In addition to football, the thing we most associate with autumn is elections. And as the multi-sided Republican debates constantly remind us, next year’s Presidential election is just around the corner. To an even greater degree than normal, that election is likely to revolve around the economy. With the lackluster recovery in danger of slipping into a double-dip recession, politicians are once again joining economists and investors in debating the ways to stimulate growth and restore America’s economic leadership. The key to growth and the election is jobs.
As has been widely publicized, employment has been a — or, more accurately, the — weak link in the recovery to date. Just as it appeared that hiring might finally be starting to gain traction, the Labor Department reported on September 2 that no net new jobs were created in August, highlighting an already bleak situation and giving literal meaning to the term “jobless recovery.” The report sent stocks into a steep decline and renewed discussion of policy alternatives to address the problem. Within a few days, President Obama spoke to a joint session of Congress and introduced his American Jobs Act.
To state the obvious, jobs are important because consumption makes up about 70% of the U.S. economy, and if consumers are reluctant to spend (for whatever reason), GDP suffers. With unemployment running at 9.1% compared to a “normal” full employment level of closer to 5%, the economy is operating at well below its potential level — at a time when we need all the growth we can muster in order to reduce government deficits and the overall level of debt in the economy. Thus, job creation is critical to addressing both short- and long-term issues.
Weakening Sentiment
Despite steady growth in the U.S. over the last two years, consumer sentiment has fallen precipitously. In August, the Thomson Reuters/University of Michigan index declined to 54.9 from 63.7 in July. The latest reading, the lowest in over 30 years, compares to a peak of about 110 in 2000 and nearly 100 in 2007, just before the onset of the Great Recession. Similarly, the Conference Board’s index dropped to 44.5 in August from 59.2 in July. Both figures represent levels typically associated with recessions. Part of the reason for the sharp falloff in August was undoubtedly the political brinksmanship in connection with raising the U.S. debt ceiling, followed by the downgrade of U.S. credit by Standard & Poor’s and the realization that the ultimate compromise did little to address the debt problem. The stock market’s summer swoon has also been a contributing factor.
In contrast to sentiment, actual spending has held up relatively well. Consumption has risen 4.7% over the last 12 months, not far below the 6% typical in periods of economic expansion. Lower interest rates have certainly helped. According to ISI, consumers are spending about $250 billion a year less on interest expense than before the recession, and the proportion of disposable personal income going to interest has declined from 9% to 6% over the same period.
Figure 1. Thomson Reuters/University of Michigan Index
Source: Bloomberg
Note: Shaded areas represent recessions as determined by the National Bureau of Economic Research
Reduced interest costs have allowed the savings rate to expand even as spending grows — a healthy trend in both respects. In much the same way, today’s lower energy costs have also helped free up funds for saving and other consumption. Still, sentiment is at a multi-decade low, and continued unemployment is largely to blame.
Today’s persistent weakness in employment can be attributed to both secular and cyclical factors. With regard to the former, educational levels are a major concern. Data clearly show that worker employability increases with academic achievement levels, so improving the education of American citizens is critically important. Employment among lower-skilled workers has also been eroded by the long-term loss of jobs to overseas competitors through outsourcing. To the extent that many of these jobs are in manufacturing, their export has meant a weaker cyclical recovery in employment following each successive recession in recent years. Another negative influence on U.S. jobs has been the winding down of the debt super-cycle, which drove economic growth at an accelerated pace through the increasing use of financial leverage. Now, the reverse is occurring.
On a shorter-term basis, the after-effects of the housing bust and an overly cautious business climate are keeping the typical cyclical recovery in check. Housing is particularly pernicious: The industry has shrunk dramatically, contributing directly to unemployment, yet it’s also a victim of the weak job market since unemployed people are unlikely to buy houses. Measured in terms of housing starts (both single and multi-family), the industry is less than a third the size it was before the recession began. According to the Federal National Mortgage Association (FNMA), unemployment in the industry totals well over a million of the 14 million people presently out of work in the U.S. If other industries dependent on housing were included, the total would be several times that amount. Part of the problem is structural: people who work in construction and related industries are typically not qualified for other, more highly skilled positions.
