The Wall of Worry

 

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There is a concept in investing called “climbing the wall of worry”.  The idea is that when there are things to worry about in the markets, investors usually do well because they are cautious.  When there are not things to worry about, investors take more risk and are usually disappointed.  We have plenty to worry about in today’s markets: a fully valued stock market; record low interest rates that will rise some day; Brexit; the potential breakup of the European Union (EU); a credit bubble in China and a slowing Chinese economy; Italian banks in serious trouble; earnings per share declining for US companies; and terrorism to name a few.

Brexit

On June 23, 2016 the British voters elected to leave the (EU) for several reasons among which are immigration, the financial support through the European Central Bank (ECB) of the southern economically weak countries and the economy in the UK.  The vote raises doubts about the survival of the EU and calls for more referendums in other countries.  There are 27 member states left.  Before Britain’s vote Donald Tusk, Poland’s former Prime Minister and President of the European Council of national government leaders, warned in a speech that ordinary European citizens did not share the enthusiasm of some of their leaders for “a utopia of Europe without nation states”.  He said, “The spectre of a break-up is haunting Europe and a vision of a federation doesn’t seem to me to be the best answer to it.”  The EU was founded in 1957 by the Treaty of Rome and this is the first time a member will leave.  The monetary union has existed for 17 years.  There is dissatisfaction in other countries like Germany, who is not happy with the monetary policies of the ECB under Mario Draghi, its president.  These include extremely low interest rates, viewed in Germany as penalizing savers, and the central bank’s asset-buying program, regarded in Berlin as sure to open the floodgates one day to inflation.  Scotland and Ireland are considering referendums to leave the UK.  In France, political conditions are equally unsuitable for grand initiative on the EU stage.  The biggest concern for French President Francois Hollande is a challenge from Marine Le Pen, the National Front’s leader who welcomed the Brexit decision and wants a French vote on EU membership.  After the attack in Nice recently, polls showed a lack of confidence in Hollande to protect the French people from terrorism.  This doesn’t mean that the EU will fall apart, or even that another country will leave, but the centrist politicians who run nearly every EU member state will be on the defensive against populist forces who oppose them and the EU.

Pension Plans

Savers, retirees, foundations, pension plans, banks and insurance companies have been suffering from the Federal Reserve’s and other central banks’ policies of near-zero interest rates.  These are people and institutions that have relied on interest from bonds and financial institutions to supplement social security in the case of retirees; to grow savings for savers; to fund the spending rate at foundations; to earn income on the deposits at banks; to earn income on the premiums paid to insurance companies; and to meet the actuarial rate at pension plans.  This applies not only to the US but all over the world as interest rates have reached historic lows.  John Authers, an economist and contributor to the Financial Times, described the problem for pension plans in an article in the Financial Times on July 9, 2016 entitled “Hunt for the middle ground to avert pension poverty”. 

Here it is:

Pensions.  I may have lost half my readership with that one word.  But if any financial issue could open wider the world’s ugly social fissures, it is pension.  An already dire situation has been rendered worse by the bond market’s drastic response to the UK referendum.

At least three basic problems bedevil attempts to ensure that people have enough to live on after they retire.  One we can do little about: people are living longer, while birth rates are declining.

A second problem has become acute with the latest fall in bond yields.  Rising prices for bonds, generally driven by a perceived risk of recession, directly translate into lower yields.  The income they pay out each year is a lower percentage of their price.

Following the referendum, UK gilt yields are at their lowest.  Ten-year gilts yield less than 1 percent for the first time.  The yields of several large economies, including Germany, were already negative. This week US Treasury yields dropped below 1.4 percent for 10-year notes, bringing them to a historic low, five years after many had assumed the bond market had finally turned.  This is alarming for everyone, but potentially disastrous for pension funds.  First, their expected returns from buying bonds are lower. As they are historically expensive, there must be a risk of a loss.

Second and more important, it is harder for them to buy income.  On retirement, if you want to guarantee an income, you must buy bonds.  The lower their yield, the more you must spend.

Few pay attention to the dry subject of pension accounting, which is just as well, as the latest figures are terrifying.  According to Mercer, the pension deficits - the extent to which a pension funds' assets lag behind the amount they need to fulfil their promises of retirement income to members of UK FTSE-350 companies leapt last month to a record of £119bn, up £21bn since May.  This was almost entirely because of the fall in gilt yields.

Mercer's actuaries suggest UK groups will have to pay extra money into their pension funds.  That will mean less money for investment and growth, and for shareholders, but beats the alternative of future penury for their staff.  Figures for the US are barely less alarming.

This leads to a final significant problem.  These numbers are for "defined benefit" pension plans, which follow the traditional model of guaranteeing an income, usually as guarantees more expensive, we have moved to "defined contribution" pension plans, in which employees pay into an investment fund, with contributions from their employers, and enjoy whatever the proceeds turn out to be.  There are no guarantees.

The DB deficits indicate problems for everyone.  Those on DC plans will want to guarantee themselves an income.  Many are already saving too little, a habit arguably encouraged by the DC structure.  This points to a flaw in the way pensions are designed.  The dichotomy between DB, or full guarantees, and DC, or zero guarantees, is dangerous, and derived from an accident of history. DB pensions took hold when yields were high, lives were short, and pensions were regarded as a form of insurance.  They could easily be afforded.  DC pensions took hold during the bull market of the 1980s and 1990s, when for a brief deluded moment it seemed people might want the maximum they could get from the market, without limiting their upside with any guarantees. Such thinking is long gone.

