Monday, October 20, 2014

Time to Plunge Into Stocks?

Heather Pelant, Managing Director of Blackrock comments, An investing Secret for When the Market Drops:
Back in August, I wrote a piece called “Why Cash is Not a Strategy.” I confessed then that like many people, I was sitting on more cash than I knew was good for me. Well, here’s an addendum: I’ve started moving off the sidelines.

Yesterday I rode the market roller coaster with countless other investors, wondering how low it would go and how to react. Shock set in when the 10-year Treasury yield – a key economic indicator – dipped below 2%. Practicing what I preach, I decided to take the cash I’d been keeping on the sidelines and bought in when I saw the Dow drop 245 points. But it wasn’t easy particularly as I watched the images of red faced traders trying to make it through what turned out to be one of the worst days in the market in the last 4 years. My stomach flipped again when I saw the market had dipped further down 460 points and I thought should I have waited a little bit longer? When all was said and done, however, I felt secure in my decision to take action and I know I’ll hold what I bought for the next 20 years. Not a bad result for a three-hour emotional roller coaster.

Of course, investing is an intensely personal decision, based on your own goals, age, risk tolerance, and so forth. But I do think that bursts of volatility are “teachable moments” about your emotional motivators and ways to potentially overcome them. Here are a few ideas to think about:

This is what buying low feels like

Buying when the market is dropping can be intimidating. It requires jumping in when everyone is selling. This is especially daunting for an investor just starting to test the waters and getting acquainted with the market. But think of it this way: buying on market dips is similar to buying something on sale. You’ve wanted it for a while, you know it is worth more than the sticker price and you’re getting a big discount. If we apply this principle to the market, it is the working definition of “buying low, selling high”. Taking a contrarian action is essentially what buying low means.

It’s a good time to start moving your cash

For those of you (or us) sitting in cash, a selloff may be the perfect opportunity to dive in at the right price. We can take an example from the playbook of savvy investors. BlackRock data indicates that when the market dipped yesterday, a number of them bought in, putting their money into core exchange traded funds (ETFs) to the tune of more than $2B. These key players know how and where to seek value – you may want to follow their lead.

Be prepared for more

Getting into the habit of buying in when the market hits a bump may be a good idea. My colleague Russ Koesterich highlights in a recent Blog post that volatility is likely here to stay for a while. We can see yesterday’s tumultuous ride as a lesson for the next dip. Stick to your long term view and don’t worry so much about the right now. Take advantage of discounted stock prices and hold on for the long haul.
Similarly, Tracy Ryniec, Value Stock Strategist at Zacks comments, Why Great Investors Love This Market:
For the first time in three years, stocks have sold off big, with the Russell 2000, the small cap index, falling over 10% and the Dow Industrials plunging as much as 450 points in one session.

It's been a rocky few weeks that has left investors shaken and on edge.

But that's the thing about stock market corrections. They create buying opportunities.

During bull markets, it's fairly easy to post solid numbers year-after-year in a portfolio. But who is still standing when the stuff hits the fan?

Great Investors Are Made Through Adversity

When market sentiment turns negative, those with the guts to get in are rewarded. Two of the greatest investors in the last 75 years, both value investors, were tested in both bear and bull markets.

Was it always easy? Heck no.

John Templeton, the founder of Templeton mutual funds, was shaped by the stock market of the Great Depression. In the same vein, Warren Buffett made his fame by going on a buying binge during the Super Bear Market of 1972-1974.

Great investors emerge when the going gets tough because that's when the greatest profits can be made.

Do You Have What It Takes?

Looking at the careers of Buffett and Templeton, three criteria for being a great investor emerge:

1) Be a contrarian 2) Timing is everything 3) Patience

Be a Contrarian: Buy When Others Are Not Buying

The classic definition of a value investor is someone who buys companies that are not on everyone else's radar. They are out of favor or, frankly, mocked. Both John Templeton and Buffett are known for being value investors.

John Templeton put himself through college during the Great Depression and then set out to start his career on Wall Street during the worst possible time.

It was the late 1930s and stocks, which had crashed during the Great Depression in 1929, still hadn't fully recovered.

In 1939, with the world going to war, he decided to buck the convention that stocks stunk. He borrowed money to buy 100 shares each of 104 companies that were selling at $1 a share or less.

Some might have thought he was crazy as 34 were in bankruptcy at the time.

But the risk paid off.

Ultimately, only 4 of the companies ended up being worthless and the rest went on to large profits.

Timing is Everything

Warren Buffett hasn't always been 100% invested in stocks.

In 1969, as stocks were heating up, Buffett cashed out of all of his holdings, telling Forbes Magazine in 1974: 'When I got started the bargains were flowing like the Johnstown flood; by 1969 it was like a leaky toilet in Altoona.'

But by 1974, after two years of stock market carnage during the super bear market of 1972 and 1973 which made stocks cheap, Buffett was back in the game.

Forbes asked him what he felt about the markets that year: 'Like an oversexed guy in a harem,' he shot back. 'This is the time to start investing.'

By the time the interview was set to run in the magazine, the markets had rallied 15% and Forbes asked him if he was still feeling the same way.

'I don't know what the averages are going to do next,' he replied, 'but there are still plenty of bargains around.' He told Forbes that the situation reminded him of the early 1950s.

Sound familiar?

Recently, Buffett was back to his predicting ways, telling CNBC on Oct 2, 2014 that he had just bought stocks after they sold off big the day before.

'The more it goes down, the more I like to buy,' he said.

Patience is a Virtue for Great Investors

Patience is also critical to being a great investor because market conditions don't always change on a dime. You have to be prepared to stand by your convictions, which can mean waiting a long time for sentiment to move your way.

Buffett added to his positions in 2009 in the middle of the doom and gloom of the financial crisis and he just added to his positions again this month.

Templeton held his 1939 investments on average for 4 years, despite a World War.

Do You Dare to Be a Great Investor?

Volatile markets are opportunities to elevate your investing game.

The investing lessons of John Templeton and Warren Buffett are there for the taking.

Both were value investors who looked for bargains when times got rocky.

That's exactly the market conditions that we find ourselves in right now. Suddenly, some stocks that were trading at all time highs are down double digits and look attractive again.

But with all the noise from television talking heads and the Internet and with thousands of stocks to choose from, how can you know where to even begin to find the right value stocks?

Finding the Best Value Stocks

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This proven strategy outperformed the S&P 500 with an overall gain of +36% in 2013. Our success accelerated in the first and second quarters of this year as the market punished overvalued stocks.

Currently Value Investor includes 24 stocks that are 'on sale' right now and are likely to head a lot higher in the months to come. Even more important, I'm currently tracking undervalued sectors with companies who show solid fundamentals, and today is the perfect time to get aboard at the ground floor for the full ride upward. This is a value service, so I am glad to report that starting today you can receive our best value stocks, plus recommendations from all of Zacks' portfolio services, for a full month at a total cost of just $1.
Every Saturday morning, I sit in front of my computer and look at snapshots of over 2000 stocks in about 100 sectors, industries and themes I track. Here is a small sample of the industries and themes I track (click on image):


I've built a large database over the years and keep adding to it. I can then screen various stocks and see which ones are overbought/oversold or if there is strength/weakness in a particular sector.

In addition, I regularly look at the YTD performance of stocks, the 12-month leaders, the 52-week highs and 52-week lows. I also like to track the most shorted stocks in various exchanges.

