The National Federation of Independent Business Small Business Optimism index rose moderately to 96.1 versus a prior 95.7 and a Street consensus of 96.0. Components were somewhat better:
- 9% of employers think it is a good time to expand
- Employers anticipating job creation falls to 10%
- Percentage of firms expecting a better economy rises to -3%
- Firms anticipating higher selling prices falls to 6%
- Firms seeing increased capital spending rises to 27%
- Firms planning to boost inventory rises to 1%
- Firms expecting better sales falls to 6%
- Firms viewing inventories as too low rises to -2%
- Employers with jobs not able to fill rises to 26%
- Firms seeing easier credit conditions unchanged at -5%
- Firms expecting positive earnings trends rises to -17%
- Firms expecting compensation to grow rises to 22%
- 598 employers surveyed for the NFIB report
The data is consistent with a cautiously-optimistic small business sector. NFIB Chief Economist, Bill Dunkelberg, stated:
“There is so much ‘noise’ and uncertainty in the economic system that small business owners are finding it difficult to be optimistic in this environment. Overall, small business is still not in a good place.”
The NFIB statement indicated: “Job creation plans faded however, suggesting weaker job creation ahead. The net percent of owners planning to increase employment fell 3 points to a seasonally adjusted net 10 percent. Historically, these are not statistics associated with periods of strong employment growth.”
Although most economic data has improved during the past few months, retail sales have disappointed. NFIB data indicate that retail sales could be an ongoing problem. The NFIB reports:
“The net percent of all owners (seasonally adjusted) reporting higher nominal sales in the past 3 months compared to the prior 3 months improved 1 point to a net negative 2 percent. Thirteen percent cited weak sales as their top business problem, one of the lowest readings since December 2007, the peak of the expansion. Expected real sales volumes posted a 4 point decline, falling to a net 6 percent of owners expecting gains.”
As we see it; the worst might be over for the small business and the economy as a whole. The real question is: How much better can it get given underlying fundamentals? What if the is “escape velocity?”
JOLTS Job Openings data indicate that the pace of job growth might be plateauing. According to JOLTS data, job openings were little changed in July, coming in at 4,673,000, down from a prior revised 4,675,000 (up from 4,671,000) and below the Street consensus estimate of 4,700,000. The hiring rate was unchanged at 3.5%, a post-recession high, but still low by the standards of previous expansions. The quit rate was unchanged at a depressed 1.8%. The quit rate is an important gauge of the health of the job market. Workers tend to voluntarily quit the jobs more often when better job opportunities are available. That the quit rate remains very depressed appears to indicate that there are few opportunities for workers to improve their employment situation from an economic standpoint.
Fed Chair, Janet Yellen, has been clear in stating that a pickup in wage growth is an important factor when considering tightening Fed policy. A low quits rate indicates that wage growth is quite stagnant. We would be surprised if the Fed alluded to speeding up the pace of tightening at next week’s FOMC meeting. We would be less surprised if the Fed expressed concerns regarding excessive risk taking and the potential for “macro-prudential” (regulatory) policies to address potentially overvalued conditions in some risk asset classes.
Both bond and stock prices are trending lower today. Some media sources blame a statement by BlackRock Inc. which stated that the Fed could boost borrowing costs more quickly due to an improving labor market. A report published yesterday by the San Francisco Fed intimated that investors might be underestimating the speed at which the Fed could tighten monetary policy.
Are investors underestimating the speed and severity of an eventual Fed tightening or are they underestimating the negative effects from a Fed tightening? For the past year, as talk of monetary policy renormalization has grown louder, pundits have opined that investors should not fear Fed policy tightening as less accommodative monetary policy should indicate stronger economic fundamentals, creating continued favorable conditions for high yield fixed income assets.
It is our view that junk debt is priced for a more robust economy than we are likely to see, at least during the next several years. As such, we see little price upside for junk debt from here on out. As junk debt might be priced to perfection, even modestly tighter monetary policy could be a negative for high-risk fixed income assets.
Our theory is: The more aggressive the Fed tightening, the higher up the credit ratings scale the damage might be. As we do not believe that monetary policy will be tightened aggressively (or soon), we are not fearful of widespread damage in the junk debt market in the near future from Fed policy, but we are concerned that small deliberate measures by the FOMC could cause trouble at the bottom of the junk debt market. We continue favor a strategy in which aggressive investors move capital out of the nether regions of the junk debt market prior to Fed tightening.