That dichotomy must be rethought as it is bound to cause strife.  Of course companies cannot in current conditions be expected to guarantee all of their employees' income in retirement; but it is equally obvious they should guarantee at least some of it, and not leave employees at the mercy of the market.  There is a lot of space between guarantees of zero and 100 percent.

Whatever the solution, the problem is critical.  If rising bond prices and poorly designed pensions are not to create yet more inequality, poverty and anger on the part of those who feel abandoned by capitalism, it is vital to work out a model for pensions that is fairer than DC, and more practical than DB.

Debt

Van Hoisington and Lacey Hunt, Ph.D. at Hoisington Investment Management Company once again have been right about the direction and magnitude of the fall in interest rates.  We suspect they will continue to be right and rates will go lower from here.  In their latest quarterly letter they remind us of the effects of too much Federal debt and its effect on GDP.  Please see an extract from their letter below:

Deleterious Levels. Federal debt has subtracted, to at least some degree, from US economic growth since about 1989 when debt broke above 50% of GDP, a level to which this ratio has never returned. The macro consequences of the debt are becoming increasingly significant. This may seem surprising to many because of confusion about the scholarly work of Carmen Reinhardt and Kenneth Rogoff (R&R) in their 2009 book, This Time is Different.

The misinterpretations pertain to a key point in R&R’s book and accusations of data inaccuracies  in the  statistical  calculations.  R&R  said  debt  induced panics  run  their course in six to ten years, with an average of eight years. The last panic was in 2008, so according to their early work the time span has either ended, or is close to ending. However, the six to ten year time reference does not apply when debt levels continue to move higher over that time period. In the latest quarter, gross federal debt was 105.7% of GDP, compared to 73.5% in the final quarter of the 2008 panic.

A number of other studies, along with R&R themselves, superseded the 2009 conclusions. In 2012 in The Journal of Economic Perspectives (a peer reviewed publication of the American Economic Association), R&R joined by Vincent Reinhardt (RR&R) identify the 26 major public debt overhang episodes in 22 advanced economies since the early 1800s, characterized by public debt-to-GDP levels exceeding 90% for at least five years. The five-year requirement eliminates purely cyclical increases in debt and most of those caused by wars. RR&R find that public debt overhang episodes reduce the economic growth rate by slightly more than a third, compared with growth rates when the debt metric is not met. Additionally, among the 26 applicable episodes, 20 lasted more than a decade, and the average duration of the debt overhang episodes was a staggering 23 years. The length contradicts the notion that the correlation is caused mainly by debt buildups during business cycle recessions and confirms that the cumulative shortfall in output from debt overhang episodes should be massive. Finally, it is interesting to note that in 11 of these episodes interest rates are not materially higher; thus, the growth-reducing effects of high public debt are not transmitted exclusively through high real interest rates.

The US has currently met RR&R’s criteria for slowing growth. Gross government debt exceeded 90% of GDP in 2010 and has continued to move higher since then, thus exceeding the consecutive five-year benchmark. Equally important, the debt problem is worsening. At the end of this year the government debt-to-GDP ratio will have surpassed 100% in each of the past five years, thus debt is moving into a significantly higher range.

The presumption of policy makers is that more deficit spending and debt is needed to address economic underperformance. While the intentions are well-meaning, the policy makers unwittingly cause an even faster rate of economic deterioration. In view of the future levels projected by such impartial sources as the Congressional Budget Office, debt will increasingly bite into the economy’s growth rate, which is a situation well documented in Japan.

The Market

The stock market is once again making new highs.  Until recently the S&P 500 Index had gone nearly 14 months since its last record peak in May 2015.  In the short term these are signs that the 8% bounce off of the late June Brexit lows is peaking.  Nine of ten S&P 500 stocks are straining above their 50-day averages.  Investing feels like an exercise in choosing the least risky asset, which means stocks – because what else is there?  Treasury yields are sagging near all-time lows, and last week investors actually paid to lend money to Berlin, Germany when they bought 10-year German bonds at a negative yield.  Roughly 30% of global bonds, or $13 trillion worth, now have negative yields, up from none just two years ago.  All of this forces investors looking for bond substitutes to go further out on a limb – into stocks, real estate, emerging markets and high yield.

It would be one thing if rising valuations were accompanied by rising profits, but second quarter earnings are projected to fall 5% for the fifth straight quarterly decline.  The S&P 500 already trades at 18.5 times what companies earned.  Record buybacks support stocks, but how long can companies keep buying back shares at these multiples?

Conclusion

The US economy seems to be the best in the world at the present time.  Interest rates in the US are higher than most other developed countries and therefore are attractive to investors seeking returns and safety.  This should continue and should keep interest rates low and going lower.  Our stock market is at an all-time high and may go higher for the same reasons.  Even though US companies are not experiencing top line growth and even though earnings per share are declining, our market is the most attractive because it is trusted and safe.

We have recommended a lower exposure to international stocks of 10% versus the long term strategic allocation of 20% for years now, and this has proved to be a good idea.  We expect the US to outperform most other markets and with less volatility.  We do expect volatility, however, to continue in both the stock and bond markets. 

 

Jamison Monroe
Chairman & CEO
Director of Consulting