Not So Random Thoughts

It has been a busy few months, not that the volume of postings to this blog (zero) is indicative. However, in the next few weeks, I will be able to share news regarding a new venture about which I am very excited and shortly thereafter release a white paper that I hope will cause many readers to reconsider the way they view the typical investment opportunity set.  But, until then, a lot has transpired in the global economy and I wanted to share with you some of what I think to be the most interesting and significant insights out there today.


THE RISK TRADE IS ON.  BUT FOR HOW LONG?

Plan sponsors and investors in general have become somewhat frustrated by the returns available from "low risk" investments such as cash and high grade bonds.  As a result they have progressively taken on greater amounts of risk in the quest for higher returns.  That is all well-and-good, but the question becomes whether and when they may have over reached and set themselves up for potential disappointment.

Consider:

• US Households now hold the largest percentage of their financial assets in risk assets (stocks, corporate bonds and mutual funds) since Q3 2000.  At 34.9% of total, holdings in these risk assets is just short of the 60-year high of 38.4% reached in Q1 2000 (blog).

• Spain, just a couple years ago, seemed on the verge of imploding.  This past month the Kingdom of Spain was able to issue notes that traded BELOW those of the US Government. Two years ago, they paid more than 7 percentage points more than Uncle Sam (article).  Even Greece has been able to issue bonds at a yield of 5% in spite of the fact that their finances (Debt/GDP) and employment situation are in worse shape than when the crisis began (blog).

• And even the riskiest markets are becoming more expensive.  Last year we saw investors gobble up offerings from Nigeria, Ghana, Mozambique and Zambia. The interest rate spread on Eurobonds issued by such frontier markets has fallen to below 400 basis points versus US Treasuries while the gap between JP Morgan's Emerging Market Bond Index and Frontier bond markets narrowed to a record 68 basis points this past month (article). 

In summary, spreads are narrow:

Issuers have flooded the markets:

And "safe" assets have been shunned:

Which raises the question of whether we've gone too far.  I don't believe we are there yet, but the caution lights are on and a reduction in risk is advised.  In a recent speech, Federal Reserve Governor Jeremy Stein cited the work of Harvard professors Robin Greenwood and Samuel Harrison who developed a credit-based early warning measure - simply the ratio of the volume of non-investment to investment grade issuance (rather than the more typical relative price measure, the comparison of spreads).  At prior stress points, this ratio reached extreme levels.  Though we are not quite there today, we are in the neighborhood (blog).  .  

STILL, THE SEARCH FOR RETURN CONTINUES

Traditional asset classes are getting pricey when measured against historical norms, whether we're looking at stock P/E ratios, bond yields or credit spreads.  So perhaps it's not surprising that hedge fund assets have reached new record highs as investors seek alternatives.  Hedge Fund tracking firm HFR noted that Assets Under Management at hedge funds reached new highs in each of the past seven quarters and that hedge funds now managed in excess of $2.7 trillion (article).  Yet, at the same time, hedge funds as a group posted their worst Q1 results in six years, and over the past 12 months, hedge funds were up just 8.53% compared to the S&P 500, up 19.32%.  Since the beginning of 2011, the HRF Equity Hedge Index (long/short funds) has actually lost more than 7% while the S&P is up 59% (article). Defenders of the industry will note that the word "hedge" implies they should lag in an up market because of the downside protection offered when things turn bad.  We will see, but investors should be very comfortable with the strategies employed by their managers and understand how they have performed in tough periods in the past, because the testing of the "hedge" may be forthcoming. 


WITH LITTLE HELP FROM EARNINGS

Over time, earnings drive stock prices - or so we have been led to believe.  In the short-run, this isn't necessarily the case as the value one places upon each dollar of earnings (the P/E ratio) can fluctuate based on expectations for the future or on current levels of risk tolerance (see above).  However, if earnings growth really is the longer-term fundamental link to equity performance, one might begin to get a little nervous.  From the last earnings peak (Q2 2007) through the first quarter of this year, we have seen the second weakest earnings cycle in more than 50 years.  Previous cycles have averaged 6.0% compounded annual growth as measured from peak-to-peak. Currently, we are on track for just 2.6% annualized -  and though well below the norm in terms of magnitude, in terms of duration, this cycle is just about average.

ROOKIE MISTAKES?

As interest rates hover near record lows, corporate treasurers have been quick to take advantage and lock-in the attractive funding costs.  Corporate debt levels have climbed, even as interest costs have fallen.  At the same time, the US Government has decided to issue its first-ever floating rate notes (FRN's).  Instead of locking in today's low rates, taxpayer interest costs will fluctuate in line with the market.  As rates rise, so will interest costs.  Should rates fall, costs may go down, though that benefit is limited as we are already close to the zero floor.  It seems to be a one-side trade and not one in the taxpayer interest.

