Buttonwood

Analysts struggle to make accurate long-term market forecasts

Historically high valuations for equities complicate the task  
 
That is pretty clear with government bonds. Anyone buying a bond with a yield of 2% and holding it until maturity can expect, at best, that level of return (before inflation) and no more. (There is a small chance the government might default.) With equities, the calculations are not quite so hard-and-fast. Nevertheless, it is a good rule-of-thumb that buying shares with a low dividend yield, or on a high multiple of profits, is likely to lead to lower-than-normal returns.
So a sensible approach to long-term investing would assess the potential returns from asset classes, given their valuations and the fundamentals, and allocate assets accordingly. That is what GMO, a fund-management company, has been trying to do for decades. It has made some common-sense assumptions about the fundamental drivers of returns and then assumed that valuations would return to average levels over a seven-year period.
 
In one sense, this process has been a success. The assets that GMO thought would perform well have offered relatively high returns; the assets it thought would perform badly have offered low ones (see top chart). But if the ranking has been correct, the level of return has not been. Assets that GMO thought would yield a negative return of -10% to -8%, for instance, have in fact suffered average losses of only -2.8%.
 
GMO’s forecasts have been pretty accurate for asset classes such as emerging-market bonds and international (non-American) shares; annual returns have been within 1.5 percentage points of its forecasts. But for American equities, GMO was too gloomy, underestimating returns by around four percentage points a year.
 
The reason for this error is pretty clear. Equity valuations have not returned to the mean, as GMO thought they would, but have stayed consistently above their historical levels. GMO was fairly accurate in its forecast for dividend growth, but its erroneous estimation of valuation accounted for all the forecast error.
 
There are two possible conclusions. One is that GMO is simply wrong about mean reversion.

Equities have moved to a new, higher valuation level. This sounds uncomfortably like the famous quote from Irving Fisher, an economist, before the 1929 crash, that stocks had reached a “permanently high plateau”. But there is some justification for a valuation shift: American profits have been high, relative to GDP, for a long period of time. This may be a result of monopoly power in some industries, or perhaps of the reduced bargaining power of workers in an age of globalisation.

A more obvious argument is that, with yields on cash and government bonds so low, investors are willing to pay a high price for equities because they represent their only hope for decent returns. But given the low level of dividend yields and the sluggish rate of economic growth, profits will have to keep rising as a proportion of GDP to allow high equity returns to continue.
 
That seems unlikely.
 
Either there will be a political reaction—governments will clamp down on firms in response to public unrest—or, more prosaically, tighter labour markets mean that wage growth will start to erode profits.
 
Either way, it is understandable that GMO does not want to give up on the idea of mean reversion just yet. Its latest forecasts are pretty downbeat (see bottom chart). The real returns from most asset classes are expected to be negative; only emerging-market equities offer a decent return. Investors who disbelieve those forecasts are in essence betting that things will be “different this time”. That is certainly possible but it requires a lot of faith.


Barbarians at the Monetary Gate

Andrew Sheng, Xiao Geng
.
Bitcoin

HONG KONG – Financial markets today are thriving. The Dow Jones industrial average, the S&P 500, and the Nasdaq composite index have all reached record highs lately, with emerging-economy financial markets also performing strongly, as investors search for stability amid widespread uncertainty. But, because this performance is not based on market fundamentals, it is unsustainable – and very risky.
 
According to Mohamed El-Erian, the lost lesson of the 2007 financial crisis is that current economic-growth models are “overly reliant on liquidity and leverage – from private financial institutions, and then from central banks.” And, indeed, a key driver of financial markets’ performance today is the expectation of continued central-bank liquidity.
 
After the US Federal Reserved revealed its decision last month to leave interest rates unchanged, the Dow Jones industrial average set intraday and closing records; the Nasdaq, too, reached all-time highs. Now, financial markets are waiting for signals from this year’s meeting of the world’s major central bankers in Jackson Hole, Wyoming.
 
But there is another factor that could further destabilize an already-tenuous leverage- and liquidity-based system: digital currencies. And, on this front, policymakers and regulators have far less control.
 
