Difficult Decisions Ahead

September 6, 2013

by Doug Noland


The repricing of global bonds continued, despite escalating tensions in Syria and soft payroll data. The latest G20 meeting was dominated by deep divisions over Syria in an increasingly divisive global backdrop. The Middle East is precariously divided. In Europe, leaders remain deeply divided over how best to deal with Eurozone issues. The American population is deeply divided on political, social and economic issues. Congress is deeply, deeply divided on seemingly everything.

The Federal Reserve is divided on the merits of unconventional measures and the future course of policymaking. The emerging markets (EM) see developing world monetary policy as highly destabilizing, with QE having stokedhot moneyinflows and “taperingrisking problematic outflows.

Within the G20, common interests have been largely supplanted by mistrust and, seemingly, irreconcilable differences. Members these days lack even a European crisis response to try to rally around. I believe the “Gconferences have basically lost the capacity to have real impact on very serious ongoing global financial and economic issues. One could argue that traditional frameworks for myriad key policy decisions – from monetary policy to crisis response to acts of war – are being transformed before our eyes. This ensures added uncertainty in an already uncertain world. Markets see only QE.

The “Credit Bubble Bulletinfocuses (ok, fixates) on Credit. I strive to keep my analysis close to home, steering clear of political debate and geopolitical pontification. Yet Creditsound or, more pertinently, otherwise – has a profound impact on wealth (creation and destruction) and wealth distribution. Protracted Credit Cycles – with their attendant booms, busts and destruction - have momentous impacts on societies and geopolitics. I work to provide an accurate chronicle of relevant events.

It’s been my thesis that we’re at the late phase of a historic global Credit boom. During much of the Bubble’s upside, the global economic pie was getting bigger. This provided powerful impetus to mutual interests, cooperation and integration. There was the capacity to forge international consensus on various pressing financial and economic issues – as well as even the ability to muster a “coalition of the willing” for major military operations.

The world is transitioning into a quite different environment. Despite desperate measure after desperate measure, a most over-extended global Bubble is convulsing erratically. The economic pie is stagnating - and on its way to contracting. This dynamic ensures an increasingly powerful pull of diverging interests, disagreement, fragmentation and confrontation.

The world has turned increasingly skeptical of U.S. policymaking, certainly including monetary policy. Round the globe, citizens and their leaders have grown tired of cooperating on just about everything - from finance to climate change to global policing. This runs up against heightened need for all of the above in an increasingly disorderly and hostile - faltering Bubble - world.

I have argued that desperate monetary inflation stoked a dangerous divergence between inflated global securities prices and deteriorating fundamental prospects. With U.S. equities near all-time highs, the market and media focus remains on Mr. Brightside. The cautious and darn right skeptical have been discredited and shoved out of the way. It has been easy to disregard the unstable global geopolitical backdrop. It’s been easy to ignore the rapidly deteriorating situation in the Middle East. With the Fed injecting unprecedented amounts of liquidity into overheated markets, it has been effortless – and highly profitable – to ignore risk more generally. Indeed, the bullish view holds that we’re in the initial phase of a new bull market – and, surely, a return to robust global growth, prosperity and cooperation.

There will come a point where the divergence between Bubbling securities markets and a sobering reality is narrowed. The longer massive monetary inflation extends this gap, the more destabilizing the eventual market dislocation. The greater the global market dislocation the greater the strain on economies, societies and alliances. And, in contrast to conventional thinking and that of the Fed, a lot of damage can be wrought in relatively short order when finance is running amuck. It’s reached the point where QE has minimal benefit, while dilly dallying and “taperingbear great costs.

Yet with global markets having come to wield unprecedented influence on Credit, perceived wealth, economic activity and overall cohesion, the temptation for central banks to continue sustaining market Bubbles is just too great. This dynamic creates great uncertainty, while at the same time further opening the window of opportunity for destabilizing speculative excess.

Understandably focused on economic issues at home, American public opinion is strongly opposed to intervention in Syria. Understandably focused on economic and domestic interests at home, few in the global community are willing to join the U.S. on Syria. President Obama has very Difficult Decisions Ahead.

The Federal Open Market Committee faces its own Difficult Decisions of its own making. It’s notoriously difficult to withdraw monetary accommodation. Central banks are invariably late in removing the punchbowl. Perhaps more pertinent, there is never a painless path to ending aggressive monetary inflation. And that’s precisely why history demonstrates that once the process of “moneyprinting (currency or “virtual”) is embraced it becomes nearly impossible to dis-embrace. The past five years (or, if you choose, go back 20) have illustrated how one bout of seemingly innocuous monetary inflation invariably begets proliferation and, in the end, intransigent monetary disorder. The big unknown is how this historic global experiment in central bank management of unrestrained, market-based electronicdigitalmoney and Credit plays itself out.

This is an inopportune time for the emerging markets to face any moderation of Federal Reserve accommodation. But this dilemma was inevitable. When the U.S. and the developed world moved aggressively with post-mortgage finance Bubble reflationary measures, EM was the “fledgling Bubblepoised to be on the receiving end of unparalleled liquidity flows. Global Credit systems and economies diverged. In time, interests would diverge. For going on five years now, loose money and increasingly aggressive QE pushed EM financial and economic Bubbles to precarious extremes. Meanwhile, developed world recoveries badly lagged. The “moneyflowed and latent global fragilities mounted.

Over the past year, incredible measures by the ECB, Fed and BOJ have had major effects. EMterminal phaseBubble excess was granted a bonus year to wreak havoc. In the U.S., stock prices inflated about 30%, as speculation went into overdrive. Throughout the U.S. corporate debt market (and only to a somewhat lesser extent globally), Bubble excesses ran wild. In the real economy, rapid price inflation reemerged in housing markets across the country. Quite simply, powerful Bubble conditions intensified, and an expanding number of sectors within the economy began to participate.

Considering the backdrop, $85bn monthly QE is inappropriate – I would argue reckless, a 7.3% unemployment rate notwithstanding. But both the global financial and economic spheres have grown addicted to aggressive monetary inflation. EM Bubble fragility has turned conspicuous. There is the global securities market Bubble, most obvious in mispriced bond markets around the world. There are less appreciated Bubbles in global equities and the “global leveraged speculating communitymore generally. All in all, there is ample global financial and economic fragility to ensure the most timid rendition of monetary policy restraint imaginable.

On the one hand, I believe a global re-pricing of debt securities has commenced. On the other, there remains sufficient global monetary inflation and emboldenedanimal spirits” to beg the question: How crazy do things get?

Syria is a frightening place. It’s in a tough and rapidly disintegrating region. The situation has regressed into the much fearedproxy war” on too many fronts. And it doesn’t take a wild imagination to see Syria as a catalyst for escalating global tensions that could stumble into a major confrontation. The Russians and Iranians are staring President Obama down.

Meanwhile, outside of crude oil, global markets show minimal concern. After all, analysts suggest it could be up to two more weeks – a veritable eternity for a speculative marketplace - before the President might act. Besides, non-farm payroll data were soft. This is expected to only further embolden the dovish contingent that was already pushing against any move to reduce accommodation (this week from Kocherlakota and Evans). It was another week that illuminated dichotomies. The reality is that the world is in the midst of far-reaching – I’m convinced troubling - changes. The market reality is that primary focus remains on the monetary backdrop.


Unrealistic Expectations

By John Mauldin

Sep 07, 2013


"In the short run, the market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine, assessing the substance [intrinsic value] of a company."

– Benjamin Graham


Way back in the Paleozoic era (as far as markets are concerned), circa 2003, I wrote in this letter and in Bull's Eye Investing that the pension liabilities of state and municipal plans would soon top $2 trillion. This was of course far above the stated actuarial claims at the time, and I was seen as such a pessimist. Everyone knew that the market would compound at 9%, so any problems were just a rounding error.

Now it turns out I may have been a tad optimistic. Two well-respected analysts of pension funds have produced reports this summer suggesting that pensions are now underfunded by more than $4 trillion and possibly more than $5 trillion. I would like to tell you that the underfunding is all the bad news, but when you probe deeper into the problems facing pension funds, it just gets worse. The two reports conclude that pension plan sponsors seem determined to keep digging themselves an ever-deeper hole. But to hear the plan sponsors tell it, the situation is readily manageable and the risks are minimal. Except that pesky old reality keeps confounding their expectations.

And that is the crux of the problem. Whether you believe there really is a problem boils down to the assumptions you make about future returns. If you believe the projections trotted out by pension fund management and the bulk of the pension consulting groups, the underfunding is a mere $1 trillion — a large amount to be sure but manageable for most states.

The emphasis here is on most. Some states and municipalities are in far worse shape than others, and to be honest with you, I don't see how some of them can meet their commitments. Others are trying to be responsible and fulfill their pension fund obligations based on the assumptions their "experts" come up with, but the problem is that those assumptions may be overly optimistic. The seemingly small difference of just 1% of GDP growth can make a huge difference in pension liabilities (and thus taxpayer obligations).This week we begin a series focusing on the problems facing US state and local pension funds. This issue has relevance to you not only as a taxpayer but also as an investor, because it goes to the very core of the question, what is the level of reasonable returns we can expect to see from our investments in the future? This is not a problem that is restricted to the US — it's global.

Sadly, we don't live in a Lake Wobegon world where all pension funds and investment portfolios are above average. Not everyone can be David Swenson, the famous chief investment officer of Yale University. Truth be told, David Swenson will have a difficult time being David Swenson in the next 20 years.


Unrealistic Expectations


The past 10 years have seen a growing number of economists and financial analysts questioning the propriety of the methods used to forecast pension fund liabilities. This is more than an academic exercise, as the numbers you choose to base your models upon make massive differences in the projected outcomes. As we will see, those differences can run into the trillions of dollars and can mean the difference between solvency and bankruptcy of municipalities and states. The implicit assumption in many actuarial forecasts is that states and cities have no constraints on their ability to raise money. If liabilities increase, then you simply raise taxes to meet the liability. However, fiscal reality has begun to rear its head in a few cities around the country and arrived with a vengeance in Detroit this summer. It seems there actually is a limit to how much cities and states can raise.

"Aah," cities assure themselves, "we are not Detroit." And it must be admitted that Detroit truly is a basket case. But it may behoove us to remember that Spain and Italy and Portugal and Ireland and Cyprus all said "We are not Greece" prior to arriving at the point where they would lose access to the bond market without central bank assistance.

In response to growing concerns over public pension debt, the Governmental Accounting Standards Board (GASB) and Moody's have both proposed revisions to government reporting rules to make state and local governments acknowledge the real scope of their pension problems. (While it is possible to ignore Moody's, based on the fact that it is just one of three private rating agencies, it is impossible to ignore GASB, which is the official source of generally accepted accounting principles (GAAP) used by state and local governments in the United States.

Under the new GASB rules, governments will be required to use more appropriate investment targets than most public pension plans have been using, bringing them more in line with accounting rules for private-sector plans. Pension plans can continue to use current investment targets for the amounts the plans have successfully funded; but for the unfunded amounts, pension plans must use more reasonable investment forecasts, such as the yield on high-grade municipal bonds, currently running between 3 and 4 percent. From my perspective, not requiring reasonable investment forecasts on already funded accounts is still unrealistic, but the new GASB rules are a major step in the right direction, and I applaud GASB for taking a very politically difficult stance.