Not to be outdone by the Treasury Department, the Federal Reserve has been lengthening the maturity of the Treasuries it holds in its portfolio.  The $2.3 trillion portfolio now shows bonds with a maturity of more than 10 years comprising 26% of holdings (versus 18% just four years ago).  Maturities of between five and ten years account for 37% of holdings versus 26% as recently as 2010.  Short-term notes (91 days to one year) were 23% of holdings prior to 2008.  Today they are zero.  This means, the Fed has taken on more interest rate risk just as rates trade near historic lows.

It appears the US Government (and by extension, taxpayers) have taken the opposite side of the bet from Corporate America.

THE DARK SIDE OF QE?

Supporters of the Federal Reserves' massive quantitative easing programs (aka QE1, 2 and 3), when confronted with the question of why things haven't worked out better, say "it wasn't big enough" - an argument that could be made no matter the size of the program or the outcome.

If you want to see what big does, however, just look at the Bank of Japan and their impact on the Japanese government bond market. The JGB market is larger in size than even the US Treasury market.  In spite of the smaller economy, the BoJ holds nearly the same amount of its own government debt as does the Fed.  So what can go wrong?  In reality, plenty.  The BoJ is, essentially, the Japanese bond market, having pushed all other players to the sideline.  For the first time in 13 years, the benchmark 10-year bond went untraded - not one single trade - for more than a day.  Overall trading volume is down nearly 70% from the same period last year.  When a central bank intervenes in a public market, prices are naturally distorted - in this case pushing yields lower than might be expected.  Given the lack of liquidity in the market, traders and investors worry what happens when the big buyer tries to catch his breath.  The answer is that yields can spike dramatically in a short period of time, leaving bond investors with large losses (article).  Better to sit on the sidelines or go elsewhere seems to be the result.

Meanwhile, savers are penalized while debtors reap the benefits of cheap money.  As discussed in a previous posting, "Winners and Losers (Nov 17, 2013), while the low interest rate policies have bailed out the banks, boosted the stock market and real estate, those with money on deposit have lost ground to inflation.  Richard Barrington, an analyst at Moneyrates.com, estimates that U.S. savers have lost $758 billion since the crisis began due to the erosion of purchasing power from the difference in interest earned and inflation  (article).  The McKinsey study cited in my earlier posting looked at the cost by estimating what savers could have earned had rates been in a more normal rate state relative to the level of inflation.  In either case, the costs are not insignificant.

HAVE I PAID MY FAIR SHARE YET?

And how can we let April 15th go by without commenting on taxes?  By this year's tax deadline, Americans as a group paid roughly $3 trillion in federal taxes and $1.5 trillion in state taxes, an amount greater than they will spend on the necessities of life - food, clothing and shelter (article). 

And, as the tax take has climbed, wealthier Americans continue to shoulder a larger portion of the federal tax burden.  According to the Tax Policy Center, the top 1% of earners, who take home 17% of all income, now pay 29.3% of all taxes (article). 

Many will argue that this is fair, or that the "rich" should do even more.  But just who are these 1% er's? According to a study by Thomas Hirschl of Cornell and Mark R. Rank of Washington University, 12% of the population will find themselves in the top 1 percent of the income distribution for at least one year during their career.  39% of Americans will spend at least a year in the top 5 percent and more than half will spend at least a year in the top 10%.  An astounding 73% will spend a year in the top 20 percent of the distribution. So rather than thinking of the top group as a fixed bastion of fat cats who deserve to be flayed annually, perhaps we should remember it is most people who dream the dream and often get pretty close, only to fail to stay there that are supposedly not paying their fair share (article).

But at least we're not the Europeans (yet).  The chart below from the consultancy of Ernst & Young shows the number of days of work it takes for citizens of a given country to pay their respective tax burden:

WHAT TO DO?

To those readers who agree that the topics raised about are potentially troublesome, the question of what to do next remains paramount.  With traditional asset classes historically expensive, economic growth below trend, the unknown consequences of Central Bank interventions yet to be felt and aggressive return hurdles to be met, we all have our work cut out.

I hope to offer at least one alternative in my coming white paper.  Please stay posted.

Winners and Losers

Consumers have not made the necessary adjustments to again become the motor of economic growth in the United States.  While progress in debt reduction has been seen in certain areas, well-intentioned, but mis-guided policies have created problems in others. Overall, the consumer is only marginally stronger than they were in the midst of the crisis.

Jobs and Income growth will be key to any consumer revival, but to date have been substandard, while the will to work seems to have eroded.  Without stronger jobs and income growth, we can not have consumption growth. Unfortunately, incomes have been in a secular decline for more than a half-century, though the accumulation of debt during this period has hidden the direct link between incomes and consumption. The days of debt-driven consumption are over and greater leverage and an easy monetary policy are not a salvation for Main Street.

