Thursday, May 28, 2015

Our Fixation with Jobs and Employment Data

The most closely watched data point for equity and bond markets continues to be the monthly employment report. Weekly new claims is also closely followed, despite its lack of relevance with the US economy now in its sixth year of expansion. Perhaps markets simply don't know where to look for data. In their suspicion that market gains have been driven largely by Fed policy, stock and bond traders alike have focused on employment as key to the Fed's next move.

The heightened concern clearly has something to do with the lackluster growth in GDP since the recovery officially began in 2009. GDP growth has run plus or minus 2% since 2010, well below its run rate pre financial crisis. Juxtaposed against this backdrop of tepid GDP growth is the anomaly of rapid gains in employment. It doesn’t seem to quite square up. 

Some have pointed to the stubbornly low rate of labor participation and its impact in magnifying the decline in the unemployment rate, pointing to U-6 underemployment, still above 10%, as a more realistic measure of the struggling labor market. But while the quantity of jobs created has had a meaningful impact on lowering the unemployment rate, the quality of job creation may best explain this anomaly.

A report prepared by Global Insight for the US Conference of Mayors found that jobs that had been created over the past five years, on average, paid 23% less than those lost during the 2008-2009 recession. Total wages lost in the move to lower paying jobs were estimated at $93 billion. The same phenomena was observed in the recovery from the 2000-2001 recession, where the annual wage of jobs created in the period following the recession averaged $5,000 or 12% less than those lost in the same sectors in the 2000-2001 recession.

In the 2008-2009 recession, where 8.7 million jobs were lost, the annual wage of jobs lost was $61,637. In the recovery that followed, the average wage of new jobs created averaged $47,171, or $14,500 less than similar jobs held prior to the recession. While the greatest number of jobs were lost in the manufacturing and construction sectors, the highest number of new jobs created were in the relatively low paying industries of food and beverage, health care and social assistance. These workers, though employed, are taking fewer vacations, eating out at restaurants less often and spending less on clothes, health care and other essentials.

If this is in fact what is going on, then the unemployment report, the data release most closely followed by the markets, might be telling us very little about the near term direction of interest rates.

Tuesday, May 26, 2015

Governor Christie and the Question of Income Inequality

Governor Chris Christie of New Jersey was recently out in front of the media tagging the Federal Reserve and the Obama Administratio with the problem of growing US income inequality. While it is undeniably true that income inequality has widened over the past six years, it's highly unlikely that President Obama supports this trend or that his administration has sought to contribute to it. The case of the Federal Reserve, however, presents an entirely different set of facts.

While the Fed's intentions may have been to drive interest rates lower than any period in US history in an effort to spur borrowing and capital formation, neither of these outcomes have actually occurred. Not by a long shot. But for the Fed to believe that these policies could be continued for seven or more years without creating distortions in the economy, is beyond naive. It borders on irrational. No disrespect to Princeton, but did Bernanke actually teach there?

The Reason Foundation in 2012 found that the Fed's policy of Quantitative Easing was "fundamentally a regressive redistribution program...It is a primary driver of income inequality". Their argument, as true today as when put forward four years ago, is that low interest rates primarily serve the wealthy, thereby driving a greater percentage of income earned in the economy in their direction. We'll explain how, but first some data on what's happened to inequality since the Great Recession.

Global Insight, in a report prepared for the US Conference of Mayors in 2012, found that the share of total income gains over the period 2005 - 2012 captured by the wealthiest 20% of Americans, was in excess of 60%. The lowest 40% received just 5.5% of these gains. The reason for this disparity lies in stock wealth and ownership, a principal beneficiary of Fed policy. According to the Economic Policy Institute, roughly 60% of stock wealth is held by the top 1% of US households. Roughly 80% of stock market gains go to the top 10% of American households.

