Your Pension May Be Monetized

By John Mauldin


One difficulty in analyzing our economic future is the sheer number of potential crises. When so much could go wrong (and really right, when the exponential technologies I foresee get here), it’s hard to isolate, let alone navigate, the real dangers. We are tempted to ignore them all. Ignoring them is usually the right response, too. We can “Muddle Through” almost anything.

But muddling through isn’t the same as smooth sailing. It’s difficult, unpleasant, and often keeps you from looking for better opportunities. Then there are times when you can’t even muddle through. Instead, you find yourself emotionally at a dead stop or even going backwards. When surviving the storm is your focus, taking those “blood in the streets” buying opportunities is hard.

Which leads to this week’s letter. Almost every day I read scores of finance and economic newsletters, websites, articles, and books. A few articles on pensions hit my inbox this week and pursuing them led me to today’s topic.

But dear gods, I can remember writing a decade ago that public pension funds were $2 trillion underfunded and getting worse. More than one person told me that couldn’t be right. They were correct: It was actually much worse. (See, I’m an optimist!)

Two years ago I wrote that Disappearing Pensions are The Crisis We Can’t Muddle Through. Nothing since then has changed my mind. In fact, failure at all levels to even begin solving the problem is making it worse. The latest estimates, as we will see, suggest that it has gotten $2 trillion or more worse in just a few years.

Note we are talking here about a specific kind of pension: defined benefit plans, usually those sponsored by state and local governments, labor unions, and a dwindling number of private businesses. Many sponsors haven’t set aside the assets needed to pay the benefits they’ve promised to current and future retirees. They can delay the inevitable for a long time but not forever. And “forever” is just around the corner.

As we will see below, the numbers are large enough to make this a problem for everyone, even those without affected pensions. The problem is “solvable”… but the solutions will be problems in themselves.

Underfunded Future

Let’s begin with the enormity of the pension funding gap. As with the federal budget deficit, the large numbers are hard for our minds to process. They are also inherently uncertain. Let me explain.

A defined benefit pension plan for, say, a city’s police department, knows it owes a certain number of retirees certain monthly benefits for life. Their lifespans are fairly predictable when the pool is large enough. (I think new biotechnologies will change this soon, but that’s another topic.)

From that, it’s simple math to calculate how much money the plan should have right now in order to pay those benefits when they are due. But then the assumptions start. The plan must presume a future rate of return on the invested portfolio, an inflation rate, and in some cases future health care costs (medical benefits are part of many plans).

So, when we say a plan is “fully funded,” it may not be so if the assumptions are wrong. The amount a plan is underfunded could be much larger than the sponsor and auditors say. In theory, it could be smaller, too, but I have never seen that happen. The accounting rules that govern all this allow (some would say encourage) the sponsoring cities, counties, and states to understate their liabilities. This lets them avoid hard decisions like raising taxes, cutting benefits, or reducing other needed services.

Here’s a Wharton School note to place this huge number in context.

Sanitation workers, firefighters, teachers and other state and local government employees have performed their duties in the public sector for decades with the understanding that their often lackluster salaries were propped up by excellent benefits, including an ironclad pension. But Moody’s Investors Service recently estimated that public pensions are underfunded by $4.4 trillion. That amount, which is equivalent to the economy of Germany, accounts for one-fifth of national debt. It’s a significant concern for public employees who were banking on a fully funded retirement to get them through their golden years. The true number could be much higher. Whatever it is, filling it will be painful for somebody. Pensioners will receive lower-than-expected benefits, taxpayers will get higher-than-expected tax bills, or citizens will see government services cut. Or maybe all the above.

Then again, if you make more realistic assumptions on future returns the unfunded liability becomes $6 trillion according to the American Legislative Exchange Council. Total state and local annual revenues are only $3.1 trillion. Total property taxes are roughly $590 billion.

Here’s more grim news from The Heritage Foundation.

Overall, the American Legislative Exchange Council estimates that pension plans have only about a third of the funds on hand—33.7 percent—that they need to pay promised benefits. Some states have significantly lower funding levels, which means they are at risk of running out of funds in the near future.

Once a state or local pension plan runs out of money, taxpayers have to fund the pension benefits of retirees as well as the contributions of current employees.

Connecticut, Kentucky, and Illinois have the lowest funding ratios, at 20 percent, 21 percent, and 23 percent respectively.

Already, Illinois spends as much on pensions as it does on welfare and public protection (that is, police and firefighters) combined, and nearly half of its education appropriations go toward teacher pensions. If the state’s pension plans reach insolvency, pensions could become its single biggest cost.

These unfunded liability estimates are high because plan assumptions are too optimistic. Almost all public pension funds assume investment returns somewhere around 7% (and some as high as 8%+). A more conservative and realistic approach would force the state and local governments to fund those pension plans at a much higher level by either raising taxes or reducing services. What local politician will volunteer to do that? Better to find a consultant to tell you what you want to hear. There are plenty of them that will, for a reasonable fee, billed to the taxpayers.

The following graphic shows how your state is ranked on a per capita funding basis. You can see the absolute numbers in the following table.

Source: Valuewalk

A further complication is that the taxpayers who might have to cover these amounts are mobile. They can move to other states with lower tax burdens, leaving behind those who, for whatever reason, can’t leave their states.