The concept of private cryptocurrencies was born of mistrust of official money. In 2008, Satoshi Nakamoto – the mysterious creator of bitcoin, the first decentralized digital currency – described it as a “purely peer-to-peer version of electronic cash,” which “would allow online payments to be sent directly from one party to another without going through a financial institution.”
 
A 2016 working paper by the International Monetary Fund distinguished digital currency (legal tender that could be digitized) from virtual currency (non-legal tender). Bitcoin is a cryptocurrency, or a kind of virtual currency that uses cryptography and distributed ledgers (the blockchain) to keep transactions both public and fully anonymous.
 
However you slice it, the fact is that, nine years after Nakamoto introduced bitcoin, the concept of private electronic money is poised to transform the financial-market landscape. This month, the value of bitcoin reached $4,483, with a market cap of $74.5 billion, more than five times larger than at the beginning of 2017. Whether this is a bubble, destined to collapse, or a sign of a more radical shift in the concept of money, the implications for central banking and financial stability will be profound.
 
At first, central bankers and regulators were rather supportive of the innovation represented by bitcoin and the blockchain that underpins it. It is difficult to argue that people should not be allowed to use a privately created asset to settle transactions without the involvement of the state.
 
But national authorities were wary of potential illegal uses of such assets, reflected in the bitcoin-enabled, dark-web marketplace called Silk Road, a clearinghouse for, among other things, illicit drugs. Silk Road was shut down in 2013, but more such marketplaces have sprung up. When the bitcoin exchange Mt. Gox failed in 2014, some central banks, such as the People’s Bank of China, started discouraging the use of bitcoin. By November 2015, the Bank for International Settlements’ Committee on Payments and Market Infrastructures, made up of ten major central banks, launched an in-depth examination of digital currencies.
 
But the danger of cryptocurrencies extends beyond facilitation of illegal activities. Like conventional currencies, cryptocurrencies have no intrinsic value. But, unlike official money, they also have no corresponding liability, meaning that there is no institution like a central bank with a vested interest in sustaining their value.
 
Instead, cryptocurrencies function based on the willingness of people engaged in transactions to treat them as valuable. With the value of the proposition depending on attracting more and more users, cryptocurrencies take on the quality of a Ponzi scheme.
 
As the scale of cryptocurrency usage expands, so do the potential consequences of a collapse.
 
Already, the market capitalization of cryptocurrencies amounts to nearly one tenth the value of the physical stock of official gold, with the capability to handle significantly larger payment operations, owing to low transaction costs. That means that cryptocurrencies are already systemic in scale.
 
There is no telling how far this trend will go. Technically, the supply of cryptocurrencies is infinite: bitcoin is capped at 21 million units, but this can be increased if a majority of “miners” (who add transaction records to the public ledger) agree. Demand is related to mistrust of conventional stores of value. If people fear that excessive taxation, regulation, or social or financial instability places their assets at risk, they will increasingly turn to cryptocurrencies.
 
Last year’s IMF report indicated that cryptocurrencies have already been used to circumvent exchange and capital controls in China, Cyprus, Greece, and Venezuela. For countries subject to political uncertainty or social unrest, cryptocurrencies offer an attractive mechanism of capital flight, exacerbating the difficulties of maintaining domestic financial stability.
 
Moreover, while the state has no role in managing cryptocurrencies, it will be responsible for cleaning up any mess left by a burst bubble. And, depending on where and when a bubble bursts, the mess could be substantial. In advanced economies with reserve currencies, central banks may be able to mitigate the damage. The same may not be true for emerging economies.
 
An invasive new species does not pose an immediate threat to the largest trees in the forest. But it doesn’t take long for less-developed systems – the saplings on the forest floor – to feel the effects.
 
Cryptocurrencies are not merely new species to watch with interest; central banks must act now to rein in the very real threats they pose.
 