In addition to the poor numbers, the quality of jobs added in this expansion has been substandard, and heavily reliant on part-timers.  This too, has depressed incomes.  It would seem regulation had a hand in this as well as in the difficulty that start-ups, the usual driver of jobs, are having.

There have been winners - namely those with the where-with-all to take advantage of the Federal Reserve's Quantitative Easing (QE) policies - borrowers, stock market investors and banks head the list.  US non-financial corporations have responded naturally to the incentives put before them, but could be in danger should they not be careful as the quality of debt seems to be in decline as its quantity increases.

The topics I will touch upon this month - debt, income, jobs and consumption are all complex and inter-related.  Any one of them could be its own post; the four together could easily become a 100+ page white paper.  However, not wishing to subject anyone to that kind of mess, especially before the holidays, I will be a bit more brief on detail than usual - though I will link to the larger studies should one wish to jump in with both feet.

Where to Begin - The Consumer

In most countries, the consumer is the largest single economic entity in the economy with spending accounting for somewhere between 50% and 70% of annual GDP.  Canada and the US are at the upper end of that range, while China is an outlier at the bottom end.  Thus any discussion around the prospects for economic growth must start with, and focus on, households, their behavior and their potential.

Consumption as Percent of GDP
Canada                70.2%
United States       68.6%
Hong Kong           65.0%
Japan                  60.9%
India                   56.8%
Euro Area            56.3%
Australia             53.9%
China                  36.6%
Sources: Federal Reserve Board, Bureau of Economic Analysis, Statistics Canada, Asia Development Bank, Eurostat  

The US Government's policy response (and that of many other developed countries) has been to attempt to re-kindle the moribund shopper, so far to little avail.  Policies from "Cash for Clunkers", to HARP to an unprecedented entry by the Federal Reserve into the market for Treasury and Mortgage securities have attempted this, albeit through various channels. However, for those who took more than one or two introductory Economics classes, the weaker than normal economic response should not have caught them by surprise, yet that is what it seems to have done to policy makers - even as a handful of market commentators shouted caution.

• "when an economy is excessively over-indebted and dis-inflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness" - Lacy H. Hunt, Ph.D. (http://www.caseyresearch.com/articles/federal-reserve-policy-failures-are-mounting) 

Let's start my analysis with a simple law of gravity - and it's not "what goes up must come down". Rather, it is an economic law of gravity, namely that "one can only spend over time what they earn over time". Empirically, this is demonstrated in the chart and table below.

Compound Annual Growth Rates over Various Time Periods to Dec 2012
                                 
                                         5 Years     10 Years     20 Years     30 Years     40 Years     50 Years
Personal Income               2.8%           4.2%          4.8%            5.5%            6.7%          7.0%
Pers Consumption Exp      2.7%           4.2%          5.0%            4.7%            6.9%          7.1%


Side Notes: 

• income growth has been in secular decline for much of the past half-century
• over longer periods, income and consumption growth are strongly linked

While over longer periods, spending and income are clearly linked, they can diverge over shorter time frames. Comparing nominal levels of spending to income as I do in the following chart, one can see how spending began to grow relatively faster than incomes from the mid 1970's until its reversal over the years 2005 - 2007.

These short-term divergences, where one can spend more than they earn, are related to borrowing behavior. Unsurprisingly, the period from 1975 described above, coincided with a build-up in household debt, while the period since 2007 has coincided with a partial rebuilding of consumer balance sheets.  This kind of borrowing activity accelerated spending beyond income growth for a period of time, but as borrowed amounts must be repaid at some point in the future (and out of income), it had the effect of stemming current growth -- and this is where policy makers have gotten it wrong by trying to recreate the same dynamic, but from a much more difficult, and unsustainable, starting point.

Economic and Fiscal policies that attempt to rekindle spending by encouraging an increase in an already large debt pile, were doomed to fail.  Consumer debt had risen to record highs in both nominal and relative (to income) terms, fueled mainly by the residential mortgage market.  A necessary part of any re-balancing requires consumers to first reduce debt and strengthen their personal balance sheets before they can safely come back to the shopping aisle.  Policy makers did not act as if they understood this.  The debt adjustment continues as it must, but is being hampered by Government policies which encourage debt accumulation.

Below, we can see that credit card debt (most of the revolving credit) has indeed corrected (down nearly $200 Billion from its December 2008 peak), as has mortgage debt (down $1.3 Trillion from its January 2008 peak).  Unfortunately, this has been partially offset by booms in student loan debt (up more than $550 Billion since December 2008) and auto loan borrowings (up $127 Billion since December 2010).  In short, total consumer credit has only partially adjusted, now resting near 2003 (relative to income) or 2005 (in absolute) levels.

