The Pension Train Has No Seat Belts

By John Mauldin

 

In describing various economic train wrecks these last few weeks, I may have given the wrong impression about trains. I love riding the train on the East Coast or in Europe. They’re usually a safe and efficient way to travel. And I can sit and read and work, plus not deal with airport security. But in this series, I’m concerned about economic train wrecks, of which I foresee many coming before The Big One which I call The Great Reset, where all the debt, all over the world, will have to be “rationalized.” That probably won’t happen until the middle or end of the next decade. We have some time to plan, which is good because it’s all but inevitable now, without massive political will. And I don’t see that anywhere.
 
Unlike actual trains, we as individuals don’t have the option of choosing a different economy. We’re stuck with the one we have, and it’s barreling forward in a decidedly unsafe manner, on tracks designed and built a century ago. Today, we’ll review yet another way this train will probably veer off the tracks as we discuss the numerous public pension defaults I think are coming.

Last week, I described the massive global debt problem. As you read on, remember promises are a kind of debt, too. Public worker pension plans are massive promises. They don’t always show up on the state and local balance sheets correctly (or directly!), but they have a similar effect. Governments worldwide promised to pay certain workers certain benefits at certain times. That is debt, for all practical purposes.
 
If it’s debt, who are the lenders? The workers. They extended “credit” with their labor. The agreed-upon pension benefits are the interest they rightly expect to receive for lending years of their lives. Some were perhaps unwise loans (particularly from the taxpayers’ perspective), but they’re not illegitimate. As with any other debt, the borrower is obligated to pay. What if the borrower simply can’t repay? Then the choices narrow to default and bankruptcy.
 
As you will see below, the pension crisis alone has catastrophic potential damage, let alone all the other debt problems we’re discussing in this series. You are sadly mistaken if you think it will end in anything other than a train wreck. The only questions are how serious the damage will be, and who will pick up the bill.

Demographics and Destiny
 
It’s been a busy news year, but one under-the-radar story was a wave of public school teacher strikes around the US. It started in West Virginia and spread to Kentucky, Oklahoma, Arizona, and elsewhere. Pensions have been an issue in all of them.
 
An interesting aspect of this is that many younger teachers, who are a long way from retirement age, are very engaged in preserving their long-term futures. This disproves the belief that Millennial-generation Americans think only of the present. From one perspective, it’s nice to see, but they are unfortunately right to worry. Demographic and economic reality says they won’t get anything like the benefits they see current retirees receiving. And it’s not just teachers. The same is true for police, firefighters, and all other public-sector workers.
 
Thinking through this challenge, I’m struck by how many of our economic problems result from the steady aging of the world’s population. We are right now living through a combination unprecedented in human history.
  • Birth rates have plunged to near or below replacement level, and
  • Average life spans have increased to 80 and beyond.
Neither of these happened naturally. The first followed improvements in artificial birth control, and the second came from better nutrition and health care. Each is beneficial in its own way, but together they have serious consequences.
 
This happened quickly, as historic changes go. Here is the US fertility rate going back to 1960.
 

Source: St. Louis Fed


As you can see, in just 16 years (1960–1976), fertility in the US dropped from 3.65 births per woman to only 1.76. It’s gone sideways since then. This appears to be a permanent change. It’s even more pronounced in some other countries, but no one has figured out a way to reverse it.
 
Again, I’m not saying this is bad. I’m happy young women were freed to have careers if they wished. I’m also aware (though I disagree) that some think the planet has too many people anyway. If that’s your worry, then congratulations, because new-human production is set to fall pretty much everywhere, although at varying rates.
 
Breaking down the US population by age, here’s how it looked in 2015.

 

Source: US Census Bureau


Think of this as a python swallowing a pig. Those wider bars in the 50–54 and 55–59 zones are Baby Boomers who are moving upward and not dying as early as previous generations did. Meanwhile, birth rates remain low, so as time progresses, the top of the pyramid will get wider and the bottom narrower. (You can watch a good animation of the process here.)
 
This is the base challenge: How can a shrinking group of working-age people support a growing number of retirement-age people? The easy and quick illustration to this question is to talk about the number of workers supporting each Social Security recipient. In 1940, it was 160. By 1950 it was 16.5. By 1960 it was 5.1. I think you can see a trend here. As the chart below shows, it will be 2.3 by 2030.

 

Source: Peter G. Peterson Foundation


Similarly, states and local governments are asking current young workers to support those already in the pension system. The math is the same, though numbers vary from area to area. How can one worker support two or three retirees while still working and trying to raise a family with mortgage payments, food, healthcare, etc.? Obviously, they can’t, at least not forever. But no one wants to admit that, so we just ignore reality. We keep thinking that at some point in the future, taxpayers will pick up the difference. And nowhere is it more evident than in public pensions.
 
