U-6 labor: Underemployment declines, supporting stocks and bonds
The below graph reflects the improvement in the overall rate of unemployment and underemployment in the U.S. labor market. The Bureau of Labor Statistics defines U-6 labor as “total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force.” After reaching its peak of nearly 17% in 2010, this rate of overall underemployment and unemployment fell approximately 1% per year for three years. However, over the past year, we have seen that the U-6 unemployment rate fell 2% in one year, reflecting an acceleration of improvement in the labor market. This trend should reinforce the overall improvement in the economy by contributing to consumption levels, while record-high stock prices, high bond prices, and stabilized housing prices reinforce new hiring. This article considers the big picture of overall labor conditions and the implications for equity and fixed income markets.
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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.
Back on track
The overall improvement in this broadest measure of unemployment and temp-related underemployment paints a positive picture for the equity and fixed income markets. As we noted in a prior series describing entitlement-related government spending, unemployment benefit–related spending rose from 1.5% of gross domestic product before the financial crisis to 3.0% of gross domestic product in 2010. With tax receipts around 17.0% of gross domestic product, that means that federal spending related to unemployment rose from around 9.0% of the federal budget to around 18.0% of the federal budget. That is a very large financial burden for the federal government and makes a significant contribution to the overall level of federal debt levels.
Tax revenue up, federal spending down
Currently, tax revenues are improving, and unemployment-related spending has declined to around 2.0%. If the broad level of unemployment continues to improve at its current pace, it would seem that this portion of the federal budget will reach normal levels within a year or two. As we noted in a prior article on federal tax receipts, federal tax receipts had dipped far below their historical norms during the financial crisis, from around 16.5% of GDP in recent year to just below 14.0% of GDP—near postwar record lows. Meanwhile, unemployment-related spending had doubled. That made a very significant contribution to the growth over U.S. net debt levels, from around 40.0% of GDP to closer to 80% of GPD today. However, with the overall economic and employment recovery improving, it would seem that the associated improvement in tax receipts and federal spending will also continue to improve, moving the U.S. economy further away from the crisis zone. While considerable works remain to be done in terms of whittling down the new debt that was acquired during the financial crisis, it would appear that the basic trend in overall economic improvement should support that effort within the next few years.
The wealth effect
The recent Federal Reserve Bank data confirmed that U.S. household net worth rose $9.8 trillion from 2012 through 2013. This included $5.6 trillion in improved equity valuation and $2.3 trillion in real estate valuation. Household net worth now stands at a record-high $80.66 trillion—a far cry from the $57.18 trillion we saw at the end of 2008. As a result of this improvement in asset values in the USA, analysts hope that sufficient spending and investment will reinforce the post-crisis recovery and continue to bring the labor market back toward full employment levels in line with historical averages.
For equity investors, this improving economic trend should support valuations and stock prices. However, the risk factor is always the unanticipated rise in interest rates. While the Federal Reserve Bank has just begun to slow down its purchase of bonds from $85 billion to $75 billion per month as the economy improves, it would seem that rapidly rising rates are still a long way away. Real interest rates in the USA are not too far off of norms in the longer end of the yield curve, as the real rate in the ten-year bond approached 2.0% at the end of 2013. Low inflation is keeping rising interest rates in check so far, and if low inflation keeps the yield curve under control, it would seem that housing and equity prices can continue to improve. However, bond prices don’t have much room to rally further, as rates are already low. In this environment of apparently diminishing asset price risk, it might be appropriate to consider exposure to higher-yielding, higher-risk fixed income securities that will rally in price as the economy improves, and cash flow earnings finally enhance the ability of highly levered firms to service and pay down their debt.
Going to Vegas: Caesar’s Entertainment
Caesar’s Entertainment rose from $5.00 per share in late 2013 to over $25.00 per share today. As the economy has improved, the company has taken action to restructure its assets and debt, with the hopes of refinancing its high cost debt. The firm is pushing for distressed debt swaps in an effort to negotiate its debt down to a manageable level—essentially changing the terms of its current borrowings and bonds with current debt holders. If successful, Ceasar’s could re-emerge with newly created bonds that are higher in credit quality, or at least lower in principal. With a more manageable debt-related burden, equity holders may also continue to benefit.
The following articles in this series consider equity ETF investment options that consider market breadth versus value and growth, as well as fixed income ETF options that consider quality versus yield.
Credit Comment: Caesar’s Entertainment CCC Credit
Caesar’s Entertainment Corporation has a fairly small market capitalization of $3.57 billion, and a CCC credit rating (below Sprint’s BB credit rating)—the highest area of the below–investment-grade category. Reducing Caesar’s $21.54 billion of debt by the firm’s $1.71 billion cash position, we’re left with approximately $23.25 billion of net debt. In contrast to Verizon’s (VZ) 9.54% profit margin and Sprint’s (S) -8.5% profit margin, Caesar’s has a negative profit margin of -19.91%. Caesar’s revenues are $8.34 billion, with an EBITDA of $1.76 billion to service its net debt of $23.25 billion, while Sprint has $5.47 billion to service debt of $25.5 billion. Meanwhile, Verizon has $48.57 of EBITDA to service its net debt of $42 billion.
These differences in debt and EBITDA earnings drive the differences in credit quality ratings from the top of investment grade, Verizon (at BBB), to Sprint (at BB) and Caesar’s (at CCC). Caesars currently has a June 1, 2017, senior secured bond yielding around 11.00%, 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 CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46% (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).