Key takeaways. What it may mean for investors WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS. Ken Johnson, CFA Investment Strategy Analyst

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1 Ken Johnson, CFA Investment Strategy Analyst Michael Taylor, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS February 21, 2018 Small Business Snapshot Part II: Labor Uncertainty Key takeaways» Small business owners are struggling to find workers with skill sets to match job openings. The industries most affected include manufacturing; trade, transportation and utilities; information technology; financial services; and education and health services.» Wage pressure has increased as the Tax Cuts and Jobs Act appears to have given business owners the confidence to raise wages. However, overall labor costs should be contained by solid consumer demand and business capital expenditures. What it may mean for investors» Investors should consider viewing labor shortages as transitory. These challenges are likely to diminish as the younger segment of the workforce develops its skill set and fills these roles. A rising labor force also should help to fuel consumer spending.» Cyclical sectors are likely to continue to outperform noncyclical sectors. To help mitigate unexpected inflation risk, investors also may want to consider incorporating Treasury Inflation Protected Securities (TIPS) into their portfolios. As noted in the first installment of our small business series, small business optimism has been soaring. Yet, small business owners still face some concerns. The latest Wells Fargo/Gallup Small Business Index survey conducted for first quarter 2018 found that, even though optimism came in at its highest level since 2007, owners of businesses with more than one employee cited hiring and retaining staff as a challenge. Uncertainty over economic conditions, including labor conditions, has been a key concern of small businesses for the past five years. The U.S. unemployment rate is near record lows, and some small business owners are struggling to find qualified workers with the requisite skills and training for their open positions. Furthermore, labor cost has become a concern as wages climb higher. In today s report, we address these two concerns. We also offer insight on how investors can glean important information from the labor-market data and what small business owners should expect going forward. The hunt for qualified workers Small business owners are struggling to find workers with skill sets to match job openings. Labor trends can be measured in many ways. One indicator we closely follow is the JOLTS (Job Openings and Labor Turnover) survey, which tracks job openings, hiring, and separations. When qualified candidate pools are low, we begin to see an 2018 Wells Fargo Investment Institute. All rights reserved. Page 1 of 7

2 imbalance between job openings and hiring. According to January s JOLTS surveys, open positions have been increasing since the Great Recession and remain near alltime highs. Yet, the overall hiring rate has grown at a much slower pace. Chart 1 breaks down the JOLTS survey data by industries over the past year those with negative values are experiencing challenges finding qualified workers as openings outpace new hires. Chart 1. JOLTS Survey for January February March April May June July August September October NovemberDecember Manufacturing Information Education and health services Transportation, warehousing, and utilities Construction Source: Bureau of Labor Statistics, December 2017 Trade, transportation, and utilities Financial activities Government Mining and Logging Professional and business services The industries most affected by these employment challenges include manufacturing; trade, transportation and utilities; information technology; financial services; and education and health services. There is no clear single cause of this dearth of qualified workers. One plausible theory is that it can be at least partly attributed to one of the largest workforce transitions in history, as baby boomers retire and the next largest generation, the millennials, increase their representation in the workforce. The gap in qualified workers could stem from millennials having less work experience than others, and from some just having graduated. Technical-skill gaps are another cause. However, there is hope. It is estimated that, by 2020, 65% of jobs will require postsecondary training and education. 1 When we look at the year-old demographic today, over 65% have some post-high-school education, and that number is growing. When this segment gains more experience, the qualified labor pool should expand. Education and training should help the problem of too few qualified workers, and it is also possible that technology could fill some of the demand for qualified workers. Today, there are an estimated 1.75 million robots in operation a number that is poised to increase to 4-5 million by The use of robots is largely concentrated in the manufacturing sector, yet as Chart 1 illustrates, manufacturing is an industry that is 1 Recovery: Job Growth and Education Requirements through 2020, June The impact of technology on labor markets, Bureau of Labor Statistics, June 30, Wells Fargo Investment Institute. All rights reserved. Page 2 of 7