What else? I'm a macro guy and love reading macro articles from various sources. In these markets, macro matters a lot more than an individual company's fundamentals and those who ignore the macro environment are doomed to underperform.

I was recently contacted by Seeking Alpha to post some of my market thoughts on their site (was on there years ago but hardly posted). I try to read as much as possible and comment as well. A few articles on macro caught my attention.

First, my former colleague from BCA Research and now partner at MRB Partners, Mehran Nahkjavani, wrote an insightful comment on the winners and losers in emerging markets as oil prices tumble. Mehran focuses on excess supply of oil but as you'll read from my comment at the end of his article, I believe the drop in oil prices has more to do with eurozone's deflation demons spreading to the rest of the word, including the United States. If that's the case, all emerging markets are in big trouble.

Second, Michael Gayed, co-CIO at Pension Partners, wrote a comment on why the real correction is to come, stating "the intermarket movement thus far has been reminiscent of the Summer Crash of 2011, though not as violent nor severe yet." (Make sure you read Michael and Charles Bilello's paper, An Intermarket Approach to Tactical Risk Rotation: Using the Signaling Power of Treasuries to Generate Alpha and Enhance Asset Allocation).

In his comment, Michael notes the following:
Inflation expectations, as shown by the TIP/TENZ ratio, now sits at support. If they break down from there, the Fed may be in trouble, as it suggests domestic deflationary fears would be rising. Small-caps could continue to outperform purely because of how oversold they are relative to large-caps this year, but there have been plenty of instances historically where equities fall even though small-caps are outperforming into the decline. Credit spreads on both the sovereign level and in the corporate space are the canaries in the coal mine. A continuation of their widening means the current correction is likely not over, could result in a panic, and bring a thematic change to how investors perceive not only the future, but central bank power to direct it. Should that occur, that would be the real correction to be afraid of.
I commented the following at the end of that article:
Michael, I agree with you, too many people are ignoring eurozone's deflation crisis and its potential impact on inflation expectations in the United States. I happen to think that inflation expectations are going to drop significantly and that's why the Fed is prepping markets for more QE.

Interestingly, Dallas Fed President Richard Fisher was on CNBC this morning scoffing at the idea of more QE but he's a hawk and is underestimating contagion effects.

One area where I disagree with you is on timing. I believe the real risk is the stock market right now is another melt-up, especially in biotech, small caps and technology. Once we get through this liquidity rally, then deflation will set in and hammer all risk assets. But this could be a few years away, imho. 
Timing is everything here. I'm actually amazed at how many people are ignoring the contagion effects of eurozone's deflation crisis and what this means for Fed policy going forward. Let me be blunt here, if inflation expectations in the United States continue to drop, the Fed will once again entertain the possibility of engaging in more quantitative easing ahead.

Most commentators dismiss the possibility of more QE ahead but watch, if things get uglier in Europe and inflation expectations keep dropping around the world, I guarantee you more QE is on the way. And I think markets are starting to realize this which is why you're seeing risk assets take off after the latest selloff.

But as I wrote in my last comment on the Fed prepping markets for more QE, you have to be very careful here or risk getting slaughtered. I would steer clear of energy (XLE) and materials (XLB) which are prone for more weakness ahead. They're bouncing back after suffering steep losses but use any relief rally to shed your positions in these sectors.

I especially want you to be very careful  of some energy companies where you can easily fall into the classic "value trap" thinking the worst is over and the fundamentals justify buying the dip or adding to your positions. 

Have a look at the one year chart of SeaDrill Limited (SDRL) by clicking on the chart below:


The stock is unquestionably oversold and it's tempting to buy it here because it's due for a bounce and you can even collect a 17% dividend yield to cushion any further weakness in the price per share. You'll read an article on drilling for dollars that tells you now is the time to buy this stock.

It's a no-brainer, right? WRONG! What this guy doesn't tell you is that other oil drilling stocks like Ensco (ESV), Noble (NE), and Transocean (RIG) have all been pummeled in the latest selloff and they all have high dividends which they will be forced to cut if the price of oil drops further. Also, some of these companies have weaker balance sheets than others, putting their dividends at higher risk (and if they cut their dividend, shares are going lower).

Sure, these stocks can bounce up from these oversold levels but I would use any relief rally here to shed positions, not initiate or add to your positions. I can say the same thing about plenty of other energy and commodity stocks. Be very careful buying the dips here because there will be further weakness in these sectors, you will end up regretting it.

And it's not just energy and commodities. This market is becoming more and more selective. I tell all my friends and family to be careful with a lot of stocks, especially high dividend stocks. I think some will outperform in a deflationary environment (because rates will remain low for many years) but others are going to get slaughtered.

Closer to home, there are a lot of Canadians invested heavily in Canadian banks because of the dividends they offer and their nice outperformance since the financial crisis erupted but there too, I would be very careful. I remain short Canada and think much darker days lie ahead as oil prices continue to tumble and euro woes hit us too.

There are a lot of things on my mind right now. A lot of scenarios playing out in my head and I'm trying to gauge the risk of each one of them. I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come. 

Keep an eye on companies like Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Seattle Genetics (SGEN), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.

Are there other stocks I like at these levels? Yes but I'm waiting to see what top funds bought and sold in Q3 before delving into more stock specific ideas. All I can say is tread carefully here and know when to buy the dips and more importantly, when to sell the rips.

Below, Richard Fisher, Dallas Fed president, says the U.S. economy is improving and he sees no reason not to raise interest rates by spring of 2015. I'm amazed at how Fisher, a well-known hawk, completely dismisses the contagion effects from eurozone's deflation crisis and how it's influencing U.S. inflation expectations. He's wrong and the threat of deflation will force him to change his views in the months ahead.


Friday, October 17, 2014

Fed Prepping Markets For More QE?

Bullard Says Fed Should Consider Delay in Ending QE:
The Federal Reserve should consider delaying the end of its bond-purchase program to halt a decline in inflation expectations, said St. Louis Federal Reserve Bank President James Bullard.

Bullard, who helped lay the intellectual groundwork for the Fed’s quantitative easing program, said U.S. economic fundamentals remain strong, and he blamed recent financial-market turmoil on downgrades in the outlook for Europe.

“Inflation expectations are declining in the U.S.,” he said in an interview today with Bloomberg News in Washington. “That’s an important consideration for a central bank. And for that reason I think that a logical policy response at this juncture may be to delay the end of the QE.”

Bullard is the first Fed official to publicly suggest the central bank should extend its asset-purchase program when policy makers meet later this month. U.S. stocks erased losses and Treasury yields rose on expectations the Fed will take action to insulate the U.S. from global economic weakness.

“We are watching and we’re ready and we are willing to do things to defend our inflation target,” Bullard said.

Fed officials are scheduled to next gather on Oct. 28-29 and have said they expect to end asset purchases after that meeting. The program has already been wound down to combined monthly purchases of $15 billion of Treasuries and mortgage backed securities, from $85 billion in December 2012.

Committee Intentions

“Fifteen billion by itself is not that consequential,” Bullard said. “But what is consequential is committee intentions on future QE, and we have certainly seen through the taper tantrum how important those can be.”

He was referring to an episode last year when Treasury yields shot up after then-Chairman Ben S. Bernanke said the Fed would start slowing bond-buying sooner than expected.

Bullard said he continues to forecast the first Fed interest-rate increase at the end of the first quarter, based on the expectation that the current global market turmoil won’t affect U.S. prospects. Economic growth could be bolstered by declines in oil prices and long-term interest rates, he said.

