Breakingviews

U.S. market rumblings point to revved up growth

By Agnes T. Crane The author is a Reuters Breakingviews columnist. The opinions expressed are her own.Rising oil prices and interest rates are election-year bait for U.S. politicians. But in reality – along with higher stock markets – they suggest a long-awaited strengthening of the economy. But sticker-shock at the pump and more expensive debt could yet knock confidence.

This week, even bearish bond traders seem to have conceded that growth prospects look brighter. U.S Treasury yields, which had been stuck in a narrow, low range since October, rose substantially, with the 10-year yield adding more than 0.3 percentage points to 2.35 percent before settling back a bit on Thursday. Stocks have been on a tear for more than five months, with the S&P 500 Index breaching 1,400 this week for the first time since 2008.

Meanwhile, the price of crude oil for future delivery, while not at its high for the year, is still up 39 percent from its low in October. Setting aside any worries over Iran, that’s a sign that U.S. and global activity is regaining strength, even with Europe still struggling.

Republican presidential hopefuls, reluctant to acknowledge the recovery, are zeroing in on unsavory by-products. Mitt Romney, for instance, blamed President Barack Obama’s energy policies for high prices at the gas pump. And voters do care. Paying approaching $4 a gallon with the summer driving season in sight is likely to upset American drivers. Newt Gingrich has even promised the unlikely feat of cutting gas prices to $2.50 a gallon if he is elected.

If 10-year bond yields go much higher, there’ll be at least two more lines of attack. Mortgage interest rates would rise in tandem, so homes would become less affordable for buyers and existing borrowers would get less juice out of refinancing. Even as a consequence of economic growth, that would be tough on the already battered housing sector. And second, significant increases in bond yields could signal fear of future inflation, undermining the Federal Reserve’s stance that it can keep short-term rates low with no material risk of prices spiraling.

The GOP candidates may be selective with their arguments, but higher fuel and debt costs do matter to voters, and to the economy – especially in the early, relatively fragile stages of a recovery. For his part, Obama will be hoping growth won’t trip on headwinds like these before it hits its stride.

Facebook’s underwriter friends are cheap insurance

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

Facebook has friended a raft of new underwriters for its forthcoming initial public offering. According to the company’s latest filing, there are now 31 of them, up from an initial six. That may be overkill, but the social network’s clout means it can line up the extra resources and reputational buffing at little, if any, cost.

Mark Zuckerberg’s firm is hoping to sell a lot of high-priced stock – $5 billion or more, with the company valued at up to $100 billion. That’s one reason to bring on board a lot of salespeople with access to different investors. Since 2005, there have been 14 U.S. IPOs with more than 20 underwriters, according to Thomson Reuters data. Microsoft had more than 100 of them for its float back in 1986, raising only about $60 million.

That said, investment banking has become more concentrated over recent decades, according to research by professors Xiaoding Liu and Jay Ritter of the University of Florida, with fewer banks involved per deal. And technology has made it easier to handle bigger offerings. So Facebook may not really need all its banks. Moreover, there’s no clear relationship with stock performance. Offerings with only 10 underwriters showed similar returns over one day, one month and six months to those with more than 20, according to the Reuters analysis.

Yet there are other reasons to have more of them. The banks involved in an IPO are, essentially, putting their seal of approval on a company and its valuation. Many will produce research afterwards – presumably with a favorable predisposition. And underwriters can’t publish research in the run-up to an offering, which reduces the chance of negative buzz.

For Facebook, there’s another argument, too. The California State Teachers’ Retirement System last month criticized the company for its all-male, all-white board. Rightly or wrongly, adding smaller banks founded and run by women and representatives of minority groups, such as Muriel Siebert & Co and Samuel A. Ramirez & Co, may help defuse that controversy.

And with Facebook’s scale, it’s unlikely to cost much, if anything, extra. The company will only pay a fraction of the 7 percent fee underwriters hope for, anyway, because everyone wants in on such a big deal. Some of the new batch of banks may be friends of convenience rather than necessity. But if nothing else, they count as cheap insurance.

Just let housing regulator DeMarco do his job

By Agnes T. Crane and Daniel Indiviglio The authors are Reuters Breakingviews columnists. The opinions expressed are their own. The knives are coming out for Edward DeMarco. The acting director of the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, has been coming under increasing attack recently from Democratic lawmakers as well as housing lobby groups. His crime: he won’t cut principal on underwater home loans backed by Fannie and Freddie. But his critics should cut him some slack.

Principal reduction can have a role to play in helping out underwater homeowners. There is, after all, some $700 billion of negative equity in U.S. housing, according to CoreLogic. Providing some relief on the amount a borrower owes could make the difference between keeping up payments and lurching into default. DeMarco’s critics argue that such a strategy should be a no-brainer for such loans held by Fannie and Freddie. They argue that since taxpayers are already on the hook for mortgages guaranteed by the government, it’s better to take a modest hit to prevent a much bigger loss should a mortgage default.

But this contention ignores an important rejoinder from DeMarco: other modification strategies such as repayment holidays and lower interest payments work nearly as well without forcing Fannie and Freddie to take a hit on the loan amount – that only happens if modifying a mortgage isn’t enough to prevent a borrower from defaulting.

And the vast majority of underwater loans – where the value of the house is less than the amount of the outstanding mortgage loan – do not end up in default. As of June last year, according to DeMarco, 80 percent of Frannie borrowers with negative equity in their homes whose loans were backed by the agencies were current on their mortgages. Blanket principal reductions would cause losses on all of them.

Critics are also ignoring DeMarco’s mandate to minimize losses from bailing out the two mortgage agencies. By attacking him, they are trying to force him to put struggling homeowners’ needs ahead of all taxpayers.

Moreover, DeMarco is one of the few who is at least proposing ways to fix America’s housing finance system, including how to shutter Fannie and Freddie. Most lawmakers, meanwhile, seem happy to keep deferring any such reforms. DeMarco’s stance as a clear-eyed regulator deserves praise, not punishment.

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.

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.