Breakingviews

U.S. stock bubble is in profit, not value metrics

By Martin Hutchinson The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

There’s a bubble in U.S. stocks – but it’s in profitability, not valuation metrics. The S&P 500 Index trades at 14 times historical earnings, so the valuation multiple isn’t excessive. But a measure of domestic U.S. profit margins stands 50 percent above its long-term average. Global profitability has soared even higher. This is unlikely to last long.

Globalization is one factor driving up profit for companies in the United States. According to a March 2011 paper by the Bureau of Economic Analysis, foreign earnings represented 40 percent to 45 percent of total profit between 2008 and 2009, against around 20 percent in the 1980s.

However, even narrowing the scope to just domestic activities, profitability is still startlingly strong. In the first nine months of 2011, the aggregate post-tax profit of all corporations totaled 7.2 percent of gross domestic income, a measure similar to GDP. That’s well above the cyclical peaks of 6.4 percent in 1997 and 2006 and the postwar record of 7.1 percent. In the BEA’s records, the ratio of domestic profit to GDI was only higher in 1929, at 8.8 percent. The current level is half as high again as the long-term average of 4.8 percent.

A chunk of the surge in profit derives from interest rates. Corporate leverage has increased in recent years, according to the Federal Reserve, and the debt of U.S. nonfarm businesses currently amounts to 60 percent of the value of their equity. However, interest rates have declined. Ten-year Treasury bonds yielded more than 10 percent in the 1980s but under 3 percent in 2011. Based on recent corporate leverage, this decline in the cost of debt would increase the typical company’s return on equity by more than four percentage points. Conversely, corporate profitability in the high interest rate 1980s was well below the long-term average.

A deceleration in profit growth, at least, may already be priced in. Standard & Poor’s calculates that analysts now anticipate less than 1 percent earnings growth for the first quarter of this year compared with a year earlier, down from their rosier expectation of more than 12 percent growth less than a year ago. But if interest rates start rising, perhaps along with wage costs, say, a sharp decline in profit could follow. Suppose the profitability of companies in the United States declines to the 80-plus year average and valuation multiples remain constant, and the S&P 500 would be at 900 rather than its current level of around 1,360. That’s food for thought for stock market bulls.

New US finance sheriff carves out shadowy domain

By Rob Cox and Daniel Indiviglio The authors are Reuters Breakingviews columnists. The opinions expressed are their own.The American banking industry has had a rough few years. The subprime meltdown, financial crisis and economic hardship have slammed stocks, slashed bonuses and crunched jobs. But life has been pretty sweet for a motley crew of companies – from cash checkers and credit bureaus to money wirers and debt collectors – operating on the edges of the regulated financial services industry. That may be about to change.

The recent recess appointment by President Barack Obama of Richard Cordray to lead the newly formed Consumer Financial Protection Bureau will, for the first time ever, throw a federal regulatory lasso around the biggest players in the shadows of finance. In the same way that enhanced regulation has curbed many of the excesses on Wall Street, so, too, may the increased scrutiny of this netherworld of the money industry.

To measure the CFPB’s impact, Breakingviews has created a proxy equity index of companies who may now fall under the purview of the agency. The “Cordray Index” consists of 15 publicly traded companies. It comprises big firms like $11 billion Western Union and $15 billion credit scorer Experian (the one non-U.S. component of the index) and those with market caps below $1 billion, such as repo-man Portfolio Recovery Associates and Advance America, a chain of stores making cash advances.

Taken as a whole, this non-bank universe has had a lucrative crisis. The index, in which we have given equal weighting to the stocks, has returned some 25 percent since the beginning of 2007, when the first rumbles of the subprime crisis began to hit the markets. By comparison, the S&P 500 Index is just now returning to its 2007 levels and banking stocks are down by nearly two-thirds.

It’s not hard to explain these divergent fortunes. For starters, few members of the Cordray Index have credit exposure. So, unlike banks, they have not had to work through piles of crummy loans. And as chartered banks pulled back, that pushed millions of customers – particularly those labeled subprime – into the arms of the alternative financiers. Economic distress, in short, has given this industry a whole new slug of newly impoverished customers.

New rules included in the Dodd-Frank Act, however, put them under a national regulatory spotlight for the first time. Just last week the CFPB announced its first formal plans to oversee some players in the non-bank financial sector. It proposed supervising debt collectors with more than $10 million in annual receipts and consumer credit reporting firms with more than $7 million in annual receipts. Additional non-bank sub-sectors will be added to this list.

Even if these companies already eschew rotten practices, with new cops on the beat, it’s hard to imagine they won’t be sweating a little more and increasing their compliance procedures. The bureau’s consumer protection mission is broadly defined, so what may seem perfectly legal to these firms might appear unfair to the watchdog. Its new oversight introduces a layer of regulatory risk that these companies have never experienced on a national level.