A pause in tapering would protect against “downside risk” and bolster inflation expectations, he said. “We could react with more QE if we wanted to.”

The Standard & Poor’s 500 Index (SPX) rose 0.4 percent to 1,870.25 at 1:37 p.m. in New York after dropping as much as 1.5 percent. U.S. 10-year Treasury yields rose two basis points, or 0.02 percentage point, to 2.16 percent.

Bullard Paper

Bullard, who doesn’t vote on policy this year, has been seen as a bellwether because his views have sometimes foreshadowed policy changes. He published a paper in 2010 entitled “Seven Faces of the Peril,” which called on the central bank to avert deflation by purchasing Treasury notes. That was followed by a second round of bond buying.

“Bullard is a very practical voice at the Fed, and changes in his views often reflect the swing in the balance of risks in the economy,” said Mark Vitner, senior economist at Wells Fargo Securities LLC in Charlotte, North Carolina.

“The Fed is highly attentive to the outlook for the economy, and the outlook for the global economy has deteriorated,” Vitner said. “Inflation looks like it has decelerated and may decelerate further.”

Stocks, Oil

The 10-year Treasury yield fell below 2 percent yesterday for the first time since June 2013 as weaker-than-forecast economic data added to concerns that economic growth is slowing. That worry has helped push down stocks, oil prices, and measures of inflation expectations, while increasing the value of the U.S. dollar relative to trading partners.

The Fed aims for 2 percent inflation, as measured by the personal consumption expenditures price index, which was 1.5 percent in August and hasn’t exceeded 2 percent since March 2012. Expectations of future inflation, which are important because they can affect spending by businesses and households, have dipped in recent months alongside a decline in oil prices.

A Bloomberg measure of market forecasts for average inflation over the next five years was 1.49 percent at 1:41 p.m. in New York, compared with 2.1 percent in June.

The Fed has said its policies are dependent on evolving economic data as it seeks to steer the economy to full employment and stable prices.

“I am saying today that maybe we should invoke the data dependent clause on the tapering,” Bullard, 53, said. “I think that is our simplest step that we can take in this circumstance.”

On the other hand, he said U.S. economic fundamentals remain strong, and he hasn’t downgraded his forecast for growth of 3 percent or more in the second half of 2014 and 2015.

“The hard data on the U.S. is good,” he said. “The last jobs report was quite strong.” The jobless rate fell to 5.9 percent in September, and payrolls expanded by 248,000.
This is the most important event during this wild and volatile week. Why? Because the Fed is telling market participants it is very worried about Europe's deflation demons spreading to the United States and elsewhere and it stands ready to act fast if deflation creeps into inflation expectations.

The most important thing Bullard said yesterday during this Bloomberg interview was this: “We could react with more QE if we wanted to.”

Now think about it. You've got Mario Draghi who is constantly being warned by German leaders not to engage in massive quantitative easing, effectively limiting the European Central Bank's response to fight deflation in the eurozone.

What Draghi is proposing is some form of asset purchases but these measures are considered mostly cosmetic which is why shares in Europe plunged earlier this week before rebounding once markets caught wind that the Fed is standing ready to move.

And European bank shares led the late week rally after selling off strongly earlier this week. Why? Because if the Fed delays its tapering, or engages in more QE, it will basically aid them into shoring up their weak balance sheets. They can basically buy U.S. bonds, lock in the spread and improve their liquidity.

The Fed is basically telling Europe's big banks: "Don't worry about Angela Merkel, Wolfgang Schäuble, and the lack of major QE from the ECB. If they don't act, we will act in a forceful manner allowing you to use our balance sheet to shore up yours."

And that ladies and gentlemen is huge news for markets because it sends a strong message to short sellers salivating at the prospect of a eurozone collapse that the Fed isn't about to stand by and let it happen. Why? Because a eurozone collapse will unleash those deflation demons and ensure the U.S. and rest of the world are heading for a protracted period of debt deflation.

Even the threat of more QE from the Fed is enough to send shivers down short sellers' spines which is why you will likely see risk assets rallying during the second half of October and into year-end. Pay attention here to the ten-year Treasury yield (^TNX), the euro/USD exchange rate, crude oil prices, and small cap stocks (IWM) which have led the rally out of the selloff earlier this week.

As far as stocks, I've said it before, the real risk in the stock market is a melt-up, not a meltdown. We're going to get a massive liquidity rally unlike anything you've ever seen, then you'll need to worry about the massive hangover and protracted debt deflation, which remains my ultimate endgame.

In this environment, you have to pick your spots carefully or risk getting slaughtered in the stock market. I would steer clear of energy (XLE) and materials (XLB) which are prone for more weakness ahead. They're bouncing back after suffering steep losses but use any relief rally to shed your positions in these sectors.

I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come. Keep an eye on companies like Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.

What's the biggest risk to my scenario? A significant crisis of confidence if the Fed actually does engage in more quantitative easing and market participants think it's way behind the deflation curve. That's the scenario that keeps James Bullard and Janet Yellen awake at night but for now, I wouldn't worry about any deep crisis of confidence. 

Below, Federal Reserve Bank of St. Louis President James Bullard talks about monetary policy, U.S. economic fundamentals and the global economy. Bullard, speaks with Michael McKee on Bloomberg Television's "Market Makers." Take the time to listen to this interview, it's by far the most important market event of the week.

Thursday, October 16, 2014

Beyond Public Sector Pension Envy?

Adam Mayers of the Toronto Star comments, A closer look at our public sector pension envy:
Canadians who don’t have a pension often cast an envious eye at their friends and family who work in the public sector, maybe as nurses and hospital technicians, teachers, firefighters, police or municipal workers.

This is because 76 per cent of private sector workers don’t have a pension of any kind. But 86 per cent of public sector employees do. Most public sector pensions are the best kind — defined benefit plans paying a monthly amount for life. Many are adjusted for rising inflation.

If you were one of the have-nots, a diligent saver socking away all you could in a Registered Retirement Savings Plan, the 2008-09 stock market crash made you worth up to 40 per cent at the bottom. Markets have recovered — the current plunge notwithstanding — but even so, public sector pension envy has been on the rise. Safe. Secure. Indexed.

A recent Toronto conference on pension reform sponsored by Canada’s Public Policy Forum, took a closer look at the divide. Critics say public sector plans are unaffordable and unfair, and should be wound up. But would it really be cheaper and fairer to do so?

Billionaire investor Warren Buffett said this spring that public pension plans threaten the financial health of U.S. cities and states. He said everyone has underappreciated “the gigantic financial tapeworm” created when the pension promises were made..

Former provincial Conservative party leader Tim Hudak brought the debate out of the shadows in the recent Ontario election. He pledged to grandfather the current defined benefit model for public servants and move to defined contribution plans which shift a lot of the risk onto employees.

Defined benefit plans guarantee that monthly payment and you can sleep easier because professionals manage the money and your company has to ante up if there’s not enough in the pot.

A defined contribution plan is one where employer and employee contribute, but the size of the pension pot varies with market conditions. When you retire it’s up to you to invest and manage the money. The risk is yours.

About 12 per cent of private sector workers have a defined benefit plan, a number that has been steadily declining. Companies don’t like these plans because investment returns are hard to predict and whatever happens to markets the risk is all theirs.

Robert Brown, a retired professor of actuarial science at the University of Waterloo, told the conference that pension envy aside, it’s a bad, bad idea to wind up these public sector plans. Brown co-wrote a paper with colleague Craig McInnes that looked at the cost of conversion.