In a future letter, I will present some good news to go with this bad news. Several new studies will clearly demonstrate new treatments to significantly extend the health span of those currently over age 50 by an additional 10 or 15 years, and the same or more for future generations. It’s not yet the fountain of youth, but maybe the fountain of middle-age. (Right now, middle-age sounds pretty good to me.)
 
But wait, those who get longer lifespans will still get Social Security and pensions. That data isn’t in the unfunded projections we will discuss in a moment. So, whatever I say here will be significantly worse in five years.

Let me tell you, that’s a high order problem. Do you think I want to volunteer to die so that Social Security can be properly funded? Are we in a Soylent Green world? This will be a very serious question by the middle of the next decade.

Triple Threat

We have discussed the pension problem before in this letter—at least a half-dozen times. Most recently, I issued a rather dire Pension Storm Warning last September. I said in that letter that I expect more cities to go bankrupt, as Detroit did, not because they want to, but because they have no choice. You can’t get blood from a rock, which is what will be left after the top taxpayers move away and those who stay vote to not raise taxes.
 
This means city and school district retirees will take major haircuts on expected pension benefits. The citizens that vote not to pay the committed debt will be fed up with paying more taxes because they will be at the end of their tax rope. I am not arguing that is fair, but it is already happening and will happen more.
 
States are a larger and different problem because, under our federal system, they can’t go bankrupt. Lenders perversely see this as positive because it removes one potential default avenue. They forget that a state’s credit is only as good as its tax base, and the tax base is mobile.
 
Let me say this again because it’s critical. The federal government can (but shouldn’t) run perpetual deficits because it controls the currency. It also has a mostly captive tax base. People can migrate within the US, but escaping the IRS completely is a lot harder (another letter for another day). States don’t have those two advantages. They have tighter credit limits and their taxpayers can freely move to other states.
 
Many elected officials and civil servants seem not to grasp those differences.

They want something that can’t be done, except in Washington, DC. I think this has probably meant slower response by those who might be able to help. No one wants to admit they screwed up.
 
In theory, state pensions are stand-alone entities that collect contributions, invest them for growth, and then disburse benefits. Very simple. But in many places, all three of those components aren’t working.
  • Employers (governments) and/or workers haven’t contributed enough.
  • Investment returns have badly lagged the assumed levels.
  • Expenses are more than expected because they were often set too high in the first place, and workers lived longer.

Any real solution will have to solve all three challenges—difficult even if the political will exists. A few states are making tough choices, but most are not. This is not going to end well for taxpayers or retirees in those places.
 
Worse, it isn’t just a long-term problem. Some public pension systems will be in deep trouble when the next recession hits, which I think will happen in the next two years at most. Almost everyone involved is in deep denial about this. They think a miracle will save them, apparently. I don’t rule out anything, but I think bankruptcy and/or default is the more likely outcome in many cases.

Assumed Disaster

The good news is we’re starting to get data that might shake people out of their denial. A new Harvard study funded by Pew Charitable Trusts uses “stress test” analysis, similar to what the Federal Reserve does for large banks, to see how plans in ten selected states would behave in adverse conditions (hat tip to Eugene Berman of Cox Partners for showing me this study).
 
The Harvard scholars looked at two economic scenarios, neither of which is as stressful as I expect the next downturn to be. But relative to what pension trustees and legislators assume now, they’re devastating.

Scenario 1 assumes fixed 5% investment returns for the next 30 years.

Most plans now assume returns between 7% and 8%, so this is at least two percentage points lower. Over three decades, that makes a drastic difference.
 
Scenario 2 assumes an “asset shock” involving a 20% loss in year one, followed by a three-year recovery and then a 5% equity return for years five through year 30. So, no more recessions for the following 25 years.  

Exactly what fantasy world are we in?
 
Their models also include two plan funding assumptions. In the first, they assume states will offset market losses with higher funding. (Fat chance of that in most places. Seriously, where are Illinois, Kentucky, or others going to get the money?). The second assumes legislatures will limit contribution increases so they don’t have to cut other spending.
 
Admittedly, these models are just that—models. Like central banks models, they don’t capture every possible factor and can be completely wrong. They are somewhat useful because they at least show policymakers something besides fairytales and unicorns. Whether they really help or not remains to be seen.
 
Crunching the numbers, the Pew study found the New Jersey and Kentucky state pension systems have the highest insolvency risk. Both were fully-funded as recently as the year 2000 but are now at only 31% of where they should be.