The best way to speed the adjustment would have been to focus on policies that could accelerate repayment - and the best way to do that would have been to spur jobs and income growth.  While much lip service has been paid to these goals, the record is, unfortunately, dismal. 

 Let's look at a few facts relating to job creation over the past few years:

• The percentage of the US population that works has fallen dramatically.  A record 91.5 million Americans are now "not in the labor force" - Bureau of Labor Statistics

• Of those "not in the labor force", a record number indicate that they have no interest in finding a job, even if one were offered - As a share of all those “not in the labor force,” the number of people who want a job has been generally declining since the early 1980's. Three decades ago, more than 10% wanted a job; more recently, that number dipped below 6% - Regis Barnichon and Andrew Figura, " 
  Declining Labor Force Attachment and 

  Downward Trends in Unemployment 

  and Participation"  

  http://research.barcelonagse.eu/tmp/working_papers/728.pdf

• The labor force participation rate is at an 25 year low - Bureau of Labor Statistics.  

• For younger people, this rate is at a 40-year low as the employment rate of persons aged 21 to 25 has fallen from 84% to 72% since 2000 - Georgetown University Center on Education, "Failure to Launch" http://cew.georgetown.edu/failuretolaunch/

• Of the jobs created since "recovery" began, a large number have been part time in nature.  The increase this time around though, was much larger than seen in previous recovery periods and remains above previous highs many months later - Bureau of Labor Statistics

• Young workers are now 30 years old when they first earn a median-wage income, up from 26 years old in 1980 - Georgetown University Center on Education, "Failure to Launch"

• Start ups (firms 5 years or younger), which have historically accounted for all NET jobs growth, are having difficulties (http://www.economist.com/news/business/21587778-americas-engines-growth-are-misfiring-badly-not-open-business)

• the average number of jobs created by start ups has fallen from the historical average of 7 to less than 5 today

• over the period 2009-11 the Obama administration issued 106 new regulations each expected to have an economic impact of at least $100 million a year

• In 2011—the last year for which Commerce Department data is available, 35% of firms operating in the U.S. were five years old or less. That compares with 40% in 2007.

• The Labor Department's establishment birthrate/deathrate, a proxy for the pace of new-business formations and failures, shows that for the first time (other than a brief moment in 2001), more companies folded, than have been formed.

It would seem clear that US Households, as a group, are not having a good go of it, and, until debt is reduced further, will continue to sputter.  So if US Households are not making much progress, has the massive amount of money and time invested by our leaders benefited anyone?  

The Winners 

Corporations, who's investment comprises about 16% of annual GDP, have seen profits climb to 80+ year highs as a percentage of National Income.

They have also rationally responded to the ultra-low interest rates and increased their borrowing.  After dipping briefly during the crisis, business debt levels have jumped to record highs since the Fed's QE policy was put in place.   

More recently, however, a larger amount of that borrowing has been done at a lower-quality standard and will need to be watched.

• Many companies have been able to increase their borrowing from exuberant markets.  More than $225 billion of "covenant-lite" loans, or loans that come with fewer protections for lenders, have been sold so far this year, according to S&P Capital IQ. That figure eclipses the $100 billion issued in 2007 and means a majority of new leveraged loans, 55%, are “cov-lite” http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html#axzz2kjbS3Zqz

• Already the amount of indebtedness in leveraged buyouts is creeping up.  The average amount of debt used to finance LBO's has jumped from a low of 3.69 times earnings in 2009 to an average 5.37 so far this year, according to data from S&P Capital IQ. At the height of the LBO boom, the average leverage was 6.05x  http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR

• Like the rest of the leveraged loan market, CLO's have enjoyed buoyant demand. At least $55.41 billion of the vehicles have been sold this year – the highest amount since the $88.94 billion issued in 2007.  http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR

• IPO growth has re-accelerated to near previous peaks http://online.wsj.com/news/articles/SB10001424052702303843104579174282457849984?mod=WSJ_hps_LEFTTopStories

Most importantly, however, little of the record borrowing has flowed into new investment (and thereby GDP).   On a nominal basis, corporate investment has only recently recovered to previous peaks and as a percent of GDP remains near historical lows - even though overall debt levels are at a record.

