Last Week Today: Federal Reserve Chair Jerome Powell gave his semiannual testimony to Congress, which can be summed up as: economy strong, interest rates to move higher. | In a CNBC interview and subsequent Tweets, President Trump expressed his view that the Fed should not raise interest rates. The President’s comments were notable for two reasons: recent administrations have adhered to a policy maintaining the Central Bank’s independence, and, in 2016, he said the Fed should be “ashamed” of creating a “false stock market” by keeping interest rates low. | The Chinese Yuan declined 1.2% to a one-year low, prompting speculation the Chinese government is weakening the currency to maintain the competitiveness of Chinese companies despite US tariffs.
For the most part, strong corporate earnings announcements last week offset trade concerns, resulting in a draw for domestic equity indices. Indeed, the S&P 500 ended the week almost exactly where it began, while the Nasdaq Index declined by 0.1%. The scoreboard overseas wasn’t a whole lot more exciting, as international developed stocks (as measured by the MSCI EAFE Index) fell 0.1%, and Chinese shares rose 0.8%. The yield curve flattened further intraweek, before steepening a tad, and the spread between 2-year and 10-year bonds ended the week at 0.3%. Commodities don’t issue earnings announcements, and the ongoing protectionist trade rhetoric was negative for the complex even as the US Dollar weakened by 0.2%: gold -1.2%, silver -1.9%, copper -0.9%, WTI Crude -0.8%.
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Labor Market Demography – The June labor market report confirmed ongoing strength in this critical economic sector. Non-farm payrolls increased by 213,000 jobs in June, and April/May payrolls were adjusted higher by 37,000 jobs, closing out an impressive second quarter in which new hires counted 632,000.
The Labor Force Participation rate increased from 62.7% to 62.9% as a booming job market continues to pull idle laborers from the sidelines. As the number of labor market entrants exceeded the number of newly created jobs, the headline unemployment rate increased from 3.8% in May to 4% in June. Regardless of the apparent contradiction, a shift higher in the unemployment rate resulting from an expanding workforce is a good thing for the economy.
The participation rate is well below the levels seen before the Great Financial Crisis (“GFC”), implying (all else being equal) there is still an abundant labor pool to tap. However, all else is not equal, and the available labor pool may not be as large as it once was owing to changing demographics. Before discussing that point, it is worth looking at how a previous demographic shift dramatically altered the labor market and increased U.S. economic output.
From a historical perspective, the current Labor Force Participation Rate appears rather impressive compared to the levels seen in the two decades from 1950 – 1970. Nevertheless, one should not take too much comfort in the comparison. Those decades reflect a different era – an era in which women were beginning to enter the labor force. Indeed, from 1950 until 1970, the female labor participation rate increased from 33% to 37%. Female employment would continue to grow, and by 2007 the women’s participation rate nearly doubled to 59% from 33% in 1950. This significant demographic shift helped push the total Labor Force Participation Rate from an average of 57% to a peak of 67%, boosting economic output in the process.
Sources: Bureau of Labor Statistics, Bloomberg, and Covenant Investment Research.
The Labor Force Participation rate remained between 66% and 67% until the GFC. Massive job losses impacted employees of both genders, and while the female participation rate deteriorated, the decline was not meaningfully different than that of the male population. Since the GFC, the total participation rate has bounced between 62% and 64%, unable to recover to its pre-crisis level. Part of the reason for the continued low participation rate is the relatively slow economic recovery from the GFC and the number of discouraged workers it engendered. Yet, the recession ended nine years ago, and the estimated 8.7 million jobs lost as a result of the GFC have been replaced (Source: Center on Budget and Policy Priorities). Even if there is some conflicting data around the exact number of jobs lost vs. jobs gained throughout and since the GFC, there is little doubt that the labor market is markedly improved. Indeed, the labor market appears tight by a variety of metrics and labor surveys (e.g., the Job Openings and Labor Turnover Survey).
If the labor market is so good, why then has the participation rate mostly remained below 63% since 2013?