Digging deeper, some 14 million mortgages are currently “under water,” representing an estimated $700 billion in negative equity, again according to FNMA. About a quarter of these are “seriously delinquent” — i.e., would typically go to foreclosure. With such a huge overhang, the market is unlikely to recover quickly, and there is still some risk that homeowners with little prospect of recovery could walk away from their mortgage obligations. A more subtle aspect of this problem is that many small business owners use the equity in their homes as a source of capital in their businesses. Since small business is a key driver of jobs growth, the decline in home values has had a negative effect on hiring.
Another big reason for persistently high unemployment is continued caution on the part of the business community — caution that, if sustained, could be self-fulfilling and drag the U.S. back into recession. The financial crisis caused many companies to focus on deleveraging their balance sheets and rebuilding liquidity. Bank of America Merrill Lynch estimates that cash now accounts for 12% of the market capitalization of nonfinancial companies in the S&P 500. While stronger balance sheets and greater liquidity may be attractive from a shareholder’s point of view, they have had a dampening effect on hiring. Another reason for the reluctance to add to corporate payrolls is the uncertain regulatory climate. Although many of the companies whose stocks we own have been hiring at a reasonable pace in order to fulfill their growth plans, others say they will not be comfortable doing so until the regulatory outlook is clearer. The Patient Protection and Affordable Care Act, for example, will require employers to provide health insurance in 2014 and impose new IRS reporting requirements. For businesses with over 50 workers, higher taxes will be levied on companies that don’t offer an “acceptable” level of health coverage. Until the true costs of these changes are well understood, many employers may take their time in hiring.
A New Normal?
There are no simple solutions to these issues (indeed one wonders if we’ve embarked on a “new normal” in jobs), but several avenues are being pursued:
- Lower interest rates: In addition to saving consumers money for current spending, today’s reduced rates may begin to help homeowners finance on more attractive terms, thereby boosting the housing market. The challenge, as we’ve said earlier, lies in the large overhang of underwater mortgages that needs to be absorbed before prices can recover. Many borrowers, however, are unable to take advantage of record-low mortgage rates because of institutional obstacles. FNMA and Freddie Mac, which together guarantee well over half of all U.S. mortgages, charge fees of up to two percentage points when underwater loans are refinanced under a government-sponsored program designed to help homeowners with negative equity of up to 25%. Banks, too, often charge additional fees of their own — even though these mortgages are arguably less risky after refinancing. The U.S. Treasury seems powerless to require the GSEs to relax their requirements, since they see their legal obligation as conserving assets and minimizing taxpayer losses. This type of regulatory conflict needs to be resolved in order for today’s low rates to have greater impact.
- Government initiatives: Various programs at both the federal and state levels have been — and are being — designed to stimulate jobs. Workforce training, for example, is taking place at community colleges and other venues to help reduce the skill gap that often exists between corporate needs and worker qualifications, particularly in the technology and service sectors. President Obama’s proposed American Jobs Act contains a series of initiatives designed to put people back to work, including tax credits for new hires, an infrastructure bank, funding for improvements to surface transportation, the extension of payroll tax cuts and subsidized jobs training at companies. It’s telling that the President’s appointee to head the White House Council of Economic Advisers is Alan Krueger, a noted labor economist known for his research on unemployment.
- Removal of regulatory obstacles: Government appears to be displaying greater sensitivity to unemployment trends by delaying implementation of regulation that would inhibit hiring. A recent example was the Environmental Protection Agency’s decision to withdraw a proposal to accelerate tighter ozone standards for cities — standards that would have slowed construction of transportation infrastructure across the country.
Unfortunately, these and other measures will take time to have any meaningful effect. In the interim, the debilitating influence of widespread unemployment and the lingering effects of the financial crisis in the U.S. and Europe are likely to keep the economy hovering near stall speed.
Stocks Attractive
If the outlook is for sluggish growth, or perhaps none at all for an extended period, one’s “knee-jerk reaction” would normally be to focus entirely on liquidity and capital preservation — and that may be the right approach for many clients. Indeed, our “three bucket” approach to asset allocation is designed to ensure that liquidity needs are always met and that capital preservation is an integral part of the plan. On the other hand, the fact that so many investors have adopted the knee-jerk reaction suggests to us that stocks today are exceptionally attractive.