Instead, much of the borrowing has been used to financially craft earnings growth via buybacks and suppressed interest expenses (see my previous post, "The Profitability Illusion") - and while this may have been great for shareholders, it has not been a positive for the economy.

http://www.economist.com/news/finance-and-economics/21587213-new-book-explains-why-business-investment-has-been-low-profits-prophet

In fact, companies which heavily repurchase their own shares have seen their stock prices outperform the overall market over both short and long time frames, according to  Andrew Wilkinson, the Chief Economic strategist at Miller Tabak & Co. The S&P 500 Buyback Index, which measures the 100 stocks with the highest buyback ratios, has surged 40% this year, compared with a 24% rally for the S&P 500

The Government is the third player in the market and has stepped up in a big way, both in its fiscal and monetary policy response.  Trillion dollar deficits were incurred.  Yet, because this borrowing has not visibly flowed into the real economy, consumers have not been able to take advantage to sufficiently clean up their balance sheets. Instead, the financial markets have benefited, as has a small group of favored industries -- notably automobiles and banking.  Some other favored players (clean energy, etc) have received subsidies or grants, but also failed to produce jobs.

Many policies, about which I won't debate the merits or intentions, have also failed to stimulate activity on Main Street.  Lets take a look at some of the unintended consequences of these actions.

The Federal Reserves QE program, which today purchases $85 billion in fixed income securities each month creates reserves which banks have left on deposit with the Fed.  The Wall Street Journal notes that of the $2.365 trillion in reserves at the Fed, only $59 billion are required to be held there.  The remainder of roughly $2.3 trillion, called "excess reserves" receive a payment of 25 basis points annually.  While this may not seem like much, it represents a transfer from the Fed to Banks of $5.75 billion each year.  Since the Fed is required to remit profits to the US Treasury every year, this reduction in Treasury profits could be construed as a "back-door" transfer from tax payers to the nation's banks. http://online.wsj.com/news/articles/SB10001424052702304069604579153290395722608?mod=WSJ_Opinion_MIDDLETopOpinion



In addition, one could say that borrowers were also net winners as they have been able to issue debt at below unfettered rates, while savers have foregone interest income.  A McKinsey Global Institutes study attempted to quantify this effect and found that Government borrowers were the biggest winners, with the US, UK and Euro Zone governments saving $1.6 trillion due to below normal interest rates.  Non-financial companies also fared well, saving $710 billion in debt service payments.  The big losers were were households who forgave $630 billion in net interest income in the United States, the euro zone and Britain, as interest rates for savers plunged.  

(http://www.mckinsey.com/Insights/Economic_Studies/QE_and_ultra_low_interest_rates_Distributional_effects_and_risks)

Another winner of recent policies have been those most involved in the stock market.  As Bianco Research shows quite clearly in the chart below, when QE policies were in place, the stock market tended to do well. On days when we were in between QE events, the markets declined.  This is a very large sample size and the results seem to speak for themselves - if you had money to invest in the stock market, you did well.  If you didn't and were dependent upon wage or interest income, you struggled.  Or as Michael Cembalest, Chairman of Market and Investment Strategy for J.P. Morgan Asset Management noted, all of the gains in the S&P 500 since January 2009 have come in weeks during which the Fed actively bought securities.  In the weeks during which the Fed did not act, the markets declined. 
(http://www.forbes.com/sites/robertlenzner/2013/10/17/dont-fight-the-fed-because-100-of-stock-market-gains-since-2009-occurred-in-the-weeks-the-fed-was-buying-bonds/)



Life was even better for those who used leverage, and another area where certain consumers chose to incur debt was in the stock market.  Margin debt today sits near record levels (shown below as a percent of total market capitalization) - and we must ask, are we just trading off near-term risk reduction at the expense of building problems down the road?  Matt King, a credit strategist at Citigroup commented that "it strikes me that one of the things we're doing is suppressing at-the-money risk and then adding to tail risks". (http://www.ft.com/cms/s/0/b92f9434-4c9a-11e3-804b-00144feabdc0.html#ixzz2kjdGLojE).  In plain english, Mr. King is saying that current actions seem to be trying to support markets today, while building up future risks should something go wrong.  I fully agree.

The belief that QE policies will continue has driven a wall of cash, more than $275 billion through late October, into US listed mutual funds and ETF's accroding to TrimTabs Investment Research.  That's the most for one year since 2000's $324 billion - which is, of course, the year the tech bubble burst.  About 1/6 of this year's total came in October alone.  TrimTabs notes that the net total of $45.5 billion through October 25th is the fifth highest monthly inflow on record (the two biggest months were January ($66.3 billion) and July ($55.3 billion).  (http://blogs.marketwatch.com/thetell/2013/10/29/277-billion-into-stock-funds-so-far-this-year-highest-since-2000/?link=sfmw).

In this post, I have attempted to show that the real economy - defined as consumer spending and corporate investment has struggled.  In addition, and despite great efforts to heal the economy, the consumer is still not in a position to act as a sustainable source of economic growth.  Corporations, who have visibly benefited from current policies have, however, not contributed to economic growth (via hiring or investment) as they normally do, but instead have rationally used the artificial conditions put in place by the Fed to increase leverage, buy back shares, craft earnings and boost share prices.  In addition, the quality of more recent borrowings has become questionable and could be a problem in the making.  The winners have been the financial markets and those who are able to participate in them as well as the banks and governments.

