Labor Market, Productivity Gains Can Fuel Expansion for Some Time

Written by: Brent Schutte Northwestern Mutual

In our Q1 market commentary, “Descending from the ‘Easy Policy’ Mountain Summit,” we forecasted increasing market volatility as investors assessed the Federal Reserve’s reaction to inflationary pressures. Would rising prices lead to a less accommodative Fed in the coming quarters? At the time, we said:

“The same leading indicators of rising economic growth we previously referenced are also pointing nearly unanimously to rising inflationary pressures in the coming months as rapid demand, low inventories and continued supply chain interruptions collide and lead to rising prices.”

In Q2, these projections played out as we predicted; and core measures of inflation — both the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), the Fed’s preferred metric — rose to levels not witnessed since the early 1990s. At the heart of this ongoing debate is whether a spike in inflation will prove transitory or will stick around and force the Fed to act, potentially creating a recessionary environment. Following the Fed’s June meeting, inflation chatter reached a fevered pitch: Fed Chairman Jerome Powell indicated members are “beginning to talk about talking about tapering,” and Fed members, on balance, moved up their forecasted date for the first rate hike from 2024 to 2023 (keep in mind this is a forecast, not a policy).

Equity markets pushed higher in the second quarter, but leadership shifted as investors seemingly positioned for the later innings of an economic cycle. After a strong first quarter for cyclicals, value and small-cap stocks (early cycle beneficiaries), in Q2 investors shifted their equity market preferences toward sectors that typically perform better later in the economic cycle: large-cap stocks and growth. The Nasdaq led markets higher in the quarter, while the 10-year Treasury yield declined from a post-pandemic high of 1.74 percent on March 31 (its high) to 1.46 percent at quarter’s end.

We view inflation as temporary, and importantly, we don’t believe the Fed harbors any desire to tighten this economy into a recession. Instead, the Fed is likely to drag its feet with rate hikes for as long as possible.

We believe the market shift to later-cycle positioning is premature.

While this economic cycle could be a bit shorter than those of recent past, it is too early to begin preparing for the later innings of an economic cycle. We believe that we will continue to see heightened levels of economic growth for much of the next year. Both service-oriented and manufacturing companies continue to report healthy new orders and record order backlogs — all against extremely restrained inventories. This is increasingly becoming a global phenomenon as other parts of the world are reopening, and we forecast they’ll rebound at a similarly vigorous pace. Case in point: The lifting of restrictions in the eurozone has pushed leading economic indicators to a 15-year high, compelling us to upgrade our outlook from neutral to overweight for equity markets in the eurozone as leading indicators translate into tangible growth in the months ahead.

Now, we would be remiss if we left out growing concerns about the coronavirus delta variant, which is spreading quickly in a few regions in the U.S. and around the world. It remains an uncertainty that we have factored into our outlook, but it doesn’t change our overall thesis. Even if the delta variant establishes a deeper foothold in some locations, the overall impact on the economy won’t come anywhere near what we experienced in spring 2020. Back then, so much was still unknown — a vaccine didn’t exist. The remedy for the problem in 2020 was far different than the expansive toolset we have at our disposal today. Still, the virus remains an unpredictable variable that could impact markets in the coming months. The thing is, you can’t trade this kind of biological uncertainty — in fact, you shouldn’t. A flare-up of the coronavirus may push back some of the recovery timeline, but it won’t derail the outlook we’ve pulled together below.


We have long suggested that three conditions typically are met before an economic cycle closes and pushes the economy into a recession:

  • The U.S. economy runs out of slack.
  • An economy without slack triggers inflation.
  • The Federal Reserve fights inflation by raising rates aggressively.

Over the past few months, rising inflation has awakened fears that we are racing into the later innings of an economic cycle. The concern is based on the assumption that we’re pushing toward condition three (an inflation-fighting Fed), but we’d argue we haven’t even reached condition one. We don’t think the U.S. economy is out of slack yet. As a result, we view inflation as temporary, and importantly, we don’t believe the Fed harbors any desire to tighten this economy into a recession. Instead, the Fed is likely to drag its feet with rate hikes for as long as possible.

Now, let’s take a closer look at the three conditions we outlined, and contrast them with current circumstances


The labor market is the most important measure of slack in the economy. Simply put, when you run out of people to hire, wages rise, which can set off an inflationary spiral. Businesses are having trouble hiring, but that's not because workers are in short supply. As the second quarter came to an end, June’s jobs report revealed that there are still approximately 7 million fewer people employed than before COVID-19. But there’s more to the labor market story. Let’s do some math.