And to make it even more interesting, the beneficiaries often no longer live in the states that pay them. Retired public employees from the Northeast might live in Florida now, for instance. They can’t even vote for the people who govern their incomes.

The broader point: As with the federal debt, some portion of this unfunded pension debt is going to get liquidated in some manner. Any way we do it will hurt either the pensioners or taxpayers.

Pension Fund Underfunding Is a Local Problem

Thirty years ago Frisco, Texas, had fewer than 20,000 residents. Today its population is well over 180,000. Corporations from all over America are moving there. Tax revenues are booming. Frisco is the happy exception that simply grew faster than its pension liabilities.

Not so Dallas, whose Police and Fire Pension System was advertised as solvent just a few years ago. Now it is so deep in the hole that the mayor says plugging the gap would take almost a doubling of city taxes. (I bought my Dallas apartment after that news was announced but such an increase would have still made my taxes cost more than my mortgage. Can you say taxpayer revolt? It wasn’t the main reason, but it did factor in to my move.) Texas Monthly recently noted:

For those of us in Texas, with our gloriously high credit ratings and fervent allegiance to low taxes, restrained spending and conservative oversight of a robust Rainy Day Fund, the news that certain big cities around the country were in a heap of trouble might have elicited nothing more than a collective, if somewhat condescending, shrug. Except for one thing: Texas’s four biggest cities were all high on the list [of the worst 15 cities]. Dallas, which came in second, is on the hook for $7.6 billion, about five times the amount of its total operating revenues. Houston was fourth, with a $10 billion shortfall—equal to four times its operating revenues. Austin, at number nine, has $2.7 billion in liabilities, and San Antonio, ranked number twelve, is $2.3 billion short. That seems like very bad news for just about any Texan. Particularly since the vast majority of Texans now live in urban areas. How can a state known for fiscal responsibility have so many cities with empty pockets?

Will Frisco residents want to pay for the Dallas pension funding problems? Is The Woodlands going to want to pay for Houston’s problems? Is Indiana ready to pay for Illinois? Of course not. How much of a crisis will we need in order to recognize we are all in this together? Probably a lot bigger than you imagine.

Make the Children Pay

While arguments progress at the national level, state and local leaders must simultaneously pay their pension benefits, provide public services, and keep taxes to a level that doesn’t sweep them out of office or drive top taxpayers away. Not to mention keep the markets happy enough to sell future bond offerings, until such time as the Fed steps in as buyer-of-last resort. A tall order.

Given those choices, the usual answer seems to be “cut services and hope no one notices.” It is happening nationwide but California is in the vanguard, thanks to its massive pension debt. This is from a recent Brookings Institution note.

Pension and health-benefit costs are bending education finances in California to their will. The sheer magnitude of the rising costs is staggering. Large numbers of school board officials who participated in our survey indicate that the rising costs are meaningfully affecting educational services. For example, many report making cost-saving changes to district budgets that include deferred maintenance, larger class sizes, and fewer enrichment opportunities for students in response to rising pension and health benefit costs.

So in effect, today’s students are paying to keep benefits flowing to retired teachers and administrators.

Meanwhile, the Berkeley city council is taking criticism for prioritizing pension payments ahead of public works projects. Voters approved bond issues supposedly dedicated to infrastructure but the city is apparently not doing the work.

Nor is it just California. In a recent study, Bank of America analysts found an inverse relationship between infrastructure investment and pension fund contributions. Each additional $1 billion in plan contributions subtracts about $2.5 billion from state and local government investment.

We have multiple parties fighting over pieces of the same pie, all hoping that Uncle Sam will step in and save them. Uncle Sam may well do it, too, but it won’t remove the pain. It will just redistribute the burden, perhaps more widely, but the aggregate amount won’t change.

In my view, this leads to some kind of Japan-like deflationary recession. If we’re lucky, it will be mild and long. It won’t be fun but the alternatives would be worse.

The Strategic Investment Conference and Possible Recessions

Newt Gingrich asked me last week about the timing of the next recession. I knew he was thinking about the election in 2020, but the data I trust the most (Steve Blumenthal tracks it here) only goes out about nine months. While global recession is a possibility in the next nine months, the US seems to be okay. But Scott Minerd at Guggenheim has raised his odds of a recession in 2020.

Timing will certainly be a topic of discussion at next week’s Strategic Investment Conference, along with many other topics. There will be several panels dealing with the ever-increasing US and global government debt. Longtime readers know I am not happy with where we are or how we got here, but the path we choose from here will make a big difference. I think we will see Japanification and massive quantitative easing throughout the developed world. As I’ve written the past few weeks, that will bring financial repression and reduced growth. Of course, there are those who want to go ahead and take the pain. It would be severe but not of Biblical proportions. But I just don’t see politicians and voters choosing such pain.

The newly fashionable Modern Monetary Theory (MMT) isn’t the answer, though even Ray Dalio is now toying with it. (I’ll be responding to him in a future letter.) Down that path is Weimar-like inflation and then hyperinflation. I don’t think that is likely, but I find it alarming that more and more people are giving MMT proponents political and philosophical cover.