To close, I would suggest you read in its entirety, the following Wall Street Journal Op Ed, that was recently penned by Andrew Huszar, a senior fellow at Rutgers Business School, and a former Morgan Stanley managing director. In 2009-10, Mr. Huszar was asked to manage the Federal Reserve's $1.25 trillion agency mortgage-backed security purchase program.  This Op Ed is Mr. Huszar's apology for the failure of the program he managed. (http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884).

Happy Thanksgiving to all your families.

"Lies, Damn Lies and Statistics"

The title to this short posting was popularized by Mark Twain, though it's true origin is open to debate.  Whether Mr. Twain or another is to be credited, I can think of no better description of the monthly government employment numbers which elicit so much attention from investors.

Last Friday, the government report that 169,000 new jobs were created in August, slightly below the expectations of economists and the average figures over the past year.  Markets interpreted such weakness to mean that the Federal Reserve would be unlikely begin its tapering of bond purchases in September as rumored.

Now for the truth.  According to the Bureau of Labor Statistics, the economy added 378,000 new jobs in August, but this number was "seasonally adjusted" downward to the reported figure of 169,000.  "Well then, that's good, you say.  The economy is stronger than we thought".  No, not so fast.  Last month when the government reported 104,000 new jobs (seasonally adjusted, of course), the economy really lost 1,186,000.

Confused?  Allow me to clarify.  The reason the government looks to adjust the monthly numbers is precisely so we don't all become schizophrenic as we see jobs swing from one million lost one month, to nearly 400,000 created the next.  Precisely because there is a seasonality to hiring (for example retailers hire many temporary employees in the months before Christmas, only to let them go in January and college students flood the job market early in the summer, but then leave to go back to school in the fall), the government tries to make one month's figures more comparable to previous months by creating the adjustment. And it is this adjusted number to which the world so frenetically reacts.  But the question remains, should we ascribe such certainty to a figure which is really just an (educated) guess?

The size of the monthly adjustments are huge.  In fact, the median monthly adjustment (using data from January 1940 to the present), is more than 75% of the actual figure - and in the last decade, the adjustment has been bigger than the actual number in nearly 50% of the months.

I would also note, since the 1960's, the size of the adjustment (on a percentage basis) has grown as have the number of months where the adjustment is bigger than the actual figure. Usually when you've had practice doing something over and over, you get better.  The government seems to be getting worse.

                                                                                         70's      80's      90's    00's 
Pct of Months Where Adjustment > Actual                         23%       29%      36%      48%
Median Size of Monthly Adjustment Relative to Actual       63%       69%      80%      97%

With such a margin for error, why do investors focus so intently on these monthly numbers?  I argue, that they shouldn't.

If one really wants to understand the state of the labor market, a better way to use these figures is to look at a 12 month moving average of the unadjusted jobs created.  By using a full year, seasonality is fairly scrubbed away and one does not need to rely on the accuracy (or lack thereof) of government adjusters.

When we do this we find:

1. job creation remains anemic compared to historical norms (even moreso when thought of relative to the size of the economy and population)
2. job creation is disappointing given the historic magnitude of the job losses that preceded the recovery
3. job creation is disappointing given the amount of government spending that was employed to accelerate the recovery
4. the monthly rate of job creation has not changed in the past two years

So, there really is no reason for the Fed to change their view of the economy as a result of Friday's numbers. The economy remains weak and is getting little better on the jobs front.  Of course, any single monthly number can be used to justify any course the Fed decides to take, but from a fundamental perspective, the jobs picture has simply not changed.

Brace Yourself for Mediocre Returns, Part 1 of 2

While Wall Street analysts debate the next market turn, far too little effort is being put into understanding the longer-term outcomes likely from various asset classes.  Though this is a more precise and, arguably more important, exercise than the one they choose to pursue, it remains a neglected area of research.  The bad news is that even under the most optimistic default and recovery scenarios, returns from nearly every fixed income segment will barely breach 4% in the coming decade.  Investment-grade segments will struggle to return to reach a “3-handle”.  Equity returns will be better, but that’s a relative comparison, and returns from most developed equity markets will struggle to crack 5%, with European markets faring somewhat better.  

