The present jump in U.S. corporate productivity heralds a boost in corporate profit margins; but positive earnings surprises have been at the cost of household income. Corporate profits are surprising on the upside because of aggressive cost cutting. Non-farm business productivity jumped in the third quarter as firms managed to boost output impressively using fewer workers for the second quarter in a row. Unit labor costs plunged in Q3, and over the past year have fallen at the fastest pace in the post-war period. The ratio of corporate selling prices to unit labor costs shot to an all-time high, suggesting that corporate profit margins will rise in the near term from already elevated levels. The dark side is that the savage corporate retrenchment is undermining household income, thus posing a headwind to consumer spending. However, this kind of cyclical productivity surge is rarely sustainable; firms are eventually forced to hire and increase hours worked as the recovery progresses. Similar dynamics will play out in the year ahead, although progress toward a self-sustaining recovery will likely be much slower than usual and this will feel like a jobless recovery. Thus, a high level of productivity and a recovery in revenue growth point to further profit gains that should underpin the market.
In the short term, U.S. Treasury yields may fall further as headline consumer price inflation (CPI) declines and core CPI deflates. Very low inflation or even deflation creates room for bond yields to drift lower, even if the economy stages a strong recovery. But in the long run, anticipate bond yields to rise steadily next year as the world economy recovers and expect a stable U.S. inflation rate around 1.5%. Thus, with inflation in check investors may stay long corporate bonds to exploit the final leg of the credit-market recovery, and fixed income closed-end funds (CEFs) should rally alongside.
Quickly improving corporate balance sheets are also moving corporate bond prices higher. A tight rein on business spending along with reduced share buybacks and dividends has pushed the level of liquid assets as a percentage of sales on corporate balance sheets to record highs. In the meantime, measures of leverage, interest coverage and debt-servicing costs have also improved. All of this suggests that the credit default rate should soon peak, validating the recent sharp tightening in quality spreads.
Overall, CEF yields remain attractive relative to the current yield hungry environment and many CEFs have underlying net asset values that continue to perform exceptionally well. Global fixed income, emerging market and convertible CEFs as well as some equity CEFs seem to offer good projected relative value opportunities versus commodity and global covered call CEFs which may be overstretched. Expect bankruptcies and defaults to trend down, thus removing some volatility from the system.
Michael Ashley Schulman, CFA
Hollencrest Capital Management