Moody's has also proposed new rules to require states to use more appropriate investment targets. Their new rules require pension plans to use investment targets based on the yield of high-grade, long-term corporate bonds, currently just over 4 percent. (Source: CLICK HERE)

What difference does a more "realistic" forecast make? According to the survey done by Moody's, it makes a difference of more than $3 trillion, or more than double the total actual assets of the 255 largest state-funded pension plans. This is illustrated in the chart below.



Current official reporting suggests that states have funded 73% of their pension liabilities. The fair-market-value approach used by Moody's and GASB suggests that funding is only at 39%. The difference is almost entirely due to the assumptions one uses about the discount rate for future expected returns.

The next two charts provide an illustration. I'm simplifying a bit, but the principles are correct. If you are a pension plan manager, you have to be thinking over very long periods of time. Someone retiring today at age 60 will likely require almost 30 years of pension payments. Someone aged 40 paying into your pension program will likely be getting his or her pension returns 50 years from now. Let's look at a few scenarios of what might happen to $1 billion over the next 40 years under various assumptions of investment returns.



Many state-funded pension plans today assume an 8% nominal return for the indefinite future. Some are beginning to forecast lower returns, but very few would forecast lower than 7%. Moody's argues that somewhere in the range of 4% nominal is more realistic. Notice that the difference after 40 years is well over four times. Even if you assume that magic returns to the markets after 2020 and returns go up to 8% thereafter (the green line in the chart), there is still a gap of $5 billion after 40 years. On assets of $2 trillion, that is a gap of $10 trillion. If you assume only a 4% nominal return for the entire 40 years, the gap is $30 trillion. For the mathematically challenged, that is not a rounding error.


Nominal or Real?


Nominal returns are only part of the story. We live in a world of inflation, and almost all pension funds are inflation-adjusted. The next chart takes the same $1 billion and extrapolates into the future but assumes a modest 2% inflation rate over the 40-year period. The small difference of just 2% annually reduces the real returns by over half. Assumptions can have very wicked children. And grandchildren.

A 4% nominal growth rate, or 2% real growth, sounds so pessimistic, but it is actually in line with what we've experienced over the last 18 years. And you want your assumptions about the future to be as conservative as possible, so that if there are surprises they are pleasant ones. Looking ahead, economic growth does not appear likely to yield pleasant surprises. We use the following chart from Jeremy Grantham at GMO about a month ago, but we need to look at it again in more detail. These are the forecasts that Grantham makes for real (inflation-adjusted) returns over the next seven years:



Notice that if you had a "balanced portfolio," equally distributed among the six equity-asset classes, your total annual real return would be in the 1.5% range. Using the same balanced approach with bonds, your total return would be 0.1%. In the black bar at far right we see Grantham's projected returns for investments in timber, which can be taken as a proxy for "alternative" investments in general. A pension fund investing 55% in equities, 35% in bonds, and 10% in alternatives (not an uncommon pension allocation scheme) would see a total annual real return of around 1.5% real, if Grantham is correct. To bring returns up to even 2% real for the next 10 years, you would have to knock the lights out for the final 3 years of the 10-year time frame.

You may ask, why does Grantham project equity returns to be so small? Can't we assume that over longer periods of time returns will be in the 8%-plus range? Sadly, 8% is an unrealistic number for long-term growth in the equity markets, as Grantham has so ably demonstrated.


Voting versus Weighing


The father of value investing, Benjamin Graham, gave us a simple illustration for looking at market valuations. He noted that "In the short run, the market is like a voting machinetallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machineassessing the substance of a company." The message is clear: what matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.
(Source: Morningstar)

At the end of the day, what the market really weighs is earnings, and that judgment is reflected in the valuation it puts on those earnings. Is $1 worth of earnings worth $8, or $25? Are you expecting a 12% return, or a 4% return? Of course, your answers depend on your view of inflation, what you think of the growth prospects of the company in the economy, and your alternatives for that dollar of investment. The markets can fluctuate a great deal around long-term trends, but they always come back to the average. We've had quite a nice stock market run over the last four years, but let's look at just the last two years, which have theoretically been part of a recovery period. Notice in the chart below that trailing 12-month earnings have been essentially flat, while the market has gone up almost 40%. Almost all of the growth in the stock market has occurred because people were willing to pay a higher multiple for the same dollar's worth of earnings. Valuations are not at nosebleed levels, but they are certainly high; and without something to seriously boost earnings, it is hard to see how the market can justify still higher valuations.