Speaking of choices, Donald Trump has a very difficult and risky one. He is the first president since Nixon opened China to seriously push back on their theft of intellectual property, the openness of their markets, and their mercantilism. I am not a fan of tariffs, but something does need to be done. If the higher tariff he just launched don’t disappear quickly, we will see a much higher recession probability. I see high probability they will try to shortstop it but wargaming the multiple scenarios is simply impossible. This is high-stakes poker with the global economy as the pot. Well, that and the future of both countries. High stakes indeed. It helps that the new tariffs won’t go on goods currently in transit. That amounts to a few weeks “time out” during which they might reach agreement before anything actually gets taxed.

If you want to better understand what we are dealing with in China, let me suggest three books. The first two are Michael Pillsbury’s The Hundred Year Marathon and George Magnus’s Red Flags: Why Xi’s China Is in Jeopardy. Different perspectives. At the conference we will focus a lot on China with both bullish and bearish speakers.

Then for a fun read, which I finished a few days ago on the plane, get David Ignatius’s blockbuster spy thriller/science fiction novel, The Quantum Spy. It will give you insights into China’s theft of intellectual property, cyber warfare and who is controlling it, as well as introduce you to the potential of quantum computers. This book is well researched, has great characters and plot, and deserves the accolades it gets. I can go on but seeing how few science fiction books I’ve recommended over the years, compared to how many I’ve read, pay attention to this one.

And with that I will hit the send button. If you won’t be at the SIC, you really should get your Virtual Pass which is the next best thing. You can watch it live, watch or listen to it later, or read the transcripts.

Have a great week! I will admit SIC week is the highlight of my year. I am really pumped about this one. So many friends, so much learning, and a lot of fun, too. How much better can it get?

Your trying to keep up with a few dozen balls in the air analyst,

John Mauldin
Chairman, Mauldin Economics

Pacific islands: a new arena of rivalry between China and the US

Beijing is making its presence felt in a region that the US navy considers strategically vital

Kathrin Hille in Honiara, Solomon Islands

The three dozen men and women sitting under huge Poinciana trees listen intently to Joyce Konofilia. A candidate in last week’s general election in the Solomon Islands, she was campaigning in a squalid settlement on a hillside above the capital city of Honiara where few residents have access to electricity and even fewer have jobs.

But when Ms Konofilia, an Australia-educated tourism consultant, had finished her stump speech, the first question from her audience was about foreign policy. A local elder rose and asked: “Do you support switching diplomatic relations from Taiwan to China?”

The Solomons, an archipelago of 630,000 people north-east of Australia grappling with poverty, corruption and occasional ethnic strife, is being hit by the full force of a rising China which claims Taiwan as part of its territory and over which it has mounted a diplomatic campaign to isolate Taipei.

While Chinese immigrants have dominated the local retail sector since the first arrivals in the 19th century, their community has swelled to more than 5,000 people over the past few years and threatens to establish a dominant position in the local economy. Chinese state-owned enterprises are building infrastructure projects, partly with Chinese loans, and bring in Chinese workers instead of offering badly-needed jobs to locals.

Similar forces are at play across the entire group of Pacific island nations as a new great power competition ignites more than 70 years after Japan and the US clashed in the second world war.

The region’s vast maritime expanses have long been controlled by the US Navy, whose base in Guam is central to its ability to project power in the western Pacific. China, however, is now making its presence felt. Beijing is attracting countries with promises to boost their development, but which might also enrich local politicians and raise fears of new colonial-style domination. In western capitals, China’s Pacific push has raised concerns that Beijing has military designs on the region.

Although China is challenging western power in other parts of the world, the calculations are different in the western Pacific, which contains economically weak countries with tiny islands and small populations that boast large maritime territories. If relatively small investments allow Beijing to gain influence over a number of governments in the region, China could then access or even control vast waters of vital strategic importance to the US.

“We are seeing everything from small-scale economic engagement to full elite capture. What is their aim? In the Pacific, there is nothing really economically worth a candle for China,” says Euan Graham, executive director of the Asia department of La Trobe University in Melbourne. “This is a pre-conflict type of shadow game, a geopolitical non-war version of island-hopping. The Pacific has become strategic again for the first time since World War II.”

The tribal chief Leliana Firisua says 'it’s a competition between third countries again, between China and the US, and China’s influence is being felt. The fallout has started affecting the region' © Kathrin Hille/FT

It is an uncomfortable reality for Solomon islanders to find themselves again on the frontline of clashing great powers. It was in Guadalcanal that the US started its main counteroffensive against Japan in the second world war. The seabed of Ironbottom Sound, the strait north of the island, is littered with the wrecks of warships.

“Once again things are starting to resemble what happened a long time ago,” says Leliana Firisua, a tribal chief and influential political figure. “It was not our war, but they came to Guadalcanal and we became victims. Now it’s a competition between third countries again, between China and the US, and China’s influence is being felt. The fallout has started affecting the region.”

The most immediate concern for Washington is Chinese attempts at gaining influence in Palau, the Federated States of Micronesia (FMS) and the Marshall Islands. These microstates have so-called compacts of free association (Cofa) with the US — agreements that give them subsidies and visa-free US residence for their citizens in exchange for the right to base its troops on their territory and block other countries from doing so.

