In general, when individuals or investors look at the headline unemployment rate of 3.6%, it seems to be a number associated with robust growth, strong corporate activity and new jobs being created in the economy. While there is no doubt that the United States economy has gained significant traction in the last few years, an unemployment rate of 3.6% is a concern more than a reason to be bullish. This article will discuss the trend in inflation and unemployment and its implication on US economic growth for the medium to long-term.
At the onset, is important to introduce the concept of natural rate of unemployment. When the economy is operating at potential GDP, the unemployment rate that exists in the economy is known as the natural rate of unemployment. In other words, it is the unemployment rate when economic growth is robust. For the United States, the natural rate of unemployment for the second quarter of 2019 is 4.6%. However, the headline unemployment rate in the United States is currently at 3.6%.
When the headline unemployment rate is below the natural rate of unemployment, it implies that the economy is producing more than its potential output and this is known as the inflationary gap or a positive output gap. Further, when the economy is in an inflationary gap, the output is above potential output and inflation is above (or well above) the target inflation rate.
What is interesting to note is that the US economy indicates that it is in an inflationary gap in terms of the unemployment rate. However, inflation has been subdued in the economy and remains one of the key concerns for the policymakers.
The point I am making can be illustrated with a basic aggregate demand and aggregate supply model for the US economy, the chart below gives the AS-AD model.
During the financial crisis of 2008-09, the US economy was at point A in the AS-AD model. The output Y1 was below the potential output of Y and the price level of P1 was below the price level at potential output.
With expansionary monetary and fiscal policies, the aggregate demand curve (representing real GDP) moved to the right from AD1 to AD. At point B, the economy is at potential output with price level higher at P and output at Y. Also, at point B, the economy should be at the natural rate of unemployment.
However, the rate of unemployment is 100 basis points lower than the natural rate of unemployment. This would ideally suggest that the economy has moved from Point B to Point C where the economy is producing above potential output and inflation is higher than the inflation level at point B. This makes sense since tight labor markets would imply higher wages and robust employment would also imply higher consumption and investment spending.
The reality is that inflation has remained subdued even when unemployment is at 3.6%. The Phillips Curve also seems redundant here.
With declining unemployment, inflation should trend higher according to the Phillips Curve, but that has not been the case with the US economy.
If there is a single factor that can explain the failure of these models, it is the demographics in the United States.
Just to put things into perspective, the civilian labor force participation rate in the US was at 66.4% in January 2007. This has declined to 62.8% by April 2019. When individuals move out of the labor force, the unemployment rate automatically declines. In other words, the current unemployment rate would be much higher when adjusted for changes in the labor force participation rate.
To discuss the negative economic implications, it is worth taking a second look at the AD-AS model. In the AD-AS mode, the long-run aggregate supply curve shifts to the right (increase in potential output level) if there is innovation, increase in labor force or an increase in capital. On the other hand, it shifts to the left (decline in potential output level), due to decline in labor growth, productivity or innovation. In the case of United States, the LRAS curve has possibly shifted to the left due to decline in the labor force. This explains why inflation remains subdued even with unemployment data suggesting the economy should experience inflationary pressure.
Theory aside, there are serious implications for the US economy in the medium to long-term. Some of the key concerns are as follows -
- Consumption drives nearly 70% of US economic growth. With rising dependency, households are likely to curtail consumption spending on a relative basis and this will negatively impact GDP as well we investment spending in the economy.
- Federal debt is currently at $22 trillion and even with improved economic conditions, government budget deficit has widened in the last few years. I expect this trend to sustain and federal debt will continue to swell.
- As federal debt increases, interest rate can potentially increase and crowding out of investments from the private sector can't be ruled out.
With these concerns, I am of the option that steady GDP growth rate in the United States will trend lower as compared to the previous few decades. It is important to note that this is a relatively long-term view, but portfolios need to be adjusted to discount these concerns.
It is being estimated that healthcare spending will increase to 19.4% of GDP by 2027. I believe that the healthcare theme is one of the best for steady returns over the long-term. Just to put things into perspective, the Vanguard Healthcare ETF (VHT) has provided returns of 9.68% on an annual basis since inception in 2004. Importantly, returns in the last 5-years have averaged 11.30% on an annual basis.
This is in sync with steady increase in healthcare spending in the United States, which is likely to sustain for the next decade. It would not be surprising to see the Vanguard Healthcare ETF provide returns of 8% to 12% on an annual basis for the next 5-10 years. Investors will therefore be positioned for healthy returns (adjusted for inflation).
Another important point to note about the Vanguard Healthcare ETF is that the ETF has a low beta. The table below gives the top ten holdings for the ETF and the respective stock beta.
Considering global economic uncertainty related to trade wars, it would make sense to consider exposure to an ETF that has low beta than a high beta ETF. Since beta represents the systematic, risk, the healthcare sector (as a whole), is relatively less sensitive to these systematic risks.
Therefore, the Vanguard Healthcare ETF serves the objective of investing in an attractive healthcare sector along with the objective of investing in defensive stocks in a relatively uncertain market and economic condition.
The decline in labor force is one of the biggest challenges faced by the US economy as it impacts several components of the GDP. However, amidst challenges, there are investment opportunities and the healthcare sector is likely to remain attractive for investment in the next 5-10 years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.