Global Perspectives

A weekly analysis of timely economic strategy issues from Wells Fargo Investment Institute.

February 21, 2018

Ken Johnson, CFA, Investment Strategy Analyst
Michael Taylor, CFA, Investment Strategy Analyst

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.

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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 the first quarter of 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 imbalance between job openings and hiring. According to January’s JOLTS surveys, open positions have been increasing since the Great Recession and remain near all-time 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 2017Chart 1. JOLTS Survey for 2017Sources: Bureau of Labor Statistics, December 2017

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 post-secondary training and education.1 When we look at the 25-35 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 2025.2 The use of robots is largely concentrated in the manufacturing sector, yet as Chart 1 illustrates, manufacturing is an industry that is 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 long-term 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.

Chart 2. Changes in the cost of wages and in nonwage benefitsChart 2. Changes in the cost of wages and in nonwage benefitsSources: Bureau of Labor Statistics, December 2017.

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 2019. 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 per-unit labor costs low.

Chart 3. Rising durable goods orders point to future capex spendingChart 3. Rising durable goods orders point to future capex spendingSources: Bloomberg, as of December 31, 2017.

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 incomeChart 4. Labor costs have largely been capped by disposable incomeSources: Bloomberg, January 2018.

Investment implications

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.

Economic CalendarEconomic CalendarSources: Bloomberg, as of February 16, 2018.

1 Recovery: Job Growth and Education Requirements through 2020, June 2013.
2 “The impact of technology on labor markets”, Bureau of Labor Statistics, June 30, 2017.

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.


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.

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.

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