But stock wealth aside, the savings provided by low mortgage rates, in an environment of tight bank lending standards, has also shifted the benefits of mortgage refinancing to the wealthy, who have the greatest chance of qualifying. Renters, of course, have not benefited at all from lower interest rates, as landlords have not only been unwilling to pass on the benefits of refinancing, but in most markets have raised rents aggressively, as home ownership rates have declined.

Meanwhile, banks, who have been able to borrow at interest rates near zero and have paid less than 1% of interest on consumer deposits for the past six years, have held credit card rates near their all-time high. Data of the Board of Governors of the Federal Reserve in a 2012 report to Congress on trends in bank credit card pricing found that average bank rates had fallen from 14.68% in the period leading up to the recession to just 13.09% by 2011. Borrow at zero, relend at 13%. Nice work if you can get it.

But the Fed is not alone in promoting income inequality. The primary problem with the disappearing middle class is that in an era of outrageous and ever escalating political campaign financing, the middle class is becoming invisible to politicians of both parties. They are neither big pharma, nor organized labor. They are neither oil companies, nor Silicon Valley; not Wall Street, Hollywood or the Trial Lawyers Association. They are invisible, except for purposes of rhetoric. 

Want to solve income inequality in America? Put a couple of hundred million dollars in the hands of an organization lobbying for the benefit of the lower and middle classes in the 2016 elections. Make the middle class matter to Washington.

Wednesday, May 20, 2015

Puerto Rico Financial Troubles Deepen

Bloomberg news reported this week that the President of the Commonwealth of Puerto Rico Senate was headed to Washington to meet with US legislators. The purpose of his visit is to lobby for an amendment to Chapter 9 of the Federal Bankruptcy Code, to allow the struggling Island to be covered under the same bankruptcy statute now available to US cities, counties and local districts.  A similar measure adopted by the Commonwealth in June 2014, the Puerto Rico Corporations Debt Enforcement and Recovery Act, was struck down by US courts as unconstitutional this past February. US Treasury Secretary Jack Lew has already informed the Island that a Federal bailout is not in the cards. 

With the news of Puerto Rico's approach to Washington breaking, it should be quite evident what the Island's plan is for resolving the debt crisis. The Commonwealth, along with the Teachers' and Judicial Retirement Systems are struggling with $37 billion of unfunded pension liabilities, high debt loads, a sluggish economy, falling tax revenue and a declining population.

For holders of the roughly $72 billion of bonds issued by the Commonwealth, this is a bit more salt in the wound. The struggling protectorate issued $3.5 billion in tax-exempt bonds in March 2014 to help stabilize its finances, constituting the largest municipal junk bond offering in history. The bonds, largely sold to hedge funds and offered at an initial price of 93 now trade around 80, resulting in a loss of 13% to those who purchased at the initial offering price just last year. Paulson & Co is reported to be one of the largest purchasers of the 2014 deal, along with DoubleLine. Commonwealth bonds are also owned by Fir Tree Partners. With the recent decline in prices, yields on Puerto Rico triple tax-exempt bonds are now higher than taxable bonds of Greece and Argentina.  

Revenue of the Island this year is projected to come in at $250 million below prior estimates, with a looming budget gap of nearly $200 million to be resolved by the end of the Commonwealth's fiscal year, this June 30. As a solution to the budget issues, legislators have proposed a $500 million reduction in spending and a hike in the Island's sales tax from its current rate of 7% to 11.5%. In addition, a bond payment of $630 million is due the first day of the new fiscal year, or July 1.  

The Puerto Rico Electric Power Authority (or PREPA) faces budget and financing challenges of its own. The Island's main energy provider is negotiating with creditors to whittle down its $9 billion of debt and avoid a default on a $416 million bond payment, also due July 1. With no legal remedies available to it and all sides lawyered up, this looks to be heading for a messy and involved litigation.

Friday, May 15, 2015

San Bernardino Circles the Drain

Just released were details of San Bernardino's bankruptcy recovery plan. Referred to more delicately as a "plan of adjustment", the proposal calls for repaying bondholders one-percent of their investment in city bonds, or a penny for every dollar loaned the city. Perhaps encouraged by the City of Stockton, who in its bankruptcy reorganization plan repaid investors 11 cents per dollar, it's nonetheless a punishing outcome for those who invested their savings in municipal bond funds that hold San Bernardino bonds.  

