Monday, June 30, 2014

Risk & Valuations, Part 3: Low interest rates do NOT lead to higher leverage (in practice)

My previous post described a model that would call for more debt in a corporate capital structure as debt becomes more expensive.  So, how does this play out in the real world?

It's a little tricky to pluck out of the data because there are cyclical factors, supply factors, monetary policy factors, etc., and all these factors are endlessly tangled up with interest rates and equity premiums.  But, I think I can at least suggest plausibility.

As a reminder, here is my graph from the previous post, demonstrating the counterintuitive consequences of changing debt and equity rates.  This was based on valuing a firm with the Black-Scholes model, treating the entire firm as the underlying asset, the equity as the call option, and the interest expense of the debt as the premium on the option.

This model predicts:

Falling Unlevered Equity Risk Premium (UERP) leads to:
(1) steeply increasing Enterprise Value (EV) (proxied in the graph by Share Price)
(2) slightly increasing leverage.

Falling Risk Free Interest Rates (RFR) lead to:
(1) increasing EV, though not as steeply as UERP
(2) steeply decreasing leverage.

If UERP declines and RFR increases by an equal amount, the net effect is a sharp increase in leverage and a small increase in EV.

In order to test the idea on historical data, I used data from the Federal Reserve Z.1 Financial Accounts report.  Using annual data beginning in 1960, from the Nonfinancial Corporate tables, I used profit before and after tax, interest paid, corporate equity, and credit market instruments from the Financial Accounts report, and added the 10 year Treasury Yield, the GDP Price Deflator, and  analyst growth estimates from NYU's Aswath Damodaran, who maintains several important data sets.  I use 10 year treasury rates because non-financial corporate interest expenses appear to track this rate.

I was able to derive several descriptive variables of nonfinancial US corporations over time, including ERP, UERP, and implied PE ratios.  The rates for corporate debt and the ERPs seem to be much higher for this data than they would be for, say, the S&P500, which is understandable.  But, the patterns appear to be similar.  Here is a comparison of my derived UERP to Damodaran's ERP, which I have adjusted to account for leverage.  Though my z.1 derived UERP is higher, the patterns are similar.

Below is a review of corporate leverage and capital premiums over the past 52 years.  The patterns roughly fit the counterintuitive predictions of the model.  (Enterprise Value is the combined value of debt and equity.)

Keep in mind when comparing equity and debt levels, they are on a log scale.

Enterprise Value stagnates when UERP is high.  Leverage increases when RFR is high.  In the great moderation period, corporate leverage has been countercyclical.  Note that debt levels are fairly constant and that most of the change in leverage is from variations in equity value.  Note that when UERP declined in the 1980's while RFR remained relatively high, EV growth increased and leverage remained high.  It was only after RFR continued to decline in the 1990's that debt declined.  Debt/Enterprise Value was at 47% in 1985 when RFR was 10.6% and it was still at 46% in 1990 when RFR was 8.6%.  (D/EV is shown in the graph below).  When RFR dropped to 6.4% by 1997, D/EV was down to 30%.  This was due to both a healthy increase in EV and a marked stagnation in debt growth.  After the shock to equity values in 2002, D/E quickly pulled back to 31% in the recovery, and, while debt started to increase in real terms after 2004, D/E continued to decline toward 30% as the economy grew.  Now, D/EV is again falling through the low 30%s as the economy stabilizes.

Both measures derived from Federal Reserve Z.1 report,
Non-financial Corporate Levels
For consistency in the peaks in EV and the duration of the stagnation, I compared 1968 to 2000 in the graph above.  In fact, leverage in 2000 was cyclically depressed due to high equity valuations stemming from growth expectations (see graph at right), so the cyclically neutral starting leverage of the low rate period was probably closer to 30%, and leverage is continuing to fall, and is now below 32%.

Note also that P/E ratios move inversely to leverage.  This is partly because when there are high growth expectations, equity values get bid up, as in the late 1990's.  But, it also reflects the fact that in low leverage contexts, equity has lower risk and volatility.  We tend to think of speculative firms as high PE firms, because the high PE is driven by growth expectations (like in the late 1990's).  But, imagine a firm that issued shares and simply invested them in short term treasuries, with a 100% payout ratio.  If it earned 2% returns, it would trade at a PE of 50.  So, high PE ratios during times of low interest rates aren't the result of firms fattening up on cheap debt.  Rather, they are a result of low leverage and a lower equity premium for the average firm.

Look again at the graph above of the Unlevered Equity Risk Premium (UERP) over time.  Notice how it was relatively high in the late 1970's and is relatively high now, and was low in the 1980's & 1990's.  Now, look at the smaller chart on PE Ratios and Debt/Enterprise Value.  The late 1970's had PE ratios around 10, but lately, PE ratios have been in the teens.  This is partly because low interest rates cause values of all durable assets to rise (the discount rate in a CAPM model would be lower, for instance).  But, partly, this is because the lower interest rates counterintuitively lower leverage, which, in turn, lowers the required return on equities.  Note the same discrepancy in the 1980's and 1990's.  The UERP was very low throughout this 20 year period.  When interest rates were still high, leverage was still high, so PE ratios were held down.  But, when interest rates fell in the late 1990's, leverage fell dramatically.  The astronomical valuations at the time were partially a product of high growth rates, but even before factoring in the high expectations, PE ratios would have been extremely high.  If I adjust Damodaran's ERP for leverage, it is pretty stable from 1985 to 1997.  But, the market ERP, which reflects the market's typical leverage, fell by a full point during that time.  So, when risk free interest rates fall, using a CAPM-type valuation measure, there is a multiplier effect due to the fact that the Equity Premium might also fall with it, due to declining financial leverage.

So, when interest rates fall, we frequently see rising stock prices.  This is commonly attributed to firms boosting net earnings by leveraging cheap debt.  But, this simply does not bear out, empirically.  Lower rates do cause the value of productive assets to rise.  But, this is related to deleveraging.  And, thus, the rising stock market is related to lower risk.