 


Sell the Swiss Franc if You Think the World Is a Better Place

Swiss franc proved slow to react to the brighter picture for the eurozone economy

By Richard Barley


SAFETY TRADE
How many euros one Swiss franc buys



For all of the controversy around aggressive monetary policy, there is little dispute that central bankers have succeeded in moving the values of stocks, bonds and currencies. The exception that proves the rule is the Swiss franc.

The Swiss National Bank has tried hard to battle the strength of its currency but where other central banks had big impacts, the Swiss franc has refused to fall. The central bank has gone deep into negative-interest-rate territory, taking its target rate to minus 0.75%. For four years it put an outright cap on appreciation against the euro, printing francs and buying foreign assets in a campaign that has taken its balance sheet to more than 100% of Switzerland’s gross domestic product.

The SNB’s cap did temporarily turn the Swiss franc around, but the chaos sparked by its January 2015 decision to abandon that policy still hasn’t fully reversed. On a trade-weighted basis and adjusted for inflation, the Swiss franc is still some 12% higher than its precrisis average, SNB data show. Against the euro, the franc has fallen 6% this year but is still stronger than the level the SNB targeted before January 2015.

The SNB’s efforts to weaken the franc have been overwhelmed by the actions of its much bigger neighbor, the European Central Bank. But now the ECB is gradually moving away from quantitative easing as the eurozone economy picks up.

On the Swiss side, extremely low inflation means the central bank has absolutely no reason to shift its policy. Annual inflation has only been above zero in 12 of the 67 months since the start of 2012 and has often been below that of Japan. The SNB forecasts inflation at 0.3% in 2018 and 1% in 2019.

The combination of weak inflation and loose monetary policy in Switzerland and stronger growth and less quantitative easing in Europe argues for the franc to weaken versus the euro.

The other factor pushing for a weaker franc is the improving prospects for the eurozone. Fear of the currency bloc breaking up benefits the franc. Swiss outward investment flows, much of which traditionally landed in the eurozone, have collapsed since the crisis. As those fears fade, so should the franc. The first time the Swiss franc showed signs of weakening this year was in the wake of the French elections, won by the staunchly pro-Europe Emmanuel Macron. A resumption of Swiss investment flows—which means investors sell francs and buy euros—could be a key factor in the franc’s path.

INTERRUPTED
Swiss residents net investments in foreign securities


EVEN LOWER, EVEN LONGER
Change in consumer prices from a year earlier


The Swiss franc won’t stop being a haven. When risk aversion rises, investors seem hard-wired to embrace it. Italian elections next year could be a flashpoint. But unless there is a specific threat to eurozone cohesion, such reversals shouldn’t prove too disruptive.

Put together, that makes the Swiss franc a sell against the euro. Even if the franc falls from its current €0.875 to €0.83, a big move in currencies, it would only be at the highest level that the Swiss central bank allowed it to go in 2015. A further decline would make those bankers happier. Investors should go along for the ride.


Economic Forecast: Theories Behind The Numbers

by: Dr. Bill Conerly

 
 
What's the theory behind my economic forecast? In simple language, it's complicated. My forecast is judgmental rather than coming from an econometric model. I begin with a "bottoms-up" prediction of major sectors, followed by a top-down reality-check. This article will explain my basic economic thought process.
 
The classical economists are in the back of my mind. They viewed the economy as self-regulating. The Pigou effect is one part of the process, but not the only one. I certainly believe we would have business cycles even in the absence of bad government policy, but I think the classicals were right that if the government took their hands off the levers of policy, the economy would come back to full employment. My judgment is that the speed of adjustment would be fairly rapid, but the slow-adjustment argument is worth considering.
 
 
Dr. Bill Conerly with data from Bureau of Economic Analysis
Economic Growth and Contraction
 
 
I read John Maynard Keynes' General Theory as a skeptical undergraduate, but I really took to it after reading Axel Leijonhufvud's splendid On Keynesian Economics and the Economics of Keynes. He said that textbook Keynesian economics had become mechanical, losing some key points. I took away two lessons. The first is that the basis for many spending decisions is soft.
 