Happy stock highs belie bonds teetering on edge

By Robert Cole The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Some nice round numbers have equity investors smiling. The Dow Jones industrial average crossed the 13,000 level for the first time since before the crisis and Britain’s FTSE 100 index is headed towards 6,000. Many in the market may be wondering if the run can be sustained. But the real danger may be lurking for bondholders.

The FTSE 100 index crossed 6,000 for the first time back in April 1998. It has risen through the mark and slipped back below it 41 times – not counting the occasions it flip-flopped during intra-day trading. In that context, investors might wonder if the event is even worth marking, let alone celebrating.

The warming U.S. economy, coupled with encouraging news on the European front, accounts for much of the renewed confidence. Investors are also attracted by what looks like discounted value. In the United States, the multiple on the more broadly based S&P 500 index, at 12.5 times forward earnings, is below the 25-year average of 15. The UK equivalent is 10.2 times. The first time the FTSE 100 hit 6,000 the forward price-to-earnings multiple was 18.9.

If recession hits and corporate earnings decline, hindsight will reveal the major indices to have been deceptively cheap. Any remaining potential upside, meanwhile, may do little more than compensate for the inherent risks in stocks. Debt markets, however, look more precarious.

Yields on 10-year bonds issued by the U.S. and British governments are still settled around 2 percent. That suggests debt instruments are as dear as they have been at any time in modern market history. They also offer little, if any, protection against inflation.

True, monetary policy on both sides of the Atlantic is about as lax as could be. What’s more, the Japanese precedent shows that bond yields and equities prices can stay persistently low together. But any feelings of vertigo by equity investors are probably misplaced. It is expensive sovereign bonds that are more likely headed for an overdue fall.

Citi, BofA prove too big to punish harshly

By Agnes T. Crane

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Sticking it to Uncle Sam should attract harsh punishment. But the fines Citigroup and Bank of America will pay – $158 million and $1 billion respectively – to settle claims they defrauded the U.S. government look easily handled. Citi has even admitted fraud in its dealings over home loan insurance. A ban from participating in the government’s mortgage insurance programs would be a better deterrent. But unfortunately, Washington needs big banks too much.

BofA’s alleged misdeeds are still murky since its settlement was conveniently wrapped up in the broader $25 billion deal between federal and state enforcers and big mortgage servicing banks over so-called robo-signing transgressions. But the complaint against Citi offers a brutal account of the drive for profit squashing quality control. The Federal Housing Administration ended up insuring shoddy Citi mortgages that, in some cases, were in default within six months.

Federal insurance programs rely to a large extent on banks’ good faith in delivering mortgages that genuinely meet the required standards. Citi’s admission that it failed to do this came only after someone blew the whistle last year. It was a breach of the government’s trust and it has cost taxpayers money.

The penalties for ripping off the government usually go beyond dollars and cents. Yet Citi’s fine, in particular, is hardly crippling. And BofA has already set aside enough money to cover a good chunk of its settlement. A temporary ban on doing business with the FHA, on the other hand, would deliver more punch and show others in the industry that Washington won’t tolerate abuses of its largess.

Yet that’s unlikely to happen. The FHA, once a niche player focused on low-income housing, now backs about a third of new mortgages including super-sized ones for wealthy home buyers. The market for FHA-qualified mortgages runs $25 billion a month. While Citi has only a 2 percent share, BofA is the largest player with more than 26 percent, according to FTN Financial, using mortgage servicing as a proxy for origination activity. Booting offending banks out of the government’s program could make mortgages even harder to come by.

Renters need to flex muscle in U.S. housing debate

By Agnes T. Crane The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Though America’s mortgage system subsidizes homebuyers, its dysfunction has cost all taxpayers dearly. Few constituencies with much clout are pushing for change. But the nation’s 39 million rental households – often an afterthought in the housing debate – ought to be up in arms. They might find unlikely allies, too.

Renters may be the only big group in the United States that isn’t invested in the status quo. Homeowners, realtors, homebuilders and banks all benefit from the government’s hand in housing, exercised through Fannie Mae and Freddie Mac, which buy and guarantee mortgages, through other federal vehicles, and through tax rules that subsidize mortgage interest.

This makes home financing cheaper and, usually, more liquid, which in turn makes homes of any given price more affordable and potentially easier to sell on. Banks and investors, meanwhile, are wedded to the security a government guarantee brings to their respective loans and bond investments. And politicians, who have long extolled the virtues of homeownership, are loath to do anything that would make it more difficult for voters to achieve their idea of the American Dream. The trouble is, that’s what would happen if reforms are introduced that reduce or scrap the role of the government’s money and policy objectives in the market.

