The Missing Ingredient of the Economic Recovery (Hint: It's Not Jobs)

Tomorrow, we may get the latest evidence that the jobs market continues to slowly improve when the Labor Departmentreleases its weekly jobless claims report. Yet despite an improving labor market, household spending isn’t picking up enough to fuel a faster recovery.

Why? As I write in my newMarket Perspectivespaper,Wage Woes, the big missing ingredient is a lack of real income growth. In other words, an improving jobs market isn’t translating into higher wages for the vast majority of the population, meaning very few can get a raise.

Now, how bad is it? Well, if you look over the last 50 or 60 years, household income typically has risen by about 3.5% annually after inflation, fueling a 3.5% or so gain in consumption. However, since the recession ended three years ago, we’ve seen household income gains roughly half of that. And this year, things are even worse. For 2013, real, or inflation-adjusted, household income growth is averaging only about 1%.

There are short- and long-term factors to blame.

Short term: In the short term, one major factor behind the muted wage growth is ongoing political and fiscal uncertainty in Washington. Even though fewer companies are laying employees off now than during the last recession, the pace of hiring isn’t as great as it would have been if there was more stability in Washington. And if hiring doesn’t increase at a faster rate, then there’s no upward pressure on wages.

Long term: Advancing technology is also creating downward pressure on wages, eliminating many middle-income jobs. At the same time, there is the global wage arbitrage, i.e. the fact that many jobs are still going overseas, putting downward pressure on U.S. wages and upward pressure on wages in other countries such as China (though some manufacturing jobs may actually come back to the United States because ofthe U.S. energy renaissance). Finally, asthe labor force participation ratehas dropped — in other words, as fewer people are in the workforce — overall U.S. disposable income growth at the aggregate level has been slowing.

So what does this mean for investors? I expect that income growth will get a bit better in 2014 as the labor market continues to improve and cyclical headwinds start to lesson. However, to the extent that the long-term forces I mention above remain in place, I expect to see slower income growth going forward over the long term.

This, in turn, probably means slower U.S. consumption and a somewhat slower U.S. economy (the somewhat because the U.S. energy renaissance will likely continue, with manufacturing becoming a larger part of the U.S. economy over time). As such,I continue to advocate remaining cautious of sectors dependent on middle-class consumptionand I continue to like more manufacturing-focused sectors of the market such as energy andtechnology.

Source: December Market Perspectives

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