An explosion in unavailable labor by 2022
The below graph captures the dramatic trend in the Baby Boomer exodus from the labor market. By that time, many of the Baby Boomers will have retired, though the youngest of the Baby Boomers, born in 1964, will only be 58 years old and still may be a decade or more away from retirement. Regardless, as the below graph shows, the available labor force will grow by 2.77 million from 2014 to 2022, and the unavailable labor force will grow by 5.26 million workers—a difference of 2.59 million workers. That’s a lot of people leaving the workforce versus joining. This article considers the decline in the labor force, the potential impact on economic growth, and the implication for fixed income ETF 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.
Will economic growth decline?
The above graph suggests that the ongoing decline in the size of the workforce could present problems for future economic growth. On one hand, a smaller population isn’t a problem in and of itself, though when the smaller population is required to support a large number of elderly people, entitlement liabilities become a potential problem. Unless the USA has a recovery in fixed investment and productivity levels grow, the U.S. could find itself facing increasingly weak GDP growth—unless Paul Krugman’s demand-side stimulus ideas are successfully implemented in the future.
The case of Japan
Japan experienced this problem after its bubble economy burst in 1990, and the numbers of post-WWII elderly people remained large. The Japanese economy failed to grow as population growth declined as the Baby Boomer population growth rates of 1.0% to 2.00% were replaced with flat-to-currently-negative growth rates. Plus, the Japanese government net debt–to–GDP exploded to 135% post-1990, as the U.S. net debt–to–GDP exploded from around 40% to 80% of GDP pre- and post-2008 crisis. In Japan, GDP also has remained flat, as productivity and investment growth failed to develop and offset the effects of a declining Baby Boomer workforce. Clearly, the U.S. needs to avoid the Japan experience with regard to the Baby Boomer transition out of the workforce and onto the entitlements payroll.
Should fixed investment and productivity growth fail to increase in the USA, the labor market demographics described in the above graph will continue to pressure growth prospects in the USA. In this environment, it’s unlikely that bond yields will rise rapidly any time soon. Plus, mid-level commercial credits (such as the BB- credit-rated Sprint) that offer attractive enhanced yield may remain an attractive source of yield pick-up for investors that can take some credit risk.
Sprint vs Verizon: Sprint earnings service debt, though operating losses raise yield and risk
Sprint is considered a high yield credit in that that firm has a market capitalization of $36.17 billion (the value of all its equities). 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’s profit margin of -8.50%, the firm has seen a -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.
In contrast, Verizon has a market capitalization of $198.36 billion. 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.
To see how the labor participation rate affects men versus women, please see the next article in this series.
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?
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. (0.62%), Sprint Communications (0.59%), and HCA Inc. (0.53%).
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).