In my previous posting, I identified a little talked about risk to corporate earnings – the substantial prop to margins provided by the Fed-created low interest rate environment.  While it is important to understand that this risk exists and its magnitude, it does little to identify when the risk becomes a market issue.  It is in this regard, Investors and Wall Street Analysts spend untold hours and countless dollars in their efforts to forecast short-term market returns.  Yet in spite of these efforts, in nearly 30 years in this industry, I have yet to meet anyone who has been able to do this successfully and consistently – this author included.  At the same time, I have seen more than a handful of practitioners who have been able to fairly accurately determine long-term returns from various fixed income and equity markets.  It is ironic then that despite these long-term forecasts being both more accurate and ultimately more important to investors such as endowments, foundations and corporate pension committees, greater efforts continue to be devoted to analysis based on short term market twists and turns.

 

This posting and the next are for those willing to look beyond the coming quarter.  Using a model I originally developed in the late 1990’s, I provide what I believe to be reasonably accurate return projections for fixed income and global equity market over the coming decade, along with the methodology for doing so.  Since its introduction, this approach has quite accurately called market outcomes.

Let’s start with fixed income markets.  As you know, a bond is a fairly simple instrument with returns accruing to just four factors: the price paid, the coupon payments received, the reinvestment of those coupons and the ultimate return of principal.  Taking each in turn, we know the price paid.  We also know the coupon payment as it is contractual in nature.  The reinvestment return of these coupons is unknown; however, as I will demonstrate below, even an immediate, radical move in interest rates will not dramatically change the overall return of a bond over its lifetime.  Finally, while return of principal to a single bond may be uncertain, when looking at the broader market of bonds of similar ratings, historical experience can provide a reasonable guide as to default and recovery rates.  Putting these together, estimating long-term bond returns is a very straight forward process.

Let’s use ten-year US Treasury notes as an example.  At July 21^st, you could buy a ten-year government security with a maturity of May 15, 2023 for a price of $93.64.  That note will pay a semi-annual coupon at an annual rate of 1.75%.  At maturity, an investor will receive $100 and along the way, twice yearly coupon payments of $0.875 (per $100 value).  While we do not know the rate at which those coupons will be reinvested, even if we assume rates rise by 500 basis points before the first coupon payment is received (to 7.48% across all maturities), the total annualized return from this note will rise only to 2.96% over the ten year period.  Conversely, if rates fell to zero and an investor received no return at all on the coupons, the ten year total annualized return on this note falls only to 2.29%.  Thus, assuming no default, one can not realistically expect anything other than a return of between 2.29% and 2.96% from buying a ten-year US government note today.  Another way of looking at this is, assuming no risk of default, the best approximation of the long-term return on a bond is probably just its current yield (on the UST, currently 2.48%).

Looking at other developed government bond markets (G-7 plus Australia and Spain), we note the 10-year yields between 0.78% (Japan) and 4.60% (Spain).  Assuming no risk of default, these again are the best estimate for ten-year local currency returns. 

Source: Bloomberg

Of course, given the recent experience of Greece and on-going concern across the Eurozone, zero chance of default might not be the best assumption.  If one wanted to insure themselves against default risk, we can look to the Credit Default Swap market to gauge the costs.  Higher yielding markets such as Spain and Italy currently have annual “insurance” costs of 3.06% and 3.08%, respectively.  Perceived “safe” markets like the US and Germany have lower insurance costs of 0.41% and 0.65%, respectively.  Calculating the “net” return with insurance, we see an expectation for ten-year returns between 2.90% (Australia) at the high end and -0.46% (Japan) at the low end.

Government markets are not the only fixed income game in town.  Lower rated corporate credits, mortgage securities and the like broaden an investor’s opportunity set.  Still, like the sovereign bond markets, the current yield on these instruments, less an assumed default and recovery rate, makes for the best long-term expectations of their likely returns.  However, since default and recovery rates are uncertain, it is best to examine these markets using scenario analysis, tweaking each of these two variables.

While there are many segments within the broader fixed income universe, for the purposes of this posting, I have chosen to project returns for US High Yield, European High Yield, Emerging Market Foreign-Pay Sovereign and US Investment Grade segments – all fairly liquid markets.  Current Yields and Spreads are shown below.

	US High Yield	Euro High Yield	EM Sovereign	US Inv Grade
Current Spread	4.45	5.28	5.06	2.05
Historic Spread	5.24	6.42	4.30	1.95
Current Yield	6.01	5.85	7.66	3.87

Source: BofA Merrill Lynch, Brett Gallagher Calculations

Once again, assuming no default, Current Yield is our best guess at the long-term return from the various fixed income segments.  However, as there is some realistic level of default expected in each of these riskier pools, building a sensitivity analysis around the historic default level and recovery rates makes sense and is detailed in the tables below. 

