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Economics: Service Sector Squeeze
New York: July 11, 2005
By John R. Stephenson

Good news this week. The unemployment rate hit a four-year low coming in at five percent. This is welcome news and it might well be signaling that the U.S. economy is now, finally, back on track. Yet, in spite of the fact that we are some forty-two months into an economic recovery, the sense of worry is palatable. In spite of good news on the manufacturing and unemployment front, it seems difficult to shake a certain feeling of dread. The stock market has hung in and the housing market is nothing short of miraculous, so why the worry? Perhaps it's just the sense that this is all happening on borrowed time.

Maybe it's all the talk of protectionism coming out of Washington these days. Or possibly, it's a war with no end in site that is wearing on our conscious. But I think that the real reason is we know that, at least at some level, our prosperity is all a mirage. That's not to say that things are going to evaporate overnight, it's just that it's difficult to see how things can get much better in a nation that is driven by consumption, where interest rates are coming off forty-year lows and the national savings rate is clocking in at just 1%.

But despite the fact that the housing, bond, equity, commodity and credit markets are awash in speculative money, is there something more? I think there is. When you examine the employment data, there is a worrying trend. While jobless claims are down and productivity is zooming, wages remain relatively muted. During the first 39 months of this recovery, total hourly compensation in the nonfarm business sector has increased by 7.5%, but productivity has increased by 13%. With wages stagnating and productivity increasing, an economy that is reliant on consumerism is increasingly challenged as incremental spending comes not from earned income, but rather from plundering the inflated value of assets (i.e. housing and stock market accounts). An additional source of worry is the fact that one of the underpinnings of a free-market capitalist economy is that workers are paid in accordance with their marginal productivity contribution. With employees working harder for less - this just isn't the case anymore.

While workers across the board are getting squeezed, it is the service sector where the brunt of the angst is being felt. In the manufacturing sector, the first 39 months of this economic recovery have witnessed an increase in hourly compensation of 16.6% whereas manufacturing productivity has clocked in at 19.7%. While worker compensation in manufacturing has failed to keep up with productivity, the gap is widest (some 5.5%) for the service sector which in this economy is experiencing the brunt of knowledge-based outsourcing to low-wage countries.

For a long time, the service sector has been shielded from global competition, but this is no longer the case. Today, services, once considered nontradable, are becoming increasingly tradable with offshore countries such as India, Mexico, China and Eastern and Central Europe acting as marginal wage setters. Currently there are 245,000 Indians answering phones from all over the world or dialing out to solicit people for credit cards or to collect on overdue bills.

But it isn't just service jobs at the lower end of the wage spectrum that are being outsourced in this new form of e-based wage arbitrage, higher value-added services are as well. In many of the small and medium sized hospitals in the U.S., radiologists are outsourcing the reading of CAT scans to doctors in far flung locals such as India and Australia. Companies such as Reuters have been using Indian nationals to conduct financial research on companies that their investors are following. Investment banks used to rely on investment research conducted by high-priced superstar analysts based in the U.S. This investment research effort often ran into the tens of millions of dollars a year for the salaries of in-house researchers who did little to analyze, but a lot to promote, the companies that the investment bankers were pursuing. But today, with the marvels of technology, well-educated Indians and other nationals are conducting much of this work offshore. India alone graduates 2.5 million college graduates a year, 89,000 which hold an MBA degree.

For the executive on the go, there is a company called Brickwork, which will provide you with your own personal assistant based in India. Say, for example, you need to research and produce a PowerPoint presentation for a meeting with your board the next day. This is something that you can ship overseas to Brickwork and your personal assistant can work on it while you sleep and email the final copy back to you in time for the meeting the following morning. The cost - some $1,500 to $2,000 per month.

Increasingly, the world is flattening and is becoming truly global. The lever that is allowing this globalization is not hardware, but rather software and a global web of fiber-optic cable which has made us all next-door neighbors. For us as individuals, it is no longer a matter of trying to decide how I fit into my city, town or country but rather how do I fit in and collaborate globally?

With wage arbitrage spreading like wildfire across the globe, is it any coincidence that we are witnessing one of the weakest economic recoveries in terms of both employment and worker compensation on record. With the manufacturing sector already beset from the outsourcing of productive capability, is it any surprise that now the service sector is feeling the pinch of an increasingly globalized working environment.

But as I have long argued, our economic problems have only worsened in the face of a Federal Reserve (U.S. central bank) policy that has been designed to reward consumption rather than saving and investment. By adding fuel to the fire in the form of extremely low interest rates, the Fed has provided excessive stimulus to asset markets (housing, stock and bond markets) as a substitute for lagging organic income generation. This sets up a wealth-dependency trap, whereby consumers are encouraged to spend, driving down their income-based savings rates and adding to an ever-mounting U.S. current-account deficit. In the meantime, asset markets of all types (equity, bond, credit, commodity and real estate) go to excess and bubble formation becomes the rule, rather than the exception.

As worry spreads from jobs to wages, the natural consequence is a protectionist backlash. Witness the latest round of China bashing by the U.S. congress. But with the genie out of the bottle, the current round of protectionist sentiment is little more than window dressing. As the problem of ever-widening imbalances between the nations that save (Asia) and the nations that spend (America) grows, the likelihood of a wrenching adjustment increases. The solution is unfortunately not an easy one - Asians need to spend while Americans need to save.

Workers who are concerned about the rise of globalization and its impact on their careers need to think about how they can compete and leverage themselves and their firms in an increasingly global world. As I have long suggested, building a personal brand - something that you uniquely are known for is one solution to the opportunities and challenges posed by globalization.

With the imbalances between the nations that save and the nations that spend growing at an alarming rate, this raises the likelihood of a more serious global adjustment to these imbalances in the future. The likely result? The U.S. dollar, as well as the bond, stock and real estate markets, might take a tumble. Investors concerned about an eventual restructuring of the global marketplace might well be advised to consider increasing their exposure to foreign stocks - Canada, a commodity producing nation might be one place to look. As always, investors are encouraged to reduce indebtedness and to take advantage of the low interest rate to secure long-term financing for housing. As well, consider holding a small portion of your portfolio in defensive areas such as utilities and gold in the event that the dollar begins to swoon.

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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