Labor conditions: AAA credit versus the sub-investment-grade Sprint
The below graph reflects the unprecedented growth in the discouraged worker in the USA since the Bureau of Labor Statistics began compiling this data in 1994. The sudden doubling of discouraged workers post-2008 has been a cause of concern for the U.S. economy, and the media has drawn considerable attention to this issue. Despite the media hoopla, as below, please note that the “discouraged worker,” while totaling 500,000 in number, represents only 0.5% of the total U.S. labor force of 97,939,800, as of January 2014. This article takes a closer look at the changes in the discouraged worker data and considers the implications for fixed income investors.
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Post–Dot Com highs: Equities up 22%, discouraged workers up 150%
Since the Clinton Era highs, the S&P 500 (SPY) has risen approximately 22%. The number of discouraged workers has risen roughly 150%. As we discussed in the prior article in this series, and as reflected during the Clinton Administration above, strong equity prices led to a sharp drop in the number of discouraged workers—from 350,000 to under 200,000. During the Bush Administration, rising equity prices didn’t do much for the discouraged worker, with discouraged workers remaining flat as equity markets rallied for four consecutive years. Once again, during the Obama Administration, equities have rallied above old highs, and the number of discouraged works has fallen from over 1,000,000 to 850,000.
This may be progress, though the ongoing pattern is becoming clear: despite economic recoveries post-2000, the level of discouraged workers is dropping, though it’s down to an increasingly higher floor. Following Clinton and the Dot Com bubble, we see that the historical effect of strong equity markets on the discouraged worker has lost much of its impact—at least for now.
Why is this?
As we noted in the prior article in this series, recent research and economist Paul Krugman have dismissed the notion of “structural unemployment” as political nonsense and an excuse for the lack of appropriate economic policy—the “Structure of Excuses.” In Krugman’s view, the current employment problems are nothing new and unique. Rather, they’re simply another chapter of ongoing economic development and recurring business cycles. As always, the government needs to come up with better policies to address the output gap—the portion of labor and resources that should be put to productive use but is lying idle.
Did labor quit, or are capitalists on strike?
As we described in a prior series, much has been made over the lack of fixed investment in the USA since the Clinton Administration. Despite the Bush Tax Cuts and the housing bubble, overall long-term investments in the USA have been exceptionally weak. The St. Louis Fed is quite puzzled by the lack of recovery in fixed investments in the USA post-2009. It just can’t figure out why fixed investments aren’t on the typical post-crash tear—possibly reflecting the disconnect between St. Louis and Bakersfield, California, the half-vacant subprime center of the foreclosure universe.
While many are aware off the pressures labor has faced as technology (think automated check-out) that Chinese exports, outsourcing, et cetera have caused, the traditional economic model would suggest that these developments should only enhance economic conditions in the USA, freeing up resources—including investment resources—to be deployed in productivity-enhancing ways. Yet, as we described in Greenspan’s lament: The lack of fixed investment in the U.S., long-term investments remain weak and long-term unemployment remains elevated.
Don’t blame the Fed—blame Washington
Despite corporate profits and equity markets remaining at record highs, as we described in a prior series, long-term fixed investment remains as very depressed levels—closer to 4% of GDP rather than the more normal 8% of GDP. Plus, with the Federal Reserve Bank’s unprecedented levels of activist monetary policy, it’s had to blame to Fed, as we noted in Why the Fed’s $4 trillion war on deflation affects ETF investors. It would appear the Fed has done more than its share of fostering an economic recovery, and we’ll leave it to the Obama Administration and Congress to come up with something that will get the long-term investment portion of our economy back to the old normal of around 8% of GDP. My hunch is that would be just the ticket to encourage the discouraged worker and restore the overall economy to its full output potential. The economy needs to see improvement in fixed investment in areas outside of the residential sector, which is still wrestling with significant shadow inventory.
Should Krugman and the recent research be correct, and Washington changes policy with respect to spurring long-term investment, it would be reasonable to expect record corporate profits, high cash balances on corporate balance sheets, and low interest rates to be put to work—right along with the discouraged worker. Should this pattern of improvement start to develop, it becomes easier to see a return to economic growth normalcy, with post-2008 growth rates returning to, and perhaps even exceeding, trend growth well over 2.5% per annum for an extended period. (Wouldn’t that make the Republicans look stupid? As if Obamacare’s early successes weren’t bad enough!) In such an environment, we would also likely see interest rates rise as deflationary pressures wane and more normal demand for investment capital develops.
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 discuss the overall view of the U.S. unemployment data as provided by the Bureau of Labor Statistics, please see the next article in this series.
For further macroeconomic analysis surrounding fixed income ETFs, please see Key strategy: Will deflation contain the bear market in bonds?.
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, S, (0.62%), Sprint Communications (0.59%), and HCA Inc (HCA).