3 struggling to find qualified workers. This seems somewhat counterintuitive, since we would expect the need for human workers to diminish as robots replace them. What is going on? It turns out that, while some of the need for skilled workers is being filled by robots, manufacturing firms, like those in many other industries, have shifted in terms of the skill sets they require. Today, more technical talent is needed, including software developers, petroleum engineers, and data scientists. Looking ahead, there are two things that business owners and investors should keep in mind. First, as educational programs (and attainment) adjust for younger workers who want to acquire the skills to do these jobs, we should expect this labor-quality disparity to diminish. In the meantime, we could see the skills mismatch of the current labor pool become a drag on productivity growth for some small businesses. Additionally, work is being done by government agencies and educational institutions to increase the presence of STEM (Science, Technology, Engineering, and Mathematics) professionals. We believe that investors should view labor shortages as transitory. These challenges are likely to diminish as the younger segment of the workforce develops its skill set and fills these roles. A rising labor force should fuel consumer spending and offer longterm investment opportunities in more cyclical sectors. The fear of rising labor costs Wage pressure has been a hot topic of late, particularly after January s jump in average hourly wages. Furthermore, with the latest National Federation of Independent Business (NFIB) Small Business Optimism survey indicating that the percentage of business owners who plan to increase wages has reached a 30-year high, it doesn t take long for uncertainty to set in. Investors and small business owners are wondering what implications these factors might have on total labor cost and profitability. Total labor cost takes into account both wages and nonwage benefit costs. Chart 2 demonstrates that nonwage benefit costs have increased at a faster pace than wage costs. The increase is even steeper when you look at only health-care costs (we will address this in our third installment). Nonwage benefit costs include benefits such as retirement savings and health and worker insurance. While these costs are rising, these benefits only make up roughly 30% of total labor cost the other 70% comes from wages and salaries. Higher wages can be a catch-22. On the one hand, higher wages typically mean more disposable income for consumers, which can help to drive business sales. On the other hand, higher wages mean higher costs for employers, driving down profitability Wells Fargo Investment Institute. All rights reserved. Page 3 of 7

4 Chart 2. Changes in the cost of wages and in nonwage benefits 9.0% 8.0% 7.0% 6.0% Changes in cost 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% Change in cost of benefits (YoY%) Change of cost of wages and salaries (YoY%) Source: Bureau of Labor Statistics, September After recent tax reforms, which have helped to fuel spending on business capital expenditures (capex), we expect capex spending to grow more rapidly this year, and possibly into The early signs are encouraging. Chart 3 shows that U.S. durable goods new orders (excluding Transportation) are on the rise. This measure is a popular indicator of future capex spending. An increase in capex would help to minimize costs by allowing workers to do more with less. In other words, while wages may increase, the output that a given worker produces would be greater which should help to keep perunit labor costs low. Chart 3. Rising durable goods orders point to future capex spending 30 U.S. durable goods new orders ex-transportation (YoY%) Source: Bloomberg, as of December 31, Wells Fargo Investment Institute. All rights reserved. Page 4 of 7

5 Another factor to keep in mind is that higher wages potentially can increase consumers demand for goods and services. As Chart 4 shows, labor cost seems to be related to growth in disposable income. This suggests that businesses did a relatively good job of managing costs based on consumer demand. When consumers had more money to spend, businesses labor costs rose as they hired more workers and increased wages to retain workers and address market demand. When consumer needs changed, so did businesses need for additional labor. Chart 4. Labor costs have largely been capped by disposable income Percent Disposible Personal Income (YoY%) Source: Bloomberg, January Investment implications Unit Labor Cost (QoQ%) 4 Quarter Moving Average We believe the Tax Cuts and Jobs Act potentially can extend our current recovery, if additional capex spending can increase worker efficiency and thereby reinforce earnings growth. Therefore, investors and businesses should not fear modestly rising labor costs in a strong labor market. A robust labor market should support increases in personal income and consumers who feel more confident about spending. Investors, in turn, should benefit from a resilient economy, a reviving consumer, and small-business growth. From an investor s perspective, this means that cyclical sectors are likely to continue to outperform noncyclical sectors. However, we do acknowledge that inflation expectations have increased as good macroeconomic data continues to be reported. To mitigate the risk of unexpected inflation, investors also may want to consider incorporating TIPs into their portfolios Wells Fargo Investment Institute. All rights reserved. Page 5 of 7

6 Economic Calendar Date Report Estimate Previous 2/21/2018 MBA Mortgage Applications % 2/21/2018 Markit US Manufacturing PMI /21/2018 Markit US Services PMI /21/2018 Markit US Composite PMI /21/2018 Revisions: Existing Home Sales 2/21/2018 Existing Home Sales 5.62m 5.57m 2/21/2018 Existing Home Sales MoM 0.90% -3.60% 2/21/2018 FOMC Meeting Minutes /22/2018 Initial Jobless Claims 230k 230k 2/22/2018 Continuing Claims 1935k 1942k 2/22/2018 Bloomberg Economic Expectations /22/2018 Bloomberg Consumer Comfort /22/2018 Leading Index 0.70% 0.60% 2/22/2018 Kansas City Fed Manf. Activity /26/2018 Chicago Fed Nat Activity Index /26/2018 New Home Sales 647k 625k 2/26/2018 New Home Sales MoM 3.40% -9.30% 2/26/2018 Dallas Fed Manf. Activity Source: Bloomberg, as of February 16, Wells Fargo Investment Institute. All rights reserved. Page 6 of 7

7 Risk Considerations Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the inflation compensation component of the principal. A holder of TIPS may be required to report this income annually although no income related to inflation compensation is received until maturity. Definitions The Wells Fargo/Gallup Small Business Index is calculated from a quarterly survey of 603 small business owners and measures current and future perceptions of their business financial situation. An index is unmanaged and not available for direct investment. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 7 of 7