In the Marshall Islands, Cary Yan, a Chinese investor, has leased large tracts of land on Rongelap, one of the atolls worst affected by US nuclear bomb tests. Mr Yan proposes to create a special economic zone which his company says would issue Marshall Islands passports to residents on its own. While he has not built anything yet, he has sold the idea to potential investors in China as a way to gain US residence rights.

The project had unexpected political consequences last year when supporters launched a no-confidence vote against president Hilda Heine hoping to replace her with someone more China-friendly. She narrowly survived the vote.

The Solomons is an archipelago of 630,000 people north-east of Australia grappling with poverty, corruption and occasional ethnic strife, as well as a rising China

In Chuuk, one of the FMS states, local politicians who have land dealings with Chinese investors are pushing for independence — a move which could collapse the country’s association with the US and present an opportunity for Chinese military interests.

In Palau, parliamentary speaker Sabino Anastacio, who is involved in a hotel project with Chinese partners, has become an advocate of switching diplomatic ties from Taiwan to China.

As well as building these relationships, China’s oceanographic research vessels have frequently criss-crossed the waters around these island states and close to Guam, where the US navy houses submarines that patrol the western Pacific. They map the seabed, observe marine life and climate patterns, and plant buoys and sensors that record how sound travels under water in different locations.

“The primary driver is seabed mineral exploration, but there are also clear military uses,” says Ryan Martinson, a China expert at the US Naval War College. “The area these vessels’ activity is concentrated in is where possible submarine warfare between the US and China would take place.”

The US Navy's base in Guam is central to its ability to project power in the western Pacific © Getty

China’s People’s Liberation Army has been building so-called anti-access and area denial (A2AD) capabilities that aim at keeping the US military out of a conflict in waters that it considers its “core interests”, especially Taiwan and the South China Sea.

“They are extending A2AD faster now,” says Alex Neill, a China expert at the International Institute for Strategic Studies. “China needs to develop its ability of navigating those waters to make their seaborne nuclear deterrent work.”

The US is starting to take notice. Washington agreed with Australia in January to build a joint military base on Manus Island in Papua New Guinea, the South Pacific country with the largest Chinese presence and recipient of massive aid from Beijing. The US is also ramping up funding to the Cofa states and has called on leaders not to switch diplomatic recognition from Taiwan to China.

However, few countries want to be caught in a geopolitical contest. “Pacific island countries don’t want to be in a situation where they have to choose sides, and even Australia would still like to think it can work with China,” says James Batley, former Australian High Commissioner to the Solomons.

Although Beijing’s total assistance to the region accounts for only 4 per cent of its global aid programme, the Chinese government uses aid strategically: it focuses on building infrastructure, and the average size of its projects is much larger than that of other donors, according to the Lowy Institute.

Voters return to their home province of Malaita from Honiara after casting their ballots in the Solomon Islands election © Kathrin Hille/FT

After a military coup in Fiji in 2006, China broke ranks with other regional powers who wanted to isolate the military government. Not only did it back the new rulers, it increased aid from $1m to $161m within two years. Fiji has since promoted regional initiatives that seek to sideline the Pacific Island Forum, a regional group that includes Australia and New Zealand — both US allies who have played a traditional role in the region.

Australia is also worried about Chinese financing of deep water ports such as Port Vila in Vanuatu and the possibility that it might seek to use such facilities as a naval base. “It is a settled view within the Australian government that China has strategic designs on such ports,” says Mr Graham. “Even if there’s only a 10 per cent risk of China putting up a base around here, it’s worth responding because the consequences would be so dramatic for Australia — we face chokepoints in Vanuatu, Fiji and the Solomons for shipping lines directly across the Pacific to America.”

The Solomon Islands government, meanwhile, caused shockwaves in Canberra in 2016 when it decided to replace an Australian-backed vendor chosen in an open tender for a subsea cable linking it to Sydney with Huawei, the Chinese technology group several western governments see as a security threat. Canberra responded by building the undersea cable for the Solomon Islands itself and paying two-thirds of the cost.

But the Chinese company is not giving up: Huawei is now offering to link up more distant parts of the country through a cable from Vanuatu. Australia say it does not object, but cautions such a project could push the country into a dangerous debt trap if financed through Chinese commercial loans.

In Tonga, Chinese money has left the country dependent on Beijing. Under a scheme currently contested in Tongan courts, China Electronic Systems Engineering (Cesec), a company linked to the PLA, paid Tongasat, a company controlled by Pilolevu, Tonga’s Princess Royal, US$50m in 2008 for parking a satellite in the Polynesian kingdom’s skies. The bulk of the funds, half of which should have gone into the national budget, went to the company, according to Tongan court documents.

Joyce Konofilia, a candidate in the Solomon Islands election, remains full of admiration for the Chinese Communist party’s record in lifting the Chinese people out of poverty © Kathrin Hille/FT

Tonga borrowed $114m between 2008 and 2010 from Beijing. Its debt to China is now equivalent to 43 per cent of the country’s gross domestic product. The royal family has subsequently launched an investigation into Akilisi Pohiva, the prime minister and main critic of the princess, in what he says is an attempt to replace him with a more China-friendly candidate.

Anne-Marie Brady, an expert on China in the region, says Beijing’s engagement in Tonga is highly strategic. “These South Pacific nations are crucial in military terms: China’s Beidou system needs their satellite slots for missile guidance and command and control,” she argues.