When I divide the interest rate into an inflation premium and a real rate, the inflation premium is the stronger influence on corporate leverage.  This is because the real rate is a sort of price of debt that reflects both supply and demand.  The inflation premium carries the tax consequences of debt versus equity for a corporation more purely.  Note also that the two surges in D/EV since 2000, when interest rates were low, were from crashes in Enterprise Value, not from planned increases in Debt.

NOPAT = Net Operating Profit After Tax
10 Year Treasury Rate is on right scale, inverted
Here is one more graph, showing Equity and Debt over time, as a proportion of NOPAT.  NOPAT is Net Operating Profit After Tax.  It's profit after tax, but before interest expense - kind of the unleveraged profit of the firm.  What's interesting is that we think of interest rates as an incentive for debt utilization.  But, what we see here is that debt has been remarkably level through both extremes of interest rates.  The effect of lower interest rates on productive investment flows mostly through equity values.  And, maybe the tax issue is a red herring.  Maybe creditors are comfortable with a general relationship of Debt/NOPAT because avoiding default is paramount, and this keeps potential debt levels under a cap.  Equity is not encumbered by this concern, so that interest rate induced increases in enterprise values must be accommodated with equity.  Also, note that under about 5% (10 year treasury rates), interest rates seem to lose their power to increase equity values.  Maybe this is because rates in this range are suggestive of underlying economic problems or are associated with deflationary distortions of economic activity.  It does make one wonder how effective we could have expected Fed policy with the stated intention of pulling down long term interest rates well below 5% to be.

The ratios above tend to make cyclical effects hard to track, because the denominators tend to go batty during downturns.  So, here is Debt (Nonfinancial Corporate Credit Market Liabilities) as a percentage of Potential GDP, graphed alongside the Fed Funds Rate.  Note that the level of debt declines as the rate declines, remains low when the Fed Funds Rate bottoms, and only tends to rise again after the Fed Funds Rate has risen and plateaued.  Debt is rising now, as a proportion of Potential GDP, in spite of the low Fed Funds Rate, but as shown in the graph above, it's still declining as a percentage of corporate capital.  That's kind of the opposite of what everyone knows, isn't it?  Isn't there a story in the paper every day about how corporate profits are high because the Fed is enabling them to leverage up with cheap debt?

This reminds me of the idea I considered recently of Treasury Bonds and Real Estate as a sort of Giffen Good for savers.  I noted how levels of Real Estate and Securities in Bank Credit (government bonds) moved inversely to interest rates.  The levels of credit have been higher when rates have been lower.  Commercial & Industrial (C&I) loans as a proportion of GDP have not followed this pattern and have declined, just as Corporate Debt as a proportion of Enterprise Value has declined as interest rates have declined.  Could the divergence of corporate debt levels from these trends among other types of credit be related to this corporate tax issue that makes debt financing more desirable in high interest rate environments?

These peculiarities change the way we might imagine firms moving through the business cycle, which I will review next.

Thursday, June 26, 2014

Risk & Valuations, Part 2: Low interest rates do NOT lead to higher leverage (in theory)

Building on the previous post, if we imagine a firm with the following beginning characteristics:

$500 million Debt
$500 million Market Capitalization
$25 million   Annual Interest Expense

then, if we view equity as an option on the enterprise (basically the Merton Model), we have a call option with a Strike Price of $500 million, an underlying asset value of $1 billion, and an option premium of $25 million per year (in the form of interest).

Now, imagine the market outlook for this equity rises, and the Enterprise Value increases to $1.5 billion.  In this Merton-like way of looking at it, we are now paying a $25 million premium for a call $1 billion in-the-money, compared to the original position which was paying a $25 million premium for a call only $500 million in-the-money.  From this perspective, the premium values have gone up.  (On options, the premium usually declines as the strike price moves away from the underlying asset price.  This change in relative rates means that the "strike price" of equity shares is more "in the money", but is still paying the same premium.)

There could be several causes of an increase in value:

1) Decreased Equity Risk Premium

2) Decreased Debt Interest Rate

3) Increased Expected Earnings

Or, an example in the opposite direction (shown in the above graph):

Imagine that interest rates change so that interest expense is $50 million, but equity risk premiums remain stable.  Enterprise value will decrease, because the higher premium will mean that equity holders bid the Enterprise value down so that they are less in-the-money than they were when the premium was lower.

Here is a graph of payouts to equities, presented as call options.  Just as call options limit the loss of the buyer to the strike price, equities limit the loss to the firms' owners to the level of equity.  In effect, debt holders are selling call options on the enterprise to the equity holders and charging them a premium.  The difference in premiums is barely noticeable in this graph because the premiums are very low compared to the enterprise value.  There are two reasons. (1) Equities are generally very "in-the-money".  There is usually a low chance of bankruptcy, which would be the equivalent of having the options expire out of the money.  (2) Most call options expire within a few months or years.  Equities are call options with no expiration date.  I am expressing the premium here in annual terms, and the annual premium will be very small compared to the perpetual value of the equity.  On an actual call option, the premium is paid up front and sort of amortizes away over time.  With debt, interest is accrued and paid periodically.  But, this doesn't really change the analogy.

The next graph is a view of the annual proportional returns to equity in the same 3 scenarios.  Again this looks very much like a graph of returns on a set of call option contracts with different strike prices or different levels of implied volatility.  There is a tradeoff between a lower breakeven level (where the line crosses the y-axis) and the slope of the payoff line as a percentage of the price of the options.

A lower equity risk premium (by increasing the market capitalization) or a lower interest rate (by lowering the "premium" on the equity option) both have the effect of leading to a new equilibrium enterprise value that lowers the slope of the proportional payout and pulls the y-axis breakeven point up toward zero.  And vice versa.

So, holding earning potential stable, the value of the firm is a product of the relationship between debt interest rates, equity risk premiums, and leverage.  And, note that, when the relative required returns of equity and debt holders diverge, the scenarios above point to higher leverage when debt is relatively more expensive!  (In hindsight, I'm getting ahead of myself.  I don't think this last sentence is supported by the simple analysis above, but it is by the analysis below.)