 

Source: Harvard Kennedy School


Other states in shaky conditions include Illinois, Connecticut, Colorado, Hawaii, Pennsylvania, Minnesota, Rhode Island, and South Carolina. If you are a current or retired employee of one of those states, I highly suggest you have a backup retirement plan. If you aren’t a state worker but simply live in one of those states, plan on higher taxes in the next decade.
 
But that’s not all. Even if you are in one of the (few) states with stable pension plans, you’re still a federal taxpayer, and that’s who I think will end up bearing much of this debt. And as noted above, it is debt. The Pew study describes it as such in this chart showing state and local pension debt as a share of GDP.

 

Source: Harvard Kennedy School


For a few halcyon years in the late 1990s, pension debt was negative, with many plans overfunded. The early-2000s recession killed that happy situation. Then the Great Recession nailed the coffin shut. Now it is above 8% of GDP and has barely started to recover from the big 2008 jump.
 
Again, this is only state and local worker pensions. It doesn’t include federal or military retirees, or Social Security, or private sector pensions and 401Ks, and certainly not the millions of Americans with no retirement savings at all. All these people think someone owes them something. In many cases, they’re right. But what happens when the assets aren’t there?

The stock market boom helped everyone, right? Nope. States' pension funds have nearly $4 trillion of stock investments, but somehow haven't benefited from soaring stock prices.
 
A new report by the American Legislative Exchange Council (ALEC) shows why this is true. It notes that the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America. The ALEC report is far more alarming than the report from Harvard. They believe that the underfunding is more than 67%.
 
There are several problems with this. First, there simply isn’t $6 trillion in any budget to properly fund state and local government pensions. Maybe a few can do it, but certainly not in the aggregate.
 
Second, we all know about the miracle of compound interest. But in this case, that miracle is a curse. When you compute unfunded liabilities, you assume a rate of return on the current assets, then come back to a net present value, so to speak, of how much it takes to properly fund the pension.
 
Any underfunded amount that isn’t immediately filled will begin to compound. By that I mean, if you assume a 6% discount rate (significantly less than most pensions assume), then the underfunded amount will rise 6% a year.
 
This means in six years, without the $6 trillion being somehow restored (magic beans?), pension underfunding will be at $8.4 trillion or thereabouts, even if nothing else goes wrong.
 
That gap can narrow if states and local governments (plus workers) begin contributing more, but it stretches credulity to say it can get fixed without some pain, either for beneficiaries or taxpayers or both.
 
I noted last week in Debt Clock Ticking that the total US debt-to-GDP ratio is now well over 300%. That’s government, corporate, financial, and household debt combined. What’s another 8% or 10%? In one sense, not much, but it aggravates the problem.
 
If you take the almost $22 trillion of federal debt, well over $3 trillion of state and local debt, and add in the $6 trillion debt of underfunded pensions, you find that the US governments from the top to bottom owe over $30 trillion, which is well over 150% of GDP. Technically, we have blown right past the Italian debt bubble. And that’s not even including unfunded Social Security and healthcare benefits, which some estimates have well over $100 trillion. Where is all that going to come from?
 
Connecticut, the state with the highest per-capita wealth, is only 51.9% funded according to the Wall Street Journal. The ALEC study mentioned above would rate it much worse. Your level of underfunding all depends on what you think your future returns will be, and almost none of the projections assume recessions.
 
The level of underfunding will rise dramatically during the next recession. Total US government debt from top to bottom will be more than $40 trillion only a few years after the start of the next recession. Again, not including unfunded liabilities.
 
I wrote last year that state and local pensions are The Crisis We Can’t Muddle Through. That’s still what I think. I’m glad officials are starting to wake up to the problem they and their predecessors created. There are things they can do to help, but I think we are beyond the point where we can solve this without serious pain on many innocent people. Like the doctor says before he cuts you, “This is going to hurt.”
 
We’ll stop there for now. Let me end by noting this is not simply a US problem.

Most developed countries have their own pension crises, particularly the southern Eurozone tier like Italy and Greece. We’ll look deeper at those next week.
 
This is not going to be the end of the world. We’ll figure out ways to get through it as a culture and a country. The rest of the world will, too, but it may not be much fun. Just ask Greece.

St. Louis and Trying to Stay Home

I haven’t done very well staying home in June so far. This week, I made last-minute trips to both New York and Houston. There is actually nothing on my calendar except for one day trip to St. Louis the week after next—until a busy August.
 
There are lots of good things happening in my business and personal life, but it’s too early to share. And in the spirit of trying to do shorter letters, let me just hit the send button and wish you a great summer week! (Unless, of course, you are in the southern hemisphere.)
 