In Honiara, Tonga’s example is seen as a cautionary tale. “We see what happened there, and in Sri Lanka and the Maldives — the huge loans, the debt trap,” says Mr Firisua. “We need to be careful because we are very small, and we could lose our sovereignty.”

But China’s pull is strong. Money from Beijing played a significant role in the country’s election — which was held last week but which could take until the end of the month before a government is formed. According to a member of parliament and a Chinese executive in Honiara, the state-owned China Civil Engineering Construction Corporation is one of Beijing’s conduits for financing local politicians. Manasseh Sogavare, a former prime minister, received funds from CCECC for his campaign to be re-elected to his parliamentary seat, the two people said. Mr Sogavare did not respond to a request for comment.

Back from a two-week visit to China paid by Beijing last year, Ms Konofilia, the candidate, remains full of admiration for the Communist party’s record in lifting the Chinese people out of poverty. “They are empowering their people,” she says, adding that she hopes to get Beijing’s support in transforming the Solomons.

But among the islanders, anger is building over the growing numbers of Chinese immigrants and their increasing economic power.

Despite Ms Konofilia’s admiration for Beijing, she has vowed to exclude Chinese investors from a broader range of industries. “We don’t want to have everybody interfere here any longer,” she says. “We want to live our lives. Just leave us be!”

 Ethnic tension: fears Chinese migration could prompt new unrest

Wu Yunmin has heard of the “tensions”. But tending to the stream of customers who browse solar-powered white goods and lamps in his uncle’s shop in Honiara, the 19-year-old Chinese migrant is too busy to think much about events 13 years ago.

In 2006, Solomon islanders turned against the growing community of migrants from China in riots that ended with most of Honiara’s Chinatown going up in flames.

Now, tension is building again as the Solomons have seen another new wave of Chinese immigration. Many observers warn of the risk of renewed unrest.

Most of the recent arrivals are young people from the coastal province of Fujian eyeing a quick fortune selling cheap clothing and household goods.

“Maybe I can soon open my own shop — it’s great business here because the locals don’t make anything themselves, you can sell them everything,” says Mr Wu, who arrived two years ago. “I can save up most of my salary because there is no entertainment here.”

While many of the previous generations of Chinese immigrants are well integrated in local society, the newcomers have little social contact with islanders and often look down on them.

According to a government report published last month, many Chinese-owned businesses pay local employees less than the legal minimum wage and refuse to pay social security contributions. Moreover, Chinese entrepreneurs are increasingly moving into the local population’s last economic niches — including betel nut farming and the cargo and bus transport business. There are even recent migrants running fish and chips shops.

“Honiara is as Wild West as it gets,” says Graeme Smith, a China expert at Australia National University. “Ironically it might get better if China had diplomatic representation as its embassy might try to control its people a bit.”

China has become the country’s largest trading partner by far — unusual for a country that still retains diplomatic ties with Taiwan. China is absorbing the archipelago’s exports of timber, minerals, fish and palm oil and providing the Solomons with everything from cooking pots to roofing iron to plastic toys.

Volatility Could Cause More Pain as Funds Betting on Quiet Sell Down Stocks

Computer-driven funds amassed big equity positions while markets were sleepy

By Michael Wursthorn and Akane Otani

Recent swings in the stock market are threatening to unravel multibillion-dollar bets that rely on calm markets, potentially adding to investors’ jitters over the past week.

Computer-driven volatility-target funds generally scoop up riskier assets like stocks during calmer periods, hoping to gain as markets grind higher. When volatility hits, it sends them scrambling to sell their stocks and move into safer assets like Treasurys. Asset managers like Vanguard Group and insurance companies run some of the bigger strategies of this type.

Because markets have been so quiet this year, with the exception of episodes like Tuesday’s trade-driven pullback, the funds are especially loaded up on stocks. That has left volatility-target funds carrying the highest level of exposure to U.S. stocks since the fall, a troubling sign for those who believe the funds exacerbated some of the market’s worst selloffs in 2018.

Volatility-targeting funds had an estimated 44% equity exposure Tuesday. That marked their highest level of equity exposure since early October, when they had a more-than 60% exposure to stocks, according to Pravit Chintawongvanich, an equity derivatives strategist at Wells Fargo Securities.

After stocks tumbled Tuesday, Mr. Chintawongvanich estimates those funds sold about $10 billion in stocks a day later, knocking their allocations down to 41%—still around their highs for the year.

“If the next spike [in volatility] is higher, then you’ll see a more extended downmarket and we’d remove equities. You can get easily whipsawed,” said Duy Nguyen, a portfolio manager and chief investment officer of Invesco Solutions, who helps manage these strategies.

That’s especially true because analysts estimate volatility-target funds manage as much as $400 billion in assets—giving them considerable heft in the stock market.

To be sure, small bouts of volatility—like Tuesday’s selling—wouldn’t necessarily spur major changes within volatility-target funds, money managers said. Instead, they could actually boost returns since many of the funds tend to focus on stocks that have a lower level of volatility than the broader market.

And few analysts believe the bull market is necessarily in danger of an imminent end. U.S. economic data have pointed to steady, if moderating growth. Inflation has also continued to be muted, which traders believe will allow the Federal Reserve to keep interest rates low.