We can teach MBA students how to find the optimum capital expenditure, but the calculations are based on a host of unknowns: future prices and future costs and future interest rates. The second lesson is that in an environment of unknowns, decision-makers often take on a herd mentality, leading to swings of optimism and pessimism. When forecasting business decisions, I look at the fundamental factors that should be driving capital spending, but I also recognize the possibility of these mood swings.

The monetarism of Milton Friedman and others heavily influenced me early in my career. I'm less a monetarist now, partly because it's so hard to find a measure of money supply for which demand is fairly stable. Nonetheless, I take monetary policy to be powerful, but not completely determinative for the economy.
 
"Real business cycle" theory shows that swings in new technology development can trigger booms and busts. For their work on this, Finn Kydland and Edward Prescott were awarded the Nobel prize in economics. Read the prize description for more about their work at the layman's level. When the tech sector develops new business models, there can certainly be a boost to capital spending - so long as the technology does not reduce the need for capital in total. I keep this in mind, but most of my effort focuses on other areas.
 
The dominant macroeconomic theory today is "new Keynesian," which emphasizes the business cycle consequences of market imperfections, such as wages and prices that adjust to new circumstances only gradually. I take this seriously, though with the proviso that when it is profitable to change wages and prices more quickly, that will happen.
 
That idea brings us to rational expectations, the notion that people make decisions using all of the information available to them. The idea is frequently criticized, even to the point of being laughed at, but let's state it a different way: You can't fool all the people all the time. Robert Lucas argues that economic policy which depended on tricking people would not long work.
 
Think of government spending to stimulate the economy. The stimulus comes only if people do not boost their savings so that they can pay a future tax bill. As more and more people worry about the federal debt burden, I think that policy is less effective.
 
I'm often asked about Austrian business cycle theory, which I studied both as an undergraduate and in my Ph.D. program at Duke. The simplistic version of this theory is that easy money policy from the Federal Reserve (or other central bank) causes more capital spending and more roundabout production processes than is warranted by the underlying productivity of capital and consumer time preference. Eventually, the misallocation of resources is corrected, resulting in a recession or depression. The downturn is necessary to correct the errors of the past. Although there are many insights from the Austrian school that I use regularly, I find the specifics of the business cycle theory less useful.

I also find a good bit of overlap between the economics of Keynes, with its emphasis on decision-making under uncertainty, and the Austrian view. This seems odd to those who see Keynesians as proponents of activist government and Austrians as opponents. The two schools are united in their emphasis on decision-making under uncertainty. (Although Hayek and Keynes are sometimes portrayed as antagonists, they were cordial colleagues. During World War II they walked the streets of Cambridge together as air wardens, checking that blackout curtains were in place.)
 
My economic theory is a mongrel, using a variety of insights developed by different theorists.
 
The most important basis is old-fashioned supply and demand, applied to different sectors of the economy. For instance, when I look at consumer spending on durables goods such as cars, I examine incomes and whether there might be pent-up demand. When business spending is surging, I'm concerned about supply-chain limitations.
 
In practice, forecasting is heavily judgmental. Some folks have computer models that they let run on autopilot. But each model is based on judgements about what factors to include and what to ignore.
 
The world is too complicated - and data too limited - to utilize all possible explanatory factors, so economists pick and choose. Whether with a computer model or a purely judgmental process, the economist makes his best guess in an atmosphere of uncertainty.


Pension Storm Warning

John Mauldin


This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves “This time is different.” It never was.)

Nevertheless, I uttered those four words in last week’s letter. I stand by them, too. In the next 20 years, we’re going to see changes that humanity has never seen before, and in some cases never even imagined, and we’re going to have to change. I truly believe this. We have unleashed economic and technological forces we can observe but not entirely control.

I will defend this bold claim at greater length in my forthcoming book, The Age of Transformation.

Today we will zero in on one of those forces, which last week I called “the bubble in government promises,” which I think is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.

Earlier this year I called the pension mess “The Crisis We Can’t Muddle Through.” Reflecting since then, I think I was too optimistic. Simply waiting for the floodwaters to drop down to muddle-through depth won’t be enough. We face an entire new ocean, deeper and wider than we can ever cross unaided.