Having fled risk assets in fear of recession and the European debt crisis, investors have been buying quality bonds in recent months, bidding up prices to the point where the yield on the 10-year Treasury bond dipped below 2% in early September for the first time in the modern era. Depending on future inflation, it’s likely that a 2% nominal yield today will turn out to be negative in real terms over the life of the bond. At the same time, the decline in stock prices over the summer provides an unusual opportunity to own good companies at reasonable prices. The price/earnings ratio on the S&P 500 is currently less than 13 times the consensus 2011 estimate of about $95 in earnings per share, and based on preliminary 2012 projections of $100+ the price/earnings is 11-12x. These levels are very close to those reached in March 2009, the bear market’s low.
Figure 2. Cumulative Employment Growth/Loss Since Beginning of Recession
Source: Bureau of Labor Statistics
Stocks look inexpensive on other metrics as well. On a price-to-book-value basis, the S&P is trading at less than two times, well below its long-term average of over three times. Further, the recent pullback has brought the yield on the S&P 500 to about 2.2% — not particularly high on an historical basis but above the yield on 10-year Treasuries for only the second time since the 1970s. On the basis of the so-called fed model comparing interest rates to earnings yields (i.e., the inverse of a P/E ratio), stocks appear extraordinarily cheap.
Of course, the critical ingredient in making these comparisons is earnings. Over the last two years, corporate profits have consistently surpassed analysts’ expectations, as expanding profit margins have more than overcome relatively slow revenue growth. If GDP growth turns negative, profits will surely suffer, but we believe a probable worst-case scenario would be about $80 per share for the S&P. Both financial and operating leverage are lower today than going into the last recession, so margins aren’t likely to shrink dramatically in an economic slowdown. Stocks could certainly go lower in such a scenario, but we believe the downside risk is less than in most recessions. It’s hard to have a bust without a preceding boom.
Also worth noting is that our reasonable worst-case scenario provides an “earnings yield” of 7% today, or a five-point equity risk premium over the 10-year Treasury bond and seven points over T-bills. Both measures are at extremes in the context of capital markets history.
Equity Income, Small Stocks and Emerging Markets
Within equities, the most compelling strategy in many respects is quality, dividend-paying stocks. Our Equity Income portfolio, as an example, has an average yield close to 4% (almost twice the 10-year Treasury bond), and, importantly, its companies have a history of steadily increasing their dividends over time. Because of the yield, quality and market capitalization parameters of the portfolio, it has been significantly less volatile than the market in recent months. Thus, we see it as an attractive means of participating in equities in today’s nervous markets.
Beyond income stocks, we find growth and value styles about equally appealing in today’s market. Our growth portfolios contain companies that we believe can grow revenues and earnings at an above-average rate almost regardless of the economic climate. Our value portfolios are also heavily populated with high quality, growing companies, reflecting our fundamentally based philosophy and aversion to owning stocks just because they are cheap. In terms of market capitalization, we continue to have a bias toward smaller stocks since, occupying niche markets, they are typically less vulnerable to broad economic headwinds. In terms of geography, we continue to advocate exposure to international markets, with a bias toward the emerging markets, particularly small caps. Our view is that smaller companies offer a “pure play” on the rapid expansion of local economies in the emerging world rather than being tied to more slowly growing global demand.
Despite our view that stocks represent excellent value, the role of bonds in a portfolio should not be underestimated. In addition to cash flow, they generally provide stability and reduce overall portfolio risk since they have a low correlation with stocks. Moreover, there are opportunities to exploit credit anomalies — i.e., where spreads relative to Treasuries are temporarily out of line. In today’s environment, for instance, we have been buying certain corporate and mortgage-backed bonds that we believe are underpriced in comparison with their relatively expensive Treasury counterparts. Although we think that the next major move in interest rates is more likely to be up than down, we believe such a move is probably a year or so away.
It’s anyone’s guess whether the combination of continued high unemployment, massive deleveraging and Europe’s financial crisis will ultimately lead to a double-dip recession, but the markets appear to have discounted many of the negatives. During periods of unusual volatility, it’s important to maintain perspective and seize opportunities as they present themselves.
William L. Paternotte, CFA
Strategic Advisor and Partner
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