3/30/2017 0 Comments
I have concerns over a disappointment in 1Q GDP growth. GDPNow stands at 0.9%, and its next update is Monday, April 3. Given the apparent lack of growth and the market's optimistic pricing of fiscal stimulus and tax cuts, I am inclined to be conservative from an investment perspective. I have been sniffing around for more defensive and yield oriented investments. What came onto my radar is the telecom sector. This is a countercyclical sector and the worst performing sector over the past year.
In addition to countercyclical sectors, I have been focused on sectors which have a relatively low correlation to the S&P 500 Index. Telecom does not have the lowest correlation, which goes to utilities then REITs, but it is lower than most other sectors. The utility sector has had a nice run up, and I might be more interested in utilities after a pullback. I do like the REIT sector, but this post will focus on telecom.
The telecom sector is relatively small at $1.9T market cap, and U.S. telecom is highly concentrated in $VZ and $T. Most of the other large telecom stocks are foreign businesses who issued depository receipts in the U.S. Given the high level of concentration and the low dividend yield of the telecom sector ETFs, I don't see an advantage to buying a sector ETF in this case. I would recommend buying either $VZ or $T directly to overweight the telecom sector. $VZ has not moved much in price for several years while $T has rallied from the low 30's to the low 40's. $VZ is also cheaper on a EV/EBITDA basis at 7.4x.
From a qualitative perspective, I don't view the 'cord-cutting' trend as disastrous to the telecom industry because customers still need to access the internet from either a cellular LTE or broadband service. Much of the weakness in telecom is a result of the 'cord-cutting' trend, and I view this secular shift as priced into the stocks at this point. Furthermore, I believe recent consolidation in the sector has lowered competitive pressures. More consolidation is also a possibility given the merger-friendly Trump administration.
$VZ has been financially levered at over 2x debt to EBITDA following the acquisition of Verizon Wireless in 2014, but the industry median leverage is higher, at over 3x. Although I don't regard telecom as an industry in the best financial health, it has stablity and significant barriers to entry.
Finally, I looked at the dividend yield. $VZ has a much higher yield than the utilities sector, 4.7% versus 3.0%. $VZ is paying out between 50% to 70% of earnings in dividends. I view this payout ratio as sustainable. 2016 was a pretty rough year for $VZ. Revenue was down 4% and eps over 20%. In 2017, revenue is expected to be flat to down a hair. Margin pressures are expected to ease leaving eps flat, good enough to easily maintain the dividend.
Since I am not feeling particularly bullish on the overall market in the short-term given the bleak 1Q GDP outlook, I am searching for stability and yield, not a supercharged growth stock. So $VZ fits the bill, and has some potential upside due to its low valuation and the friendly regulatory environment. I could see $VZ making new ATHs this year, a 16+% upside. That would bring $VZ's valuation in line with $T (8.6x) on a EV/EBITDA basis.
Neel Kashkari is the President of the Minneapolis Federal Reserve Bank. Kashkari was the only dissent at March 15 FOMC meeting, when the fed funds rate was increased by 25 bps to a range of 3/4 to 1 percent. Kashkari published an article, Why I Dissented, a couple days later to explain his decision-making process. This article provides clear insight into the mind of central banker who believes there is more slack in the labor market.
Kashkari first looks at inflation. The Fed's stated inflation target is 2% which Kashkari distinguishes from the ECB's inflation ceiling of 2%. Kashkari goes on the highlight the Fed's inability to accurately forecast inflation, pointing out medium-term inflation forecasts have been too high 100% of the time over the past 5 years.
Kashkari highlights contained inflation expectations.
Kashkari goes on to discount the market-based measures of long-term inflation expectations, because... "financial markets are guessing about what fiscal and regulatory actions the new Congress and the Trump Administration will enact."
Inflation is running low in most developed economies, not just the U.S..
Then Kashkari gets into the employment side of the dual mandate. He highlights the U-6 measure of unemployment which includes people who have given up looking for work or are involuntarily part-time.
Kashkari sees some remaining slack in the labor market from several sources. First, the U-6 unemployment rate is still 1% above the pre-recession level. Second, the recent relative strength in jobs per month (averaging 200,000 versus 80,000-120,000 labor force growth) has not moved the headline unemployment rate much below 5% because more people want to work than are being captured by the employment models and surveys. The employment-population and labor force participation ratios, for ages 25-54, also remain below pre-recession levels.
Kashkari admits the Fed does not know for certain the level of maximum employment and acknowledges this target changes over time. As evidence, Kashkari points to the Fed's own 5.6% estimate of maximum employment from 2012 which we now know was definitively too high. Kashkari sees the labor force continuing to grow, either by workers re-entering or choosing not to leave, which has kept a lid on inflationary pressure so far.
Finally, Kashkari says the current level of the neutral real interest rate is 'around zero'. With inflation at 1.7% and a target range for the real fed funds rate between -0.95 percent and -0.7 percent, Kashkari sees monetary policy as somewhat accommodative.
I like Kashkari's transparency. His opinion is worth a read.
3/16/2017 0 Comments
The Federal Reserve Bank of New York published an interesting research article, A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances, by Bhalla, Chakrabarti, and Livingston. As the title suggests, the researchers examine K-12 funding and expenditure changes in N.Y. and N.J. schools following the Great Recession. The article details the effect of the federal stimulus program, the American Recovery and Reinvestment Act (ARRA) of 2009, on school funding. Finally, the article looks at state budgets, and how those impacted school funding.
