Weaker labor impacts earnings: Verizon versus Caesar’s Entertainment
The Baby Boomer effect
The below graph reflects the rise and fall of the U.S. labor market participation rate as the Baby Boomer generation—and women—have entered the US labor market, though they’re now exiting the labor market. According to the Bureau of Labor Statistics projections, the U.S. labor participation rate is forecast to reach 61.7% by the year 2022—a rate not seen since the early ’70s, when the Baby Boomer began entering the market. So the below bulge in labor participation data can be seen as reflective of the prior graph of U.S. population growth. Americans born in the later 1940s entered the labor market in a big way over the course of the ’70s. Plus, women also joined the workforce as the single-earner household faded into history. However, this generation is now exiting the workforce, and this could have a significant impact on the economy in the next five years. This article takes a look at the effect that the Baby Boomer generation’s exit from the labor force is having on 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.
As we noted earlier in this series, recent economic analyses and key economists have been dismissive of the “structural unemployment” thesis accounting for the ongoing high level of unemployment in the U.S. economy. Economists have attributed the ongoing high level of unemployment—including the long-term unemployed and “discouraged workers”—to more diverse factors, including technological innovation, deregulation, and (to a smaller extent) outsourcing labor to other countries, such as China. It would appear that the main factors driving unemployment in the USA are largely endemic to the domestic U.S. economy’s normal evolution, and that updated social and economic policies are required to assist the labor market in adapting to the new labor market dynamics. In short, the root of the problem is policy—not an inherent structural flaw in the U.S. economic system itself. All things are in a constant state of change and adaptation, and often swift adaptation within specific sectors of the U.S. economy—involving land, labor, and capital utilization—can require policy changes to speed the adaptation process.
A constructive economic outlook
As the above graph suggests, the available labor force as a percentage of the entire U.S. population is shrinking. On one hand, this development could provide more employment opportunities for those born after the Baby Boomer generation, post-1964. On the other hand, the Baby Boomer generation portion of the labor force has been characterized as quite productive, and generally has had a positive impact on both the creation of employment for the younger generation as well as the associated wages—especially for the male portion of the workforce. Plus, as we’ve noted earlier, the Baby Boomer generation has consumed very heavily—supporting the post-1970 economic growth rate off the USA. Overall, the retirement of the Baby Boomer generation paints a mixed picture. This generation has contributed a high level of very productive individuals who have contributed to employment creation and wage growth for the younger generation and supported increasingly high levels of personal consumption in the USA.
Cautious economic outlook
On the other hand, this bulge in the population will also lead to higher demands on entitlements going forward as well—Medicare and Medicaid. Those born after 1964 will likely face higher tax rates to cover the rising costs of entitlements, though with modest improvements in labor force opportunities and technologically driven productivity growth, the anticipated rise in entitlement costs for the retired may not be as large a burden as the economists have forecast. In other words, it may become increasingly likely that the employment rate picture will improve, though with elevated levels of personal and public debt, and rising entitlement obligations, tax rates could be higher in the future, and the net income (including the ability to consume) of those born after 1964 could face significant economic pressures. In this case, it will be important to pay close attention to both wage and consumption data in the USA. Should wages and consumption weaken in the face of slower overall economic growth the post-Baby Boomer generation might be happy to have more employment opportunities though less than satisfied with the purchasing power their paychecks provide.
It’s still too early to see the net impact of the Baby Boomers’ exit from the labor markets on the overall economic picture, though the prior graphs would suggest that we’re halfway through the exodus from the workforce. The future liability in terms of entitlements raises questions, as the overall benefit of the Affordable Health Care Act will be a new regulatory environment in evaluating the costs of these Medicare and Medicaid costs for the overall U.S. economy.
Currently, early indications suggest that Obamacare is working better than expected, and that this policy could lead to net savings for the USA—quite contrary to the skeptics’ claims. In the near term, these trends shouldn’t put too much pressure on rising rates, as it’s becoming increasingly likely that that higher deficits and more bond supply have become muted by the dramatically improved Federal Budget, in light of higher capital gains taxes (which are still extremely low by historical standards) and basic economic growth. Plus, further declines in interest rates are also unlikely, as the Federal Reserve Bank continues to maintain exceptionally accommodative monetary policy, which is gradually improving the prices of assets in the USA (houses, stocks, and bonds), and supporting the slow though improving economic growth picture. In this scenario, either of the two below investment considerations for fixed income ETF investors might be suitable—depending upon the individual investor’s appetite for, and ability to undertake, various levels of credit or duration risk in the underlying portfolios.
Quality versus yield: Verizon and Caesar’s Entertainment
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), and Verizon also has a whopping $48.57 in EBITDA (six times larger than Sprint) to service its net debt of $42 billion—only 1.68 times larger than Sprint. 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.
Ceasar’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 9.54% profit margin and Sprint’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 (BBB) to Sprint (BB) and Caesar’s (CCC).
To see the numerical growth in available versus unavailable workforce in the USA, please see the next article in this series.
To see how the “discouraged worker” impacts U.S. financial markets compared to the Baby Boomers generation dynamics, please see Is the discouraged worker a lagging indicator for the S&P 500?
To learn more about these and other fixed income ETF investments, please see Fixed income ETF must-know: Has the bear market in bonds begun?
Short duration, higher credit risk: SNLN & BKLN
If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans that offer a floating rate coupon based on short-term interest rate pricing, which is typically the 90-day interbank rate, known as “three-month LIBOR” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London). Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration.
The duration of these “floating rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate in comparison to corporate bonds, of closer to 80% in comparison to closer to 50% in the case of similar rated bonds. It’s important to note that both of these ETFs invest in loans that are rated in the BBB to B area, and they do involve more risk of loss than portfolios rated in the AAA to A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8% and BKLN around 4.95%.
Longer duration, lower credit risk alternatives: AGG & LQD
Should investors be wary of the credit risk, they could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG), which maintains a duration of 5.11 years, though a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. LQD includes higher commercial credits such as Verizon (VZ)(0.70%) and Blackrock Funds (BLK)(0.67%), whereas SNLN holds lower-rated commercial credits such as Caesar’s Entertainment (CZR)(2.35%) and Hudson’s Bay Company (HBC)(1.50%).
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).