Thursday, June 06, 2013 - The World is Changing

The World is Changing

by Sinclair Noe

DOW + 80 = 15,040
SPX + 13 = 1622
NAS + 22 = 3424
10 YR YLD - .03 = 2.07
OIL + .91 = 94.41
GOLD + 11.00 = 1414.70
SILV + .04 = 22.69

Today is June 6; on this date 69 years ago, nearly 200,000 Allied troops invaded the Normandy coast. Today is and will always be D-Day.

The world is changing. For the first time in modern times, the emerging markets now account for more than half of global GDP. And they are continuing to grow; the majority of global growth the rest of this decade will happen in the developing world. India and China alone will make up almost half of it. The growth in emerging markets is partly a matter of playing catch up. Emerging markets have more room to grow; developed markets have already experienced the growth. The center of world economics is shifting, and it is shifting to the east.

The International Labor Organization released its annual "World of Work" (PDF) report today. The employment rate won't return to pre-crisis levels in emerging markets until 2015, while advanced economies will have to wait until 2017 for their work woes to end. But even then, the number of unemployed people is still set to grow 4% to 208 million in 2015. How can the employment rate and unemployment levels rise simultaneously? Because the unemployed are dropping out of the work force: In more than half of the countries surveyed, labor force participation declined largely due to discouraged workers giving up the job hunt.

Perhaps worse: job quality is worsening around the globe, even where the unemployment rate is falling. The emerging markets are finding it easier to create more and better jobs because they're starting from a low base. It's easy to improve job quality in a country where most people make less than $10 a day; it's much harder in a country where the median income is $50,000 per year. For most advanced economies, the new jobs being created are of lower quality.

Based on the report, the trend is a boon for the wealthy. Top incomes in advanced countries have resumed their upward trend. Meanwhile, the middle class is shrinking due to the growing disparity between higher and lower incomes, which exacerbates overall inequality.

When Friday's jobs report is released, the unemployment rate and the number of new jobs will come in for close scrutiny. The market traders will examine the numbers and buy or sell or scratch their heads. The estimates call for a net 165,000 jobs added in May. Today, the Labor Department reported weekly initial claims for jobless benefits decreased by 11,000 to 346,000. The Federal Reserve will be watching; we know the Fed has set a target of 6.5% unemployment; that's the point, they say, when they will start raising rates and winding down their easy-money policies.

The unemployment rate started climbing from a low of 4.4% in the summer of 2007. I don't know why the Fed doesn't use that as their target. The rate topped out at 10.1% in October 2009. We started the year at 7.9%. The unemployment rate is currently 7.5% and it isn't expected to change with tomorrow's report. So, it looks like there has been quite a bit of improvement, unless you look at the employment rate; this is the proportion of the population that is working, not the proportion that isn't. In 2006, 63.4% of the working-age population was employed. That percentage declined to a low of 58.2% in July 2011 and now stands at 58.6%. By this measure, the labor market's health has barely changed over the past three years.

The headline unemployment rate, currently 7.5%, only measures people who are actively searching for work but don't have jobs. There is another measure of unemployment; U6 counts those marginally attached to the workforce—including the unemployed who dropped out of the labor market and are not actively seeking work because they are discouraged, as well as those working part time because they cannot find full-time work. The U6 unemployment rate in April was 13.9%; that's down from 17.1% in 2009, but still wicked high.

While the unemployment rate has fallen over the past 3½ years, the employment-to-population ratio has stayed almost constant at about 58.5%; historically low. Jobs are always being created and destroyed, and the net number of jobs over the last 3½ years has increased, but the working-age population has also increased. Job growth has been just slightly better than what it takes to keep the employed proportion of the working-age population constant.