Brown summarized the finding by saying it will cost us a lot of money to cap the plans. Going forward, retirees would end up with a smaller pension and at the end of the day taxpayers would foot the difference with income supplements.

“It is a lose-lose,” Brown said.

Here are some of Brown’s other conclusions:
  • Private and public sector goals are different. It’s in the best interests of companies to cut costs and focus on profits. But when they off-load costs, they don’t care who picks them up. When the public sector does it, they offload the costs onto themselves, or another government.
  • Large, well-run defined benefit plans are efficient. They keep fees low and reduce risk by spreading their costs over a large number of plan members. They have a long time horizon which smooths out market ups and downs. These things help a defined benefit plan produce up to 77 per cent more income than a defined contribution plan with equal contributions, Browns said.
  • The risk of a public pension failing is far less likely than a private one.
  • The only way a defined contribution plan can lower costs is by decreasing benefits. In Nebraska and West Virginia where state plans were converted, they’ve partially switched back.
  • If public sector funds are capped and new ones set up, governments will have to run two funds in parallel for decades. If a legacy plan is underfunded the government is on the hook to cover the gap.
  • The conversions would carry a big political risk for governments in the form of job action and legal challenges. They would be seen as breaking contracts negotiated in good faith.
In the end the message wasn’t so much that public sector pensions are too rich, but that workers in private sector have been abandoned. Their employers are leaving them to make retirement decisions they are often ill-equipped to make, in an increasingly complex and unpredictable world.
You can read Brown and McInnes' paper here. I agree with Mayers, the message is not that public sector pensions are too rich but that the private sector has abandoned its employees, leaving them to fend for themselves in increasingly volatile and complex public markets.

Go back to read my recent comment on the brutal truth on DC plans where I discussed why defined-contribution plans are doomed to fail, ensuring more people will retire in poverty which will actually increase the social welfare cost to the state, increasing public debt:
...while shifting to defined-contribution plans might make perfect rational sense for a private company, the state ends up paying the higher social costs of such a shift. As I recently discussed, trouble is brewing at Canada's private DB plans, and with the U.S. 10-year Treasury yield sinking to a 16-month low today, I expect public and private pension deficits to swell (if the market crashes, it will be a disaster for all pensions!).

Folks, the next ten years will be very rough. Historic low rates, record inflows into hedge funds, the real possibility of global deflation emanating from Europe, will all impact the returns of public and private assets. In this environment, I can't underscore how important it will be to be properly diversified and to manage assets and liabilities much more closely.

And if you think defined-contribution plans are the solution, think again. Why? Apart from the fact that they're more costly because they don't pool resources and lower fees --  or pool investment risk and longevity risk -- they are also subject to the vagaries of public markets, which will be very volatile in the decade(s) ahead and won't offer anything close to the returns of the last 30 years. That much I can guarantee you (just look at the starting point with 10-year U.S. treasury yield at 2.3%, pensions will be lucky to achieve 5 or 6% rate of return objective).

Public pension funds are far from perfect, especially in the United States where the governance is awful and constrains states from properly compensating their public pension fund managers. But if countries are going to get serious about tackling pension poverty once and for all, they will bolster public pensions for all their citizens and introduce proper reforms to ensure the long-term sustainability of these plans.

Finally, if you think shifting public sector DB plans into DC plans will help lower public debt, think again. The social welfare costs of such a shift will completely swamp the short-term reduction in public debt. Only economic imbeciles at right-wing "think tanks" will argue against this but they're completely and utterly clueless on what we need to improve pension policy for all our citizens.

The brutal truth on defined-contribution plans is they're more costly and not properly diversified across public and private assets. More importantly, they will exacerbate pension poverty which is why we have to enhance the Canada Pension Plan (CPP) for all Canadians allowing more people to retire in dignity and security. These people will have a guaranteed income during their golden years and thus contribute more to sales taxes, reducing public debt.
Let me be even more brutally honest. As I watch Europe's deflation demons spreading, I worry that we're in for a protracted period of low growth and that what I saw on my recent trip to the epicenter of the euro crisis is a glimpse of the future of developed economies.

High unemployment, crushing public and private debt loads, reduced pension benefits and wages are not just a European problem, they can easily materialize everywhere and sink developed economies into a protracted period of debt deflation. This is what's spooking markets right now, the very real risk that deflation is coming and there's virtually nothing that monetary authorities can do about it.

Think about it. Joe and Jane investor are going to open up their monthly statements from their mediocre mutual funds which are likely underperforming in these tumbling markets and if they're getting ready to retire, they're going to be overwhelmed by retirement angst because they probably don't have enough to safely and securely retire in dignity.

And what about Warren Buffett's dire warning on pensions? I agree with him, America's looming pension disaster will not disappear but the answer isn't to scrap defined-benefit plans and replace them with defined-contribution plans. The answer is to reform them and introduce better governance akin to that of Canadian public pension plans.

In fact, Buffett's own pension strategy is not to scrap DB plans for supposedly "lower cost" DC plans and his pension wisdom clearly argues that fees matter a lot, which bolsters the case for large, well-governed public pension DB plans for every citizen.

Finally, it's important to remember that most people don't have Buffett's deep pockets, track record and lieutenants outperforming this market. America's new retirement reality is much more somber which is why I think now more than ever, it's time to go Dutch on pensions, ensuring every citizen can retire in dignity and not worry about the vagaries of public markets which are demolishing even the most sophisticated hedge fund investors (see clip below).

Wednesday, October 15, 2014

Are Europe's Deflation Demons Spreading?

Ambrose Evans-Pritchard of the Telegraph recently commented, Dam breaks in Europe as deflation fears wash over ECB rhetoric:
A key gauge of deflation risk in Europe is flashing red, dropping to record lows on fears of fresh recession and lack of decisive action by the European Central Bank.

The sudden lurch downwards came as Bank of America warned that France’s debt ratio could rocket to 120pc of GDP within five years, unless the EU authorities take radical steps to reflate the region’s economy. Italy’s debt could threaten 150pc even earlier.

The 5-year/5-year forward swap rate monitored closely by traders plummeted beneath 1.77pc on Friday morning as a global growth scare drove European stock markets to a 12-month low (click on image).


“This rate is the most important market signal on the planet right now. Everybody is watching the chart, and it has just gone off a cliff,” said Andrew Roberts, credit chief at RBS.

Bond markets echoed the refrain, with yields on 10-year German Bunds falling to an all-time low of 0.88pc on flight to safety, though the bond rally can also be seen as a bet by traders that the ECB will soon be forced to launch full-blown quantitative easing.

Mario Draghi, the ECB’s president, has adopted the 5Y/5Y rate as the bank’s policy lodestar, used to distill expectations of future inflation. Any fall below 2pc is deemed a risk that expectations are becoming “unhinged” and could lead to a Japanese-style deflation trap.

Mr Roberts said the ECB’s plan for asset purchases - or “QE-lite” - does not yet add up to a coherent strategy. “We don’t think they can boost their balance sheet by more than €165bn over the next two years by buying asset-backed securities (ABS) and covered bonds together, given the haircut effects. The sums are trivial,” he said.

RBS estimates that the inflation rate has already dropped to below 0.1pc in the eurozone if one-off tax rises and fees are stripped out, and this measure may turn negative in October. “Deflation is already knocking on the door. We think it could happen as soon as next month given the latest fall in food prices,” said Mr Roberts.

“We are reaching the end game in Europe. If they don’t launch real QE and start reflation by the end of the year or soon after, the consequences are too awful to contemplate,” he said.

Ruben Segura-Cayuela, from Bank of America, said low inflation has become “the biggest threat to the dynamics of public debt” in the eurozone, warning that debt ratios risk “spiraling up” even at levels of around 0.5pc.

France’s debt will keep rising from 93pc to 102pc of GDP by 2016, even in the best of circumstances. It will reach 117pc under a “lowflation scenario”, and 120pc if there is no further fiscal tightening. Spain’s debt will hit 113pc under similar circumstances. “What worries us is that we are not even stress testing for deflation,” he said (click on images below).


Bank of America said the ECB may have to take far more radical steps, pledging to violate its own 2pc inflation limit deliberately in order to break out of the vicious circle. “A commitment to keep nominal rates low for a long period does not necessarily work, and alone does not guarantee a recovery. The situation in the euro area might require more forceful action, a nominal anchor that implies the central bank committing to overshoot its inflation target,” it said.

This is almost impossible to imagine, given the political character of the eurozone. Any such move would breach EU treaty law.

It remains far from clear what the ECB intends to do. On Thursday, Mr Draghi vowed “new measures” to head off deflation if necessary, but traders are looking past the rhetoric for hard facts. The ECB’s balance sheet contracted by €10bn last week, falling back to levels of early July. Mr Draghi has yet to flesh out his vague plan to boost it by €1 trillion.

The US Federal Reserve, the Bank of Japan and the Bank of England all set clear timetables, spelling out exactly how many bonds they would buy, and the scale has been much larger in proportion to GDP. The ECB has merely given pledges, and these have since been qualified by the Bank of France, and have been openly attacked by the Bundesbank.

Germany’s five economic institutes - or Wise Men - said the ECB’s asset purchases will add “hardly any” extra stimulus to the real economy and may be unworkable in any case. They said there are not enough private securities that can plausibly be bought, and noted that a previous scheme to buy €40bn of covered bonds had run into the ground.

Analysts are watching German politics just as closely as ECB language. The rise of Germany’s AfD anti-euro party raises the political bar even further for full-fledged QE, and eurosceptics have announced their intention to file cases at the German constitutional court to block asset purchases once they begin.

The court has already ruled that the ECB’s backstop measures for Italian and Spanish debt (OMT) “manifestly violate” the EU Treaties and are probably “Ultra Vires”, which prohibits the Bundesbank from taking part. Pending cases on QE would raise questions over whether the Bundesbank might have to step aside on asset purchases.

The current circumstances are very different from July 2012, when Mr Draghi had the full political backing of the German finance ministry for his OMT rescue plans. This time he must battle critics across the whole political spectrum in Germany.

Giulio Mazzolini and Ashoka Mody, from the Bruegel think tank in Brussels, said the eurozone seems to be tipping into a “debt-deflation cycle” as rising debt and deflation feed off each other, yet the authorities remain paralyzed and still refuse to face up the gravity of the threat. “Even now, ECB officials regard deflation to be unlikely,” they said.
Andy Davis of NewsWeek also reports, Deflation Threatens Economic Recovery in the Fragile Eurozone:
A few years ago, Isabel Huerta, a mother of two living in Valencia, would never venture into a branch of Spain’s leading department store, El Corte Inglés, on a Saturday. “It was always so crowded,” she says. “You couldn’t even get inside the changing rooms.” Not any more. Nowadays, you can drop into any of the four stores in the city on a Saturday afternoon and browse in peace. The aisles, she says, are almost empty. Assistants pursue the few customers that do bother to show up around the shop floor, doggedly chasing an increasingly elusive sale.

Even for the undisputed royalty of Spanish retailing, these are humiliating times but the travails of El Corte Inglés serve as a reminder that no one is immune from the chill that has descended on the country’s consumers. According to Spain’s official statistics office, the Instituto Nacional de Estadística, in 2008 the average Spanish household spent €31,711. Over the following five years that figure fell consistently, dropping to €27,098 last year.

That’s a pretty steep decline, but it tells only part of the story because these figures take no account of inflation. Prices in Spain went up about 9.5% between 2008 and the end of 2013. This means that simply to keep up with rising prices a person would, in theory, have needed to spend nearly €35,000 in 2013 to buy the same quantity of goods and services that €31,711 would have bought in 2008. But instead of going up by 9.5%, household spending dropped by 14.5%. After allowing for inflation, Spanish households spent very nearly 22% less in 2013 than they did five years earlier.

Averages, of course, are not necessarily very informative. They capture a huge range of data from the wealthiest families to the poorest, and churn out a middle-ground figure that reflects everybody to some extent and nobody completely. But when an average falls that far that fast, it is a safe bet that very large numbers of people are cutting their spending to the bone. And when we consider that, thanks largely to the collapse of its construction boom, Spain now has adult unemployment of about 25% – three times the level in 2007 – and joblessness among the under-25s of nearly 54%, it comes as no surprise.

Very similar things are happening right across the southern part of the Eurozone, but nowhere more brutally than in Greece, where adult unemployment stands at about 27% and youth unemployment is double that. Again, however, those figures do not tell the whole story, according to financier Andreas Zombanakis.

“You have to look at the 1.5m ­headline unemployment number in a ­different way because you have a theoretical workforce of about 4.5m people in Greece, of which the wider public sector including the electric company, for example, makes up about 1 million. The public sector has had no redundancies, none, zero. So the private-sector workforce is about 3.5m people, and out of that 3.5m you’ve got 1.5m unemployed – you’re looking at almost one in two. And then you’ve got the other mind-blowing statistic, which is that 400,000 families today in Greece have no one in employment.”

Shocking though such statistics are, they are not new. People across the southern Eurozone have been feeling the economic screws tightening on them for a long time. The biggest falls in output and sharpest rises in unemployment were in fact a couple of years ago when the Eurozone crisis was at its most acute. Back in 2012 and early 2013, retail sales in Spain were falling at up to 10% year-on-year. Now the decline has slowed to less than 1%.

But even as the pace of collapse has moderated during 2014 and perhaps even bottomed out, something else has changed. Inflation rates have fallen steadily across Europe and, more recently, attention has focused increasingly on a new threat: deflation.

The prospect of inflation turning negative for any length of time is one that alarms the great and good of the world economic order, so much so that few of them like to speak openly about it. In January, Christine Lagarde, managing director of the International Monetary Fund, broke ranks, warning that the threat was growing. “With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery,” she told an audience at the National Press Club in Washington DC. “If inflation is the genie, then deflation is the ogre that must be fought decisively.”

The Genie and the Ogre

When Lagarde made those comments, inflation in the Eurozone had already fallen to 0.8%, well below the European Central Bank’s target of “below but close to 2%”. Since then, it has more than halved to 0.3%. If deflation really is the ogre that Lagarde suggests, its footsteps seem to be getting louder.

In some places, it has already arrived. Greece’s inflation rate has been slightly negative for more than a year; in Portugal inflation has been negative for 10 of the past 12 months; inflation in Spain weakened significantly about a year ago and has been bouncing around zero ever since, with the most recent monthly readings the weakest so far. Italy, meanwhile, now seems to be heading down the same path, recording its first ­negative year-on-year inflation figure in August, at -0.09%.

Why does the prospect of deflation get policymakers so worried? The explanation is that deflation is a symptom of extremely weak demand. This leads to a slowdown in economic activity and less investment by companies, which see no point in expanding and creating jobs. Profitability and wages therefore remain subdued and the result is lower trend rates of economic growth that have, in the past, proved extremely hard to reverse.

So far, so gloomy. The real problems, however, stem from the effect that this process has on our ability to deal with our debts. When prices are rising at more normal rates incomes usually follow suit with the result that, over time, our ability to support a given level of debt – whose value is fixed – gradually improves. By the same token, periods of very high inflation can quickly erode the “real” value of debt, making it much easier to repay.

Deflation puts that process into reverse. Prices and incomes decline and this means that, relative to our income, the value of our debts gradually goes up. Where inflation lightens our burden, deflation makes it heavier.

Philippe Legrain, who was independent economic adviser to the former president of the European Commission, José-Manuel Barroso, argues that it is Europe’s debt levels that make the present situation particularly worrying.

“The existential threat is the huge debt, both private and public,” he says. “The focus tends to be almost exclusively on public debt but, actually, everywhere apart from Greece and Italy private debt is much more substantial. If you look at the combined figures for public and private debt, there’s been a significant reduction in the US and some in the UK, but there’s basically been none at all in the Eurozone and in fact in some cases there’s higher debt now than there was seven years ago.

“So we’ve had seven years of crisis and no progress in tackling the underlying problem, which is why I laugh when officials say the crisis response is working.” Their error, he says, is to highlight the current, slower, rate at which debt is accumulating, rather than concentrating on the huge pile that has already been accumulated. “Until you’re in a position to bring down that debt Europe is going to be in big trouble and vulnerable to much worse.”

Deflation is part of “a continuum of problems”, says Legrain. “If you have very low inflation it makes it much harder to bring down debt and if you have deflation it’s harder again, but I wouldn’t fixate on whether inflation is plus 0.2% or minus 0.2%,” he says. “With the huge mountains of debt we have now even very low inflation makes it extremely difficult to grow out of the problem.”

The Mileuristas

To many people, Legrain’s analysis accords with the reality they are experiencing – fractions of a percent either side of zero makes no difference to everyday life. Ximo Barranco teaches economics in a Spanish secondary school and, even though he’s aware that Spain’s inflation data suggest prices are falling, he hasn’t noticed any obvious signs of this for himself. What he has experienced, however, is one of the harbingers of deflation – wage cuts. His salary has been cut twice over the past couple of years, once by 8% and once by 5%. When people are learning to live on significantly less income, the cost of living will still feel prohibitive even if the official data says prices have stopped rising. Ximo says that even though he is earning less than before, he is now making greater efforts to save and that many more people he knows are doing unpaid overtime than used to be the case.

Like many others, however, he is happy just to have a job. Working for less money beats unemployment in a country where, once unemployed, the chances of staying that way are high. At the end of 2007, less than one in five of Spain’s unemployed had been jobless for more than a year, according to the Organisation for Economic Co-operation and Development. By the end of 2013, it was more than 50%. In Greece, it was more than 70%.

Between 2009 and 2013, “real wages” (i.e. after taking inflation into account) fell 2% a year in Spain, just over 2% a year in Ireland and Portugal, and 5% a year in Greece. The OECD recently warned that this trend posed a growing threat. “Any further reduction of wages risks being counter-productive because then we would run into a vicious circle of deflation, lower consumption and lower investment,” said Stefano Scarpetta, the organisation’s director for employment. One telling sign of the shift can be found in the Spanish term mileurista. Back in Spain’s boom times, this was a slightly disparaging label for someone who earned €1,000 a month, implying pity that they couldn’t get a better job. Nowadays, people tend not to use the word in that way – many Spaniards today would be happy to be called a mileurista.

Anthem For Doomed Youth

Conditions like these are prompting pronounced shifts in behaviour and attitudes in the “crisis countries” that make it more likely they will continue on the path they seem to be on. Jorge Martin, an analyst covering Spain for the consumer research company Euromonitor, argues that one of the surprising things about the country’s downturn has been the relative lack of social unrest that has accompanied the crisis. The buffer in Spain and elsewhere has been the strength of family ties, which have seen most young people give up on the idea of moving out of their parental home and many older offspring move back in. And the young are not the only ones returning, says Martin.

“A lot of people are taking their elderly relatives from retirement homes and bringing them back to live with them in order to be able to live on their pension and to support the expenses of that household.” State pensions, he points out, offer a guaranteed source of income to families that are struggling.

Andreas Zombanakis says that in Greece similar things are happening, although, because urbanisation was a more recent phenomenon, the process has brought with it an added layer of dislocation and disillusion. “The generation that hit adulthood in the 1960s and 1970s probably did six years of school and then went to work on farms but as they got wealthier they wanted a better life for their children.” Many of these youngsters remained in education and progressed to trade schools or university, but, since the crisis, huge numbers of the jobs they went into have disappeared.

“Suddenly these people are returning to the land because they’re unemployed,” says Zombanakis. “They’re going back to their villages in order to survive because in the village you can eat so at least you won’t go hungry. Now that generation is being forced to take on jobs as farmers, so you have two generations that have had their dreams and their efforts come to nothing. You have the electrician or the carpenter or the bank employee who is now back doing what his parents did. And you have his parents, who made all these sacrifices to educate their kids and who suddenly see that all this effort was for nothing. You’ve shattered the dreams of two ­generations.”

For many younger and better qualified people, moving back in with their parents is only a stopgap. Ultimately, a growing proportion of them will leave the country in search of better pay and greater opportunity.

Felipe Rueda graduated from a Spanish university in summer 2013 and, like almost all his contemporaries, found it impossible to land full-time work of any sort. Along with several of his friends, he registered as self-employed and found that this enabled him to start earning, albeit at very low rates.

“It seems to open more doors than if they have to give you a contract and pay your social security,” he says. “A lot of the people in my year, on my degree course, are self-employed for that reason. You have to be a bit cunning. There are people who won’t give contracts to friends of mine but they tell them, ‘Look, register as self-employed, invoice us for half and we’ll pay you the other half on the black.’ I know of several cases like that. They’re getting €6 or €7 an hour but they’re happy because they’re working.”

Rueda has set his sights on escape. He is attending language school to improve his English and says his girlfriend has already looked into securing visas for the US. “I accept it as a positive thing, like an adventure,” he says. “If my country won’t offer me work, well maybe there are other countries that want me.”

Emigration from Spain is rising quickly. Having seen an enormous inflow of immigrants mainly from South America in the decade or so to 2010, the country’s population is officially forecast to shrink by about 5% over the coming decade largely as a result of immigrants returning to their countries of origin. Leaving alongside them, however, will be a growing number of younger Spaniards like Rueda and, unfortunately for the Spanish economy, they will often be university graduates with high earning potential – the next generation of ­middle-class professional taxpayers.

If large numbers of unemployed migrants leave, that may be a blessing in the short term if it eases the burden on overstretched welfare systems. But losing well-qualified members of their workforce will naturally make it harder for crisis-hit economies to return to the kind of growth rates that will help them to stabilise, and eventually reduce, their huge debt burdens. Even before the financial crisis, Europe was facing a looming problem thanks to low birth rates and a growing number of elderly citizens who will rely on the taxes paid by a shrinking band of younger workers to fund their pensions. The economic disaster that hit countries such as Greece, Spain and Portugal has tilted the balance further towards the danger zone.

No More Babies

The statistics on numbers of live births tell a worrying story across all these countries. Between 2008, when the number of live births reached a short-term peak in Italy, Greece, Portugal and Spain, and 2013 the number of babies being born each year went into a dramatic decline. In Italy, the total dropped nearly 11% and it looks likely that within the next year or two, fewer than 500,000 babies will be born per year in Italy for the first time since reliable records began. Spain saw its total number of live births drop 17.9% over the same period, Greece fell 20.4% and Portugal 20.8%.

“Most of my friends don’t think they will be starting families in the near future because they don’t have stable jobs. They’re worried and they think they will have to wait for a long time,” says Cathy Camarasa, a 32-year-old Valencian with a four-month-old daughter. She expects to return to work shortly, since her maternity pay runs out after 16 weeks.

The collapse in birth rates across the southern Eurozone stands as the clearest indicator of how profoundly the economic crisis has changed the way people think and behave. “It’s a sign of a sick society when people are afraid and don’t want to take on the financial burden of a baby,” says Legrain. “I think it’s quite a rational reaction. You saw the same thing with the break-up of the Soviet Union.” And this change is likely to have a long-term effect on these countries, further reducing the potential of their economies to grow and escape their debt burdens, and deepening the problems that lie in wait within their pension systems.

The Informal Economy

People’s belief in the ability of the state to help and support them has already been severely undermined, partly because governments have cut services and pushed up taxes in order to repair their own threadbare finances. To some degree, increases in taxes such as VAT temporarily pushed up the rate of inflation by increasing the prices of goods and services, in the process ratcheting up the pressure on stretched household budgets.

By common consent, this has increased the size of the black market in these countries. Money that should go to the state to finance public services instead goes under the table – ­employers are only willing to take on people like Rueda and his friends if they can hire them as self-employed contractors, thereby avoiding employers’ social security contributions, and can pay half their wages in cash. That makes the financial position of governments worse but it helps to cushion the austerity for some people at least.

“If they thought tax evasion was bad before the crisis it’s worse today and that in a way for me explains why life on the streets is better than the official statistics show, because the black economy is still big,” says Zombanakis. “And the reason I say that is when you’ve got a country where the vast majority of businesses are very small, tax evasion is high because it’s in the nature of the small trader. So when the plumber comes to your house to fix your toilet cistern and he asks for €100 in cash or €123 with VAT, you’ll give him €100 in cash. That’s a rational response. He saves money on his income tax and you pay less VAT.”

Similarly, Yannis Palaiologos, an ­Athens-based journalist and author of The 13th Labour of Hercules, a recent book on the Greek crisis, says that many Greeks who are able to get away with it, avoid paying pension contributions.

People have more immediate uses for their cash and, in any case, there’s a widespread assumption that the Greek pension system is bust and therefore will not be able to support them when the time comes. However, he adds that over the past 18 months government efforts to improve collection rates and reduce levels of black market employment have been making inroads.

‘Goldilocks Deflation’

Of course, a major part of the reason that governments in the Eurozone’s ­crisis countries have been pushing up taxes such as VAT is that they are under acute pressure from the authorities in Brussels to cut their borrowing and bring their huge budget deficits under control despite the obvious risks of increasing taxes at the same time as wages are falling and unemployment is high. This, however, is part of the Eurozone’s policy for dealing with its problems.

In January, the president of the ­European Central Bank, Mario Draghi, wrote to the Dutch MEP Auke Zijlstra, that “very low or negative inflation rates for some countries reflect the necessary temporary adjustment and rebalancing processes”, assuring him that deflation “is not something we see or expect to see at the euro area level”. Others, particularly in Germany, are even more candid. Hans-Werner Sinn, head of Germany’s influential Ifo Institute for Economic Research, wrote recently that “deflation is not a danger for southern Europe but an essential precondition for restoring competitiveness”.

Draghi’s letter, however, begs some crucial questions. How can anyone be sure that this period of ultra-low ­inflation in southern Europe will turn out to be a “temporary adjustment” and that things will pick up again once the “rebalancing processes” are complete? And how can they be certain that it won’t spread northwards and encircle the Eurozone?

In the years before the financial ­crisis, economists used to talk about a Goldilocks economy that was neither too hot and therefore at risk of excessive inflation, nor too cold and at risk of recession. Implicit in the remarks of figures such as Draghi and Sinn is the idea that it is possible to have “Goldilocks deflation” – enough to cure the patient without killing him – and that it will be possible to reverse the process when they judge it has gone far enough.

This belief lays bare perhaps the greatest risk to the future of the Eurozone economy – that officials trying to guide its course are subject to the “illusion of control”, a well-documented psychological bias that leads us to believe we can shape processes that are in fact immune to our influence.

And they may be encouraged in this belief by the strange phenomenon of so-called “inflation expectations”. In judging the risks of inflation or deflation, economists tend to rely on indicators of what people expect inflation to be in future, derived either from prices in the bond markets or from surveys of consumers.

The problem is that both are proving extremely unreliable.

Anchors Away

Bond market measures of inflation expectations have provided no early warning of the steady fall in inflation that the Eurozone is now witnessing. Instead, they have continued to signal a belief that prices will rise at around 2% a year. The consistency of this message has been important to Eurozone officials and has been taken to indicate that there is little imminent threat of deflation. Inflation expectations are said to remain “well anchored”, in the jargon, although recently market forecasts have belatedly started to weaken.

Surveys of consumers give very ­similar results. For example, an inflation expectations survey carried out quarterly across several countries for M&G, a UK asset manager, consistently shows that consumers expect inflation to be roughly what it has been over the past few years. In August 2013 consumers in Spain said they expected inflation one year ahead to be 2.8%. In fact, Spanish inflation in August 2014 was -0.4%. When asked the same question in August 2014, they forecast that inflation in a year’s time would be 2%.

All in all, putting any degree of faith in inflation expectations to tell us whether we’re on the right track looks pretty unwise.

“The fall in inflation over the past year happened without anyone expecting it,” says Philippe Legrain. “Obviously, if people start expecting deflation and that shapes their behaviour then it is harder to get out of it, but you can still get stuck in deflation without people anticipating it in the first place.

“Expectations can be lagging – they don’t need to anticipate. If you’re an economist you think they anticipate but that’s because economists take a different view of the world than most people.”

In effect, that means that by the time people start saying that they expect deflation it will already be well advanced because their expectations are shaped by the recent past, not by any particular insight into what is going to happen.

One possible – even likely – future for the Eurozone, according to many commentators, is that it will follow the path that Japan has trodden for the past 20 years, since the aftermath of its own financial bust in 1989.

“My baseline scenario is Japanese-style stagnation – i.e. a prolonged period of very low growth, very contained price rises and bouts of deflation, and underlying that a failure either to write down excessive debts or to tackle once and for all the problems in the banking system, which of course are linked to the extent that those debts are owed primarily to the banking system,” says Legrain. The worrying aspect of this parallel is that once deflation set in, Japan has found it all but impossible to bring it to an end and even decades later is still struggling to escape it.

Rather than paying attention to what people think will happen to ­inflation, anyone looking for clues about the immediate future in the Eurozone should take a look at what people say when asked about matters rather closer to home – what they expect to happen to their own net income over the next 12 months. Everywhere we turn the vast majority think they will be getting the same or less a year from now. The most recent data for France is particularly striking: 48% of people are expecting a pay cut in the coming year, by far the highest proportion in the M&G survey.

Confining the ogre to southern Europe might turn out to be harder than we thought.
I just came back from Greece, the epicenter of the euro crisis, and wrote all about how deflation is sinking that country into an abyss, opening up the door to dangerous political dynamics that will likely spur another eurozone crisis.