Your trying to figure out how we will muddle through this debt train wreck analyst,


John Mauldin
Chairman, Mauldin Economics


Watch the Fed’s balance sheet, not interest rates

The US central bank’s unwinding has contributed to turmoil in emerging markets

Gillian Tett


Urjit Patel, the governor of India's central bank, warns that the turmoil in emerging markets could get worse as the Fed's balance sheet unwinds © Bloomberg


When the mighty US Federal Reserve started to unwind its bloated $4tn balance sheet last year, some investors braced themselves for a shock. But it did not immediately transpire — or at least not in a way that American cable television shows (or a president) might notice.

On the contrary, US markets seemed so impervious to the unwinding that many investors have almost forgotten that it is happening. Instead, the main, obsessive focus for debate around the Fed right now is whether it will raise policy rates three or four times this year.

But if Urjit Patel, the governor of India’s central bank, is correct, this obsession with US interest rates misses the point. Writing in the Financial Times earlier this week, Mr Patel argued that the Fed’s balance sheet unwinding is quietly contributing to the current turmoil in emerging markets. He warned this could soon get much worse.

This is not because Mr Patel thinks that the Fed was wrong to embark on the unwinding. Instead, he worries that President Donald Trump’s subsequent tax cuts have caused the US deficit to unexpectedly widen, sparking much higher-than-projected issuance of US debt. Indeed, some $2.34tn of treasuries will be sold in the next two years. 

Global investors will need dollars to buy those bonds. However, the rub is that the Fed’s unwinding is sucking dollars out of the system, currently at a pace of $20bn a month, which is slated to rise to $50bn next year (or a cumulative $1tn of liquidity by December 2019.) That creates a dollar liquidity squeeze, Mr Patel fears, and means that “a crisis in the rest of the dollar bond markets is inevitable”, with a growing “possibility . . . a ‘sudden stop’ for the global economic recovery”. So he wants the Fed to change course — by slowing that unwinding.

The Fed itself has not responded in public to this remarkable plea. But investors should take note on several counts. For one thing, central bank governors do not usually warn so bluntly about the risks of a looming financial shock. Nor do they usually shout so loudly about controversial fiscal issues — let alone in another country.

But Mr Patel is not the only non-American central bank governor or official who now has these concerns. On the contrary, similar sentiments have been privately tossed around at a number of international meetings in recent weeks, as the full impact of Mr Trump’s tax cuts have become clear.  

Will the Fed listen? Under the new leadership, that is unclear. Jay Powell, the new chairman, recently offered some intriguing hints about how he thinks the Fed should view its impact on non-US markets — at least in respect to US interest rates. Last month, he told a seminar organised by the IMF and Swiss National Bank that while cross-border “spillovers [from policy] are to be expected in a world of highly integrated financial markets”, the last decade of data suggested that the role of US monetary policy on global markets is “often exaggerated”. 

By way of proof, he noted that capital flows to emerging market economies slackened in 2011 when the Fed eased policy, but increased in 2013 when it tightened — even though logic might suggest that tighter US policy should suck capital from those economies. The Federal Reserve “played a relatively limited role in the surge of capital flows to EMEs”, he concluded.

This suggests that Mr Powell himself will have little sympathy if EMEs try to blame the Fed for any market turmoil, or ask it to change course. In any case, he, like other senior Fed officials, seems (justifiably) very keen to stay on the same path at this point, to ensure that the Fed has firepower when the next recession hits. 

But some Fed officials accept Mr Patel’s point that higher bond sales are changing the landscape. They also know that it will be much easier to modify the process of unwinding, if necessary, than tweaking high-profile rates since the Fed has huge discretion in this field. After all, most politicians (and White House officials) do not have the foggiest idea about the details of the balance sheet now.

The main conclusion for investors is that they should heed Mr Patel and recognise that interest rates are not the only game in town. They need to watch to see what the Fed does (or does not) do next with that balance sheet. And while Mr Patel is entirely correct to suggest that the Fed needs to take Mr Trump’s tax cuts into account, and consider tweaking policy, I would not bet many dollars (or rupees) that the Fed will ever publicly accept his plea. Investors in emerging market assets should be warned.


America and the world

Donald Trump’s demolition theory of foreign policy won’t work

Even if the president strikes a deal with North Korea, his approach will harm America and the world
.



PICTURE this: next week in Singapore President Donald Trump and Kim Jong Un crown their summit with a pledge to rid the Korean peninsula of nuclear weapons. A few days later America and China step back from a trade war, promising to settle their differences. And in the summer, as sanctions bite, the streets of Tehran rise up to cast off the Iranian regime.

These gains would be striking from any American president. From a man who exults in breaking foreign-policy taboos, they would be truly remarkable. But are they likely? And when Mr Trump seeks to bring them about with a wrecking ball aimed at allies and global institutions, what is the balance of costs and benefits to America and the world?

Don’t you ever say I just walked away

You may wonder how Mr Trump’s narcissism and lack of detailed understanding could ever transform America’s standing for the better. Yet his impulses matter, if only because he offers a new approach to old problems. Like Barack Obama, Mr Trump inherited a country tired of being the world’s policeman, frustrated by jihadists and rogue states like Iran, and worried by the growing challenge from China. Grinding wars in Afghanistan and Iraq, and the financial crisis of 2008, only deepened a sense that the system of institutions, treaties, alliances and classically liberal values put together after 1945 was no longer benefiting ordinary Americans.

Mr Obama’s solution was to call on like-minded democracies to help repair and extend this world order. Hence the Iranian nuclear deal, choreographed with Europe, Russia and China, which bound Iran into the Nuclear Non-Proliferation Treaty. And hence the Trans-Pacific Partnership, which sought to unite America’s Asian allies around new trading rules that would one day channel Chinese ambitions.

Mr Trump has other ideas. He launched air strikes on Syria after it used nerve gas in the name of upholding international norms—and thus looked better than Mr Obama, who didn’t. Otherwise he treats every relationship as a set of competitive transactions. When America submits to diplomatic pieties, conventions or the sensitivities of its allies, he believes, it is negotiating with one hand tied behind its back.

If any country can bully the world, America can. Its total military, diplomatic, scientific, cultural and economic power is still unmatched. Obviously, that power is there to be exploited, which is why every president, including Mr Obama, has used it to get his way abroad even if that involves threats, intimidation and, occasionally, deception. But it is hard to think of a president who bullies as gleefully as Mr Trump. No other modern president has routinely treated America’s partners so shoddily or eschewed the idea of leading through alliances. None has so conspicuously failed to clothe the application of coercive power in the claim to be acting for the global good.

In the short term some of Mr Trump’s aims may yet succeed. Iran’s politics are unpredictable and the economy is weak. Mr Kim probably wants a deal of some sort, though not full disarmament. On trade, China would surely prefer accommodation to confrontation.

Yet in the long run his approach will not work. He starts from false premises. He is wrong to think that every winner creates a loser or that a trade deficit signifies a “bad deal”. He is wrong, too, to think that America loses by taking on the costs of global leadership and submitting itself to rules. On the contrary, rules help deter aggressors, shape countries’ behaviour, safeguard American interests and create a mechanism to help solve problems from trade to climate change. RAND, a non-partisan think-tank, has spent two years assessing the costs and benefits of the postwar order for America. It powerfully endorses the vision that Mr Trump sneers at—indeed, it concludes, this order is vital for America’s security.

Mr Trump’s antics would matter less if they left the world order unscathed. But four years will spread anarchy and hostility. The trading system will be unable to enforce old rules or forge new ones. Short of a war with, say, Russia, America’s allies will be less inclined to follow its lead. In Europe more voices may complain that sanctions against Russia are harmful. In Asia countries may hedge against America’s unreliability by cosying up to China or by arming themselves, accelerating a destabilising arms race. Countries everywhere will be freer to act with impunity. These changes Will be hard to reverse. Sooner or later, America will bear some of the costs.

Worst of all, Mr Trump’s impulses mean that China’s rise is more likely to end in confrontation. He is right to detect a surge in Chinese ambitions after the financial crisis and the arrival of Xi Jinping in 2012. That justifies toughness. But Mr Trump’s dark, zero-sum outlook is destined to lead to antagonism and rivalry, because it refuses to see that China’s rise could benefit America or to follow the logic that China might be content to live within a system of rules that it has helped devise.

I just closed my eyes and swung

If the “master negotiator” so underestimates what he is giving up, how can he strike a good bargain for his people? He values neither the world trading system nor allies, so he may be willing to wreck it for the empty promise of smaller bilateral deficits. That could lead to retaliation. Iran could resume nuclear work, as ruling clerics ape North Korea’s strategy of arming themselves before talking. Mr Trump may give Mr Kim the prize of a summit and an easing of sanctions in exchange for a curb on North Korea’s long-range ballistic missiles. That would protect America (and be better than war), but it would leave Asian allies vulnerable to the North’s nukes. America First today; in the long run America Alone.

America’s unique willingness to lead by fusing power and legitimacy saw off the Soviet Union and carried it to hegemony. The world order it engineered is the vehicle for that philosophy. But Mr Trump prefers to fall back on the old idea that might is right. His impulses may begin to impose a new geopolitics, but they will not serve America or the world for long. Remember the words of Henry Kissinger: order cannot simply be ordained; to be enduring, it must be accepted as just.