Storms from Nowhere?

This year marks the first time on record that two Category 4 hurricanes have struck the US mainland in the same year. Worse, Harvey and Irma landed directly on some of our most valuable and vulnerable coastal areas. So now, in addition to all the problems that existed a month ago, the US economy has to absorb cleanup and rebuilding costs for large parts of Texas and Florida, as well as our Puerto Rico and US Virgin Islands territories.

Now then, people who live in coastal areas know full well that hurricanes happen – they know the risk, just not which hurricane season might launch a devastating storm in their direction. In a note to me about Harvey, fellow Rice University graduate Gary Haubold (1980) noted just how flawed the city’s assumptions actually were regarding what constitutes adequate preparedness. He cited this excerpt from a recent Los Angeles Times article:

The storm was unprecedented, but the city has been deceiving itself for decades about its vulnerability to flooding, said Robert Bea, a member of the National Academy of Engineering and UC Berkeley emeritus civil engineering professor who has studied hurricane risks along the Gulf Coast.

The city’s flood system is supposed to protect the public from a 100-year storm, but Bea calls that “a 100-year lie” because it is based on a rainfall total of 13 inches in 24 hours.

“That has happened more than eight times in the last 27 years,” Bea said. “It is wrong on two counts. It isn’t accurate about the past risk and it doesn’t reflect what will happen in the next 100 years.” (Source)

Anybody who lives in Houston can tell you that 13 inches in 24 hours is not all that unusual. But how do Robert Bea’s points apply to today’s topic, public pensions? Both pension plan shortfalls and hurricanes are known risks for which state and local governments must prepare. And in both instances, too much optimism and too little preparation ultimately have devastating results.

Admittedly, public pension liabilities don’t come out of nowhere the way hurricanes seem to – we know exactly where they will strike. In many cases, we know approximately when they’ll strike, too. Yet we still let our elected officials make impossible-to-fulfill promises on our behalf. The rest of us are not so different from those who built beach homes and didn’t buy hurricane or storm surge insurance. We just face a different kind of storm.

Worse, we let our government officials use predictions about future returns that are every bit as unrealistic as calling a 13-inch rain in Houston a 100-year event. And while some of us have called pension officials out, they just keep telling lies – and probably will until we reach the breaking point.

Puerto Rico is a good example. The Commonwealth was already in deep debt before Irma blew in – $123 billion worth of it. There’s simply no way the island can repay such a massive debt. Creditors can fight in the courts, but in the end you can’t squeeze money out of plantains or pineapples. Not enough money, anyway. Now add Irma damages, and the creditors have even less hope of recovering their principal, let alone interest.

Puerto Rico is presently in a new form of bankruptcy that Congress authorized last year. Court proceedings will probably drag on for years, but the final outcome isn’t in doubt. Creditors will get some scraps – at best perhaps $0.30 on the dollar, my sources say – and then move on. We’re going to find out how strong those credit insurance guarantees really are.

“That’s just Puerto Rico,” you may say if you’re a US citizen in one of the 50 states. Be very careful. Your state is probably not so much better off. In 10 years, your state may well be in the same place where Puerto Rico is now. I’d say the odds are better than even.

Are your elected leaders doing anything about this huge issue, or even talking about it? Probably not.

As it stands now, states can’t declare bankruptcy in federal courts. Letting them do so would raises thorny constitutional issues. So maybe we’ll have to call it something else, but it’s going to end the same way. Your state’s public-sector retirees will not get what they were promised, and they won’t take the outcome kindly.

Blood from Turnips

Public sector bankruptcy, up to and including state-level bankruptcy, is fundamentally different from corporate bankruptcy in ways that many people haven’t considered. The pension crisis will likely expose those differences as deadly to creditors and retirees.

Say a corporation goes bankrupt. A court will take all its assets and decide how to divvy them up. The assets are easy to identify: buildings, land, intellectual property, cash, etc. The parties may argue over their value, but everyone knows what the assets are. They won’t walk away.

