Why the US labor recovery supports equities and high yield credit

Part 3
Why the US labor recovery supports equities and high yield credit (Part 3 of 13)

The Fed favors the wealthy: Good for investors, not middle America

Why quantitative easing is really trickle-down economics in disguise

The below graph, while hard on the eyes, points to a very disturbing—and eternally recurring—pattern of reflationary economics. Please look at the trends in the red line (the top 5% of income bracket) versus the black line (the bottom quintile income bracket). Do you see a pattern? Hint: the left axis reflects the year-over-year growth in real wages. Guess which quintile fares the best. Guess which quintile fares the worst. This data reflects year-over-year growth in real wages minus the annual CPI (inflation) figure. This picture makes one important point quite clear: things haven’t been the same since the Dot Com crisis for any quintile of income in the USA. However, just look at the number of years since 2001 that the bottom quintile has been in the negative wage growth territory—under the thick horizontal black line. This article considers the trends in real income growth across quintiles of income levels in the USA and the implications for equity investors, as high unemployment is generally proportional to levels of income and education.

Highest Quintile Real Wage Growth Outpaces All OthersEnlarge Graph

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 Reagan revolution versus the Clinton anomaly

As we noted in a prior article on the tax history of the USA, Shutdown 101: US tax receipts, the great vanishing act, the Reagan Era really changed the entire taxation landscape of the USA.

US tax history: Supply-side excess?

Tax Reform Act of 1981: Omnibus Budget Reconciliation Act

  • Top tax rates dropped from 70% to 50% and reduced capital gains to 20% from Carter’s 28%.
  • Accelerated depreciation schedules were developed in order to encourage fixed investment

Office of Tax Analysis estimates four-year average tax revenue loss of -2.89% of GDP due to this 1981 act—and subsequent tax reforms under Reagan add back 1.94%, for a total net loss of tax revenue of 0.94% of U.S. GDP under all Reagan-era tax reforms—roughly $50 billion per year from 1981 to 1989.

Tax Reform Act of 1986

  • Top individual tax rates lowered from 50%to 28%, while corporate tax rates lowered from 46% to 34%.

1987 Balanced Budget and Emergency Deficit Control Reaffirmation Act

  • Automatic spending cuts via “sequester” were introduced to achieve deficit goals, though they required sequestration procedures be amended to conform to the U.S. Constitution under Bowsher v. Synar.

U.S. publicly held debt (net debt) versus GDP doubled under Reagan, from around 25% in 1980 to nearly 50% by the time Bush Sr. left office in 1993. This boosted growth rates, but perhaps not enough to compensate for the large growth in Federal debt. But as the above graph reflects, the growth rate in real wages to the top quintile in the USA was exceptionally strong by historical standards.

The Clinton anomaly: Trickle-up tax policy

Bill Clinton’s first tax package is reflected in the above graph as a huge anomaly—this tax deal impacted the wealthy more than the poor.

1993 Omnibus Budget Reconciliation Act

  • Bill Clinton’s first budget was also known as the Deficit Reduction Act of 1993.
  • It called for the increase in the marginal tax rate from 31% to 36% for wages over $180,000, with additional 10% for those earning over $250,000, and increasing corporate tax rates from 34% to 36% for corporations with earnings over $10 million.
  • Clinton didn’t deliver middle class tax cuts in the end, though tax increases on high earners and corporations were credited for the budget surpluses and decline in federal debt levels.
  • However, angered Republicans picked up 54 Seats in the House and eight in the Senate, and Speaker of the House Gingrich pushed Clinton to cut Medicare, Medicaid, and discretionary spending, leading to the government shutdown on November 1995.

1997 Balanced Budget Taxpayer Relief Act: Clinton forced to repent prior tax hike

  • Clinton lowers capital gains rate from 28% to 20%, taking pressure off of the Democratic Party’s large loss in Congress and the Senate.
  • Democrats regain Congress after this capital gains cut came into play and Newt Gingrich is partially appeased.

Yes, the Clinton anomaly was short-lived. How dare he engage in tax policy that leads to brief-lived real wage growth that favors the poor! That wage growth strike was hammered down when Clinton’s first tax policy initiative was recanted at the behest of Newt Gingrich and the Republican Party, in Clinton’s subsequent 1997 Balanced Budget Act. Say it ain’t so, Joe.

The Nixon anomaly

Interestingly, the above graph also has one other anomalous spike in 1972—the Nixon shocks of 1971, in which the U.S. devalued its currency, ran large deficits, repealed the income tax credit, removed 2,000,000 poor Americans from the U.S. tax rolls, and saw unions grab large wage gains. The world thought Nixon was a closet Democrat. But, even in this case, the Republicans would not let this anomaly persist. As inflation began to spread, the USA, under Federal Reserve Chairman Arthur Burns, saw the dollar suspend its long-standing convertibility to gold, and the subsequent oil shocks of October 1973 added fuel to the inflationary fires that began to spread though the U.S. economy. While stoking inflation helped the lowest quintile in 1971, inflation eventually spun out of control and had a boomerang effect.

The Carter hangover

As the above graph shows, the inflationary policies of the Nixon and Ford Administrations did a lot to stimulate the lower quintiles of the labor market through stoking inflation. However, as inflation spun out of control, Jimmy Carterr found himself taking office under conditions, much like Obama in 2009: the economy was falling apart at its seams. So much for trickle-up economics. A good idea, though terrible execution—much like the subprime credit market itself.

Why the Federal Reserve bank’s policies are Reagan Era supply-side economics in disguise

As the above graph reflects, with the brief exceptions of the Nixon and Clinton Era “save the poor” tax policy initiatives, ongoing supply-side remedies to the economy persistently manifest themselves in a recovery phase in which the real wage growth of the top one and two quintiles on the USA handsomely outperform the bottom three quartiles.

Why is this?

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. Unemployment shrank from the post–Dot Com crisis of 6.0% to 4.5%—still well below the 5.6% magic NAIRU (non-accelerating rate of employment) number. Yet, did we get wage inflation? 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 recovered—though at 6.7%, it’s still above the NAIRU rate of 5.6%. Yes, this time we’re drifting even farther 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 (SPY) 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 (a change 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. But the wealthy are seeing their real wages recover—and that should improve the supply-side, trickle-down spending feedback loop. So, help may be on the way for the lower three quintiles of the USA in the future. But in the meanwhile, this development should support the equity and bond prices of the investing class—high yield bonds may continue to outperform.

To see how the long-term unemployed are faring in relation to the broader labor market, 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:  Sprint is below investment grade but high quality as the economy improves

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).

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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