U.S. Import Tariffs: Why the Cost Will Be High
  
steel mill

         
The Trump administration’s decision last week to impose tariffs on imports of steel and aluminum from Canada, Mexico and the European Union will have costly ramifications, according to experts in international finance, trade and economics.

The tariffs – 25% on steel and 10% on aluminum – will jeopardize U.S. ties with longstanding allies and raise prices of goods that use steel and aluminum, thus hurting demand, investment in factories and jobs on both sides of the equation, they warned. Retaliatory tariffs are inevitable, and the matter could face drawn-out challenges at the World Trade Organization, they said.

According to Ann Harrison, Wharton professor of management and business economics and public policy, the tariff move is “shocking,” both because few expected Trump to follow through on his threats to do so, and because it involved the closest allies of the U.S. “They are just outraged and very upset,” she said of Canada, Mexico and the EU. “This move violates international law, and [these allies] see it as a rejection of longstanding relationships.”
 
Canada will most likely retaliate with its own tariffs on its imports of U.S. products while it pursues negotiations to find a mutually acceptable solution, said Patrick Leblond, a senior fellow at the Centre for International  Governance Innovation in Ontario, Canada. Leblond is also an associate professor and chair on business and public policy at the University of Ottawa’s Graduate School of Public and International Affairs.

Leblond noted that Canadian Prime Minister Justin Trudeau has the strong support of Canadians to push back against the U.S. tariffs. “Canadians are ready to … bite the bullet for as long as it will be necessary,” he said. They would also look for how the tariffs play out on U.S. products exported to Canada against the backdrop of the mid-term U.S. Congress elections in November 2018.

“The Trump administration keeps asking for things that it knows are impossible, once it seems to think it has a victim on the hook,” said Mary E. Lovely, professor of economics at Syracuse University’s Maxwell School of Citizenship and Public Affairs and a nonresident senior fellow at the Peterson Institute for International Economics. “Our allies are increasingly waking up to that and beginning to have some solidarity in knowing they’re all being treated in a way that is contrary to international law, and which is politically not viable within their own countries. So it doesn’t look like they have many options other than to resist.”

A Trade War Looms

The EU has already challenged the Trump tariffs at the WTO, but it could take a long time for a resolution, said Harrison. Some countries like Mexico have chosen to act without that longer process “because they’re just so infuriated by these actions,” she added. Other countries have described the U.S. move as a “safeguard action” — trade parlance for attempts to protect its industries for domestic reasons — she noted. “It adds tremendous pressure and begins to diminish the rules-based global trading system that the U.S. has established over the last 60 years.”

The matter is likely to weigh heavily at the G-7 meeting this coming weekend in Quebec, Canada, with a sharp divide between the U.S. on one side, and the other six members outraged over the Trump tariffs. The Trump administration had originally announced the tariffs in March, covering several other countries, but suspended them to make way for negotiations on how best to reduce perceived national security threats to the U.S. The administration has since reached agreements with South Korea, Australia, Argentina and Brazil on steel; and with Australia and Argentina on aluminum. It failed to reach similar agreements with Canada, Mexico and the EU, leading to the re-imposition of the import tariffs, effective June 1.
Leblond said Trudeau was hopeful of some kind of a deal before the latest tariff action, but called off a planned visit to Washington, D.C., when he learned that the U.S. would insist on its demand for a “sunset clause” in the renegotiations of NAFTA (North American Free Trade Agreement) that are underway concurrently. Under the proposed sunset clause, the three members of NAFTA — Canada, Mexico and the U.S. — must renew the 23-year-old agreement after five years, or else it would lapse. Trudeau also rejected the U.S. justification of the tariffs on national security grounds. “The idea that we are somehow a national security threat to the United States is quite frankly insulting and unacceptable,” he said at a press meet last weekend.

Lovely noted that the U.S. has always had issues with the EU, such as its demand that the latter lower tariffs on automobiles. She said that with its latest action, the U.S. is following a pattern of “asking for things which are quite extraordinary within the context of the World Trade Organization and how trade liberalization has always happened.”

By antagonizing its allies and trading partners, the U.S. is also undermining the chances of forging a common front to deal with China, Leblond said. He expected the leaders of other countries attending the G-7 summit to impress upon Trump the need to preserve that potential of a common front, but was not hopeful that those entreaties would work. “I’m not sure they will be very successful because this is how Trump tends to negotiate: He hits first and then says, ‘Well, if you want me to stop hitting you, you better accept all these other things that I would like to get from you.’ The other leaders will say, ‘That’s not going to work, and so you choose what you want to do.”