Further reported in the city's plan, are significant reductions to its firefighting forces, in a region well-known for wildfires. The bankruptcy plan also calls for cuts to ambulance services, park maintenance and graffiti removal, while extending a temporary sales tax, approved by voters back in 2006. As if these cuts to services weren't troubling enough, given the drubbing bondholders will take on their investment in San Bernardino bonds, it's hard to see how the city will raise money in the future for needed public projects. Fool me once...

A study of salaries of the 120 highest paid firefighters in San Bernardino reported by Bloomberg shows the top one-third drawing an average salary of $190,000 per year; the next third $166,000. In retirement, as early as age 50, these firefighters may be eligible for annual pensions of up to $171,000 per year, an obligation the city will need to pay for many years to come. This might, in part, explain the types of management decisions that led up to the city's bankruptcy. 

Nevertheless, it has us wondering just what becomes of cities like San Bernardino, Stockton and Detroit. Higher taxes, reduced services and limited public improvements are hardly the building blocks of future growth and economic prosperity. Yet 200,000 residents continue to call San Bernardino their home, raise their families there and seek to enjoy its public amenities. The city has let these residents down, much in the way it now proposes to let down investors who loaned it money to build out its infrastructure. Let's just hope, and against significant odds, that the city's plan of recovery actually works.

Wednesday, May 13, 2015

Chicago Junk Bonds

Hard to believe it's come to this, but municipal bonds issued by the Second City are now considered junk bonds. Moody's lowered the rating on Chicago's bonds this week to "Ba1", below investment grade. The rating change was prompted by the rating agency's continuing concern with the city's public employee pension liabilities. The unfunded portion of the city's ten public pension funds now totals a daunting $37 billion. Standard & Poor's and Fitch continue to rate the city in the "A" category, however, showing a considerable divergence in views with Moody's on the depth of the city's woes.

The rating change for the city comes on the heels of a recent ruling of the Illinois State Supreme Court, which just last week struck down a pension reform measure championed by Governor Pat Quinn and passed by the Illinois State Legislature in 2013. That ruling, potentially disastrous for the state facing its own massive unfunded pension debt, also has negative implications for Chicago.

The rating change affects over $8 billion of bonds outstanding, with investors holding those bonds seeing their price degrade day by day. General obligation bonds issued by the City of Chicago in 2012 and due in 2033 yielded just 3.75%, or a spread of roughly 100 basis points to high quality municipal bonds. By 2014, however, with concerns already beginning to emerge about the city's pension problems, bonds of the city of equivalent maturity were sold at a yield of 4.87%. The yield represented a spread of 170 basis points to the high quality index.

As of today, those same bonds issued just last year at 4.87% are now trading at a yield of 5.51% or at a spread of 2.81% to the index.  With price moving inversely to yield, this represents a loss of $5.45 per $100 of value (or 5.45%) to investors who purchased the bonds at the offering just last year. If the bond ratings are similarly dropped by S&P and Fitch, the bonds will unquestionably fall much further in value.

Far higher interest rates on new borrowings of the City and the losses suffered by investors in the city's outstanding bonds may be the least of it, however, with interest rate swaps entered into by the city from years earlier posing a vexing problem for the troubled city. The downgrades may permit banks that had entered into interest rates swaps and other derivative products with the city to now demand payment on upwards of $2.2 billion of those agreements. Similar downgrade provisions helped force Jefferson County, Alabama into bankruptcy a few years earlier.

The past few years have seen some of the largest, and most frequent bankruptcy filings of local government in US history. Jefferson County, Alabama, the cities of Vallejo, Stockton, San Bernardino, Central Falls, Harrisburg and Detroit have all filed, largely due to excessive debts and pension liabilities. The Commonwealth of Puerto Rico, with a staggering $73 billion of US municipal debt outstanding now teeters. Chicago, now in junk status, is on deck.