Source: FTN Financial
While there are several contributing factors to this puzzle, the demographic shift represented by retiring Baby Boomers is a major force holding down the participation rate. It’s also worth noting that the demographic turnover is depressing measures of wage growth because as the Boomers retire, they are generally replaced by less experienced (and cheaper) labor.
The first members of this aging generation first entered the “55-years and older” cohort seventeen years ago in 2001. While the GFC delayed retirement for many of the Boomers, the strong performance of risky assets over the last nine years has made retirement achievable for many. For others, though they may not feel financially comfortable retiring, Father Time has caught up physically, forcing them into retirement. The aging of the Baby Boomer generation is expected to put downward pressure on the Labor Force Participation rate, which the Bureau of Labor Statistics forecasts will decline to 61% by 2026.
The economic implications of the aging population in the U.S. are important. In simple terms, if one thinks of the economy as a boat, the economic boat can move faster in one of two ways:
- More people rowing (i.e., a growing labor force), or
- Fewer people rowing faster (i.e., higher productivity)
On the first point, the accelerating rate of Baby Boomers leaving the workforce is reducing the number of people available to row. Moreover, tighter immigration laws are preventing the U.S. from importing workers to replace retiring Baby Boomers. To the second point, labor productivity has remained stubbornly low since the GFC. While productivity has shown brief signs of accelerating, this volatile data series has, heretofore, not exhibited consistent improvement. Perhaps robots will solve the productivity problem, but that remains to be seen.
The Bottom Line: The demographic shift of women entering the workforce provided a boost to the Labor Force Participation Rate and economic growth in the United States. We are currently in the midst of another seismic demographic change, but this one is a headwind to economic growth. Absent improvements in productivity, economic growth in the United States will be hard pressed to remain above 3% per annum on a sustainable basis (higher growth in 2018, spurred by fiscal stimulus, notwithstanding) as there are simply fewer people to employ. Slower economic growth, combined with average (if not high) current valuations, should temper investors return expectations for risky assets in the coming decade.
Last Week Today: Brett Kavanaugh was nominated to fill Anthony Kennedy’s Supreme Court seat. The announcement did not immediately impact markets, but Kavanaugh’s skepticism of regulatory agencies is consistent with President Trump’s goal of a small government and could prove beneficial to businesses in the long run. | Oil output in the U.S. topped 11 million barrels a day – 7.9mm barrels away from energy independence. | The NFIB Small Business Optimism Index rose 3 points in June to 107.8 (second highest level in the survey’s 45-year history) with high numbers in compensation, profits and sales trends. “For years, owners have continuously signaled that when taxes and regulations ease, earnings and employee compensation increase,” said NFIB President and CEO Juanita Duggan, supporting a key plank of President Trump’s platform. | The U.S. unveiled additional tariffs of 10% on up to $200B of Chinese Imports; unsurprisingly, given the nature of the relationship thus far, China promised (or are they negotiating Trump-style?) to impose additional tariffs in retaliation. On that topic, for those of you that didn’t see it, last week the New York Times produced a great infographic on the evolution of the trade war from 18 to 10,000 imported products (no subscription required).
Despite some intra-week volatility related to news on tariffs, it was a solid week for risk assets. The Nasdaq Index led domestic stocks with a 1.8% gain (a new high), and the broader S&P 500 Index notched a respectable gain of 1.5%. International equities followed closely with the MSCI All Country World Index rising 1.0%. The yield on the 30-year US Treasury bond didn’t budge, but the two-year yield climbed 0.04% (more on this below). The commodity complex experienced a rough week as a rising US Dollar (+0.8% for the week) and concerns about global growth pressured prices: Gold -0.9%, Silver -1.4%, Copper -1.5%, and WTI Crude -4.4% ($70.58 per barrel).
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A Cautionary Tale: Changes in the maturity and credit quality profiles of investment grade (“IG”) bonds since the Great Financial Crisis (“GFC”) have led to increased volatility and lower risk-adjusted returns as compared to high-yield (“HY”) bonds. Generally considered to be the “safer” option relative to high-yield bonds, investors in IG bonds may not be adequately compensated for the risk they are bearing at this time.