Upping the Ante?

Trump has repeatedly said that the U.S. has been “ripped off by other countries” for years on trade, and has held those countries responsible for America’s trade deficit woes. According to Harrison, “The U.S. has been playing a game of trying to open other countries’ markets for its goods for generations and generations.” She saw the tariffs as more of a negotiating stance on Trump’s part. “He’s really kind of upping the ante and playing a game where he’s saying we feel violated.” She also pointed out that Trump’s claim on trade deficits is misplaced. “[The trade deficit] has nothing to do with exports on the part of other countries. It’s more about the fact that our country borrows more than it essentially makes and it needs to support that in some way.”

The tariffs will end up hurting everybody, according to Harrison. “The best way to understand this is to think about a bully in the playground,” she said. The bully thinks he’s the strongest person on the playground and makes demands from his friends, but it turns out that he has somehow misjudged his allies and in fact is living in a different world than 30 or 40 years ago, she added. “They’re going to fight back. And you end up in what’s known as a prisoner’s dilemma where everybody fights everybody and everyone is left off much worse off than they were before.” The EU may be one place where Trump could actually get what he wants because it is fragmented with different interests between its members, especially with the Brexit negotiations, she added.

Consumers, Jobs, Investments

Harrison predicted that the tariffs and the retaliatory actions by other countries would lead to higher prices of products that use steel, such as automobiles. “Even if companies redirect their supply chains from other parts of the world in order to avoid the tariffs, it will still mean higher prices in terms of transportation, for instance,” Leblond added.

The resulting higher prices will mean lower volumes as consumers will either buy cheaper cars or delay buying cars, Leblond said. The uncertainty and the higher costs will in turn compel companies to put off investments, or invest in other growth markets like China, he warned. All said, it would impact job creation and wealth creation.

Automakers have estimated that the tariffs would add about 1% to the cost of cars, and they may pass on anywhere between two-thirds or all of it to customers, said Lovely. “If it’s a $5,000 tax, it would funnel through right to the [customer’s] wallet,” she said.

At risk are also the jobs of steelworkers both in the U.S. and in the countries at the receiving end of the import tariffs, as one recent study claimed. Lovely said the auto industry, for example, is so well integrated across the U.S., Canada and Mexico that “we don’t even know how to separate American and Canadian content.” Caught in the crossfire are the unions that represents steelworkers on both sides, and they have argued against tariffs on Canada, she added.

The overall pain may be lessened because the U.S. economy is on an upswing now, Lovely pointed out. “However, we already see a [so-called] Goldilocks labor market, because while unemployment is very low, wages haven’t really picked up the way that we would like to see. This could threaten that.”

The tariffs will also hurt Trump’s voter base. “Trump is ostensibly doing all this for the people, but the people whose interests are most likely to be affected are against these tariffs,” said Harrison, referring to the steelworkers unions. “Part of the reason they’re opposing it is because their brothers in Canada in the same union are also going to be hurt.”

Harrison also dismissed the idea that tariffs could improve the well-being of Americans who are not well off. “The average [annual] wage of the lower 50% of the population is something like $18,000, which is scary, but tariffs are not the way to solve that problem,” she said. “The steelworkers themselves are telling us that.”

The Question of National Security

Lovely said Trump has used national security as the pretext for the tariffs under Section 232 of the Trade Expansion Act of 1962. “It affords maximum discretion to the President; it’s a tool that he can pull off the shelf and use rather quickly.”

Harrison pointed to two impacts of the Trump tariffs. “First of all, it really denigrates international law in the sense that we all know that it’s not being used for national security,” she said. If other countries take this to the WTO, and it rules against the U.S., “it weakens that body,” she noted. “The second cost, of course, is that it alienates our allies. Therefore it actually weakens national security for us to make this claim, because it puts a big wedge between us and our closest allies who have stood by our side in a variety of different situations, and we could meet again in the near future.”

Hopes of a Rollback

The Canadian government has begun a month-long public consultation process where it would receive inputs from industry and others on how best to deal with the tariffs. If the Trump administration does not roll back the tariffs by then, Canada could impose retaliatory tariffs on imports from the U.S., Leblond said. If Trump follows through on his threat to impose tariffs specifically on automobiles and other products, that would escalate the current situation, he warned.

However, Leblond was hopeful of a rollback by Trump. “We’re hoping that that the retaliation response from the Canadians and the Mexicans will be enough to put pressure on the Trump administration to back down and get back to negotiating in good faith, and try to get a new NAFTA deal that would be good for everyone,” he said.