If the pandemic had not occurred, the U.S. economy would’ve likely kept adding jobs in 2020. In 2019 (pre-COVID) U.S. employers added 2 million people to payrolls. We’ll use a conservative estimate and say an additional 1.5 million likely would have been added to payrolls if COVID hadn’t occurred. That brings us closer to 8.5 million fewer people employed than would have been had the pandemic never occurred. There are also 3.5 million fewer people looking for a job today than before the pandemic. Finally, the U.S. labor force naturally grows each year as the adult population expands. The U.S. population of working age grew by nearly 1.2 million people since COVID, which would mean an additional 700,000 workers or so based upon historical labor force participation rates.

Even if the delta variant establishes a deeper foothold in some locations, the overall impact on the economy won’t come anywhere near what we experienced in spring 2020.

Adding it all up gives us an estimated 12.5 million fewer people employed or looking for jobs today than what likely would have been — ceteris paribus — if COVID had not happened. This represents a significant amount of slack in labor markets that will likely take some time to eliminate — and that just gets us back to levels we would have seen if all conditions were normal in 2020. Prior to the pandemic, it’s worth noting the economy was still adding jobs without inflationary pressures emerging through Q1 2020.


Any discussion of inflation needs to begin with the basics: Inflation is caused by demand exceeding supply, along with consumers’ reactions to the prospect of higher prices.

One reason inflation is higher in 2021 is simply math. Inflation was artificially low last year because of COVID, and now that we are moving back to normal, year-over-year inflation will be higher because we’re lapping a year of incredibly low inflation.

The other factor is a rather quick snap-back in demand. People are growing confident, and they are spending or increasing demand for goods and services. Consumers can decide to spend far faster than a retailer can transport goods across the world to replenish inventories in response to that demand.

Supply chains are still not up to speed due to lingering COVID-19 impacts, and that’s put robust demand and slim inventories on a collision course that’s driven large price increases in various parts of the economy. However, that will likely subside as suppliers and businesses catch up in the coming months.

Inflation has also been driven by large price increases for a few goods (cars and oil) but not necessarily the many. One way to get a better sense of how prices are moving on most goods we purchase is to remove large outliers (both upward and downward) and look at central tendencies of the components used to calculate inflation. The Cleveland Federal Reserve has created two measures that do just that. The Cleveland Fed’s 16 percent trimmed mean CPI is at 2.6 percent year over year, while their Median CPI is at 2.1 percent. Similarly, the Dallas Fed’s trimmed, mean PCE shows a tame 1.9 percent year-over-year advance. All these point to more moderate trends in inflation.

Yes, at some point we will have a correction, but a review of history shows these are a bit less common than most believe.

Before we close out this discussion, let’s shift to a “real indicator” that gained prominence during the second quarter: lumber. The price of lumber over the quarter encapsulates how the relationship between supply and demand can grow unbalanced, but also how the imbalance is corrected rather quickly.

Lumber recently experienced a boom and a subsequent bust in prices. In early 2020 lumber traded near $450 and fell to $260 on April 1 as the world began to fear the pandemic’s impact on the economy. In the subsequent months, housing and remodel demand grew, but the lumber supply chain couldn’t keep up — mills were either closed or short-staffed due to COVID-19 restrictions. That caused the price of lumber to hit $900 at year’s end and near $1,000 at the end of the first quarter. As the economy reopened, lumber prices soared to $1,686 in early May, only to fall back to $716 by the end of the quarter as production picked up and demand slowed a bit.

We think lumber’s story really drives home our view that current inflationary pressures are likely transitory and driven by a few anomalies rather than more systemic causes. We think other price anomalies driving inflation higher may follow a similar path, easing inflationary pressures as supply and demand return to equilibrium. However, looking out further, as we move into the latter half of 2022 and into early 2023, we expect the labor market will heal and once again bring the business cycle — and inflation — back to the fore.

Fortunately, there’s more good news. If (and that’s a big if) we are bumping up against labor slack constraints (tight labor market) in late 2022, then productivity is going to be critically important to meet supply demands and keep inflation tamed. Fortunately, productivity has been in a strong uptrend since the late 2010s, which is strikingly similar to the latter half of the 1990s, which led to a long economic cycle. The uptrend in productivity appears set to continue because the pandemic pulled forward a host of technological innovations that will benefit the global economy for years to come. A recent study by the McKinsey Global Institute estimates productivity could increase by 1 percent annually until 2024. Not only would this increase U.S. growth, but it would also keep inflation at bay and keep the economic cycle ticking.


