Why the US labor recovery supports equities and high yield credit (Part 2 of 13)
Discouraged workers versus encouraged workers
The below graph paints a comprehensive picture of the overall U.S. labor market to date—reflecting dramatic post-crisis recoveries in all measures of the U.S. labor force—U-1 through U-6. Please remember that the “discouraged worker” as described in the earlier article in this series only constitutes 500,000 of a total 2014 labor force of 98 million workers. Note that the number of discouraged workers in the U.S. is the difference between the official employment rate (U-3) and the U-4 rate of employment (that little gap between the red and green lines). This article takes a closer look at changes in the overall labor market (the other 97.5 million workers) and considers the implications for fixed income investors.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Half empty or half full?
The above graph reflects the progress in the recovery of the U.S. labor market. While overall employment rates are quite poor by historical standards, it would appear that the recovery is on track. As corporate profits reach record levels and corporate balance sheets swell with cash liquidity in a low interest rate environment, it would appear that there’s ample room for investment and growth. From this perspective, the glass is half full. On the other hand, the fact that investments and (by association, to some degree) employment remains low would suggest that the glass may remain half empty for some time. As economist Paul Krugman has pointed out, the problem is not with supply—we have plenty of that. The problem is with the demand side of the economy.
Krugman: The demand-side problem
As Paul Krugman points out in his New York Times column on September 26, 2010: “Oh, and where are these firms that ‘can’t find appropriate workers’? The National Federation of Independent Business has been surveying small businesses for many years, asking them to name their most important problem; the percentage citing problems with labor quality is now at an all-time low, reflecting the reality that these days even highly skilled workers are desperate for employment… So all the evidence contradicts the claim that we’re mainly suffering from structural unemployment.”
In other words, the claim that the labor force isn’t not properly trained for jobs that are open is a political myth.
Plus, on February 9, 2014, Krugman writes: “If you think the typical long-term unemployed American is one of Those People — nonwhite, poorly educated, etc. — you’re wrong, according to research by the Urban Institute’s Josh Mitchell. Half of the long-term unemployed are non-Hispanic whites. College graduates are less likely to lose their jobs than workers with less education, but once they do they are actually a bit more likely than others to join the ranks of the long-term unemployed. And workers over 45 are especially likely to spend a long time unemployed.”
The evidence has a liberal bias…
Krugman questions the orthodox supply-side economist’s doctrine: “But evidence has a well-known liberal bias. The more their economic doctrine fails — remember how the Fed’s actions were supposed to produce runaway inflation? — the more fiercely conservatives cling to that doctrine. More than five years after a financial crisis plunged the Western world into what looks increasingly like a quasi-permanent slump, making nonsense of free-market orthodoxy, it’s hard to find a leading Republican who has changed his or her mind on, well, anything… And this imperviousness to evidence goes along with a stunning lack of compassion.”
To see a graph showing how the wealthy outperform the poor in economic recoveries, please see the next article in this series.
For more detailed analysis of the U.S. labor market, please see Is Baby Boomer retirement more good news for stocks and labor markets? and US labor: Is the discouraged worker bad for stocks and bonds?
The overall employment data picture certainly has improved, and the sustained rally in equity prices seems to be making a significant contribution to the wealth effect, as the wealthy are now in a better position to both consume and pay capital gains taxes on equity-related capital gains. It would appear that this trend can and will continue—as long as consumption doesn’t begin to falter, and thereby provide further support to the equity market. However, the social policies surrounding the unemployment issue will remain, and the equality debate isn’t likely to subside soon. On the fixed income side, the economic recovery has led to higher rates during 2013—making the ten-year yield almost double from 1.50% to 3.0%, though the recent drop in rates to 2.60% in 2014 suggests that rates aren’t rising much further very soon. Current thinking suggests the ten-year Treasury may be a bit range-bound in the 2.50%-to-3.0% range for a while, as low inflation keeps real interest rates fairly high—at least relative to 2010 levels. Should inflation finally pick up, we could finally see nominal rates in the ten-year bond rise through 3.0%.
A credit comment: CIT Group, rebounding with the recovery
CIT has a market capitalization of $9.57 billion (the value of all its equities) and is considered a high yield credit. Its debt is considered below the investment-grade cut-off of “BBB” rating, as it’s in the BB (junk bond or below–investment-grade) category. Reducing the firm’s $23.17 billion of debt by the $6.18 billion of cash holdings leaves approximately $17 billion of net debt, and a 1.77 debt to equity ratio. CIT Group currently has a February 19, 2019, senior unsecured bond yielding 3.46%, versus Sprint’s August 15, 2007, senior unsecured bond yielding 2.95%, Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile USA’s February 19, 2019, senior unsecured bond yielding 3.00%, and Caesar’s Entertainment’s June 1, 2017, senior secured bond yielding around 11.00%.
An improvement in labor and credit conditions would likely improve CIT Group’s credit rating—though with a BB- senior unsecured bond yielding 3.46% versus T-Mobile USA’s BB- company-guaranteed bond yielding 3.00%, CIT’s unsecured yield reflects a strong fundamental credit (Bloomberg & Capital IQ, December 31, 2013 Quarter).
Credit outlook: High credit quality and longer-duration (TLT & BND) versus lower credit quality and mid-duration (HYG & JNK)
For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.
However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.
Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp. (0.62%), Sprint Communications (0.59%), and HCA Inc. (0.53%).
Equity outlook: Cautious
Should the debt ceiling debate re-emerge after the mid-term elections in November, and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Plus, even the global blue chip shares in the S&P 500 (SPY) or Dow Jones (DIA) could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the budget and federal debt issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment, or individual companies such as Wal-Mart Stores (WMT).
Without sustained improvement in economic growth data, there’s little doubt that the debt level issue and tax reform will be a big issue later in the year. Current economic data noted in this series suggests that the probability of the 2013 sequester issue returning—in one form or another—could be higher than many think. The data is simply not that robust—yet.
Equity outlook: Constructive
However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this series, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the S&P 500 (SPY) price-to-earnings ratio standing at 19.65 versus the historical average of around 15.50, the S&P is slightly rich in price—though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that is “on strike,” including corporate profits, into long-term fixed investments. This could lead to greater economic growth rates and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).
Browse this series on Market Realist:
- Part 1 - Why post-2008 labor market dynamics support equities and credit
- Part 3 - The Fed favors the wealthy: Good for investors, not middle America
- Part 4 - Why the newly unemployed are supporting the S&P and credit
- Mutual Funds
- Paul Krugman
- Discouraged workers