But rent-payers ought to like that idea. They miss out on the huge tax deductions mortgage interest payers get. And their savings bring in more return when the Federal Reserve hikes interest rates, in contrast to households with equity in homes that in theory go up in value when the Fed pushes lending rates lower and lower. Meanwhile, renters have been hurt by fallout from the housing bust. As taxpayers, they are set to suffer the costs of the government’s attempts to shore up housing – more than $150 billion and counting in losses at Fannie and Freddie alone. And as struggling homeowners hit the rental market, rents are going up too.

At the same time, the ranks of renters are filling up with younger Americans who have witnessed the nightmare of homeownership rather than the dream espoused by older generations. The 44-and-under crowd has been hard hit, with their homeownership rate falling by more than seven percentage points since 2005 to 62.3 percent, according to the U.S. Census Bureau. This matters since they will tell their tales for years to come, potentially undermining the belief that homeownership is part and parcel of American prosperity.

Meanwhile, borrowers who owe more than their home is worth are weakening a key supposed advantage of homeownership: that mortgage deeds bring good deeds to a neighborhood. That probably still applies when someone has a chunky equity stake in their home. But more than a quarter of homeowners now do not. This group is much less likely to fork over, say, $20,000 to fix a leaky roof if it’ll only help the bank’s bottom line rather than their own. Underwater homeowners look a lot like renters with giant mortgage millstones hanging around their necks.

Still a long slog ahead for U.S. jobs

By Daniel Indiviglio and Richard Beales

The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

There’s still a long slog ahead for the unemployed in America. Jobs growth has started picking up. But even at a rate of 250,000 a month, a hair above January’s figure, full employment may not be reached until 2020. A new Breakingviews calculator shows how a faster or slower rate of job creation changes that picture.

The important headline variable is the jobs growth reported in the U.S. monthly employment report – the stronger, the better. But a few other factors also matter when looking ahead. One is population growth, and another is how quickly the labor participation rate increases toward a more typical level. That’s the percentage of the population defined as either working or looking for work.

Since the recent recession began, millions of workers have become discouraged and temporarily given up on finding a job. The labor participation rate has declined from 66.4 percent in 2007 to 63.7 percent in January. Suppose participation recovers to that 2007 level by January 2020. This trend coupled with population growth at the average rate seen between 2003 and January this year would call for almost 200,000 new jobs a month just to hold the unemployment rate – 8.3 percent as of January – steady.

Then there’s the question of what level of joblessness reflects, essentially, full employment, since there will always be people between jobs. The calculator allows this input, as well as the other key ones, to be changed, but starts out assuming that 5 percent unemployment is the target.

With these assumptions, full employment would only be reached again in America in early 2020. If the monthly job creation rate jumped to 300,000, that date would be brought forward nearly four years.

Gingrich makes Goldman 4-letter word – to no avail

By Daniel Indiviglio

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The Florida Republican primary’s big winner tonight may be Wall Street’s most infamous bank. Front-runners Newt Gingrich and Mitt Romney are trying to connect one another to the financial crisis. Gingrich paints his rival as an agent of the giant vampire squid, while Romney criticizes his opponent for being paid handsomely for advising Freddie Mac to inflate the housing bubble. But in a state still in pain from the bust, Romney’s line is winning.

In Florida, the battle occurs through the airwaves. Romney, the former Massachusetts governor, has spent more than $15 million advertising in the state, four times as much as his competitor. One Romney ad, in particular, zeroed in on Gingrich’s role in the housing bubble.

It argued that the former House speaker was paid $1.6 million by Freddie “while Florida families lost everything in the housing crisis.” Such criticism strikes a painful chord in Florida. In Tampa and Miami, for instance, home prices are down about 50 percent from their peak, according to S&P/Case-Shiller’s indexes through November.

Though he doesn’t have the financial firepower of Romney, Gingrich is attacking from a different angle. He has been complaining loudly about his opponent’s connection to Wall Street, claiming that the crony capitalism he says is embraced by President Barack Obama would continue in a Romney presidency. Gingrich even asserted in a Fox News interview this week that Republicans would be letting Wall Street and Goldman Sachs buy the election if Romney wins.

Each criticism is a stretch. Gingrich’s advice hardly led Freddie to suddenly decide to lower loan standards and pour more gasoline onto the raging housing boom. Similarly, Romney is a client of Goldman’s and has received a hefty amount of campaign contributions from some at the bank, but that doesn’t mean he’s in bed with the squid.