What about leverage?

Conventional wisdom is that firms leverage up when interest rates are low.  But, some financial analysis gives the opposite intuition.  The Modigliani-Miller Theorem posits that we should be indifferent to debt vs. equity, as, in a market without asymmetrical frictions, the risk premiums should adjust with leverage so that Enterprise value is unaffected.  From this starting point, debt is favored due to preferential tax treatment.  As leverage increases, the cost of both debt and equity increase, so there is usually some optimal leverage level where enterprise value is maximized.  As with the scenarios above, counterintuitively, since higher relative debt expenses create more tax savings, this model suggests that the higher the relative cost of debt, the more debt a firm should utilize.

If we price equity as a call option, using Black-Scholes, this is indeed the outcome we get.  Here is the graph of the relative value per share of a single firm in various interest rate contexts.  All operational expectations and tax rates are constant here.  All of these changes are a product solely of interest rates.

Capital Asset Pricing Model (CAPM)As a reminder, here is the Capital Asset Pricing Model:

The discount rate applied to the future cash flows of a firm, for the purposes of valuation, is a combination of the risk free rate, the relative market-correlated volatility of the firm's equity (Beta), and the Equity Risk Premium (expected market return minus the risk free rate).

So, the following graph displays the relative value of a share of stock in a company whose equity is valued with a Black-Scholes model using Enterprise Value (equity + debt) as the underlying asset on the option.  Expected volatility, tax rate, revenue, and earnings are stable.  The variables that change are the risk free interest rate (RFR), the unlevered Equity Risk Premium (ERP), and the amount of debt the firm uses.  The required return on equity is RFR+ERP.  Each line shows the share value of the firm with a given RFR/ERP combination, as the debt level increases.

I hope this graph isn't too difficult to read.  Basically, enterprise value increases with leverage, because of the tax benefit from interest expense.  But, default risk and equity volatility both rise as leverage rise, so at some level of leverage, the after-tax discount rate applied to expected cash flows becomes more powerful than the tax advantage, pushing enterprise value down at extremely high leverage levels.

Note that, as we should expect, valuations rise for the unleveraged firm (no debt, all equity) as the composite interest rate declines (see labels on left scale).  But, because of the tax advantage of debt, the other relationships between rates and valuations are counterintuitive.

If ERP is stable, but RFR falls (the red arrows), the cost to the firm for debt and equity would both fall.  Intuition would suggest that firms might leverage up in response to cheaper debt, but because of the counterintuitive value of debt, the optimal firm would deleverage.

If RFR is stable, but ERP falls (the purple arrows), the cost of debt would remain stable, but the cost to the firm of equity would fall. Intuition says this should cause firms to offer more equity, because investors will demand fewer earnings for the same amount of capital.  Again, the optimal firm does the opposite, and leverages up with debt, even as enterprise value rises.

Finally, if RFR rises while ERP falls by an equal amount (the green arrows), the cost of equity remains stable while the cost of debt rises.  Surprisingly, even though the discount rate on equity capital has not changed, (so that the value of the unlevered firm would not change at all) the optimal firm can increase its Share Price and Enterprise Value by leveraging up, and trading equity for debt as the debt becomes more expensive!

For instance, look at the scenarios where the cost of equity capital is 5%.  For the scenario where RFR=1% and ERP=4%, the firm's Share Price is relatively unresponsive to leverage.  But moving up to the scenario where RFR=4% and ERP=1%, now the firm can leverage up with the more expensive debt and increase its Share Price by nearly 20%, just by adjusting its capital the now more expensive debt!

If this seems like it can't be true, keep in mind that the beta of the firm's equity is increasing with leverage.  So, if RFR=2% and ERP=3%, then the unlevered firm's equity will require 5% returns.  But, when the firm replaces 50% of the equity with debt, the firm's earnings per share will be twice as volatile, so equity will now require 2+(2*3)=8% returns.  So, for firms that have required returns to equity of 5% when they have no debt, the required rate of returns will rise more for the firms with higher ERPs as debt (and beta) rises.  So when we compare these firms that have equal unlevered valuations as they utilize debt, earnings per share will be higher when debt is cheaper, but risk adjusted value to equity in these cheap debt scenarios will be lower.

An Aside

I will dig into the implications of this in upcoming posts, but as an aside, this analysis shows one of the many ways that taxes on capital damage an economy.  The advantage of leverage is greatly increased by the presence of corporate taxes.  If we didn't tax corporate profits, firms would tend to be much less leveraged.  Ownership would be more widely spread, and the economy would be less vulnerable to panics, crashes, defaults, and bankruptcies.

Tuesday, June 24, 2014

Risk & Valuations, Part 1: Leverage and Profit Margins

I would like to begin this series by addressing the notions that corporate profit margins and P/E Ratios are unsustainably high.

Let me preface this by saying this is not intended as a bullish forecast of equities.  But, if equities decline, it will not be because P/E ratios are too high or profit margins are unsustainable.  The reason is that the relationships between these measures and corporate values are not stable over time, especially when corporate leverage is changing.

First, let me compare firms with exactly the same operating results and sum-of-the-parts valuation premiums, but with differing levels of leverage.  I will assume static interest rates and risk premiums, and book values equal to market values.  (Edit: next line should say "different financial leverage".)

As firms deleverage, all else equal, valuations and net margins increase.  These changing valuation metrics are not signs of truly higher valuation multiples.  They reflect the fact that the equity holders are buying a fundamentally different security that happens to go by the same name.

If we think of equity as a perpetual call option on the firm's unlevered assets, then if we compare a firm at two points in time that moves from context 4 to context 3, we can treat the enterprise value as the asset price, the equity value as the strike price, and the annual interest expense as the option premium:
Asset Price
Strike Price
Annual Premium
$1 Billion
$500 Million
$25 Million
$1 Billion
$250 Million
$12.5 Million

So, a firm that undergoes a fundamental change in leverage is like a call option with a different strike price.  (As an aside, with options, the strike price is set and the premium changes with market sentiment.  For a firm with stable leverage, the premium and strike price (interest expense and debt level) remain stable, so if market sentiment changes, it's the underlying asset price (enterprise value) that must change for the market to clear.)

Or, thinking of it another way, an investor with $500 million could borrow $500 million and buy Firm 2 at a firm P/E of 10, and get the same payout as she would if she simply bought the equity of Firm 4 at a firm P/E of 6.67.

Changes in these measures can simply reflect a change in leverage.

There are several financial market fundamentals that this simple model demonstrates.

1) The changing PE ratios are a product of the Equity Risk Premium, which changes as beta changes.  If the volatility of the market as a whole changes, as the result of deleveraging or of improving growth prospects, PE ratios for the whole market will rise.

2) The debt in this model assumes negligible credit risk.  Corporations normally use debt with credit risk, and the level of debt is determined by the leverage that produces the highest enterprise value, given the implied market risk premiums for different funding sources.  There are a lot of moving values in that mechanism which the simple model above is not concerned with.

The point of this simple model is that corporations could be adjusting their leverage for reasons related or not related to the 2nd point above.  A demand shock might cause corporations to delay some investments even though they don't want to shrink their capital base over the long run.  Or, the market may be moving to an equilibrium with lower leverage for any number of reasons - equity investors may be less willing to pay for beta, pushing the market leverage level down.

High PE's can certainly signal a dear price.  But, high PE's and high profit margins, together with lower leverage, can also, ironically, signal safety.

Monday, June 23, 2014

Risk and Valuations - A Series

I have been thinking about the effect of changing risk appetites and economic activity, and I believe that the product of these relationships is frequently counterintuitive, so that conventional wisdom about changes in the marketplace is informed by imperfect intuitions.  These wrong intuitions then form the foundations for additional interpretations that are built on shaky foundations.

I hope some of these ideas are new and useful.  I realize that I'm going down the rabbit hole a bit here, and am demanding a bit of attention from my readers.  I hope you find these ideas compelling enough to think about them and follow me all the way through.  Feedback is welcome, especially if you make it through the entire series.

I will post these ideas in a series.  I hope to post about 3 parts per week until the end:

Section 1: Valuations, Interest Rates, and Asset Allocation

Part 1: Leverage and Profit Margins
Valuation ratios and net profit margins measure a moving target.

Part 2: Lower interest rates do not lead to higher leverage (in theory).

Part 3: Lower interest rates do not lead to higher leverage (in practice).

Part 4: Valuations and leverage through the business cycle.

Part 5: A theory of asset allocation
Maybe asset allocation should account for the level of corporate leverage.

Section 2: Risk Trading and Robust Societies

Part 6: At some margin, being short-sighted is rational
We are optimizers.  Certainty is very valuable.

Part 7: A Risk-Based Theory of the Firm
Equity holders buy risk from both labor and creditors.  Can we model firms based on risk-trading?

Part 8:  Beta has its own alpha
There could be discrete changes in risk when moving between asset classes.

Part 9: The Greenspan Put
Stay calm and NGDPLT.

Part 10: Risk Aversion and Demand for High Wage Labor in International Markets
Production doesn't move to where wages are low, it moves to where wages are rising!

Part 11: Allocations with Stocks & Bonds
If risk trading is the main factor determining risk premiums, then inflation-protected fixed income might provide decent diversification benefits.

Thursday, June 19, 2014

Mortgage Cramdowns and Monetary Accommodation

There have been programs for mortgage reductions and calls for more.  It strikes me as an unusual position.  Essentially, it is a type of bankruptcy proceeding where the equity holders retain full ownership.  I see the proposal being proposed for homeowners.  I wonder if anyone ever proposes it for commercial contexts?  Where the government intervened with GM to alter the proceedings against the bondholders, it appears to have been for the benefit of the labor unions, not the previous equity holders.

I wonder how markets would differ if that was the norm.  What if bankruptcies triggered haircuts for creditors, but equity holders  retained their ownership?

Debt would be a lot more expensive and a lot more cyclical.  Creative destruction and flexible asset allocation would be hampered.  Banking would be very difficult.

Is the housing context so different from the commercial context that the case for housing cramdowns could be that much better than the case for equity-friendly corporate cramdowns?

I suppose an Austrian critique of monetary policy is that monetary accommodation is exactly this - a haircut for creditors while the equity holders retain control, which hampers creative destruction.  So, maybe the incoherent position would be to support monetary accommodation but not to support housing cramdowns.

But that is my position....Culturally, or pragmatically, we accept that the underlying value of currency is flexible, whereas the legislated alteration of mortgage contracts seems like the undermining of the respect for contracts, an important feature of a civil economy.  I'll admit that this is a somewhat arbitrary distinction.  Both actions involve discretionary public policy with clear winners and losers.  Hmm, cognitive dissonance....

Tuesday, June 17, 2014

If we are the 100%, then who will be the scapegoat?

On the heals of yesterday's post, I came across this unfortunate post by the usually great Bill McBride, at  In it, he pulls out the old canard that corporations like high unemployment because it pulls down wages.  To concoct this story, you begin with (1) the truism that prices move inversely to excess supply, so that, similar to any good or service, wages tend to stagnate when unemployment is high.  Then, you add (2) the truism that, as with any buyer, a corporation would prefer lower prices over higher prices.  Sprinkle liberally with assumptions of sociopathic levels of self-interest, and a wink-wink about how we all KNOW how THEY are, and Voila, you have (3) corporations love it when you are hurting.

He even manages to point to the very Paul Krugman quote that I originally linked to critically on this topic, at the end of this post.  Of course, he likes Krugman's comments.

Here is a quote McBride has from Kash Mansori:
[T]his opens up an interesting line of reasoning, one that is certainly not new but which this data reminds us of. If a bad labor market means that workers get a smaller share of the productivity they bring to their employers, then the owners of companies will have a strong preference for a weak labor market. Firms don't like recessions, of course -- it's hard to make money when your sales are falling. But companies do enjoy the way that a very slow recovery in the job market can allow them to keep wages down, and thus keep a larger share of the output of their workers for themselves. 
Let's see.  How about this:
If recessions mean that firms don't have enough demand for their products, then consumers will have a strong preference for a weak economy. Consumers don't like recessions, of course -- it's hard to make money when you lose your job. But consumers do enjoy the way that a very slow recovery in GDP can allow them to keep prices down, and thus keep a larger share of the output for themselves.
How about this:
If a supply shock means that consumers have a shortage of products and services to choose from, then workers will have a strong preference for natural disasters. Workers don't like natural disasters, of course -- it's hard to make money when your town is in disarray. But workers do enjoy the way that natural disasters create demand for labor at high wages, and thus they keep a larger share of the output for themselves.

Of course, that last version is sometimes stated favorably!  In fact, replace "natural disasters" with "immigrant roundups" and many people consider it the explicit basis of public policy!

So, I just stated the same argument with the characters changed.  Oddly these three paragraphs garner very different reactions:

1) Exactly!  We need to counteract this terrible preference that corporations have!

2) That's stupid.  Of course consumers don't want the economy to be sour.

3) Exactly!  The destruction is terrible, but at least it will put people to work!

I would like to put a vote in that our reaction to version #2 is the correct reaction to all the versions.

By the way, here are US Total Compensation and US Domestic Corporate Profits, Indexed to the previous peak of profits in 2006 3Q.  First, a close-up since 2006, then a graph all the way back to 1947.

And let's be clear about what these three gentlemen above are declaring: that corporations (the BLUE line) secretly like extended economic dislocations because it gives them an advantage in bidding down labor compensation (the RED line).  Without further comment, here are the graphs of Wall Street's "Dirty Little Secret":

Well, OK, I will make one further comment, because I realized that this is another example in a running theme here at IW that interpretation trumps everything.  Here is the article at "A Wealth of Common Sense" that triggered Bill's rumination.  The article discusses how times of economic distress are good times to invest with risk.  But, there is nothing in that article about corporations gaining at the expense of labor.  The closing paragraph is:
Yet it’s still true that expectations matter with forward looking markets. This is why the best time to invest is when assets are beaten down in price with low future expectations as opposed to those times of sky high expectations and large price increases.
This was an article about sentiment and contrarian mentality.  If anything, the article runs along with the point I have been making - we're all in this together - capital recovers when labor recovers.  Yet for Bill McBride, the article reinforced the exact opposite viewpoint - that corporations recover at your expense.

You know those little toys you can get where you can only read a secret code if you place a little red plastic lens over it that filters out some of the colors?  In complex matters, most of the time we don't need the little plastic lenses - and I'm talking about all of us here, even though it's going to take someone else to point my filters out to me.  That's the thing about filters.

Monday, June 16, 2014

We are the 100%

This chart is kind of messy, but it basically outlines a problem with a lot of commentary I see on the economy.

This compares growth in commercial loans, the unemployment rate (inverted), inflation adjusted wage growth, and inflation adjusted short term interest rates.  This is a mixture of quantities and prices and it's also a mixture of labor and capital.  And, they all basically move together....

The economy is overwhelmingly more complementary than competitive.  When more labor is utilized, more capital is utilized.  When the price of labor rises, the price of capital rises.

So, analysis that says that rising wages will lead to inflation or that rising wages means labor has more bargaining power is flat out wrong.  Unemployment is falling because frictions in the marketplace are being worked out.  Wages are rising because those reduced frictions mean the pie is getting bigger.  More workers, more loans, higher wages, higher returns - these are all products of an economy functioning well.  This is a tidal chart, and all the boats are being lifted together.

Analysis that says rising interest rates is usually the result of a tightening Fed, tamping demand for credit, is flat out wrong.  Rates rise because the economy is functioning better.  The Fed is usually only able to raise the Fed Funds target because the improved economic context is expanding investment and returns.

Policy and punditry that focuses on good guys and bad guys, pitting labor against capital, takings and givings, can be satisfying, and it seems so right.  But, it only seems right because our brains evolved in a Malthusian context.  I know so many people who recognize the value of the human ability for acceptance and empathy toward diverse and wide-ranging cultures and lifestyles, but when it comes to economics they turn into a bunch of feces throwers.  Sometimes these monkey-minds we all are saddled with will just see what they are going to see.  I don't know if we can ever get safely beyond these predilections.  Whether it's with military adventures or social and economic planning, we are suckers for leaders who want to "get tough" with somebody, to our own detriment.

I dream of a world where we all imagine those we want to get tough with, and we vote instead for generosity and trust, where capitalists and central bankers see rising wages and feel hopeful, where workers see high corporate profits and feel a swell of good cheer.

Here's an even messier version of the graph, with the YOY change in public equities added (the orange line).  The main difference is that equities, being a flexible and residual measure of ownership, are a leading indicator...a sort of canary in the coal mine.  If you're ever in a coal mine, and the foreman says it's time to "get tough" on the canary, you probably don't want to stick around to see how it turns out.

Thursday, June 12, 2014

Labor Force Participation for "Prime Age Workers"

Bill McBride has a great piece on labor force participation for "prime age workers".  This is referring to workers 25-54 years old.  There is some tradition in using this indicator.  But, the fact of the matter is that LFP rates for 25-29 and 45-54 year old workers is lower than it is for 30-44 year old workers.  All the lowest participation age groups within this set are unusually populated right now.  The decline in prime age worker LFP is still capturing a lot of demographic factors.  Breaking LFP out in 5 year baskets, all of these age groups generally follow long term trends, except for the 25-29 year old male category, which has an unusual decline of about 2% over the past decade.  So, we can debate what is happening with 20-somethings, but this just isn't a story about 41 year olds.  The thing is, the data to clarify this error is readily available.  There is no excuse for making this mistake.