Opinions on the best way to invest in junk debt are varied, but nearly all agree that diversification is critical. By having a diversified portfolio, one can be less affected by one or more defaults or debt restructures versus having a concentrated portfolio. Investors need to understand that the lower one reaches down the credit quality ladder, the greater the chances of default and the less reliable the income stream.
It is our concern that too many investors and advisors are using junk debt for income enhancement without fully considering the risks. Bonds rated BB have a reasonable possibility of paying interest and maturing as scheduled. By the time we get down to CCC, income becomes significantly less reliable and maturity at par not at all a forgone conclusion. Because of the total return nature of junk debt, we have argued for years that junk debt speculations should be made with a portion of investors’ capital targeted for equity investing. We do not envision a junk debt meltdown, but as monetary policies renormalize, so should asset price behavior and correlations between asset classes.
Street Fighting Man
We have been warning about the deterioration in the quality of leveraged loans for more than two years. FINRA issued warnings regarding leveraged loan risk in 2012 and the Fed began to express concern last year. Now Moody’s has published a report indicating that leveraged-loan safeguards are the weakest since at least 2008.
Moody’s analysts led by Jessica Reiss wrote in the report: “Lenders are being exposed to rising risk as they forfeit key levers they have traditionally been able to pull when a company is starting to experience financial distress.”
The report went on to say that covenant quality has become “consistently weaker not only in the number of loans with sparser terms, but in the terms themselves — a factor that has caused rapid erosion in loan scores in just a few short years.”
We have seen signs in the credit markets that investors are beginning to push back. Although Treasury yields have trended lower during the past month, high yield bonds yields have remained fairly stable. The resulting spread widening is a sign that investors are unwilling to accept less yield for the amount of credit risk to which they are exposed. Investors will only tolerate yields going so low versus credit risk before they say “enough.”
We have seen signs of this in the preferred securities market. A few years ago, corporations were able to issue floating-rate and fixed-to-float preferreds with floating spreads of 100 basis points or less over one-month or three-month Libor rates. Investors have become wise to the fact that it matters how much over the benchmark and not just that fact that a coupon floats when considering a variable-rate investment vehicle. Recently, new fixed-to-float preferreds have offered spreads of +250 to over +400 over Libor benchmarks. With Libor rates closely tied to the Fed Funds rates and the Fed likely to raise the Fed Funds Rate slowly and moderately, we would want a floating spread of at least 350 basis points before considering a floating-rate or fixed-to-float preferred.
Keep an eye on the U.S. dollar. With the European economic recovery still in “spring training” and renewed signs that Japan’s economy is sputtering, the U.S. dollar should continue to strengthen. This could be a negative for exporters and up-stream energy companies, but could be positive for consumer cyclical businesses and mid-stream energy companies. A stronger dollar could lower the prices of imported goods and should continue to exert downward pressure on energy prices. This could provide a benefit for consumers which is similar to a consumption tax cut.
Today’s auction of $27 billion three-year Treasury notes met with good response. The bid/cover ratio rose to 3.17 from 3.03 at the last auction, indicating stronger demand. The bid/cover ratio was the highest since 3.38 at July 8, auction. Indirect bidders, which include foreign central banks, bought 33.1% of the amount sold, compared with 36.2% in the prior auction. Primary dealers bought 46.6 percent, compared with 44.8 percent in the previous sale. Direct bidders purchased 20.3 percent.
Although indirect bidder participation was down a bit and primary dealers had to pick up the slack, that the bid-to-cover ratio increased indicates that today’s auction was fairly strong. A recent back-up in yields on the view that the economy is picking up steam undoubtedly attracted investors. Tomorrow, the Treasury will re-open the current 10-year note in the amount of $21 billion. The Treasury will reopen the current 30-year government bond for $13 billion on Thursday. Yields of long-dated Treasuries have edged higher in recent trading sessions. The new supply coming to market is partially to blame. We believe that there is ample demand for U.S. Treasuries to absorb the new supply with little difficulty.
During an interview this morning on CNBC, DoubleLine Capital CEO and CIO, Jeff Gundlach opined that the 10-year Treasury yield could remain range-bound between 2.20% and 2.80% for the foreseeable future and that the yield curve could flatten with yields around 3.00% across the board. This is in line with Bond Squad’s outlook.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC