In our January, 2013 Riggs’ Report, we discussed the fiscal cliff and debt ceiling negotiations at length. So here we are nine months later, in the midst of a government shutdown surrounded by rancorous debate on both sides of the aisle and the investment markets getting increasingly frustrated with the lack of leadership and governance at the federal level. But this is not new territory for our country. In fact, over the past 32 years, Congress has only passed the entire federal budget by its September 30th deadline four times—in 1977, 1989, 1995 and 1997. Further, they have shut down the Federal Government 17 times.
On average, the stock markets have come under modest pressure prior to and during a government shutdown. Not unlike what we have experi‐ enced in the past two weeks. Historically, the month following a gov‐ ernment shutdown markets have tended to move higher. The bigger issue facing the markets is the debt ceiling debate. Pressure could be put on the stock market if it appears that Washing‐ ton will not be able to resolve the debt ceiling issue. During the 2011 debt ceiling battle, the S&P 500 declined 16.8% from July 22nd to August 8th. So far, the market decline we have seen feels like a healthy pull back that should set the stage for a market rally going into year‐end but we are closely watching what is going on in Washington.
To Taper or Not to Taper?
Before the government shut down took center stage, much of Wall Street was focused on whether or not the Federal Reserve Board would begin to taper their Large Scale Asset Purchase Program (LSAP) (also known as QE3). Currently each month, the Federal Reserve purchases $40 Billion of U.S. Treasuries and $45 Billion of Mortgage Backed Securities. Additionally, they have been reinvesting principle, so the total month‐ ly purchases likely exceed $100 Billion. With the Federal Reserve serving as a $100 Billion customer each month, demand has remained steady keeping interest rates and borrowing costs low.
In our April, 2013 Riggs’ Report we noted:
“What would cause the Federal Reserve to end this policy? If the economy enters a peri‐ od of self‐sustaining growth with real improvements in the labor market, if we see a significant pickup in inflation and/or inflation expectations, or if there is a concern that the program is failing and its efficacy comes into question, the Federal Reserve may shift its current monetary policy.”
We have seen some improvement in the economy. While it may not be self‐sustaining, it is improved. The unemployment rate has improved, although a large piece of that improvement has been from workers leaving the labor force. The big issue is that there is growing concern with the efficacy of these Large Scale Asset Purchase Programs and the negative effects they may have on the economy down the road. We be‐ lieve this is why the Federal Reserve began to publicly discuss tapering of its bond purchases this summer. Virtually everyone on Wall Street expected the Federal Reserve to announce in September that it would begin tapering. However, Federal Reserve Chairman Bernanke and his Board surprised the markets by decid‐ ing to stay the course and keep the asset purchase program in place. No doubt the dysfunction in Washington and the likelihood of an ugly budget and debt ceiling debate weighed on their decision to continue prop‐ ping up demand to the investment markets through the Large Scale Asset Purchase Program.
For the Fixed‐Income Investor
What would the impact of the Federal Reserve tapering its $100 Billion reinvestment in the markets? This chart is an inverted log scale of Ten‐Year Treas‐ ury yields. This chart depicts the bond market from 1960 to today. One can see the recent selloff that the bond markets experienced this summer when the Fed‐ eral Reserve began to discuss reducing its bond purchases.
Our best guess is that the Federal Reserve will begin to slowly reduce the amount of its bond purchas‐ es, either later this year or early next. As the Federal Reserve gradually reduces the level of purchases of Treasuries and Mortgage Backed Securities, we will see interest rates move higher and bond values move lower.
For Fixed Income investors, we will continue to proactively work to provide you the best risk managed returns the markets can provide and continue to augment returns when we deem it reasonable. However, we feel that fixed‐income investors may find themselves swimming against the tide for an extended period of time, perhaps decades. Therefore, we recommend keeping fixed‐income allocations at a minimum.
Reshaping the U.S. Labor Market
We are seeing a real di‐ chotomy between corporate profits and employment as illus‐ trated by the chart. The red line and left scale depicts after tax corporate profits as a percentage of GDP. While the blue line and right scale depicts the U.S. Labor Force Participation Rate. The shaded areas indicate recessions. As you can see, corporate profits have more than fully recovered from their 2009 recession lows. However, the same cannot be
said for employment. After rising steadily since the mid 1960’s, the number of employment age people work‐ ing peaked in the late 1990’s and then began to decline. Since the great recession from 2008 to 2009, the decline in the labor force participation rate has accelerated dramatically. Today the labor force, as a percent‐ age of the working age population is at the lowest level since 1978!
From its peak in 2009, the unemployment rate has fallen from 10% to 7.3%. However, there are 2 Mil‐ lion less people employed today than there were at the end of 2007. Some of the factors that are effecting employment levels are:
- In 35 states, for a couple with one child, the total package of unemployment benefits, Medicaid and food stamps is greater than what they could earn working full time for minimum wage. Thus, creating a disincentive for employment.
- Young people are especially hard hit with more students opting to continue their education seeking advanced degrees, rather than enter the work force during a difficult job market.
- With nearly 9 Million people now receiving Social Security disability checks, increases in the number of disability benefits recipients account for roughly 25% of the decline in employment participation.
- Advancements in automation and technology are impacting employment and we believe that we are in the early stages of a dramatic shift in the use of automation and robotics that will change the job market as we know it.
It appears we have reached a tipping point, where technology is becoming cheap enough and reliable enough, that as the cost of employment increases many companies will look to replace workers with automation. Therefore, even as the economy shows signs of improvement, employment will likely continue to lag.
Since 2009, 16% (roughly 1 Million) of all new jobs have been in the food service industry. This indus‐ try is on the cusp of a major shift towards automation that will enhance profitability and increase productivity. However, it will also reduce demand for unskilled and low skilled workers. For example, in 2014 Chili’s Bar & Grill, a national dining chain, will be installing tens of thousands of table top tablets across all of its 1,266 stores in the United States. From these tablets, customers will be able to order appetizers as soon as they sit down, see the drink specials, order their meals and refills, look at and select their dessert. While they are dining, they can play games and join loyalty clubs. When they are done, customers will be able to pay with a credit card and receive an emailed receipt, all from the table top tablet. This will allow each server to service more tables, thus reducing the number of wait-staff needed for each shift.
McDonald’s has installed more than 7,000 touch screen kiosks across Europe and it will not be long until that technology is introduced to the United States. These kiosks can improve productivity and profit per store, while reducing labor cost.
Automation and robotics will have a major effect on the low skilled worker across all industries, just as it reshaped the manufacturing industry in the 80’s. Many of the people, who would have worked in factories in the 70’s and 80’s, moved towards other industries, such as food service, in the 90’s and 2000’s, though at lower wage rates. Whether it is in food service or agriculture, low skilled workers are at risk. Today, robots are being tested that can move through an orchard or vineyard, identify and pick fruit individually at the precise level of ripeness desired. What then will the migrant farm hand do to support his or her family? These technologies while having a positive effect on corporate profits and will have a dramatic effect on the demand for unskilled and low skilled workers, with significant long‐term economic, social and political ramifications.
We see modest improvement in the economy while the jobs situation remains challenged. We believe the fixed‐income markets will continue to be challenging. The equity markets have done well this year and should continue to move higher into year end.
As you can see your porfolios are doing well. We have continued to consolidate holdings in areas with good near and long term growth prospects. Our expectation for the fourth quarter remains positive. As always, we remain vigilant and proactive in our approach to wealth preservation.