Why the US labor recovery supports equities and high yield credit (Part 6 of 13)
The below graph reflects the U-3 unemployment rate. This is the “official rate of unemployment” often referred to in unemployment data releases. This data series represents “total unemployed as a percent of the civilian labor population,” which is currently 97,939,800, as of January 2014. This article considers the relationship between the stock market and the official unemployment rate, and the implications for both fixed income and equity 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.
The stock market leads unemployment declines
As the above graph reflects, employment data has a small lag against stock market performance. Very notable are the strong gains in the equity markets up to the Dot Com bubble bursting in 2001. During the Clinton administration, equity markets rallied strongly, bringing the official unemployment rate down to a mere 4.0%. This rate of unemployment was lower than the “NAIRU” rate of 5.6%—the non-accelerating rate of inflation. Despite this exceptionally low level of unemployment, then–Federal Reserve Bank Chairman Allan Greenspan was somewhat befuddled as to how unemployment could be so low without creating wage inflation in the labor market. The thinking was that the digital revolution had fundamentally changed economic conditions, such that exceptionally low levels of unemployment may no longer lead to immediate rises in wages. Clearly, the historical relationship between low unemployment and inflation had changed. Was the change a function of a technologically more advanced and efficient labor market, or was the central bank simply underestimating the growing undercurrents of global deflation?
Deflation and labor markets
Post-Clinton, the Dot Com bubble collapse was followed by Bush Tax cuts and a second bull run in equity markets. This time, as reflected in the above graph, unemployment shrank from the post-Dot Com crisis of 6.0% to 4.5%—still well below the 5.6% magic NAIRU number. Yet, did we get wage inflation? Once again, we did not. What we got was asset inflation—a housing bubble. Still, no wage inflation.
Deflation and housing markets
Once again, post-subprime crisis, the unemployment rate has recovered, though at 6.7%, is still above the NAIRU rate of 5.6%. Yes, this time we are drifting even further away from the pressures of wage inflation. In fact, the economy is still wrestling with asset deflation in the housing market—the sector of the economy that affects middle-America the most. From Peak to trough, the Case-Shiller national housing prices fell from 190 to 125—a 34% decline. This index now stands at 150—still 20% below peak levels. Meanwhile, the S&P 500 is 23% above its pre-crisis peak. The ten-year bond yield has fallen from 5.20% in 2007 to 2.70 today. With a DV01 at 0.0865 for the ten-year Treasury (changes in the price of the bond associated with a one basis point change in the ten-year Treasury yield), the 2.50 decline in the ten-year Treasury bond yield equates to a 250 x 0.0865 = 21.65% gain in the ten-year bond price.
Deflation for the middle class: Stocks are up 20%, bonds up 20%, and housing down 20%
Given the above data, it’s no wonder who has benefitted the most from the Federal Reserve’s banks low interest rates and quantitative easing policies—those who have the lion’s share of their net worth in stocks and bonds—and a lot of it. For the middle class, 13.3% of mortgages are still underwater, though much better than the 24% in the fourth quarter of 2010. As such, it might appear that quantitative easing at the Fed has a significantly disproportionate effect on the wealthy relative to the middle class. However, if the Fed wishes to stimulate spending and investment, incentivizing those with the most to spend and invest may be prudent policy. However, to get the economy firing on all cylinders, the middle class will could also use a 20% gain in their housing prices to simply break even, though getting housing prices back to 2007 levels would definitely put them back in the black. Until that occurs, it would appear the middle class balance sheet will be under constraint.
The improving prospects for U-3 labor are encouraging. Perhaps an unemployment rate below the NAIRU target of 5.6% could put some reflationary pressure on the deflated economy—at least the housing portion. Stocks and bonds have fared much better. The Fed’s $4 trillion war on deflation appears to have taken half of the pain out of the housing market collapse. Perhaps a self-sustaining recovery can help to reflate the economy even further. As things progress, it’s possible that the low rate environment will continue to support both equities and credit markets. However, in this new world labor economy, it seems that wage inflation—despite strong equity markets and sub-NAIRU rates—may be a thing of the past. Something appears to have changed. In this environment, it might be advantageous to consider mid-level credit exposure to gain enhanced yield, as investment grade credit yields remain extremely low.
To see how the U-3 unemployment compares to the unemployment rate that also includes “discouraged workers,” or U-4 data, 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?
A credit comment: Yield versus quality—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.
In contrast, Verizon has a market capitalization of $198.36 billion, and a credit rating of BBB+. Reducing the firm’s $96.61 billion of debt by the firm’s very large $54.13 billion cash position, we’re left with approximately $42 billion of net debt, and a 0.98 debt-to-equity ratio. In contrast to Sprint, Verizon has a positive net profit margin of 9.54%, and a 26.03% return on equity. Verizon’s revenues are $120.55 billion (roughly three times larger than Sprint’s) and Verizon also has a whopping $48.57 in EBITDA (six times larger than Sprint’s) to service its net debt of $42 billion—only 1.68 times larger than Sprint’s. Clearly, Verizon’s very large EBITDA earnings relative to its modest debt levels would suggest that even in the case of economic weakness—related to labor and consumption or most anything else—Verizon has a far superior ability to service its debt. Perhaps a strengthening labor market and overall economy can support Verizon’s operating margins and debt service capabilities relative to Sprint in the future.
Sprint currently has a August 15, 2007, senior unsecured bond yielding 2.95%, versus Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile US’ February 9, 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)
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: