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Economics: A New Era?
New York: January 22, 2007
By John R. Stephenson

Something strange is going on. Throughout the western world, both unemployment and inflation remain low. In the Eurozone, the unemployment rate is at a fourteen year low, Canada is at a thirty-year low and in the U.S., the unemployment rate is a scant 4.5%. Could we be entering a new era, one in which the economic holy grail of low inflation and full employment are achieved, or is there something else at work?

Perhaps. But for inflation to remain low, costs must be contained. One key component of the overall cost picture is labor, which lately has remained pretty quiet. But there is reason to believe that we could be shifting to an era of higher costs (inflation) as labor, once dormant, shifts increasingly to the driver's seat. The reason for this change is demographics. After years of layoffs, restructurings and the like, a scarcity of workers, rather than a surplus, may be facing North American companies. In this new era, it may be workers, rather than management, that hold the cards.

Throughout the west, the population is aging with a scant supply of new workers rising to take the place of retiring workers. With birthrates plunging (less than two births per couple), the number of new workers entering the system is beginning to slow. To keep economic growth on track, countries will have to make up the human capital deficit either through productivity gains or through immigration. In regions of the world where immigration is discouraged (such as Japan and Europe), the impending labor shortage is particularly acute. In the U.S., things are somewhat better as the birthrate has remained largely flat, but this has been primarily achieved because of the strong contribution to the birthrate from the Hispanic immigrant population.

Last week, the U.S. financial markets were pleasantly surprised by a stronger than expected jobs report. While the markets had expected flat job growth, the actual release showed an increase of 167,000 jobs. Not only that, but new statistics from the Labor Department have shown that workers' pay has risen at its fastest rate in six years. With the labor supply increasingly tight, is it any wonder that wage growth is starting to accelerate?

This thesis is backed up by the United Nations, which reports that the population of the developing world is expected to accelerate at precisely the same time as the population of the developed world begins to decline. With low birth rates and an aging demographic in the West, skilled labor is likely to become an increasingly scarce resource.

Figure 1: United Nations Population Projections

Source: United Nations, 2002 population report

During the 1990's, corporate profit margins soared, as labor bore the brunt of management's relentless push for cost containment. With the outsourcing of jobs to the emerging markets of China and India, management was able to look like heroes for slashing costs and padding profits. With rising profits and a soaring stock market, CEO's became heroes with paychecks to match.

But today, things may be different. With labor markets increasingly tight at home, CEOs and division managers may not be able to pad their compensation through stock options and bonuses simply by firing a few hapless workers.

As the North American population ages and wave after wave of the baby boom generation begin to retire, workers with strong skill sets and a good work ethic will increasingly become scarce commodities. With wage growth likely to increase rather than decrease, the economic miracle of low inflation and full employment may begin to stall, as workers demand and get more of the economic pie.

While the outlook for stocks is still good here at home, investors should consider exposure to the emerging markets. Markets such as China, India and Brazil are increasingly providing more and more of what the world needs — commodities and labor. Already, the growth of the emerging markets has been very strong, as witnessed by the dramatic rise of the EEM, an emerging markets exchange traded fund ("ETF").

Figure 2: Emerging Markets on a Roll

Source: First Asset Investment Management Inc.

With labor pressures here at home set to rise, investors might be smart to spread their bets around. A recent report in the Wall Street Journal highlighted a growing concern — the rising junk debt levels of U.S. companies. With private equity and leveraged buyout firms running amok, the Wall Street Journal reports that 71% of the outstanding debt of S&P-rated US industrial corporations is now classified as junk.

With the proportion of junk bond financings of U.S. equities increasing, the potential risks to the financial system increase. Investors should avoid too much concentration in a single asset class and should consider gold (either the mining companies or ETF) as a hedge against a serious problem with either the U.S. dollar or the financial system. Emerging markets, where labor and commodities are plentiful, have been on a roll lately and are likely to continue. Investors, looking to capitalize on the strong growth of the emerging markets in the years to come, should consider some of the many exchange traded funds that combine the ease of stock purchases with the diversification of a mutual fund.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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