Tuesday, May 12, 2015

April Employment Report

The April employment report of the Labor Department showed a 223,000 change in non-farm payrolls with the unemployment rate dropping to 5.4%, in line with forecasts. Less noticed perhaps in the report were the significant downward revisions to the March employment report, with jobs being revised down by 40,000 to 85,000 for the month. The bond market has taken the news hard, as if April employment exceeded forecasts and March was revised higher, rather than lower. Go figure.

The fascination, though, with the employment report in both equity and debt markets is slightly puzzling. The theory, of course, is that job creation creates income and spending power to drive consumption and GDP. It would also signal improved confidence of businesses, seeking greater employment. But there's a disconnect between theory and practice, with Q1 GDP significantly below the economy's tepid 2% annual pace and forecasts for Q2, equally as grim.

Nevertheless, it's the unemployment rate, that soundbite of 5.4% that seems to catch the attention of bond traders around the globe. This fascination sustains, despite great controversy surrounding the number itself, and the impact of a stubbornly low labor participation rate upon the calculation. If we are trying to measure the propensity of consumers to, well, consume, perhaps the unemployment rate is not the best measure.

In addition to the unemployment rate, the Bureau of Labor Statistics also publishes a ratio of employment to population. This, to our thinking, might be a better representation of the portion of the population that is both generating income and consuming, versus the portion of the population, like children and the elderly, that primarily consume. The latter two groups, in effect, access financial resources to support their spending from parents, savings and governmental spending, rather than through income generation.

This ratio has been stuck, stubbornly, at 59%, give or take a couple of basis points, since 2009. After falling considerably from its levels in the years preceding the financial crisis, the ratio has failed to recover during the economic recovery that began in 2009. There can be many explanations for this, including the advancing of the Baby Boomers into retirement, a process that itself has been linked to the sluggish recovery, rather than the other way around. It can also be linked to the explosion of student loan borrowing, elevating college and post-college attendance. And lastly, it can be attributed to the soaring rates of disability claims, following the Great Recession.

Whatever the explanation, America needs to find a way to employ a greater share of its population and raise the median wage of that employment if the intent is to once again rely upon the consumer to fuel economic growth. The latter will be a subject of a future post.

Thursday, May 7, 2015

Rising Yields on Treasury Bonds

We've seen a startling and unexpected move to higher yields on the UST 10-year over the past two weeks, with yields rising from 1.87% on April 17 to 2.24% on May 6. Market professionals are scratching their heads to understand the backup in rates amidst weak Q1 GDP, durable goods, factory orders and most recently, ADP private payrolls. 

Much of the latest tantrum followed a prescient call by Bill Gross on shorting German BUNDs, for which those investors following his advice would have profited considerably. Soon to follow were prognostications by a variety of equity guys, including Warren Buffet, who while a demonstrated equity maven, might not be the best source of advice on bonds. Warren's a bit like your family doctor, who skilled in medicine seeks to give advice on a range of subjects beyond his expertise.

For his part, Warren is an old school cronie, not unlike John D. Rockefeller or J. P. Morgan, who built fortunes on the intersect of politics and business. But a bond trader, not so much. Equity guys fail to understand how bonds trade or the simple fact that bonds, unlike stocks, have terminal value.  

For those who make their living in the sector, bonds trade on price, not yield. The price reflects the ownership of a stream of future cash flows. As robust economic activity and the prospect of inflation discount the value of those cash flows, bonds diminish in value. Conversely, weak economic growth creates value. In the deflationary world that Bernanke so feared, bonds would scream.

All of which is to say, the weak level of recently reported economic fundamentals argues that the current tantrum may not have legs and, at least in this one instance, an investor might profit by taking the other side of Warren's trade.