I think generally what is going on here is that the "prime age workers" category is a source of data that is seemingly credible but is currently providing a false signal for LFP pessimism.  Frankly, I think an article using "prime working age" to make pessimistic points about LFP mostly just informs the reader of two things.  (1) The author has a preconception that LFP has been especially bad and that the unemployment rate understates problems in the labor economy, and (2) the author hasn't taken some very basic disciplined steps to check their preconception.

I don't mean to be too harsh.  This is an example of how difficult analysis of the economy is.  We are all engaged in a battle against our own self-dealing misconceptions and lack of understanding.  If we're lucky, we might occasionally find a window into the chaos that gives us a slightly less misinformed viewpoint.

from Sober Look
In fact, here is an excellent post pointing to my possible ignorance, from soberlook, that makes a strong case that the US labor force participation has a real problem that isn't just about aging demographics.  Here are a couple graphs from the article.  The Canadian comparison is very compelling, although the case there does not look like it's a cyclical issue.  Canada has been on a different trend than the US for nearly 20 years.  I suspect that this points to our disability program that locks people into dependence.  Nearly 9 million, or almost 4%, of adult Americans are on disability.  Canada doesn't even have a national level program, from what I can tell.

This could be pulling the labor force participation levels down for 50-65 year olds in the US in a way that makes demographics much more of a dampener here than it is in Canada, without appearing in the age group data as a significant deviation from trend.

Here are comparisons of male labor force participation that I found at Fred.  Much of the gap appears to be coming from the older age group that is most heavily affected by disability programs in the US.  Participation is actually growing in this group, but not as sharply as in Canada.

from Sober Look
Another graph from their post appears to show a sharp change in trend concurrent with the recession among workers with less than a high school diploma, but the level of participation is significantly higher than it was anytime before about 2004.  This data only goes back to 1992.  It begins at about 41-42%, declines slightly, then begins climbing in the mid-1990's, until the recession.  I wonder if these trends relate to Welfare reforms during the Clinton presidency and recent changes in Federal social policy that may have added frictions in low wage and marginal labor markets.

The change in trend among less than high school workers is sharp enough that there is probably some policy or cyclical issue at work, but this could be similar to the disability issue, in that this is a category deceptively influenced by baby boomer demographics.  Here is a graph of educational attainment over time from this article.  This category is skewed toward older workers, so this is not a measurement that we would expect to be stable over time.  This peak in LFP for this category could mostly be a product of a mass of "less than high school" workers reaching ages that peaked in typical LFP in the 2000's.  Actually, thinking about it, this is probably much more of a factor than policy issues.  Less than high school education level is fairly stable at around 11% for all age groups under 65 years.  But, for 65+, it's about 19%.  So, as there is generally an age-related decline in aggregate LFP, this group should have been seeing more of a demographic decline, since there is an especially large number of these workers who are now over 65.  I'm surprised that LFP in this group didn't begin declining earlier.  And, I would expect the demographic factor to be largely baked in at this point.  If this is simply demographics, we should see this group's LFP stabilize.

I still think a careful look suggests structural issues over cyclical ones, although even if the issue among the less than high school workers is structural, the structural and cyclical issues are intertwined.

Wednesday, June 11, 2014

April 2014 JOLTS

JOLTS were reported Tuesday, and Job Openings jumped in April, putting the Beveridge Curve in territory that would have signaled full employment 10 years ago.  This is great news.  I think it signals that the employment strength we have been seeing in the last couple of months is not a statistical aberration, and it gives me more confidence that we will see more employment gains over the next couple of months.

One caveat, though, is that the 2000's vintage Beveridge Curve was not typical.  The JOLTS data doesn't go back any farther than that, so it's hard to find versions of the relationship tying into older data.  Here is one that I've found from the Federal Reserve Bank of San Francisco.  The relationship in the 1970's and 1980's would target us at 8% unemployment or more with April's Job Openings level.

We all like to push our own policy preferences onto these statistical canvasses, and I'd like to do that as much as the next guy.  But, the 70's and 80's had their own, minor, baby boomer generation that was hitting retirement, and I wonder if the rightward shift has to do with behavioral tendencies of an older work force that tends to be unemployed less, but for longer durations, than younger workers.  Maybe a 3.1% Job Openings rate corresponds to a 6.3% unemployment rate in the current demographic context.

On the other hand, the difference between where the Beveridge Curve is now and where it was 10 years ago is roughly equal to the unusual number of very long duration unemployed, which is probably a combined product of demographics, EUI, and the recession.  The shape of the distribution of unemployment durations would suggest that the Beveridge Curve has more room to shift back to the left.  We are, after all, still to the right of all historical Beveridge Curve locations outside of that 15 year period in the 1970's & 1980's.

Here are graphs of the trends in Openings, Quits and Hires, and the long term levels of all the JOLTS categories (below).  I would have been ecstatic if we had seen a rise in Quits along with this rise in Openings, but still, trends remain positive.

Also, here is a graph of employment flows, through May.  These kind of tell a similar story to the other indicators.  Flows into and out of Employment and Unemployment are roughly back at a level that would normally correspond to full recoveries.  But flows into and out of the Labor Force remain high.  Again, this points to a labor market mostly functioning at recovery levels, but with a large pool of marginally attached workers.  I see lots of narratives about this group that are really more about the narrative authors than they are about the group itself.  I suspect that all those narratives and more exist here, so if we take everyone's expectations and throw them in a blender, we'll get a decent picture of what to expect.  I think there is some upward drift in the Labor Force flows over the past 20 years, having to do with the demographics I discussed above, so I suspect that unemployment will continue to retain an extra 0.2-.03% of marginal workers, even in full recovery, but most of this group will slowly re-enter the workforce.

I think this is reinforced by the Quits data.  It has not shifted like the Openings data has, in relation to unemployment.  I felt like it pointed to a slightly overstated unemployment rate a few months ago, but with the recent decline in the unemployment rate, the Quits/Unemployment rates seem to be in line with previous levels.  This suggests that current workers see the current groups of unemployed workers as potential competitors, which, to me, argues against the narrative that the unusual group of very long term unemployed is a product of a skills mismatch.  If that was the case, workers would be quitting as if unemployment was at 5%.