For this analysis, I have turned to data gathered by Moody’s Investors Service which examines cumulative 10-year default percentages beginning annually in 1970.  I then convert this cumulative figure into an annual one and plug the median default experience (noted by red font), the worst 10-year default experience, the best 10-year default experience and the 25^th and 75^th percentile default experience.  Because of the longer history of the US data, I use that experience for other speculative markets as well (note: using a common data set with an inception date of 1983, European High Yield and EM Sovereign Debt actually have lower default rates than the US Universe over the common period – in the case of sovereign debt, about half that of US Corporates, though the range of outcomes is also wider). 

Default rates are calculated using Moody’s study of Cumulative 10-Year default rates over the period 1970 to 2010.  Following the cumulative default outcomes, in parenthesis, I show the annual equivalent default that results in the cumulative figure and that is used in the sensitivity tables below.

	Baa-Rated	US, Euro, EM Sovereign
Worst Case	10.34% (1.10%)	43.60% (5.65%)
25th Percentile	5.87% (0.61%)	38.53% (4.80%)
Median	4.74% (0.50%)	33.15% (4.00%)
75th Percentile	3.76% (0.38%)	19.88% (2.20%)
Best Case	1.16% (0.11%)	8.23% (0.85%)

Source: Moody’s, Brett Gallagher

* Users familiar with Moody’s data may note that my model default assumptions, when converted to annual rates, are lower than the annual average default rates over the period.  As certain outsized years have the effect of distorting the overall calculation of “average” and, as we are looking at a 10-year horizon, I feel the cumulative data, converted to an annualized figure, is more relevant.

 Using a wide range of default and recovery assumptions, we are able to construct a narrow range of likely outcomes for nearly any fixed income segment we desire.  While the returns due to risk assets appear relatively attractive when compared with developed sovereign markets, the range of returns are far below historic experience and most investors assumed return assumptions.

US High Yield Debt – Current Yield 6.01%, Median 33.1% 10-year Cumulative Default

                                       

		Annualized Default Rates
Recovery Rate		0.85%	2.20%	4.00%	4.80%	5.65%
	20.0%	5.31%	4.43%	3.30%	2.83%	2.34%
	25.0%	5.34%	4.50%	3.45%	3.00%	2.54%
	30.0%	5.37%	4.58%	3.59%	3.18%	2.75%
	35.0%	5.40%	4.66%	3.74%	3.35%	2.95%
	40.0%	5.43%	4.73%	3.88%	3.52%	3.15%
	45.0%	5.46%	4.81%	4.01%	3.68%	3.35%
	50.0%	5.49%	4.89%	4.15%	3.85%	3.54%

European High Yield Debt – Current Yield 5.85%, Median 33.1% 10-year Cumulative Default

                                             

		Annualized Default Rates
Recovery Rate		0.85%	2.20%	4.00%	4.80%	5.65%
	20.0%	5.16%	4.27%	3.14%	2.67%	2.17%
	25.0%	5.19%	4.35%	3.29%	2.84%	2.38%
	30.0%	5.22%	4.43%	3.44%	3.02%	2.59%
	35.0%	5.25%	4.50%	3.58%	3.19%	2.79%
	40.0%	5.28%	4.58%	3.72%	3.36%	2.99%
	45.0%	5.31%	4.66%	3.86%	3.53%	3.19%
	50.0%	5.34%	4.73%	4.00%	3.69%	3.39%

US Investment Grade (BBB) – Current Yield 3.87%, Median 4.7% 10-year Cumulative Default

                                              

		Annualized Default Rates
Recovery Rate		0.11%	0.38%	0.50%	0.61%	1.10%
	20.0%	3.76%	3.57%	3.48%	3.40%	3.06%
	25.0%	3.77%	3.58%	3.50%	3.43%	3.10%
	30.0%	3.77%	3.60%	3.52%	3.45%	3.14%
	35.0%	3.77%	3.61%	3.54%	3.47%	3.18%
	40.0%	3.78%	3.62%	3.56%	3.50%	3.23%
	45.0%	3.78%	3.64%	3.58%	3.52%	3.27%
	50.0%	3.79%	3.65%	3.60%	3.54%	3.31%

EM Sovereign (USD Pay) – Current Yield 7.66%, Median 33.1% 10-year Cumulative Default

                                             

		Annualized Default Rates
Recovery Rate		0.85%	2.20%	4.00%	4.80%	5.65%
	20.0%	6.85%	6.00%	4.92%	4.46%	3.98%
	25.0%	6.88%	6.07%	5.05%	4.62%	4.18%
	30.0%	6.91%	6.14%	5.19%	4.78%	4.37%
	35.0%	6.93%	6.21%	5.32%	4.94%	4.55%
	40.0%	6.96%	6.29%	5.45%	5.10%	4.74%
	45.0%	6.99%	6.36%	5.57%	5.25%	4.92%
	50.0%	7.02%	6.43%	5.70%	5.40%	5.10%

In my next post, I turn to global equity markets.