U.S. private sector emerges from government shadow

By Martin Hutchinson

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The U.S. private sector is emerging from government’s shadow. Headline annualized GDP growth of 2.8 percent in Friday’s fourth-quarter data looks more anemic when inventory growth is netted out. But overall in 2011, as government has retreated private enterprise has regained strength.

At first glance, the first estimate of fourth-quarter economic growth was disappointing. The headline number was below the consensus forecast, while nearly two percentage points of growth were represented by inventory accumulation, generally considered a negative factor since it isn’t usually sustainable. Personal consumption expenditures were subdued, growing at just 2 percent, as was non-residential fixed investment, at 1.7 percent.

But on closer inspection the figures were stronger than they looked. Relatively weak final sales and domestic consumption followed surges in those factors in the previous quarter, while the inventory build-up followed a previous quarter drawdown, thus probably holding few negative implications for the future.

Moreover, government has been shrinking and the private sector correspondingly strengthening. For 2011 as a whole U.S. GDP grew by only 1.7 percent. But gross private product, which excludes government expenditure, grew by 2.7 percent. In the fourth quarter, the private sector grew at a robust 4.5 percent annual rate, while government shrank at both the federal and state and local levels.

Inflation was also subdued during the quarter, presumably affected by the decline in resource prices in the autumn. For 2011, the price index for personal consumption expenditures, Federal Reserve Chairman Ben Bernanke’s favorite inflation metric, grew at 2.4 percent, a restrained level – if still 0.4 percentage point above the Fed’s newly stated target.

Uninvited guest, Mr 99 Percent, crashes Davos

By Rob Cox 

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The most difficult guest to avoid bumping into at the World Economic Forum this year has no badge. He was not invited to the annual gathering in Davos, but he haunts the panels, hallway conversations and politicians’ speeches. He is Mr. 99 Percent, the specter of the unemployed and disenfranchised.

Not everyone at the Swiss conference is a member of the privileged 1 percent, but the whole point of the endeavor is to bring together the powerful of the world (and Mick Jagger). And the Indian billionaires, Chinese entrepreneurs, Wall Street chieftains and leaders of organized labor agree on one thing. An increase in civil unrest would be bad for business. The only beneficiaries of last year’s confrontations in the streets of downtown Manhattan, north London or Santiago were the makers of tear gas and barricades.

But the power-brokers and plutocrats cannot agree on what should be done. The Forum’s agenda is a bit schizophrenic. A Wednesday panel, “The Seeds of Dystopia,” focused on how to keep the 225 million unemployed around the world from losing faith in capitalism and civic institutions. One idea was to pay more attention to limiting the ratio of executive compensation to average worker pay.

But at the same time, and just down the hall, a hedge fund manager, a consultant and a corporate chairman discussed “The Compensation Question.” Their answer, in a nutshell, was that it’s a matter for shareholders – leave us alone.

Some panels are defensive. “The Dark Side of Connectivity” focused on the security risks created by new technologies such as the social networks that let protesters – from Cairo’s Tahrir Square to Manhattan’s Zuccotti Park – organize in real time. But some people are hopeful. Former U.S. Treasury Secretary Larry Summers sees the cries against wealth disparity as a symptom of the economy’s woes. By that token, the protests will diminish as growth rebounds.

Fed doubles risk of being whipsawed by market

By Martin Hutchinson

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The U.S. Federal Reserve could be setting itself up for an uncomfortable surprise. It extended its commitment to keep interest rates near zero from about 18 months to three years on Wednesday. Job creation, the departure of Chairman Ben Bernanke or rising inflation could force a damaging reversal before then – or lead the Fed to drag its feet to avoid one.

In his press conference, Bernanke said that with the fed funds rate at zero the U.S. central bank had two means of affecting monetary policy, namely securities purchases and guidance. By pushing out the date when it expects rates to start going up from mid-2013 to late 2014, the Fed has potentially reduced yields on long-term paper.

Bernanke also outlined the Fed’s long-run goals and policy strategy, setting a soft inflation target of 2 percent, based on the annual change in the price index for personal consumption expenditures. He noted that a hard target would be incompatible with the Fed’s dual mandate, which includes promoting full employment as well as minimizing inflation.

The U.S. unemployment rate was 8.5 percent in December, down 0.6 percentage point since August. Should that pace of improvement continue, unemployment would reach the Fed’s estimated “normal” range of 5.2 percent to 6 percent by mid-2013 – well before Bernanke’s new zero-rate end date.

Meanwhile, the PCE price index was up 2.5 percent in November from the previous year. Given that’s already above the Fed’s soft target, it seems likely that inflation will rise sufficiently within the next three years to warrant an interest rate rise. Finally, Bernanke’s own term of office ends in January 2014. This year’s elections may determine whether he will get another term, and a different chairman could spearhead a very different policy.