We won't be getting back many of the jobs that were lost during the downturn. At the present slow pace of job growth, it will require more than a decade to get back to employment levels we had before the downturn. The Federal Reserve's quantitative easing monetary policies may have helped, but certainly not enough; they are still a very, very long way from their mandate of maximum employment. The Fed may want to taper off QE, but that is more like to hurt than help. Better would be redirecting QE. Pumping money into the banking system has not been effective at achieving maximum employment and it risks the possibility of asset bubbles, which threaten price stability – the Fed's second mandate.

The argument has been that more direct attempts to stimulate the labor market are the responsibility of fiscal policy, but that doesn't dismiss the Fed from its dual mandate.

One thing the Fed has accomplished is to bring down mortgage rates over the past 5 years. Each year, rates inched lower and lower, until the last month. The 30-year fixed rate mortgage has now bounced from just under 3.5% a month ago to 4.16% this week. Not surprisingly, there has been a big drop-off in refinancing applications. We might see a little bounce in new purchases, as some people will try to jump in before rates move any higher. Now refis provided some stimulus, since lower mortgage payments means more money to spend. But the effect is likely not as great as you might think. The big winners are the banks; they make money when you refinance.

Now how much any borrower benefitted from a refi depends on how big a rate reduction he got. People who refied repeatedly on the way down would give away a lot of the gain. The people who may have fared the best, ironically, were those who had been barred from refinancing in the early years of the rate decline by being underwater but later got access via HARP. HARP refis were just shy of 1.1 million in 2012 and were 440,000 in 2011.

Remember that personal income fell in January, and the growth in subsequent months has been so weak as to be insufficient to make up for the decline, and the sequester is putting a further brake on the economy. So the rise in rates is yet more drag, and more reason why the Fed is likely to avoid taper.

Those low mortgage rates were a big part of the housing recovery; they enabled a lot of people to stay in their homes, even if they were underwater; they enabled others to purchase; and they enabled investors to swoop in. Remember that price spikes in most markets usually occur on the margins, and the renaissance of the real estate investor was certainly a compelling component for big price swings in the recovery. Investor buyers have been coming in and filling the void, but they’ve also been outbidding buyers who are actual families. In markets where it’s heating up, non-investors are getting frozen out.

So the recent rise in rates, when you add that to the very conversion of home to rentals already leading to more tenant-favorable conditions in some of the hottest market, is certain to put a damper on speculator appetite. On the one hand, the cooling of appetite by investors will aid some end-buyers who are mortgage financed and have been unable to compete with “cash” buyers (who may also be using leverage, just not via a mortgage). But higher rates means less buying power, unless lenders start loosening terms. They’ve been pretty stringent up to now. Are they going to help facilitate this investor pump and dump?

And now it looks like the recent rise in rates is affecting the big dog investors. A couple of big operators had planned initial public offerings: Colony Capital’s IPO of a portfolio of nearly 10,000 homes, expected to fetch $260 million looks to be on hold for now, and a new filing by American Homes 4 Rent looking to raise $1.25 billion seems to be moving forward. But the Financial Times reports those liquidity events may be running into a roadblock of higher rates:

“Colony American Homes has postponed a US float as the sudden jump in market interest rates has damped investor appetite for newly issued shares in real estate investment trusts…

“Colony had garnered enough interest from investors to price its shares near the low end of a $11.50 to $13 per share range...

“The company decided that an IPO fundraising was not vital to its day-to-day operations and felt it could hold off until the credit markets stabilise, the person added. Colony declined to comment…

“Bankers have said the recent downturn in shares of publicly traded Reits would hurt valuations for companies in the sector preparing for initial public offerings and secondary share placements….

“That pressure has been acutely felt by newly issued shares in Reits with similar business strategies to Colony. Silver Bay Realty Trust has fallen 6 per cent since raising $281m in December, while American Residential Properties has dropped 11.7 per cent since it raised $287.7m from a May float.”

Of course, the Fed might commit to keeping the punchbowl on the table for a while and the party might continue for a while, but you've got to think that the exit strategy for these moderately large investors, and even for the bigger players was to find a liquidity event and make a fast and profitable exit. Do they really want the long grind of collecting monthly rental checks?