In the meantime, Canada would engage with its partners in the U.S. at multiple levels — Congress, state legislatures, governors, city-level leaders and the business community, Leblond said. In that exercise, Canada would essentially try to bring as much pressure as possible on the Trump administration to abandon its tariff move, he said. “[The hope is] we can put an end to this. Everyone is hurting with this. No one benefits.”


Go Ahead—Gamble on a Calm Market. What Could Go Wrong?

By Randall W. Forsyth
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Party like it’s 2017? Speculators are once again betting the stock market’s return to low volatility will persist despite the array of uncertainties it faces.

Unlike last year, however, when amateurs piled into complex and risky exchange-traded funds that moved inversely to the VIX—the Cboe Volatility Index on options on the S&P 500—it’s professionals who have ramped up their short positions in VIX futures and options contracts his time.

David Rosenberg, Gluskin Sheff’s lynx-eyed chief economist and strategist, points out speculative shorts in the VIX nearly doubled last week, to 44,380 futures and options contracts, from 25,556 the previous week, according to the most recent data from the Commodity Futures Trading Commission. “This is the largest net short we have seen since prior to the violent February sell-off that was in fact accentuated by these products,” he writes in his “Breakfast With Dave” daily commentary.

At that time, stocks tanked as the VIX surged amid suddenly heightened uncertainty over interest rates and inflation. As reported in this space then (“The Real Cause of Stocks’ Big Stumble,” Feb. 10), expectations of more-aggressive policy tightening followed news of accelerating wage growth indicated in the January employment data. That, in turn, upset the market’s presumption of slow, predictable interest-rate increases—a big factor underpinning the historically low volatility in all markets, from equities to government securities to currencies.

Betting that the future would be like the recent past, complacent speculators piled into wagers on persistently subdued volatility as a sure thing. That was aided and abetted by the ready availability of products such as the now-shuttered VelocityShares Daily Inverse VIX Short Term exchange-traded note, which was known mainly by its ticker, XIV, rather than the mouthful of its title.

As the VIX soared from a low in the single digits last year to a peak over $50 in the ensuing market mayhem in February, the sure thing came a cropper, as they almost inevitably do. XIV lost 90% in value before its sponsor liquidated the ETN, wiping out many speculators and producing the inevitable lawsuits.

While XIV is gone, the ProShares Short VIX Short-Term Futures exchange-traded fund (ticker: SVXY) soldiers on and has quietly climbed 23% since April 2, to $13.67 at midday Wednesday, though it remains 90% below its 52-week high of $139.47. But that’s not where the pros play; they use VIX futures and options on the Cboe to take advantage of the steady decline of the stock market’s so-called fear gauge as it has steadily receded through the teens to a hair above 12 Wednesday.

That’s a sign of complacency returning to the market, Rosenberg writes: “Pretty incredible to see this sort of position from the fast-money crowd given the very real possibility of a trade war on the horizon.”

That is far from the only uncertainty overhanging global financial markets. Perhaps the least extraordinary source of risk is that of global monetary policy.

The Federal Open Market Committee meets next week, and the policy-setting panel is all but certain to vote an additional quarter-percentage-point increase in its federal-funds target range, currently set at 1.50%-1.75%. What market participants really want to know is the expected outlook for further hikes, specifically if there will be one more hike this year or two.

Even more uncertainty surrounds the European Central Bank’s outlook. The ECB could outline plans at its policy meeting next week to unwind its bond-purchase program, according to various media reports. Market participants and policy makers well remember the “taper tantrum” of 2013, when the Fed merely disclosed plans that it was contemplating a reduction of quantitative easing securities purchases. The actual reversal of QE did not begin until 2017.

In addition to conflicts on the trade front and monetary policy, there are also the minor matters of geopolitical conflict and this year’s midterm elections.  
Nevertheless, bullish sentiment continues to rebound. According to the latest Investors Intelligence poll of advisory comment, bulls rose to 52.9% from 50.0% in the previous week, nearly 10 percentage points above the early May reading of 43.1%.






Bears dipped to 17.7% from 19.2% the two preceding weeks. The spread between bulls and bears widened to 35.2%, from 30.8% the previous weeks and just 22.5% in early May. That widening bull-bear gap moves Investors Intelligence to observe: “Risk is now rising.”

Yet speculative bets are going in the other direction. The buildup in short positions in VIX futures and options implies either growing confidence or, as Rosenberg suggests, complacency.

The last time those sentiments prevailed was when the S&P 500 and Dow Jones Industrial Average reached their peaks last January. Those marks are again being approached but haven’t been topped, just as the market’s fear gauge fades.