Whatever the factors are that are keeping unemployment over 6%, it looks to me like the nuts and bolts of this economy are ready to finish the labor recovery this year.

Tuesday, June 10, 2014

Interest Rates in Late 2014

Could we see another summer bump in interest rates?

Here is a simple version of a Taylor Rule rate, which is now at 2%.  I realize that the Taylor Rule is not necessarily applicable in the current climate.  And, I would even argue that the Taylor Rule overestimated the natural rate by about 2% in the 2000's and could be overestimating the natural rate by up to 3% to 4% now.  This would have to be the case for the current yield curve to be reasonable, because the Taylor Rule rate would be somewhere near 4% by the time the market expects the Fed to raise rates.  I'm not sure that that is the case.  One sign regarding this issue will be how inflation behaves over the next year.  Seasonally adjusted, month-over-month inflation, while noisy, is showing an increase.

Weekly updates on loans and leases in bank credit also remain strong.  The three charts below all have a $500 billion scale over 4 years to show the relative performance of Commercial & Industrial Loans, Real Estate Loans, and Consumer Loans.  Real estate is, by far, the largest absolute pool of bank credit, so the capacity for real estate loans to add to credit growth is substantial.  So far this year, consumer and industrial credit has been growing at an annualized rate of more than 5%, which is about the lowest level of growth we would expect to see in a sustained recovery period, and that has mostly been due to growth in Commercial and Industrial Loans of more than 10%.  The real estate credit market will be an area to watch.  I expect to see a sharp recovery.

These factors kind of multiply on themselves.  If home prices continue to rise, household net worth will improve, fewer homeowners will be underwater, and the rise in price itself will feed more housing demand.  Mortgage costs are very low compared to rent, so this should be a multiplicative mechanism for some time.  Similarly, rising inflation might signal that monetary policy has become loose at the current levels of interest rates and excess reserves.  This will be a signal that both (1) the Fed will raise rates earlier than we expected, and (2) the natural rate is closer to the Taylor Rule rate than we thought it was, suggesting that rates will need to rise faster and farther than we thought.

On a month-over-month basis, inflation has now shown 2%+ level growth for two months.  The May readings will be very interesting.

We could very easily be sitting here in September 2014 with inflation at 2.25% unemployment at 5.8%, and bank credit growing at 10% per year.  That would trigger a sharp change in attitudes toward interest rates.  I think that is the position to have exposure to right now.

Corporate spreads have recently fallen to ranges that typically coincide with rising rates.  Here is a graph comparing various spreads with the level they were at in June 2004 when the Fed Funds rate began to rise.  And another graph focused on more recent movements.  I think we should take these as a signal of the state of credit markets.  Continued spread compression along with expanding credit would suggest strong supply and demand in credit markets.

PS.  Don't misunderstand me.  I am not arguing that the Fed is too loose and needs to tighten.  I am saying that we have been in a context where monetary policy has been too tight, even with rates were near zero and the Fed expanding its balance sheet.  But, if this economy continues to recover, there could be a bit of a tipping point where increasing inflation and expanding bank balance sheets mean that the Fed would need to follow rates up in order to prevent inflationary developments.  I would still want the Fed to be fairly accommodative, but the interest rate is a moving target, and the time for a 2% interest rate target that is somewhat accommodative may come sooner than it now seems like it might.  We should hope for this outcome.

Monday, June 9, 2014

May 2014 Employment Review

I had wondered if this month would confirm a strong employment trend, which would have corresponded to a range of 5.9%-6.3%.  Or, this month could suggest that trends are continuing along the long term pace and last month was a statistical aberration, which would have corresponded to a range of 6.1%-6.5%.  The month came in at 6.3%, and it looks like a combination of the two.  There was some statistical reversion compared to last month, but with some hopeful signals.

The first graphs here are from flows data.  These are pretty noisy numbers, so it is tough to see much change from month to month.  All of these flows reverted back from last month's strong movements, which was expected.  The trends are all moving in the right direction, but last month's improved unemployment numbers were partly from unusual movements.

The next graph is the comparison of insured unemployment and total unemployment.  There was some snap-back this month.  This will bounce around from month to month, as all of these indicators do, but last month's drop in unemployment was much closer to the trend in this relationship than this month's pause.  This points to more potential for falling unemployment in the coming months.

The remaining graphs are related to unemployment by duration of unemployment.  This data shows strong confirmation of less persistent unemployment coinciding with the end of EUI.  First, regarding this month's unemployment, the total number of unemployed workers remained about the same as last month.  But, note that this comes from an increase in very short term unemployment and a decrease in long term unemployment.

Both initial and continued claims on unemployment insurance have been declining recently, so this increase in short term unemployment is probably either (1) the result of a surge in quits (which we won't be able to confirm until JOLTS data for May is released in July), or (2) the result of a statistical aberration in the May numbers, overstating unemployment.  Both of these would be reasons for bullishness on employment.

This improvement in unemployment churn is evident in the % of long term unemployed exiting unemployment, which surged this month to more than 38%.

The next graph is the unemployment by duration graph, again, but in line graph form.  This helps to see the shape of unemployment over time, and the change in unemployment durations as we have left EUI.  I was originally wrong about exactly how this would play out, because I didn't fully account for the fact that many of the very long term unemployed have timed out of even EUI.  So, there is a group of very long term unemployed that is slowly shrinking, by about 0.05% of the labor force per month.  They are not effected by EUI.  By the end of 2013, for unemployment durations under about 75 weeks, the labor market was fairly normalized, but EUI and the existence of marginally attached workers and very long term unemployed workers were continuing to push unemployment durations higher.  The end of EUI increased the exit rate from unemployment for workers across durations.  This is visible in this line graph.  The decline in very long term unemployment has continued to decline at a stable pace.  But the big change in the past 8 months has been the additional decline in 5-26 week unemployment (which also pulled down the "over 26" category at a stronger pace).