Not so in a public bankruptcy. The primary asset of a city, county, or state is future tax revenue from households and businesses within its boundaries. The taxpayers can walk away. Even without moving, they can bypass sales taxes by shopping elsewhere. If property taxes are too high, they can sell and move. When they take a loss on the sale, the new owner will have established a property value that yields the city far less revenue than it used to receive.

Cities and states don’t have the ability to shed their pension liabilities. They are stuck with them, even as population and property values change.

We may soon see an example of this in Houston. Here in Texas, our property taxes are very high because we have no income tax. Your tax is a percentage of your home’s taxable value. So people argue to appraisal boards that their homes are falling apart and not worth anything like the appraised value. (Then they argue the opposite when it’s time to sell the home.)

About 200 entities in Harris County can charge taxes. That includes governments from Houston to Baytown to Hedwig Village, plus 20 independent school districts.

There’s a hospital district, port authority, several college districts, the flood control district, a multitude of utility districts, and the Harris County Department of Education. Some homes may fall within 10 or more jurisdictions.

What about those thousands of flooded homes in and around Houston; how much are they worth? Right now, I’d say their value is zero in many cases. Maybe they will have some value if it’s possible to rebuild, but at the very least they ought to receive a sharp discount from the tax collector this year.

Considering how many destroyed or unlivable properties there are all over South Texas, I suspect cities and counties will lose billions in revenue even as their expenses rise. That’s a small version of what I expect as city and state pension systems all over the US finally face reality.

Here in Dallas I pay about 2.7% in property taxes. When I bought my home over four years ago, I checked our local pension and was told we were 100% funded. I even mentioned in my letter that I was rather surprised. Turns out they lied. Now, realistic assessments suggest they will have to double the municipal tax rate (yes, I said double) to be able to fund fire and police pension funds. Not a terribly popular thing to do. At some point, look for taxpayers to desert the most-indebted cities and states. Then what? I don’t know. Every solution I can imagine is ugly.
 
Promises from Air

Most public pension plans are not fully funded. Earlier this year in “Disappearing Pensions” I shared this chart from my good friend Danielle DiMartino Booth:


 
Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade. You read that right – not doubled, tripled or quadrupled: quintupled.
 
That’s nice when it happens on a slot machine, not so nice when it’s money you owe.

You will also notice in the chart that much of that change happened in 2008. Why was that? That’s when the Fed took interest rates down to nearly zero, meaning it suddenly took more cash to fund future payments. Also, some strapped localities conserved cash by promising public workers more generous pension benefits in lieu of pay raises.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs. And that estimate is based on the aggressive assumptions of pension funds that they will get their predicted rate of returns (the “discount rate”).

Kentucky, for instance, has unfunded pension liabilities of $40 billion or more. This month the state budget director notified local governments that pension costs could jump 50-60% next year. That’s due to a proposed reduction in the system’s assumed rate of return from 7.5% to 6.25% – a step in the right direction but not nearly enough.

Think about this as an investor. Do you know a way to guarantee yourself even 6.25% average annual returns for the next 10–20 years? Of you don’t. Yes, some strategies have a good shot at doing it, but there’s no guarantee.

And if you believe Jeremy Grantham’s seven-year forecasts (I do: His 2009 growth forecast was spot on), then those pension funds have very little hope of getting their average 7% predicted rate of return, at least for the next seven years.


 
Now, here is the truth about pension liabilities. Let’s assume you have $1 billion in funding today. If you assume a 7% compound return – about the average for most pension funds – then that means in 30 years that $1 million will have grown to $8 billion (approximately). Now, what if it’s a 4% return? Using the Rule of 72, the $1 billion grows to around $3.5 billion, or less than half the future assets in 30 years if you assume 7%.

Remember that every dollar that is not funded today means that somewhere between four dollars and eight dollars will not be there in 30 years when somebody who is on a pension is expecting to get it. Worse, without proper funding, as the fund starts going negative, the funding ratio actually gets worse, sending it into a death spiral. The only way to bring it out of the spiral is with huge cuts to other needed services or with massive tax cuts to pension benefits.

The State of Kentucky’s unusually frank report regarding the state’s public pension liability sums up that state’s plight in one chart:


 
The news for Kentucky retirees is quite dire, especially considering what returns on investments are realistically likely to be. But there’s a make or break point somewhere. What if pension plans must either hit that 6% average annual return for 2018–2028 or declare bankruptcy and lose it all?

That’s a much greater problem, and it’s a rough equivalent of what state pension trustees have to do. Failing to generate the target returns doesn’t reduce the liability. It just means taxpayers must make up the difference.

But wait, it gets worse. The graph we showed earlier stated that unfunded pension liabilities for state and local governments was $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns? Now the admitted unfunded pension liability is $4 trillion. But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.


 
We throw the words a trillion dollars around, not realizing how much that actually is.
 
Combined state and local revenues for the US total around $2.6 trillion. Following the next recession (whenever that is), the unfunded pension liabilities for state and local governments will be roughly three times the revenue they are collecting today, and that’s before a recession reduces their revenues. Can you see the taxpayer stuck between a rock and a hard place? Two immovable objects meeting? The math just doesn’t work.

Pension trustees don’t face personal liability. They’re literally playing with someone else’s money. Some try very hard to be realistic and cautious. Others don’t. But even the most diligent can’t control when the next recession comes, or when the stock market will crash, leaving a gaping hole in their assets while liabilities keep right on rising.

I have had meetings with trustees of various government pensions. Many of them want to assume a more realistic discount rate, but the politicians in their state literally refuse to allow them to assume a reasonable discount rate, because owning up to reality would require them to increase their current pension funding dramatically. So they kick the can down the road.

Intentionally or not, state and local officials all over the US made pension promises that future officials can’t possibly keep. Many will be out of office when the bill comes due, protected from liability by sovereign immunity.

We are starting to see cities filing for bankruptcy. That small ripple will be a tsunami within 7–10 years.

But wait, it gets still worse. (Do you see a trend here?) Many state and local governments have actually 100% funded their pension plans. Some states and local governments have even overfunded them – assuming they get their projected returns. What that really means is that the unfunded liabilities are more concentrated, and they show up in unlikely places. You think Texas is doing well? Look at some of our cities and weep. Look, too, at other seemingly semi-prosperous cities all over the country. Do you think the suburbs of Dallas will want to see their taxes increased to help out the city? If you do, I may have a bridge to sell you – unless you would rather have oceanfront properties in Arizona.

This issue is going to set neighbor against neighbor and retirees against taxpayers. It will become one of the most heated battles of my lifetime. It will make the Trump-Clinton campaigns look like a school kids’ tiddlywinks smackdown.

I was heavily involved in politics at both the national and local levels in the 80s and 90s and much of the 2000s. Trust me, local politics is far nastier and more vicious. And there is nothing more local than police and firefighters and teachers seeing their pensions cut because the money isn’t there. Tax increases of up to 100% are going to become commonplace. But even these new revenues won’t be enough… because we will be acting with too little, too late.

This is the core problem. Our political system gives some people incentives to make unrealistic promises while also absolving them of liability for doing so. It also places the costs of those must-break promises on innocent parties, i.e. the retirees who did their jobs and rightly expect the compensation they were told they would receive.

So at its heart the pension crisis is really not a financial problem. It’s a moral and ethical problem of making and breaking promises that profoundly impact people’s lives. Our culture puts a high value on integrity: doing what you said you would do.

We take a job because the compensation package includes x, y and z. Then someone says no, we can’t give you z, so quit and go elsewhere.

The pension problem is going to get worse as more and more retirees get stuck with broken promises, and as taxpayers get handed higher and higher bills. These are irreconcilable demands in many cases. It’s not possible to keep contradictory promises.

What’s the endgame? I think much of the US will end up like Puerto Rico. But the hardship map will be more random than you can possibly imagine. Some sort of authority – whether bankruptcy courts or something else – will have to seize pension assets and figure out who gets hurt and how much. Some courts in some states will require taxes to go up. But courts don’t have taxing authority, so they can only require cities to pay, but with what money and from whom?