Besides that, trade tensions ratcheted down by the end of the week after Treasury Secretary Steven Mnuchin said negotiations with Chinese officials were “constructive.” The Cboe Volatility Index, or VIX, fell 16% Friday, while the S&P 500 added 0.4%. The broad index still fell 2.2% over the week, its worst weekly performance since late December.

But critics argue that such funds, along with the growing prevalence of automated trading, have altered the market’s natural tendencies, from sharpening moves in the S&P 500 to fueling historic stretches of tranquility, like in 2017.

With dozens of volatility-targeting funds employing similar, but nuanced, automated approaches around insulating investors from the stock market’s shocks, they typically sell stocks simultaneously during the worst downdrafts, analysts said. The group’s equity allocations swung from 83% in late December 2017 to 21% in February following 2018’s initial selloff, according to Wells Fargo. Allocations rose again in subsequent months, hitting 67% in early October, prior to the market’s decline, and bottomed out at 16% in late December.

Those moves weren’t spread over a long period. Instead, funds sold most of those assets over a few trading sessions, making their impact on the market that much more apparent, analysts said. If Tuesday’s decline had been more severe, on the scale of a 3% pullback in the market, Wells Fargo estimates that volatility-targeting funds would’ve sold roughly $36 billion worth of stocks.

That pales in comparison to October, when stocks began their fourth-quarter plunge, draining more than $100 billion from volatility-targeting strategies in a short span, Mr. Chintawongvanich said.

“You can see these funds moving together,” said Damian McIntyre, a portfolio manager at Federated Investors, who manages a volatility-targeting fund that is near the top of its equity-allocation range. “That can exacerbate any selloff and add a couple percentage points to the pullback.”

In some ways, the worries cropping up about volatility-target funds reflect broader concerns that investors have gotten complacent after a stunning market rebound.

Because investors have grown increasingly confident that risky assets will extend their rise, some traders worry unexpected developments like a further breakdown of trade talks or disappointing economic data could send markets sharply lower.

Stocks, commodities, and even ultra-risky assets like bitcoin have jumped this year, thanks to central banks signaling a pause in their rate-increase campaigns and global growth showing some signs of stabilizing. The S&P 500 has risen 15% this year, extending gains after logging its best quarterly performance since the financial crisis. U.S. crude-oil prices have soared 36% and bond yields, which fall as prices rise, have retreated from the multiyear highs they hit in 2018.

The rally has encouraged investors to pour money into riskier corners of the market while betting on declines in so-called haven assets. Individual investors have also grown more confident that stock prices will continue climbing, according to the American Association of Individual Investors, whose most recent weekly survey showed above-average levels of bullishness.

“We may not be getting close to the top, but it looks like we’re getting close to the end of the pendulum where the market has gone a bit too far one way,” said Frank Cappelleri, senior equity sales trader and chief market technician at Instinet.

Gold - The Calm Before The Storm

by: Florian Grummes

- Gold in corrective down-wave since end of February.

- Gold needs to clear resistance around US$ 1,350 – 1,375.

- Commitments of Traders report does look promising.

- Seasonality urges to be patient until end of June at least.

- Ascending triangle is bullish and could push Gold towards US$ 1,500 by spring 2020. 

The Midas Touch Gold Model™ Update May 2019
“The beginning of wisdom is the definition of terms.”
- Socrates
“Feelings are invulnerable to rational thought.”
- Stephen King
While gold (GLD) has been showing some signs of life over the last few days, I want to give you a comprehensive update about the current status of our Midas Touch Gold Model™. A detailed description of the model and its philosophy can be found on our website. As a summary, its strengths lie in versatility and quantitative measurability as it is carefully examining as many perspectives on the gold market as posible.
Since the nasty sell-off in summer 2018, gold prices had recovered in a slow but therefore convincing fashion towards the well-known multi-year resistance zone around US$1,350–1,375. But since February 20th at a peak of US$ 1,346, the gold market is in a clear correction and the final low of this down wave is not yet confirmed.
At the same time, the Midas Touch Gold Model has just recently improved to a neutral stance after flashing a sell signal since end of February. And although the three technical time frame components of gold in USDOLLAR (monthly, weekly, daily) currently do not look that bad, it still takes a gold price above US$1,310 to turn around the weekly chart. We need to consider that in such an extremely low volatile environment as gold finds itself right now, a fast US$30 plus move to the upside could already be the big game changer!
Looking at the current Commitments of Traders report (CoT), the medium-term outlook for gold is rather encouraging. The smart money, which of course are the commercial hedgers, does not hold a huge short opposition on gold futures. It might be still large enough to trigger a final panic sell-off towards June or July but certainly not a massive US$ 100 plus down wave.
Source: Seasonax
Combining the CoT-Report with gold's seasonality, the most likely scenario sees a continuation of the ongoing mild correction towards at least the 200- day moving average (US$1,253).
Probably between June and mid of August, gold should therefore find a bottom between US$ 1,200 and US$ 1,250.
Source: Tradingview
In the bigger picture, this would not violate the series of higher lows but strengthen the promising ascending bullish triangle formation which gold seems to tinker since its low at US$1,045.
If you consider the four ratio components of the Midas Touch Gold Model, none of them is screamingly bullish at the moment. In fact, the DowJones/Gold-Ratio is rather close to lose its bullish signal! But should the “sell in May cycle” plus the US-China trade dispute force stock markets lower, this power ratio would remain in favour of gold. The other three ratios will likely catch up once gold has seen its trend reversal in the next few months.
When goldmining managers have to justify the weak performance of their stocks, they often complain about ETFs as a passive investment competitor. Certainly, the current holdings of the GLD Gold ETF of 740 tonnes are rather shallow, but you can be sure that once gold can break above US$1,360, generalist investors will rush into these products as they did between 2004 and 2011.
Back then, the ETFs were one of the main drivers behind gold's bull market. But for the time being, the Midas Touch Gold Model considers GLD's recent stock movements as bearish. And talking about the miners and ETFs, the GDX and GDXJ have a sell signal since April 1, but it does not take much to flip this into a bullish reading which would signal a bounce from oversold levels.
Finally, the US Dollar might be the missing puzzle for gold's return. So far, gold has held up surprisingly well as the US-Dollar has been strengthening over the last 14 months. Currently, the model detects a sell signal for the US-Dollar and therefore a bullish signal for gold, while US real interest rates above 1% remain an argument against gold.
Source: Tradingview
Overall, the model is neutral and advises a neutral and patient stance until the typical summer low (normally to be found between end of June and mid of August). Should gold not dive too deep until these summer lows, the sleeping 5,000-year-old golden dinosaur might indeed have enough power to break through the resistance around US$1,360 later in autumn/winter and catapult himself towards US$1,500 by spring 2020!