The Federal Reserve has committed to maintaining easy policy until the labor market heals and has signaled its desire to go past that even if inflation rises. While the Fed still maintains its historical dual mandate of stable prices and maximum employment, the “new” Fed has shifted its focus from fighting inflation (as it did in the 1970s and 1980s) to maximizing inclusive employment. The Fed put this new framework into place in 2020 and is committed to it. The Fed believes its pre-emptive, outlook-based rate hikes, which focused on inflation for the last 40 years, likely had negative implications on employment. The focus now is employment outcomes, and the Fed will tolerate inflation above 2 percent to get more job growth.

This does not mean the Fed will not taper asset purchases. We anticipate the Fed will announce during its Jackson Hole Symposium in the third quarter that it will begin to taper its Quantitative Easing (QE) program in 2022. However, let’s be clear — tapering bond purchases is light years away from aggressively raising rates and tightening the economy into a recession. Real interest rates are negative and won’t be turning positive any time soon. Indeed, if tapering proceeds at an orderly pace, we aren’t talking about the first rate hike until late 2023.

When you add all of this up, this economic cycle could continue for many more years. We believe that the economy will continue pushing higher and pull the markets with it. As we push into the second half of 2021 and into 2022, we remain constructive on the equity markets, albeit a bit less than in previous quarters given the explosive upside we have witnessed.


Over the past few quarters much of the commentary has been fixated on the potential for a correction given the market’s strong rise and seemingly heightened valuations. Yes, at some point we will have a correction, but a review of history shows these are a bit less common than most believe.

We reviewed price data going back to 1950 and found there were 24 separate occasions in which the S&P 500 (U.S. Large Cap stocks) fell by more than 10 percent, which is defined as a correction. That may surprise you — only 24 times in 70 years have U.S. Large Cap stocks fallen by more than 10 percent. Of those corrections, only 10 have turned into bear markets, which is defined by a drop by more than 20 percent. Of those 10 bear markets, only three occurred without the economy experiencing a recession. This is lesson number one: Corrections and bear markets are a bit rarer than the average investor believes, and the deeper market drops are almost always connected with recessions.

Let’s be clear — tapering bond purchases is light years away from aggressively raising rates and tightening the economy into a recession.

The second lesson: Non-recessionary corrections and bear markets are often sharp but short in duration. Indeed, the average loss during a pullback that is not connected to a recession is 16.4 percent, with the average time to hit bottom being four months and the average breakeven recovery period being 10 months.

Contrast this with the average recessionary pullback being a 32.1 percent loss, taking 15 months to bottom and 38 months to recover losses. We should further note that these are based upon prices only, not total returns that assume reinvested dividends (which would certainly shrink the timeline to breakeven).

For all the talk and chatter about stocks being expensive and due for a correction, we note that the probability of one occurring, at least based upon history, is less than commonly perceived. And of the total 24 corrections and bear markets, nearly half, or 11, of them lasted eight months or less. Please contemplate these numbers before you decide to pull back based upon a fear of what could be.


All the analysis above does not preclude extreme events from happening and causing markets to fall. After all, we just had a recession caused by COVID-19, something which may occur once a century. Still, for long-term investors the tune doesn’t change: Stocks recover, and we eventually move higher. But those who sold when fear was highest likely booked losses.

We said it last year, but it merits repeating since we will eventually have another correction and recession: We believe that people invest to garner or retain financial security. Everyone focuses on gaining or retaining financial security by investing when times are good. It’s easy to invest and stick to a plan during the good times.

But true success in markets depends on how one behaves when times are bad. That is when financial security is truly gained, maintained or, unfortunately, lost. Think about the 24 times in the past 70 years that tempted investors to sell and lock in losses. When you sell at the bottom, you miss so much of the upside that inevitably occurs on the opposite side. Just 24 brief periods in the span of seven decades could define your success or failure, and we encourage you to keep this in mind if the market falls.

This is where Northwestern Mutual and our expert advisors play a crucial role. They devise a plan that not only thinks about what could go right but also contemplates all the things that could go wrong and upend that well laid roadmap. Advisors provide context, conversation and information to keep you steadied. And it’s not always just financial markets that go awry. Life can throw other curve balls your way, and you can protect against those unexpected events, as well. Think of it this way, investments for growth, life insurance for protection and guaranteed growth and annuities for guaranteed retirement income.

Related: The Backward K and Coming Earnings Surprises