This has probably mostly played out at the lower durations.  As these cohorts age, the longer duration categories will inherit smaller cohorts because of these higher exit rates, so that, over time, long duration unemployment will decrease as a result of employment trends that are already established today.  Generally, long duration unemployment in the near future can be roughly estimated by the relative behavior of the shorter durations.  Next is a graph comparing actual long term unemployment to the unemployment predicted by shorter durations.  Here we can see how there was unusual employment behavior specific to "over 26 week" durations.

The next graph shows the difference between the forecasted long term duration unemployment and the actual long term unemployment.  I consider this to be a rough approximation of the number of very long unemployed workers.

May's continuation of these trends continues to suggest that, excluding the very long term unemployed, the unemployment rate is down to about 5.3%.  A 5.5%-5.7% unemployment rate by the end of 2014 still seems reasonable.  Compared to today's 6.3% rate, in broad terms, it looks to me like about 0.1% will come out of 15-26 week durations, about 0.2%-0.4% will come from the natural continuing decline in "over 26 weeks" as the higher exit rates of recent cohorts continue to move through the durations over time, and about 0.3% will come from the continued decline in very long term unemployed (shown in the last graph).

Wednesday, June 4, 2014

Optimistic Take on Unemployment

Here is an optimistic take on unemployment from Jeff Stibel at the Harvard Business Review.  (HT: Tyler Cowen)  He forecasts an unemployment rate of 5% by July 2015.  His reason is that small business expansion has been very laggardly in this cycle, and is just now entering the acceleration phase that we would normally see earlier.
This recession was marked by an overall decline in small businesses (typically we see small business starts accelerate), decrease in mean employment size of small businesses, and a lack of turnover for the most tenured employees. All of this led to high unemployment rates. Optimism indexes show a similar trend: bigger businesses have gained in optimism at a faster pace than their smaller counterparts, contrary to past recoveries.Contrast these trends with what has happened historically and it is clear that these anomalies are critical; any projection that relies too heavily on historical patterns is likely to be imprecise when the historical account materially differs from present events.
Moreover, the trends we’ve seen since the beginning of the recession are beginning to shift. Our data is finally showing that the smallest of businesses are growing  more optimistic about their prospects, which will eventually lead to the increased hiring that typically comes at the start of a recovery. If the trend holds, it means that the typical post-recession jobs growth will be inverted during the current economic recovery. Thus, we should begin to see an acceleration in new jobs and rapidly decreasing unemployment.
There are a large number of factors that could be in play here.  One factor could be the influence of real estate equity in small business and start up funding.  Possibly the delayed recovery of housing and of small business employment are related.

In any case, the thesis appears to be built on some of the uncontroversially peculiar trends in this cycle.  I would add that the commenters on the article have created an almost museum-quality demonstration of all the biases and "mood affiliation" positions that can create a profitable tradable position if they are held universally enough.

Tuesday, June 3, 2014

May 2014 Employment

It's hard to know what kind of movement we will see in the unemployment rate this month, after such a sharp decline last month from 6.7% down to 6.3%.  Unemployment insurance claims continue to signal optimism.  Here are the weekly figures in initial and continued claims:

The second graph is my comparison of continued claims to the unemployment rate.  As with last month, there are two trends working in the favor of good news.  One is that continued claims have been declining dramatically, which should coincide over time with a general decline in unemployment.  The other trend is the convergence we should expect to see between the actual unemployment rate and the unemployment rate we have historically seen relative to the insured unemployment rate.

Of course, there is a lot of noise, month to month, with all of these indicators, but the trends look positive.  I believe that the divergence from historical unemployment levels was related to the generous level of Emergency Unemployment Insurance (EUI), which ended at the end of 2013.

The new level of continued claims would correspond to an unemployment rate of 6.1% without any additional convergence to the historical unemployment level. (edit: this estimated May level is the last point on the blue series in the graph.)  If the end of EUI is creating a new trend with a more steeply declining unemployment rate, then this month could see another gap down, with an expected range of, say, 5.9% to 6.3%.  The decline in continued claims may be a result of generally faster unemployment exit rates across unemployment durations, related to the end of EUI.  If that is the case, then we should expect there to be a convergence to historical trends along with the decline in UI, since there should also be an increase in unemployment exit rates for unemployment of durations slightly over 26 weeks, in addition to the decline in unemployed workers who are still eligible for regular UI.  So far, however, there appears to be a population of very long term unemployed whose exit rates remain very slow and, lacking a change in their own trend of employment behavior, will slow some of the convergence to historical levels until well into 2015.

If I am wrong about this new trend, and last month was mostly a noise event, we might be looking at an expected range of more like 6.1% to 6.5% in May.

Monday, June 2, 2014

Another Look at Minimum Wage Labor Force

The other day, I looked at this relationship.

In that post I looked at the annual change in the number of minimum wage workers compared to the annual change in the relative minimum wage:

I also looked at the historical levels of minimum wage employment to historical relative minimum wage levels, compared to the EPI estimates:

In this post, I thought I would compare the scatterplot of annual changes to the trendline that would be implied by the EPI estimate:

Also, I have extended the linear trend of the EPI estimate to the minimum wage levels that were in place back to 1979 (about $11.90 in current dollars, as a proportion of average wages):

It simply seems implausible to me that this relationship has shifted to this degree.  Assuming no job losses and a linear behavior (which is probably conservative compared to EPI's accelerating curvilinear trend), at a minimum wage of $11.90, the EPI trend would imply that 20% of the labor force is currently working at that wage level or less.

Just to clarify, the notion that MW causes some job loss only proposes that some portion of this huge difference is due to job loss.

The notion that MW causes no job loss would depend on this entire shift being due to an exogenous shift in wage distribution.  It would have to depend on an average increase in minimum wage workers as the MW increased that is incrementally steeper than it has ever been in any single annual data point in the last 35 years, including the most recent MW increases.