China Tariffs May Change Fed’s Tune

Tariffs enacted on Chinese goods could send inflation higher, making it harder for the central bank to adhere to its dovish stance

By Justin Lahart

Jerome Powell is chairman of the Federal Reserve. Photo: jonathan ernst/Reuters 

Low inflation is the biggest reason the Federal Reserve has for not raising interest rates. The U.S.-China trade impasse could take that reason away.

Inflation was muted last month. The Labor Department on Friday reported that consumer prices rose 0.3% in April from March, putting them 2% above their year-earlier level. Prices excluding food and energy items, the so-called core economists examine to better understand inflation’s trend, were up 0.1% from March, and 2.1% on the year.

The data suggest the core of the Fed’s preferred inflation measure from the Commerce Department, which runs cooler than the Labor Department’s, remains below the central bank’s 2% target. This has been the focus of Fed officials who want prices to move higher so that too low inflation doesn’t become embedded in consumer expectations.

The Fed may soon get what it wants. Friday’s increase in tariffs on $200 billion of Chinese goods to 25% will, if it isn’t reversed, boost inflation. Absent any adjustments in China’s currency against the dollar, core inflation would increase by 0.4 percentage point, Deutsche Bank economists calculate.

To the extent that companies are able to find alternatives to imports from China, the effect on prices would be mitigated. Still, coupled with the passing of some transitory factors that have pushed it lower, inflation looks likely to get warmer.

It will get warmer still if President Trump follows through on his threat to place 25% tariffs on an additional $325 billion in Chinese goods that aren’t currently taxed. Unlike the current tariffs, these would affect many finished consumer goods, such as apparel, and as a result feed more directly into inflation. Moreover, since China counts as the world’s major producer for many of these products, the ability of importers to find alternative suppliers would be limited.

Would a tariff-induced increase in inflation cause the Fed to rethink its decision to not raise rates this year? Probably not. First, the central bank would likely view the effect of the price increases on inflation as temporary. Second, the tariffs also would have an economic cost—particularly if met by countermeasures from China—that could create a drag on growth.

Nevertheless, steeper inflation figures could also set a higher bar for the Fed to ease if growth cools, or if markets tumble in response to an escalating trade fight.

The central bank has been a friend to investors lately. That could change.

Why China Decided to Play Hardball in Trade Talks

Chinese negotiators emboldened by perception U.S. was willing to compromiso

By Lingling Wei in Beijing and Bob Davis in Washington

Chinese President Xi Jinping, left, with President Trump last month at a ceremony in Beijing. Photo: nicolas asfouri/Agence France-Presse/Getty Images

The new hard line taken by China in trade talks—surprising the White House and threatening to derail negotiations—came after Beijing interpreted recent statements and actions by President Trump as a sign the U.S. was ready to make concessions, said people familiar with the thinking of the Chinese side.

High-level negotiations are scheduled to resume Thursday in Washington, but the expectations and the stakes have changed significantly. A week ago, the assumption was that negotiators would be closing the deal. Now, they are trying to keep it from collapsing.

Adding to the pressure, the U.S. formally filed paperwork Wednesday to raise tariffs on $200 billion of Chinese goods to 25% from the current 10% at 12:01 a.m. Friday. Beijing’s Commerce Ministry responded by threatening to take unspecified countermeasures. At a campaign rally in Florida Wednesday night, Mr. Trump said Chinese leaders “broke the deal” in trade talks with the U.S.

In the current negotiations, the U.S. thought China agreed to detail the laws it would change to implement the trade deal under negotiation. Beijing said it had no intention of doing so, triggering Mr. Trump’s threat Sunday to escalate tariffs and bringing the dispute into the open.

