; and could afford to supplement their children’s education during school closures. Many others, on the other hand, put themselves at risk daily to earn meager paychecks or had to choose between being able to pay rent and having to care for and/or become de facto substitute teachers to their children. That this divide continued to grow in “bad times,” building on a decade-old debate about excessive executive compensation that started during “good times,” laid bare the systemic disadvantage some members of our society face.

As with every major labor relations issue in recorded history, there comes a breaking point, and this just might be that for the current times. For a long time, corporate executives have been focused on short-term profitability, leading them to take their workforce for granted. But assuming employees are satisfied simply because they are showing up to work is inviting the workforce to call their bluff and not show up. And that seems to be what workers are doing today. In response, corporate managers are slowly coming to grips with the need to improve pay, benefits and working conditions to attract the people they need to operate their businesses, as Treehouse Foods openly recognized in the earnings call we quoted earlier in this letter. Once again, this is an extension of the pre-pandemic pressure they faced to rationalize the astronomical compensation increases paid to top executives, while rank-and-file employees saw few gains at all. We discussed the potential impact to corporate earnings of this trend in the previous section of this letter, but here, we will highlight a view of the same data from a different angle.

One alternative explanation of the recent quits rate is tied to the topic du jour: inflation. The economy closed 2021 with historic levels of inflation. While it is true that supply chain issues increased the cost of goods across most industries, we should not lose sight of two observations. First, part of the supply chain disruption came because of a shortage of workers to transport goods. That is, this very phenomenon contributed to a key driver of recent inflation measures. However, the supply side of the economic equation is not all to blame. There is a general consensus among many analysts that inflation has also been fueled by increased consumer spending. Some, including we at Zeo, argue that there is pent-up discretionary spending demand due to the pandemic-induced shutdowns in 2020, either because decisions were delayed or because consumers have discovered money burning a hole in their pockets. (Incidentally, this is also part of the explanation for the early-2021 Reddit- and Robinhood-fueled boom in retail market behavior.) As we noted before1, labor cost increases in recent months have been real and significant as well, throwing more fuel on this inflation fire, though not as early in the inflation story as many analysts argued.

Unfortunately, the inflation numbers themselves obscure the metrics most commonly used to evaluate consumer spending, the personal consumption spending index, which aims to capture the value of goods and services purchased by consumers. With inflation rampant, the value of those goods and services increases proportionally with or without demand changes. As a result, it is difficult to glean insight into the potential increase in actual spending decisions being made. Or is it?

While it is true that consumers may spend more, it is also true that there is more flexibility when it comes to discretionary spending. If consumers were being “forced” to spend too much overall, we would likely see them pull back in some optional areas. Empirically, this doesn’t seem to be happening, and one data point worth watching to get a sense of this is the Federal Reserve’s consumer credit measure. Figure 2 shows the year-over-year change in consumer credit across the economy over the last 40 years. The Fed is seeing a clear increase in consumer credit to record growth numbers right now. While some of this could be from consumers who are taking on debt to cover their day-to-day living expenses, corporate earnings among companies who benefit from discretionary spending are telling a different story. Put simply, we believe what we are seeing is, at least in part, an intentional spending spree by the US consumer.

 

Figure 2

Figure 2: 40-year history of total seasonally-adjusted net monthly change in the Federal Reserve Consumer Credit (also called Household Credit). This measure tracks the outstanding amount of credit (or loans) used by consumers to finance purchases of goods or services. It can include everything from credit card lending to auto loans, to lines of credit, but it excludes mortgage loans. (Source: Bloomberg Finance LP, Federal Reserve)

 

This is where the labor market quits rate has the potential to foretell two different scenarios:

One is the tale of a consumer who misinterpreted a temporarily strong bank account as a windfall, providing the confidence needed to tell her boss to “take this job and shove it.” In this story, our protagonist (the consumer, not the employer) realizes later that she has burned through her short-term funding from the reduced spending in the pandemic and with a little assistance from the US government. The power she held to make demands of her employer may give way to a more conciliatory tone as she finds herself in more urgent need of a job. If this were to be how this economy plays out, employers may once again regain the power to keep costs in check, but consumer spending and credit would almost certainly take a dive. The risk of a stagflationary environment, in which inflation remains an issue for structural reasons but the economy begins to stagnate, becomes real. Stories of Japan from the 1980s may once again start circulating around Wall Street, as they have every few years for the last two decades.

The second scenario is that the data we are discussing is a sign of a systemic change in the labor market, one that does not just predate the pandemic but predates most current Wall Street careers. Figure 3 shows the US labor force participation rate since 1947. It is hard not to notice that an increase in labor force participation coincided with the coming of age among the baby boomer generation. It is also interesting to note that, among the people quitting their job in frustration are people choosing to use the pandemic as a catalyst for retirement. As it turns out, the current labor force participation is only now returning to levels the economy last saw in the 1970s – around the time the boomers entered the workforce.

 

Figure 3

Figure 3: The US Labor Force Participation Rate tracks the total labor force as a percentage of the working age position in the United States. (Source: Bloomberg Finance LP, US Bureau of Labor Statistics)

 

Put another way, it is entirely possible that employers would be mistaken to wait for their former employees to get desperate and come back hat in hand asking for their old jobs back. We may be witnessing a structural reset of the labor market to participation rates which represent a more sustainable level given the aging baby boomer population. If this is indeed the case, employers will need to chase every possible worker, invest heavily in productivity and innovation and do whatever else will be needed to maintain their ability to operate their businesses and deliver on the ever-increasing and potentially unrealistic expectations of their stakeholders. It may be too late to just pay more. If this is the case, this impact won’t be a one-time blip as in years past but a potential long-term paradigm change to which Wall Street and Main Street will need to adjust.

That said, we don’t believe it is wise or necessary to try to predict which of these two scenarios will come to pass, and it’s possible that neither will. There are countless potential outcomes which can be imagined from the data. But this is the key to a resilient fundamental portfolio. By planning for many plausible scenarios and assembling issuers who have risk profiles which can withstand or thrive in them, one is not just preparing for the known potential outcomes. Broad and continual scenario analysis also leads to portfolio characteristics which tend to be generally resilient. In this way, one can build confidence in the portfolio’s ability to perform as expected even in scenarios that have not been contemplated. This stands in contrast to the more common strategy of aiming to identify the right scenario and positioning to profit if it happens. This approach is high risk/high reward, but it does save the manager a lot of work and analysis. And it may work for a time, especially in FOMO-driven markets like today, with pundits competing to see who can come up with the cleverest term to describe what they are predicting. Until it doesn’t.

If only the markets put as much time and energy into understanding and preparing for the consequences of these labor market circumstances as they put into branding them. Personally, we are partial to “Lying Flat.” After all, that is how one can avoid getting mauled by a bear… or a bear market for that matter.

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Our investment approach is designed to identify resilient companies, with strong fundamentals regardless of what happens in the markets and the economy. We are not trying to be on the right side of directional moves, outlooks or predictions of what will happen in the future. To do so runs counter to the risk management philosophy that underpins our investment process. We believe the factors that impact creditworthiness should persist across scenarios, both known and unknown. It has been our experience that a focus on resiliency characteristics – cash flows, liquidity, responsible corporate behavior and disciplined financial strategy – can differentiate the companies who will thrive in the coming uncertainty around interest rates, inflation, labor costs and politics which make the next few years among the least predictable in the last several decades for the markets.

*****

By Venk Reddy
Originally published in Q4 2021 letter

Important Disclosure Information

Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.

For more information contact Zeo directly at 415-875-5604 or visit www.zeo.com.

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