Valuing Big Tobacco, Part VI

Includes: LO, MO, PM, RAI
by: CRG Research

In this article, we'll examine the macroeconomic dynamics impacting Altria (NYSE:MO), Reynolds American (NYSE:RAI), Lorillard (NYSE:LO) and Phillip Morris (NYSE:PM). We'll take a look at employment, and fiscal and monetary policy. In the previous article, we examined the microeconomic dynamics impacting the firms.

The working-age population is the total number of people aged 16 years and over who are not in jail, hospital, or some other form of institutional care. The labor force is the sum of the employed and the unemployed. The civilian noninstitutional population increased from 239.9 million in August 2011 to 243.6 million in August 2012. The civilian labor force increased from 153.7 million to 154.6 million during the same period. The labor force participation rate is the working-age population who are members of the labor force. The participation rate declined 600 basis points to 63.5 percent.

Three labor market indicators are the unemployment rate, the labor force participation rate, and the employment-to-population ratio. The unemployment rate is the percentage of the people in the labor force who are unemployed. Between August 2011 and 2012 the number of unemployed persons declined from 13.9 million to 12.5 million, and the unemployment rate declined from 9.1 to 8.1 percent. The employment-to-population ratio is the percentage of people of working age who have jobs. The employment-to-population ratio remained stable at 58.3 percent. The improvement in the labor market is positive for the share price of tobacco firms.

Aggregate hours are the total number of hours worked by all people employed, both full time and part time, during a year. The aggregate weekly hours remained stable at roughly 34 hours in August compared to August 2011.

The unemployment that arises from normal labor turnover is frictional unemployment. The unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs is structural unemployment. The fluctuating unemployment over the business cycle is cyclical unemployment. Full employment occurs when there is no cyclical unemployment, or equivalently, when all the unemployment is frictional or structural. The divergence of the unemployment rate from full employment is cyclical unemployment. The unemployment rate at full employment is called the natural employment rate. A larger than normal portion of the 8.1 percent unemployment rate is from structural unemployment. Also, some cyclical unemployment remains. The estimates of the natural rate of unemployment range from 6.0 percent to 7.8 percent.

The quantity of real GDP at full employment is called potential GDP. Based on the data, actual GDP is about 5-6 percent below potential GDP. Keynesian theory predicts that a negative output gap should lead to falling inflation. That said, the slightly elevated inflation rate suggests potential GDP may be lower than estimated and the output gap smaller. That means, interest rates may have to rise sooner than expected to prevent inflation's acceleration.

Potential GDP can increase for any of three reasons: The full-employment quantity of labor increases, the quantity of capital increases, and technology advances. A faster pace of growth means higher interest rates and higher interest rates means less demand for the shares of tobacco firms.

The annual statement of the outlays and tax revenues of the government of the United States together with the laws and regulations that approve and support those outlays and tax revenues make up the federal budget. The use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is called fiscal policy. Recently, Congress adopted a stopgap measure to fund the federal government's day-to-day operations. The legislation will give most agencies a 0.6 percent budget increase after the start of the fiscal year until March 27, 2013.

The government expenditure multiplier is the magnification effect of a change in government expenditure on goods and services on aggregate demand. Government expenditure is a component of aggregate expenditure, so when government expenditure changes, aggregate demand changes. Real GDP changes and induces a change in consumption expenditure, which brings a further change in aggregate expenditure. The increase in government expenditure is positive for the share prices of tobacco firms if interest rates remain low. A decrease in federal spending in 2013 could be recessionary, and cause the share price of tobacco firms to decline.

A monetary policy instrument is a variable that the Fed can directly control or closely target. A targeting rule is a decision rule for monetary policy that sets the policy instrument at a level that makes the forecast of the ultimate policy goal equal to its target. On September 13, 2012, the FOMC decided to purchase additional agency mortgage-backed securities at a pace of $40 billion per month. The increase in the Fed's balance sheet will increase the quantity of money and the supply of loanable funds, decrease long-term interest rates, increase consumption expenditure, investment and net exports, increase aggregate demand, and increase real GDP and the inflation rate.

Currently, the macroeconomic environment remains a positive contributor to the shareholder returns of the tobacco firms. The declining unemployment rate is bullish for shares of the tobacco firms. Expansionary fiscal policy is bullish for shares of the tobacco firms. Also, expansionary monetary policy is bullish for the share price of the tobacco firms. However, the recent rise in long-term interest rates makes the dividend yield of the firms less attractive and has contributed to a decline in the share price.

To be continued...

Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.