By Putnam Fixed Income Team | Feb. 1, 2023
Originally published Dec. 14, 2022

The Putnam Investments Fixed Income Team is carefully watching job losses in the U.S. ahead of a widely expected economic downturn. Read on for why they think this metric is a key aspect of employment data and could be an early indicator that can tell us more about where we are in the economic cycle. Investors can access the expertise of Putnam Investments through two U.S. equity funds on the Canada Life™ shelf, the Canada Life US All Cap Growth Fund and Canada Life Pathways U.S. Equity Fund.

• The U.S., Europe and China offered glimmers of hope for risk assets in November, but our focus remains on the outlook for job losses.
• Some market participants and Federal Open Market Committee (FOMC) members are debating whether profitable businesses might hoard labour, but we would note that businesses that close lose all their jobs.
• By analyzing new business formation and hiring, we can point to sectors likely to face profitability pressure and greater job losses, as well as tentative signs this is starting.

Young businesses are a major source of employment, a key variable determining the economic cycle. In the short-lived COVID-19 recession of February to April 2020, new business formation slowed for a short period, but then surged. By early 2022, the pace of net business formation had reached the highest pace of the last 30 years.

A sizeable number of young firms have not faced the forces of creative destruction yet. The current business failure rates for young establishments are at historical lows: 14.8% for newly formed businesses, 12% for businesses between one and two years old, and 9.6% for businesses between two and three years old. On average, 21% of new businesses fail within a year, and this figure rises to 24% during a typical recession.

Business formation accelerated in all non-farm business sectors but was especially significant in some industries. Information technology almost doubled the pace of business formation from 2020 to 2022. Newly formed businesses in professional, scientific and technical services (including management services); finance and insurance; transportation and warehousing; administrative services; and education also increased more than 50% in the last two years. Professional, scientific and technical services and health care continue to constitute the largest share of newly formed firms. Some of the sectors with higher than usual new business shares had a notable contribution to employment growth in the past two years.

Professional and business services, along with transportation and warehousing, did not have any job losses on an annual basis and continued to add to payrolls. In professional and business services, newly formed firms were the main sources of job growth. In transportation and warehousing, older firms contributed to job growth as well. As the impact of monetary tightening starts to affect businesses' profitability and increase business failure rates, employment gains are likely to slow and then contract in these sectors. Since the share of young businesses is larger in professional business services, job losses in this sector may be significant.

Administrative services also added significantly to employment after the Covid pandemic. Most job gains in this sector reflect the expansion of other businesses. The increase in temporary help services, a large administrative services subsector, has been the key contributor to employment gains. More and more businesses are relying on temporary help services because of the flexibility they provide. Large businesses report they are hiring more temporary workers given the uncertain outlook of this inflationary cycle. When the economy turns, this sector will be reporting a lot of job losses even though many of the established firms may not fail.

Retail trade added considerably to employment growth. This sector may not currently be dominated by newly formed businesses, but given its structural decline, the share of newly formed businesses, 15.6%, might be a bit high. As retail trade tends to have small profit margins and is currently employing more staff now than prior to Covid, it is highly exposed to bankruptcies and job losses.

Finance and insurance did not have job losses on an annual basis, and the share of newly formed businesses is now around historical averages. Now that housing activity has been slowing, finance and insurance is likely to report job losses.

Health care is one of the largest employers and has a high proportion of newly formed businesses. Still, job losses by older businesses were so large that total employment has not recovered to pre-Covid levels yet. Health care employment tends to be one of the least affected by a downturn. Unless we have another health care shock, employment in this sector should be sustained.

The information sector seems to have the most froth (when prices of assets increase beyond their intrinsic value and become more tied to sentiment than fundamentals), as the proportion of immature businesses is very high. This sector typically has high business and employment turnover, but its overall contribution to total employment growth is small. When high funding costs start to bite, it might not matter much for total employment but could weigh more on financial markets, which are heavily exposed to technology firms' balance sheets. The share of information technology and communication stocks in the global portfolio of all publicly traded bonds and equities as well as private assets peaked at a little above 15% in December 2021 and is still very high. The share of U.S. tech companies in this portfolio at the December peak was even greater than at the top of the dot-com bubble.

Financial market exposure to corporate sector balance sheets is skewed to large businesses and well-established firms. Closely watched market indexes and spreads might not be the place to look first for signs of rising business failures in sectors that grew rapidly after the pandemic began.

The young, risky businesses are more frequently financed by banks and private capital and represent a large part of alternative investments. This area of the market grew rapidly in the decade of low interest rates and low volatility after the global financial crisis. Alternative investments now represent close to 8% of the global portfolio – not a negligible source of return or risk. This area is dominated by private equity.

Among subcategories of private equity, venture capital is likely to have the largest exposure to new establishments and is likely to be tested in the next downturn. These assets are highly illiquid and typically valued only once per year. Sectors to watch for significant job losses are information technology, administrative services and professional services.

If private equity is tested and somewhat shaken, credit and loan markets with exposure to private equity might be affected. The impact of the Federal Reserve's tightening is not likely to be confined to the crypto world.

Many companies start downsizing before business closures occur. In sectors likely to have more business failures, job losses might start in line with other sectors but then accelerate as defaults and closures rise. The recent ADP report pointed to small job losses in those sectors that are more exposed. There were also some tentative signs in the Bureau of Labor Statistics (BLS) November report household survey. We might be at the very early stages of this adjustment. Business failures will come after.

FOMC participants speaking after the November rate hike talked about intentions to slow the pace of hikes. They discussed the uncertain timing in the economy's response to monetary tightening – even as U.S. financial conditions loosened considerably in November. The widely expected downturn is still likely to arrive, but perhaps later than many – including some FOMC members – have in mind.