The next chart is from my friend Lance Roberts. Quoting Lance:

As you will notice each time that corporate profits (CP/S) and earnings per share (EPS) were above their respective long-term historical growth trends, the financial markets have run into complications. The bottom two graphs [see below] show the percentage deviations above and below the long-term growth trends.

What is important to understand is that, despite rhetoric to the contrary, "record" earnings or profits are generally fleeting in nature. It is at these divergences from the long-term growth trends where true buying and selling opportunities exist.

Are we currently in another asset "bubble?" The answer is something that we will only know for sure in hindsight. However, from a fundamental standpoint, with valuations and profitability on a per share basis well above long-term trends, it certainly does not suggest that market returns going forward will continue to be as robust as those seen from the recessionary lows.



So what does this academic discussion about future returns have to do with pension funds? It matters because pension funds make assumptions about their future ability to meet their obligation to pay retirees a monthly check based upon their assumptions about returns. In the next few weeks we're going to look at specific states and their assumptions and what that means for their taxpayers in terms of their budgets.

We all know that Illinois is in difficult straits. The state of Illinois has set aside $63 billion to pay for future benefits. But between now and 2045 they're going to have to pay out 10 times that much$632 billion. By the state pension fund's own estimate, they need another $83 billion to be adequately funded. Just a few years ago their deficit was a mere $50 billion. Compound interest means that the longer you ignore your problem, the faster it gets worse.

Total state revenues for Illinois were $33 billion for fiscal year 2012. Let's see if we can find a politician to propose that they take 25% of the budget every year for the next 10 years to reduce their underfunded pensions (as opposed to the 12% they allot currently). Mayor Emanuel, do you have a plan?

Because the pension plans are so underfunded, they would need to see average investment returns of nearly 19 percent per year to cover future payouts. The state predicts its pension funds will earn investment returns between 7 and 8.5 percent per year. Even these returns may be overly optimistic. Over the last decade, the pension funds have earned average investment returns of only 4.5 to 6 percent per year. The funds' unrealistic investment targets have already increased the state's total pension debt by more than $14.3 billion since 1996. (Source CLICK HERE).

The unfunded liability in Illinois is $22,294 per person. What we will find next week is that there are states that are actually in worse shape than Illinois in that regard. And no, California is not one of them. (Hint: they have Republican governors. Oops. That's not supposed to happen. Especially if the governors are considered to be vice-presidential material. Just saying…)

We will also look at the specifics of Detroit. One of the ugliest reports I've read in the last year is the report of the new "emergency" manager of Detroit, outlining his proposal to take the city out of bankruptcy. It makes for some of the most dismal reading anywhere. But buried in the data is this interesting chart that the Detroit Free Press created. Note that the unfunded healthcare liability is far larger than the pension liability. That provides another avenue for us to look down. In the meantime, you might look and see what your city or state assumes about the returns on its pension funds. Then look at what the difference between that amount and 4% nominal might be and see what the effect would be on your tax rate. I suggest you do that only with an adult beverage close at hand.



We will close with one sentence from the report of the Detroit emergency manager, referring to the ability of the city to pay its obligations to those who have already retired: "Because the amounts realized on the underfunding claims will be substantially less than the underfunding amount, there must be significant cuts in accrued, vested pension amounts for both active and currently retired persons." Sadly, that sentence is likely to be cut and pasted into many similar documents around the country unless changes are made now. If you wait until you are Detroit (or Greece), it is too late.

It is quite late and time to hit the send button. Have a great week.

Your hoping he can find above-average returns somewhere analyst,

John Mauldin

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