Unemployment is going to rise. The Bank of England said last week that it expects the official jobless rate to rise from 5 per cent now to around 7.7 per cent by June – although its trajectory depends in part on whether the job retention scheme is extended and how many laid-off migrant workers return home. Which poses the question: what does this mean for equities?
Shares tend to do badly when unemployment rises. Rising unemployment in 2008-09, for example, was accompanied by falling prices and falling unemployment in the late 1990s and mid 2000s saw shares do well. This does not, however, mean that rising unemployment causes shares to fall. More likely, the same things that are bad for jobs – such as a weak economy – are also bad for equities.
But there’s something more interesting, shown by my chart. High unemployment in the past has been good for equities, in that it leads to higher returns in the following three years. High unemployment in the mid-1980s, early 1990s and 2010 all led to good returns, whilst low unemployment in the early 1970s, late 1990s, mid 2000s and 2019 all led to bear markets.
In theory, there’s a rational explanation for this. High unemployment is a sign of a weak economy, which is when equities are unusually risky as there are big dangers of earnings disappointments and corporate failures. Such dangers mean the equity risk premium should be high which should mean higher subsequent returns.
However, while this might explain why high unemployment leads to good returns, it cannot explain why low unemployment leads to falling prices. Even in the best times, the equity risk premium should be positive, pointing to positive returns.
Something else, then, explains the pattern in my chart. One thing is simply that equities over-react to good and bad economic times, causing them to become under priced when unemployment is high and over priced when it is low. Harvard University’s Matthew Rabin has explained why this happens. We project our current tastes into the future and don’t anticipate that they’ll change. So in recessions we don’t anticipate that the coming upturn will increase our taste for risk and equities, and in booms we fail to foresee the coming recession will reduce our appetite for risky assets.
Unemployment, however, doesn’t only lead to ordinary cyclical upturns. Variations in joblessness do something else: they change the balance of class power. Low unemployment in the early 70s squeezed profit margins terribly, causing equities to plummet. And equities did well in the 80s because mass unemployment reduced workers’ bargaining power and so restored profit margins. As New York University’s Sydney Ludvigson and colleagues have shown, the main reason why shares have done so well since the 1980s is not that the economy has grown but that shareholders have captured a higher fraction of that growth.
All this looks like good news for equity investors. It suggests that the high unemployment we’re likely to see later this year should boost share prices.
But there’s a danger here, pointed out by Stephen Marglin and Amit Bhaduri in a classic paper in 1989. It is the case, they say, that cuts in workers’ bargaining power can raise profit margins and economic growth by encouraging firms to invest and expand. In this case, we have the pattern in my chart, whereby what’s bad for workers is good for shareholders and vice versa.
This, however, is only one possibility. Sometimes, full employment can actually be good for profits if it raises consumer spending and encourages firms to invest in labour-saving technology: one firm’s investment, remember, is another’s revenue. Sure, profit margins might not be great in this world. But if economic activity is high enough, shareholders get a smaller slice of a bigger pie so returns on capital will be good. In this world, low unemployment is good for shareholders and high unemployment bad. The interests of capital and labour coincide.
This isn’t a fantasy world. It’s exactly what we had in the 1950s and 1960s when full(ish) employment was compatible with good equity returns. It was only in the 1970s that this world fell apart to be replaced by one of profit-led growth.
Which poses a threat to shares now. It’s possible that high unemployment will cause workers to restrain their spending. If so, we’ll see weak demand, except for a brief blip as the pent-up demand caused by lockdowns is released. Equities might then be hit by earnings disappointments when any post-lockdown euphoria wanes.
Personally, I suspect this is a risk not a certainty. But nobody should invest on the basis of my suspicions. The point is that to be bullish of equities you must discount this risk – which means you must believe that the interests of capital and labour conflict. Equity bulls must be vulgar Marxists.