Tuesday, May 5, 2015

Early Social Security Benefits and the Labor Participation Rate

Marketwatch reported today on the percentage of Social Security recipients taking "early" benefits from Social Security. A surprisingly high 73% of recipients or nearly three out of four, now elect to take benefits prior to full retirement age, thereby significantly reducing the benefits that they will receive in retirement.  

Full retirement age for those born between the years 1943-1954 is defined as age 66, with the date gradually increasing.  For those born 1960 or later, 67 becomes the new full retirement age. Social security benefits are available to those retiring earlier than these ages, but at a reduction of 13% for those electing benefits at 65, the age most commonly associated with retirement (reduced benefits are actually available as early as age 62, but at a 30% reduction). For those waiting until age 70 to take social security, benefits increase each year by 8% relative to the full retirement age, up until age 70 when they are capped. The benefit claimed at any of these ages, is then fixed for the duration of the person's retirement.

These changes were put in place as part of the Social Security Amendments of 1983 (HR 1900) when the Trustees of the Social Security Trust Fund first became concerned about the solvency of the Trust relative to future benefit payments. Interestingly, this act also expanded Social Security benefits to members of Congress and the White House and instituted the taxing of benefit payments to recipients. What Congress giveth with one hand, they taketh away with the other.

Most retirement planners advise people to wait as long as possible to claim benefits. But the point of this article is not to advise people on their selection, but rather to examine the social and economic issues that drive behavior. There are several reasons why people might take early, reduced benefits including illness, or because they believe they can invest the funds at a higher rate of return. The most common reason, though, is that they simply need the money. But there is another reason to consider: Social Security benefits are not guaranteed. The Trustees of the Fund can change the level of benefits going forward at any time.

Of these reasons, the fact that people need the money is both the most likely explanation and the most telling of the limp recovery following the financial crisis.  Along with the significant rise in disability claims over the past six years (and the vast expansion of the student loan program) early social security benefits likely explains the last piece of the puzzle in the pronounced and lengthy decline in the labor participation rate.

Friday, May 1, 2015

Rising Rents

There was an interesting article on Business Insider today about the rising cost of rental housing in America. If you rent your home or apartment, or know someone who does, you're well aware of what has happened to rents over the past five years. The article mentions one important factor driving demand, the shift from homeownership to renting following the financial crisis, with 36% of people currently renting versus 31% before the crisis.

This is a very compelling consideration, and raises some important questions about housing policy, the banking sector and the Federal Reserve. What's driving the increased demand for rental housing are several factors, including limited supply and cumbersome local zoning/approval requirements for new development. But also driving rents are the tightened mortgage approval standards of banks for home ownership, following the collapse of the shadow banking market. The shadow banking market (or the market for private label mortgage backed securities) fueled the growth of sub-prime loans, no-doc loans and other inventions of the early 2000s by providing a secondary market for banks to sell these newly originated loans. With this market still largely defunct and in an environment today of weak personal income growth and rising bank lending standards, those seeking new housing are increasingly forced into the rental market.

Now landlords, amidst this growing demand for rental housing are for the large part killing it. They've been able to finance new multi-family or refinance existing developments at historically low interest rates, while enjoying ever escalating rents from tenants. Nice work if you can get it. But this pronounced shift to rental housing once again highlights Fed policy, post recession and it's wealth effect on the average citizen.

Large corporations have been able to reduce borrowing costs dramatically since 2008, now borrowing 10-year debt at interest rates as low as 3.00%.  But small businesses have struggled to access financing for new projects. Owners of homes have been able to refinance their mortgages at generally lower rates, although bank standards have biased approvals to the wealthiest with the best credit in an environment of greater regulation. And let's not forget the wealth effect the Fed has created for the owners of stocks. But bear in mind, as with home refinancing and corporate financing, stocks are very narrowly held (with 80% of stock ownership held by the top 10% of Americans by wealth) thereby shifting this benefits of Fed policy to the wealthiest.

All this raises the very obvious question about who has benefited and who has not from the Fed's six-year policy of zero interest rates and whether it might be time to redress these imbalances that the Fed has created.