US labor: Is the discouraged worker bad for stocks and bonds? (Part 1 of 9)
The below graph reflects the relationship between the stock market, as reflected in the S&P 500 (SPY), and the growing number of discouraged workers in the USA. Discouraged workers are the portion of the U.S. labor market that has essentially stopped looking for work. The labor data in this series is provided by the U.S. Bureau of Labor Statistics, or BLS. This series on the U.S. labor market considers the historical and post-2008 trends in the U.S. labor market to determine whether current data suggests labor conditions impact both equity and fixed income markets.
Is the discouraged worker a new paradigm post-2001?
Clinton’s sweeping capital gains tax cuts in 1997 and subsequent strong growth in investment led to strong equity market returns and an exceptionally strong decline in the number of discouraged workers—falling from around 350,000 in 1994 to a mere 200,000 in late 2000—just before the Dot Com bubble burst. That is how politics and economics are supposed to work in conjunction to grow prosperity and reduce the number of “marginal workers” in the U.S. workforce—those in and out of work and typically on some form of public assistance.
Bush came into office in a situation somewhat like Obama. The stock market bubble was collapsing, and unemployment rose from the spectacular low of 4% to 6% in a year. Discouraged workers rose from roughly 200,000 to 300,000 from 2001 to 2006. As the above graph shows, the additional Bush Tax Cuts of 2001 and 2004, which lowered capital gains rates to as low as 15%, seemed to have led to a (sputtering) equity market recovery. The Federal Reserve Bank subsequently lowered short-term rates from 5.25% to 1.00% to support the economy. Yet, despite these measures, and four consecutive years of solid equity markets, the number of discouraged workers remained unfazed—in complete contrast to the Clinton Era.
Like his predecessor, Obama also came into office in a collapsing economy—only this time tenfold worse. During the Dot Com bubble, the loss of wealth as associated with a handful of speculative stocks was somewhat contained and remedied fairly quickly with tax cuts and low rates. In the post-2008 case, the U.S. was facing an entirely different phenomenon, much more akin to the Great Depression. When Obama came to office, not only were equity markets collapsing—but all housing was also collapsing. The lost of wealth due to declining home prices decimated middle America much more than the Dot Com speculative bubble. Sure, bond prices rallied, but not nearly enough to compensate for declining home and equity prices—which devastated middle America. Once again, just like during the Bush Administration, we’ve seen five years of equity market gains, but the number of discouraged workers remains high.
The above graph seems to reflect an ongoing problem in the U.S. labor market that has left both the Federal Reserve Bank and the Bureau of Labor Statistics perplexed. The discussion surrounding the new dynamics of the discouraged worker now exists within the context of “structural change” in the U.S. economy. While many point to outsourcing, cheap Chinese manufactured goods, technological innovation, and job skills mismatch as the cause of structural unemployment, economists like Paul Krugman have another view. From Krugman’s perspective, the current period of weak employment is not structural, and current research supports his view. According to Krugman, the government’s reference to structural unemployment is more of a means for the political sphere to avoid policy responsibility, as noted in his recent New York Times column, “Structure of Excuses.”
A note on credit: Sprint versus Verizon
Sprint (S) has a market capitalization of $36.17 billion (the value of all its equities), and it’s 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 $33 billion of debt by the $7.47 billion of cash holdings leaves approximately $25.5 billion of net debt, and a 1.29 debt-to-equity ratio. However, given the last quarter profit margin of -8.50%, the firm has seen a negative 18.48% return on equity. Sprint is a large company with $35.49 billion in sales revenue, and it still has $5.47 billion in earnings before interest and taxes (EBITDA) to service its net debt of $25.5 billion.
This is sufficient debt service capability, though a weakening economic environment in the USA could compromise the debt service ability in the future. With $48.57 billion in EBITDA and $42 billion in net debt, Verizon is clearly in a much stronger financial position than Sprint. Unless we see labor and productivity increases in the future, companies with weaker earnings margins like Sprint could face further pressures on their bond prices and higher yields. However, the 2013 Softbank merger or acquisition and capital infusion of $5 billion may also improve Sprint’s credit outlook and operating health going forward. While Sprint is in fairly stable condition, it’s not as strong as its competitor, Verizon (VZ), with relatively lower debt levels and more cash on its balance sheet. Sprint currently has an August 15, 2007, senior unsecured bond yielding 2.95%, versus Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile (TMUS) US’s February 19, 2019, senior unsecured bond yielding 3.00%, CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46%, and Caesar’s Entertainment’s June 1, 2017, senior secured bond yielding around 11.00% (Bloomberg & Capital IQ, December 31, 2013 Quarter).
To see how many workers have become discouraged since the BLS began capturing discouraged worker data in 1994, please see the next article in this series.
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).
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