What Was So Bad About the Employment Report?

You may have heard the encouraging news last Friday that the unemployment rate fell to an 8-year low of 4.7% in the month of May.  Or maybe you heard the discouraging news that only 38,000 jobs were created in May – the lowest monthly tally since late 2010.  Upon first glance, these two reports would seem quite contradictory as to the health of the labor market.  So let me see if I can clear up the ambiguity.

Without getting into the minutia, I should first point out that the two pieces of economic data are derived from two different monthly surveys.  The Household survey, as its name suggests, is a survey of a sample of US households.  The monthly unemployment rate is produced from this survey.  The Establishment survey, on the other hand, is a survey of a sample of private and government employers.  The monthly non-farm payrolls figure, which is a measure of how many jobs were added or lost across the economy, is produced from this survey.  So, why did the results of one survey appear so positive while the other seemed so dismal?

The answer is that over the past couple of months, people left the labor force in droves.  Following a six-month stint during which the civilian labor force grew by over 2.4 million people, over 800,000 people left the labor force in the months of April and May.  This abrupt reversal is difficult to explain given the backdrop.  If jobs are plentiful, wages are rising, and the supply of available workers is dwindling – all indicators of a tight labor market – then people should be incentivized to enter the labor force and take advantage of the available opportunities.  This happened from October, 2015 to March, 2016, but it suddenly ended in April.  And people were exiting the labor force despite two notable trends: 1) steadily-rising growth in average hourly earnings to over 6-year highs in recent months; and 2) job openings at their highs since the BLS started providing this metric in 2000.  The labor market is clearly getting tighter, but people don’t seem to care – at least for the past two months.

6-8 1

Source: Bureau of Labor Statistics.

Now, to explain the drop in the unemployment rate, let me first provide some definitions taken directly from the Bureau of Labor Statistics web site.

  • People with jobs are employed.
  • People who are jobless, looking for a job, and available for work are unemployed.
  • The labor force is made up of the employed and the unemployed.
  • People who are neither employed nor unemployed are not in the labor force.

It is a counterintuitive notion, but the unemployment rate can actually improve (i.e., decrease) even as the labor market is deteriorating.  Why?  Because as active job seekers give up searching and leave the labor force (as defined above), this results in a decrease in both the numerator and the denominator of the unemployment rate.  By way of example, let’s assume we live in a country with an unemployment rate of 5.0% consisting of 95 million people who are “employed” and 5 million people who are “unemployed”.  Now, assume that job prospects deteriorate, causing 500,000 of those “unemployed” people to get frustrated and give up their job search, thereby leaving the labor force.  The numerator of the unemployment rate, which is the “unemployed”, would fall to by 500,000 to 4.5 million.  The denominator, which is the “labor force”,  also falls by 500,000 to 99.5 million.  The new unemployment rate becomes 4.5%, or 4.5 million divided by 99.5 million.  Under this scenario, the labor market clearly deteriorated, which is why unemployed workers became frustrated and ceased their job searches.  Nevertheless, the unemployment rate fell by 0.5%.

6-8 2Source: Bureau of Labor Statistics.

Now that we know that the drop in the unemployment rate from 5.0% in April to 4.7% in May was the result of people leaving the labor force, we can now see how the drop was consistent with the discouraging +38K addition to non-farm payrolls.  In addition, it becomes much easier to explain the market reaction to the data.  Since the end of the day last Thursday (the last day prior to Friday’s employment report), the S&P 500 is up (albeit modestly), the yield on the 10-year Treasury bond is down from 1.80% to 1.70%, and the dollar index has fallen by 2.1%.  The value of the dollar, which has fluctuated in recent years based largely on the prospect of Fed interest-rate hikes, has an inverse relationship with most commodity prices.  Therefore, most asset prices, including stocks, bonds and commodities, have had a positive reaction to last Friday’s woeful employment data.  That’s right folks.  Bad news is still good news and good news still ain’t so great.  The simple reality is that investors continue to covet low interest rates over all else, including an improving economy.

6-8 3Source: Bureau of Labor Statistics.

What are the investment implications of the sudden downturn in the labor-market data?  Unfortunately, not a whole lot.  Employment data is widely viewed as a “lagging indicator”, which means that the weakness in the data over the past couple of months simply confirms the economic growth deceleration we saw in the first quarter.  However, the continued slide in the labor participation rate is clearly not a harbinger of an imminent breakout from the 2.0-2.5% economic growth since the Great Recession. Whether prospective workers are leaving the labor force due to demographic trends (retiring baby boomers) or out of frustration, fewer people working or looking for work is never a good thing for an economy so dependent on consumer spending.  For now, probably best to tread carefully in industry sectors relying on this source of revenue.