The change in total funding per pupil is summed up by this graph:
N.Y. had a marginal decline in funding while N.J. had steep cuts of greater than 12% in each school year, 2008-09 and 2009-10. Most public school funding comes from three government sources: federal, state (sales & income tax), and local (property tax). Pre-recession in 2008, school funding in N.Y. and N.J was pretty similar:
After the Great Recession, school funding in both states experienced significant shifts. N.Y. received a much larger increase in federal funding, and N.J. suffered a larger cut in state funding. These charts signify the change in school funding by source.
The two funding channels that showed the greatest change were federal and state.
Federal allocation of ARRA funds to education was $97.8B. N.Y. received $4.4 billion more federal funding than N.J.. Some of this difference can be explained by demographics. First, N.Y. was eligible for more aid through the State Fiscal Stabilization Funds ($53.6B) simply because it was a larger state. N.Y. ($3.8B) had 6.2% of the nation's population in age group 5-24, while N.J. ($1.3B) had 2.7%. Second, Title I funding ($10B) was for low-income schools. N.Y. ($0.9B) had a greater proportion of students from low-income families, 46% vs 31% in N.J. ($0.2B). Third, IDEA Grants ($12.2B) were for special education students. The number of special education students in N.Y. ($0.8B) was greater than N.J. ($0.4B). Finally, N.Y. ($0.7B) qualified second in Race to the Top (RTT), a program designed to reward states with high-performing schools and educational improvements. RTT funding was dispersed to the top 10 states, while N.J. placed eleventh.
State funding also showed major differences. The first major difference is N.J.'s state law which requires the state budget to balance every year. A state budget deficit cannot be carried forward to the next fiscal year like it can be in N.Y.. In addition, N.J. state tax revenues declined much more than state tax revenue in N.Y. following the Great Recession.
In January 2010, Governor Chris Christie, facing a budget deficit, cut $475 million in state aid to N.J. schools.
I find this study interesting for several reasons. First, it quantifies part of the impact of the last federal stimulus package (total ARRA bill was $787B). Today, the federal government is again considering a stimulus program which would look starkly different due to its reliance on tax cuts rather than increased spending. Second, it quantifies the impact the recession had on two state budgets which one might assume at the outset to be quite similarly. Finally, the article shows how school budgets react to severe budgetary change.
A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances by New York Federal Reserve Bank
The Atlanta Fed's GDPNow forecast of 1Q growth has fallen to 1.2% from 3.4% on February 1. What is behind this precipitous drop and should we be concerned about a slowdown from 1.9% in 4Q?
The Atlanta Fed publishes a historical breakdown of the contributions to the GDPNow estimates. The total drop in the GDPNow estimate is 2.1% (3.4% - 1.2% does not equal 2.1% due to rounding). The majority of the decrease, 1.4% of 2.1%, stems from PCE, or consumer spending on goods and services. The drop is PCE makes sense since it's the component of GDP. If more of the drop had come from inventory (-0.4%), government spending (-0.3%) or net exports (-0.1%), then it would be less concerning.
The next GDPNow update is March 15 which is 44 days before the GDP report is scheduled to be released on April 28. FRB Atlanta publishes the report below on forecast error over time.
So the current forecast is 1.2% plus/minus 1.4%, a fairly wide band. Upcoming GDPNow updates are scheduled on March 15, 16, 24 and 31.
Are other GDP forecasts also showing weakness? The NY Fed's Nowcast stands at 3.1%, not showing the recent slide in growth GDPNow is picking up. The Cleveland Fed's monthly forecast is 1.8%. Moody's Analytics forecast is 1.0%, and Moody's forecast has come down quite a bit since February, similar to GDPNow.
CNBC Rapid Update is a weekly survey of Wall Street economists' estimates of current quarter GDP growth. The CNBC Rapid Update stands at 1.5%. The WSJ Economic Forecasting Survey polls Wall Street monthly and is currently 2.2%. The Philadelphia Fed publishes a quarterly Survey of Professional Forecasters last updated February 10, which has 1Q GDP growth at 2.2%. One nice element of this report is it shows the change in the forecast from the previous forecast prior to the election.
The change in the current forecast from the previous shows when economists believe the pickup in growth will occur. The growth forecast for 2017 only increased from 2.2% to 2.3%, with 1Q unchanged. The larger increase in growth is in 2018 and 2019 which both increased from 2.1% to 2.4% and 2.6% respectively.
There is a disconnect between the business and consumer surveys and the hard economic data right now. Part of this difference is due to timing because easier financial conditions, improved confidence and expectations for fiscal stimulus take time to feed into the economic data. Therefore, the growth acceleration story remains intact even with a weak 1Q GDP print. The question is how long the market will wait for the strong data to surface. The disconnect between the perception of growth and the actual data must narrow eventually. Either the data will strengthen to confirm the pickup in growth, or the perception of an impending bump in growth will come back to the reality of continued subdued performance.
The stock market has priced in a pickup in economic growth subsequent to the 2016 Presidential election. If this acceleration in growth does not materializing at some point, the market may be vulnerable to a reversal.
Michael Grove, CFA