In many states we literally don’t have the laws and courts in place with authority to deal with this. And just try passing a law that allows for states or cities to file bankruptcy in order to get out of their pension obligations.

The struggle will get ugly, and innocent people on both sides will be hurt. We hear stories about retired police chiefs and teachers with lifetime six-digit pensions and so on. Those aberrations (if you look at the national salary picture) are a problem, but the more distressing cases are the firefighters, teachers, police officers, or humble civil servants who served the public for decades, never making much money but looking forward to a somewhat comfortable retirement. How do you tell these people that they can’t have a livable pension? We will see many human tragedies.

On the other side will be homeowners and small business owners, already struggling in a changing economy and then being told their taxes will double. This may actually happen in Dallas; and if it does, we won’t be alone for long.

The website Pension Tsunami posts scores of articles, written all across America, about pension problems. We find out today that in places like New York and Chicago and Cook County, pension funds have more retirees collecting than workers paying into the fund. There are more retired cops in New York and Chicago than there are working cops. And the numbers of retirees just keep growing. On an individual basis, it is smart for the Chicago police officer to retire as early possible, locking in benefits, go on to another job that offers more retirement benefits, and round out a career by working at least three years at a private job that qualifies the officer for Social Security. Many police and fire pensions are based on the last three years of income; so in the last three years before they retire, these diligent public servants work enormous amounts of overtime, increasing their annual pay and thus their final pension payouts.

As I’ve said, this is the crisis we can’t muddle through. While the federal government (and I realize this is economic heresy) can print money if it has to, state and local governments can’t print. They actually have to tax to pay their bills. It’s the law. It’s also an arrangement with real potential to cause political and social upheaval that Americans have not seen in decades. The storm is only beginning. Think Hurricane Harvey on steroids, but all over America. Of all the intractable economic problems I see in the future (and I have a vivid imagination), this is the most daunting.

Chicago, Lisbon, Denver, Lugano, and Hong Kong

I will be in Chicago the afternoon of August 26, meeting with clients and friends, and then I’ll speak at the Wisconsin Real Estate Alumni conference the morning of the 28th, before returning to Dallas that afternoon and flying with Shane to Lisbon the next day. My hosts are graciously giving me a few extra days to explore Lisbon, and Portugal is one of the last two Western European countries I have never been to. After this, only Luxembourg is left, so the next time I’m in Brussels or Amsterdam on a Sunday, I’m going to get on a train and go have lunch in Luxembourg.

On Wednesday morning the 27th I will be on CNBC with my friend Rick Santelli. As usual, we’ll talk about whatever’s on the top of Rick’s mind at the moment. It makes for a hellaciously fun discussion.

I return to Dallas to speak at the Dallas Money Show on October 5–6. You can click on the link for details. I will speak at an alternative investments conference in Denver on October 23–24 (details in future letters) and return to Denver on November 6 and 7, speaking for the CFA Society and holding meetings. After a lot of small back-and-forth flights in November, I’ll end up in Lugano, Switzerland, right before Thanksgiving. Busy month! Then there will be a (currently) lightly scheduled December, followed by an early trip to Hong Kong in January. It looks like Lacy Hunt and his wife, JK, will join Shane and me there. Lacy and I will come back home exhausted from trying to keep up with the bundles of indefatigable energy that JK and Shane are.

Boston was a very intriguing two full days of meetings. There is the potential to expand the services that my firms can offer readers and investors into areas that I never knew might be possible. It is truly exciting, and I hope we can pull it off.

I am off to meet with a close friend from out of town and compare notes on the world, one of my favorite things to do. I know we all have times when we wish we were being more productive, when we wondering why are we here and not moving the ball forward. But when I get to spend time with good friends, old or new, I somehow never feel that way. And while our pension systems may be going to hell in a handbasket, friendships will remain forever. You have a great week.

Your wishing I could see a better path forward analyst,