The hardened battle lines were prompted by Beijing’s decision to take a more aggressive stance in negotiations, according to the people following the talks. They said Beijing was emboldened by the perception that the U.S. was ready to compromise.

In particular, these people said, Mr. Trump’s hectoring of Federal Reserve Chairman Jerome Powell to cut interest rates was seen in Beijing as evidence that the president thought the U.S. economy was more fragile than he claimed.

Beijing was further encouraged by Mr. Trump’s frequent claim of friendship with Chinese President Xi Jinping and by Mr. Trump’s praise for Chinese Vice Premier Liu He for pledging to buy more U.S. soybeans.

An April 30 tweet, in which Mr. Trump coupled criticism of Mr. Powell with praise of Chinese economic policy, especially caught the eye of senior officials. “China is adding great stimulus to its economy while at the same time keeping interest rates low,” Mr. Trump tweeted. “Our Federal Reserve has incessantly lifted interest rates.”

“Why would you be constantly asking the Fed to lower rates if your economy is not turning weak,” said Mei Xinyu, an analyst at a think tank affiliated with China’s Commerce Ministry.

If the U.S.’s resolve was weakening, the thinking in Beijing went, the U.S. would be more willing to cut a deal, even if Beijing hardened its positions.

That assessment, however, flies in the face of a strong U.S. economy. Gross domestic product in the first quarter rebounded from the end of 2018, with growth clocking in at a seasonally adjusted annualized rate of 3.2%, up from 2.2% the prior quarter. The jobs report for April, released on Friday, showed the unemployment rate falling to 3.6%, the lowest in nearly 50 years.

But at the same time, China’s economy has stabilized this year following months of weakness. Although China’s exports dropped unexpectedly in April, its first-quarter growth came in at 6.4%, beating market expectations. The generally improving economic picture gave Beijing more confidence in trade talks, as did a recent conference on the country’s vast infrastructure-spending program, called the Belt and Road Initiative, which was attended by about 40 heads of government and state.

Chinese leaders saw the conference turnout “as China has more leverage to improve relations with other countries and with the U.S. business community,” said Brookings Institution China specialist Cheng Li. “It made them play hardball.”
If China misread the signals—and vice versa—it wouldn’t be the first time.
 The history of U.S.-China trade negotiations is filled with misunderstandings, as the two nations, with very different political systems, struggle to figure out each other’s intentions.

Pocketbook IssueMany Chinese-made consumer goods areamong the imports targeted for tariffincreases on Friday. In 2017, the U.S. imported$42 billion of those products.Consumer goods imported from China, 2017Source: Peterson Institute for InternationalEconomicsNote: Figures may not add up to total due torounding.

When China was negotiating to join the World Trade Organization in the late 1990s, for instance, China’s premier visited Washington mistakenly expecting then-President Clinton to approve a deal. At the end of negotiations in Beijing, then-U.S. Trade Representative Charlene Barshefsky walked out on the talks, convinced that Beijing was jerking her around, only to come back and finish the deal.

“China has often pushed back on specific commitments during the negotiations,” said Clete Willems, who recently left as White House trade negotiator to take a job at the law firm of Akin Gump. “These are difficult things to undertake, but critical to a successful outcome.”

In addition to the tariff increase slated for Friday, Mr. Trump has also said he plans to “shortly” levy new 25% tariffs on $325 billion of Chinese goods, a move that would widely affect consumer goods.

The aggressive U.S. response initially cast doubt on a trip by Mr. Liu to Washington this week. Mr. Liu is now scheduled to lead talks beginning Thursday, a day later than originally planned. He is scheduled to have a one-on-one dinner with U.S. Trade Representative Robert Lighthizer Thursday.

Unlike prior visits, Mr. Liu wasn’t given the title of Mr. Xi’s “special envoy,” suggesting that he doesn’t have the power to make significant compromises. The Chinese delegation has also been slimmed down from the 100-plus team originally planned, although the entourage will also include Commerce Vice Minister Wang Shouwen and Finance Vice Minister Liao Min.

In another apparent sign of mixed signals, Trump administration officials had thought they had made it clear that they were weary of negotiations and that it was time for Beijing to make specific commitments to change laws, including adding protections for intellectual property and barring the forced transfer of U.S. technology.

Comments last week by Mick Mulvaney, the president’s acting chief of staff, were supposed to drill home that notion. The talks “won’t go on forever,” he said in Los Angeles. “At some point in any negotiation you go, ‘We’re close to getting something done so we’re going to keep going.’ On the other hand, at some point you throw up your hands and say, ‘This is never going anywhere.’”

But at the same conference, Treasury Secretary Steven Mnuchin sent the opposite signal, saying the talks were “getting into the final laps.”

As talks resume Thursday, one big question mark is whether China will agree to U.S. demands for changes in Chinese law to implement the trade deal. Beijing maintains this would impinge on Chinese sovereignty and take too long to implement, but Beijing had made similar commitments in prior trade deals, including those it signed to join the WTO in 2001.

U.S. officials say Beijing has failed to make good on those commitments, while China has promised to further liberalize its economy.

“The U.S. is correct to seek a multiprong approach of not relying solely on commitments but also actually changes to the laws, so as to ensure Chinese leadership intentions are fully conveyed down to all local levels of government,” said Harvard Law Professor Mark Wu.