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The structural unemployment myth: Implications for equity markets

Marc Wiersum, MBA

US labor: Is the discouraged worker bad for stocks and bonds? (Part 4 of 9)

(Continued from Part 3)

US wealth distribution: Why perception isn’t the reality

The below chart reflects the large disconnect between real versus perceived levels of wealth distribution in the USA. Perhaps the disparity between perception and reality, as in the case of the discouraged worker, is generally understood through less than clear media coverage—the Fox News effect. Somehow, the U.S. population has the impression that wealth distribution is much more “fair” than the actual and obvious data would suggest. How can it be that the U.S. population is so out of step with such basic demographic data? One wonders how long this disconnect can persist, and if this very issue, as a result of the ongoing “structural unemployment” debate, could gain a much larger role in shaping future political and economic policy. Interestingly, it was just announced that Nobel Laureate economist Paul Krugman will leave his position at Princeton University to dedicate more time to this fundamental issue at the City University of New York, CUNY. This article considers the simmering “equality” debate within the context of wealth distribution and considers the implications for changing social policy—and its impact on equity markets.

For a more comprehensive review of the U.S. macroeconomic environment driving the labor market data in this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Media spin: Discouraged workers drive the unemployment rate

In the case of the discouraged worker, much ado has been made over the “half million” Americans who have dropped out of the workforce. It’s not fully appreciated that a more normal level of disappointed workers had been around 200,000 to 300,000, and had more than doubled to around 700,000 during the recent economic crisis—though it’s halfway back to more normal levels once again, as economic growth has been improving (just under 500,000).

Plus, as we’ll cover in the next series on U.S. labor markets, it has been noted that much of the improvement in U.S. nationwide unemployment, the official unemployment rate or U-3 rate of unemployment, from 10% to 6.5%, has been due to people dropping out of the workforce. Prior to the crisis, the labor participation rate had been roughly 66.5%, though recently, it stands at 63%. As such, it has been claimed that up to 80%—depending upon the data source—of the decline in the unemployment rate has been due to people giving up on finding work. As we discussed earlier and noted in the first graph of this series, discouraged workers currently comprise a mere 0.45% of the workforce, though they had been as low as 0.10% of the workforce during the Clinton Administration, and as high as 0.70% post–2008 crisis. Clearly, the discouraged worker is a fairly small portion of the total workforce, though they did comprise 0.70% of the workforce when unemployment was at its peak of 10.0%. So, if the declining labor force participation rate is driving the improvement in unemployment, the main cause of the shrinking labor force cannot be the discouraged workers.

Media Spin: The Baby Boomer effect

As we’ll discuss in our next series, the 4.5% decline in the labor force participation rate from the 67.5% high in 2002 to 63.0% today is largely due to demographic changes. The Baby Boomers are in fact retiring. It might appear that the 2008 crisis has contributed to the Baby Boomers’ decision to withdraw from the workforce. As a simple matter of demographics, the Bureau of Labor Statistics has estimated that the labor participation rate in 2022 would decline further from today’s rate of 63.0% to around 61.7%. In other words, the Baby Boomer generation’s withdrawal from the workforce isn’t news, and the large-scale decline in the labor participation rate has been in the cards for a long time.

A simple linear estimation of the rate of decline in labor participation would suggest that, even if the financial crisis of 2008 hadn’t occurred, it might be the case that the labor participation rate might be about 1.0% higher today than it currently is—64.0% versus 63%. While somewhat marginal, we could argue that this represents an additional 1 million workers who left the workforce earlier than they may have on their own accord. Then, throw in an additional half million discouraged workers, and the numbers actually start to add up—that’s around 1.50% of the workforce that may have opted out due to being discouraged (0.50%) or simply because they felt they were getting too old to deal with the workforce anyway (1.0%).

Why?

You could argue that an additional 1,000,000 of the Baby Boomer generation threw in the towel earlier than they might have liked. It’s possible that many of these 1,000,000 Baby Boomers who left the workforce left because they were, in some shape or form, discouraged. It’s well noted that it’s hard for people over the age of 45 to find similar positions in the current economy, and even harder for the older Baby Boomers born prior to 1955 to find work. It’s possible that many of the Baby Boomer generation decided to take what they had in their 401K’s, home equity, and social security and stop looking for work in a labor environment in which the odds are stacked against them.

Wealth distribution implications

With many of the Baby Boomers leaving the workforce and the high level of voter turn-out among the elderly, who have strong feelings for Medicare and Medicaid, it might appear that the Democratic party also picked up an additional 1.50% of the workforce, or roughly 1.5 million voters, as a result of the financial crisis. No surprise that Obama got a second term. While Republicans continue to threaten entitlements such as Medicare and Medicaid just as its ranks are set to explode, it would seem that campaigning against “entitlement” reform is increasingly a losing ticket, given current demographics in the labor market and the USA as a whole. Many of these Baby Boomers didn’t get wealthy post-1945, and as they have a strong tendency to vote and watch PBS news, there’s a good chance this large and idled segment of society is likely to have a growing impact on social policy issues surrounding the above graph—the distribution of wealth.

Conclusion

As we discussed in the 2014 macroeconomic overview Crisis management: Investing in a low-growth economy, the U.S. economy (including tax receipts and budgetary spending) has improved significantly since the U.S. crisis. The revenue-to-expenditure equation is back in line, with real GDP growth right at about 2.5% trend growth since 2010. However, the growth rate post-crisis has been a bit choppy and less robust than post-recession norms. It’s within this context that investors will need to be wary of higher taxes in the future, as U.S. businesses as well may face greater tax burdens as entitlement spending rises and the growing number of retired Baby Boomers vote to protect their entitlements. The mid-term elections this year should provide further insight as to the direction of public policy.

A note on Credit: CIT Group versus T-Mobile USA

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).

To see how equity indices have continued to rally despite large number of discouraged workers and early-retiring Baby Boomers, 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).

Continue to Part 5

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