Risks in the IG bond sector are higher along two critical dimensions:
- Duration (aka, interest rate risk) – Since the GFC, the duration of the IG bond market has been ratcheting higher as corporate management teams have taken advantage of the low interest rate environment to extend the maturity of their loans. Investors, seeking higher yielding instruments, have accommodated the corporations by snapping up the longer-dated bonds. The longer average maturity of the IG bond market combined with low yields on the loans have increased the sensitivity of the market to interest rates, raising the risk level should rates move higher. Interestingly, the duration of the HY bond market has declined since the GFC.
- Credit Quality – While higher interest rate risk can lead to increased volatility, this risk is far less critical to the safety of one’s investment (i.e., the return of invested principal) when compared to the declining credit quality of the IG bond market. Since the GFC, BBB-rated bonds (one level above a high-yield credit rating) have increased from 34% to nearly 50% of the IG bond sector. In contrast, the credit quality of the HY bond sector has been relatively stable. Similar to rising duration in the IG bond market, the low interest rate environment has allowed corporations at the bottom rung of IG credit quality to issue more debt to an investor base desperate for yield.
In both IG and HY markets, security selection is essential and can obviate some of the risks highlighted above. However, investors considering broad exposure to the IG market need to recognize that the combination of higher duration, and lower credit quality have increased risk in the sector relative to the high yield bond market.
The Yield Curve & the Real Economy: The yield curve continues to flatten, but why does it matter? Year-to-date the 2-year bond yield has risen 0.7% (to 2.58%), while the 10-year bond yield (2.83%) has only increased 0.42%, leaving a narrow 0.25% gap in the 2/10 spread. The flattening is even more notable in the longer-dated 30-year bond, whose yield is up 0.19% year-to-date, leaving only a 0.35% “term premium” for lending the government your money for thirty years (2.93%) vs. two years. In other words, the yield curve is becoming dangerously close to inverting. An inverted yield curve has predicted the last seven recessions dating back to the 1960’s… but it has also produced false positives.
Note: The solid blue line is the yield curve today; the dotted line reflects the yield curve as of December 31, 2017. It is clear that the entire yield curve has shifted higher. However, the shift has been uneven – the yields of shorter-dated treasuries (toward the left side of the chart) have increased more than the yields on longer-dated bonds (the bar chart on the bottom depicts the interest rate changes along different maturity dates of the yield curve). Sources: Bloomberg and Covenant Investment Research.
Although the yield curve has an imperfect track record, the Federal Reserve has openly stated they don’t want to invert the curve. Words are well and good, but actions speak louder, and the Fed’s monetary policy is on a collision course with the market. In practice, the Fed sets short-term rates, but the market sets long-term rates (absent the Fed directly buying longer-dated bonds, a la “Operation Twist” in 2011, and they are not in that business today). An inverted yield curve would suggest the market believes the Fed has raised rates beyond the neutral level, constraining future economic growth. Absent an increase in longer-dated yields, the next Fed rate hike (likely in September) is apt to invert the curve between 2-year and 10-year bond maturities.
Economists and investors pay close attention to the shape of the yield curve because it has a direct impact on credit creation by banks, the lifeblood of economic expansions. A bank’s cost of funds is determined by the overnight rates set by the Fed, whereas the market sets the interest rate that a bank can earn on making long-term loans (as reflected in the yield curve). An inverted curve puts banks in a position where there is a strong possibility that they will not earn enough from a loan to cover their cost of funds while earning a profit. A bank’s only upside in making loans is repayment of principal plus interest/fees earned while the principal is outstanding. Unlike purchasing equity in a company, with a loan, there is no potential for capital appreciation. Hence banks are conservative with their balance sheet. Therefore, an inverted yield curve discourages credit creation, dampening economic growth. Declining economic growth is a vector toward a recession. It is, for this reason, there is so much coverage in the media about the shape of the yield curve. It is important to recognize that an inverted curve does not guarantee a recession is forthcoming, but it certainly improves the odds of one occurring.