Germany is finally waking up to the reality that the eurozone crisis will not be contained. There are signs that a poor run of German data may be softening Chancellor Angela Merkel's opposition to public spending but as I wrote in my recent comment on the mighty greenback, my fear is that it's already too late as the ECB and Europe's leaders are way behind the deflation curve.

Deflation is a common theme on this blog. I've been warning about it for a long time because it will be the final endgame, one that will have profound implications on public and private markets. The worry right now is that eurozone's woes are spilling over to the rest of the world, threatening the fragile U.S.-led recovery that's underway.

And if you think deflation is only a eurozone problem, think again. Slowing global growth, particularly because of weakness in Europe, as well as a surging dollar and plunging oil prices, have spurred selling in U.S.Treasury Inflation Protected Securities (TIPS) since late summer, disrupting a comeback they had enjoyed in the first eight months of the year:
TIPS breakevens have been collapsing since early August. In the last three weeks, following the Fed's most recent meeting and an unexpected monthly drop in the benchmark U.S. Consumer Price Index on the same day in mid-September, the downward momentum in breakevens has been at its most intense since the financial crisis.

"The CPI definitely set the tone. The stronger dollar and weaker energy prices are definitely having a major impact," said Martin Hegarty, co-head of inflation-linked bonds at BlackRock, the world's largest asset manager with $4.3 trillion under management.

Last week, for instance, 10-year breakevens, a gauge of where inflation will be in a decade, fell to their lowest since late 2011. They dropped below the key 2 percent level targeted by the Fed at the end of last month. On Friday, they ended at 1.97 percent.

"The market is readjusting its global growth expectations," said Gemma Wright-Casparius, who oversees Vanguard's $26.1 billion TIPS fund, the biggest U.S. fund of its kind.

Only last week, the International Monetary Fund downgraded its forecast on global growth this year to 3.3 percent from the 3.4 percent it previously expected, and gave worryingly high probabilities for recession and deflation in Europe.
And it's not just TIPS, U.S. Treasury yields are sinking fast, signalling a major slowdown in global and U.S. growth. The benchmark U.S. 10-year Treasury bond’s yield dropped below 2% to 1.868% on Wednesday, the lowest intraday level since May 2013 as anxiety over the global economic outlook intensified.

The plunge in oil prices to a four-year low is also worrisome because it too signals a profound change in global growth expectations. Analysts are right to note that falling oil prices will eventually stimulate demand because of falling gas prices but there is something more pernicious at play here, the real possibility that global deflation demons are spreading throughout the world, including right here in North America.

In my recent comment on the crazy action in the stock market, I expressed serious concerns on energy stocks (XLE) and think that this sector is in for a protracted period of weakness. I can say the same about Materials stocks (XLB) which are plunging toward 52-week lows. This is yet another reason why I'm short Canada and other countries that benefited from the energy/ commodity boom.

News of a potential Ebola pandemic is also weighing on global markets. God forbid one develops as this will be the final nail in the deflation coffin. Nothing like a life threatening virus to keep people from shopping and traveling.

Finally, despite the negative tone of this comment and huge volatility in global stock and bond markets, I'm not ready to cede to all those growling bears warning of an imminent collapse. Global deflation demons are spreading but I expect a forceful and vigorous fight from monetary authorities throughout the world to squelch these demons. My only fear is that it's already too late and that the ECB and now the Fed are way behind the deflation curve.

Below, Brean Capital's Peter Tchir and JPMorgan Asset Management's Philip Camporeale discuss investor fears about deflation with Bloomberg's Trish Regan on "Street Smart."

Tuesday, October 14, 2014

Going Dutch on Pensions?

Mary Williams Walsh of the New York Times reports, No Smoke, No Mirrors: The Dutch Pension Plan (h/t Suzanne Bishopric):
Imagine a place where pensions were not an ever-deepening quagmire, where the numbers told the whole story and where workers could count on a decent retirement.

Imagine a place where regulators existed to make sure everyone followed the rules.

That place might just be the Netherlands. And it could provide an example for America’s troubled cities, or for states like Illinois and New Jersey that have promised more in pension benefits than they can deliver.

“The rest of the world sort of laughs at the United States — how can a great country like the United States get so many things wrong?” said Keith Ambachtsheer, a Dutch pension specialist who works at the University of Toronto — specifically at its Rotman International Center for Pension Management, a global clearinghouse of information on how successful retirement systems work.

Going Dutch, however, can be painful. Dutch pensions are scrupulously funded, unlike many United States plans, and are required to tally their liabilities with brutal honesty, using a method that is common in the financial-services industry but rejected by American public pension funds.

The Dutch system rests on the idea that each generation should pay its own costs — and that the costs must be measured accurately if that is to happen. After the financial collapse of 2008, workers and retirees in the Netherlands took the bitter medicine needed to rebuild their collective nest eggs quickly, with higher contributions from workers and benefit cuts for pensioners.

The Dutch approach bears little resemblance to the American practice of shielding the current generation of workers, retirees and taxpayers while pushing costs and risks into the future, where they can metastasize unseen. The most recent data suggest that public funds in the United States are holding just 67 cents for every dollar they owe to current and future pensioners, and in some places the strain is palpable. The Netherlands, by contrast, have no Detroits (no cities going bankrupt because pension costs grew while the population shrank), no Puerto Ricos (territories awash in debt but with no access to bankruptcy court) and nothing like an Illinois or New Jersey, where elected officials kicked the can down the road so many times that it finally hit a dead end.

About 90 percent of Dutch workers earn real pensions at their jobs. Their benefits are intended to amount to about 70 percent of their lifetime average pay, as many financial planners recommend. For this and other reasons, the Netherlands has for years been at or near the top of global pension rankings compiled by Mercer, the consulting firm, and the Australian Center for Financial Studies, among others.

Accomplishing this feat — solid workplace pensions for most citizens — isn’t easy. For one thing, it’s expensive. Dutch workers typically sock away nearly 18 percent of their pay, most of it in diversified, professionally run pension funds. That compares with 16.4 percent for American workers, but most of that is for Social Security, which is intended to provide just 40 percent of a middle-class worker’s income in retirement.

Dutch employers contribute to their system, too, but their payments are usually capped. While that may seem a counterintuitive way to make sure that pensions are well funded, it actually encourages companies to stick with pension plans. If the markets drop, Dutch employers do not receive urgent calls to pump in more money — the kind of cash calls that have prompted so many American companies to stop offering pensions. In the private sector, only 14 percent of Americans with retirement plans at work have defined-benefit pension plans — the ones that offer the most security — compared with 38 percent who had them in 1979. And if the markets rally and a Dutch pension fund earns more than it needs, the employers are not allowed to touch the surplus. In the United States, companies have found many ways to tap a pension surplus. The problem today is that there usually is no surplus left.

Dutch companies, as well as public-sector employers, typically band together by sector in big, pooled pension plans, then hire nonprofit firms to invest the money. Terms are negotiated sectorwide in talks that resemble American-style collective bargaining.

This vast collaborative process may sound too slow, too unwieldy and maybe even too socialist for American tastes. But standing guard over it is a decidedly capitalist watchdog, the Dutch central bank. More than a decade ago, after the dot-com collapse, a director of the central bank warned of a looming pension funding crisis. In response, the central bank in 2002 began to require pension funds to keep at least $1.05 on hand for every dollar they would have to pay in future benefits. If a fund fell below the line, it had just three years to recover.

American public pension funds have no such minimum requirement, and even if they did, there is no regulator to enforce it. Company pensions are bound by federal funding rules, but Congress has a tendency to soften them.

The Dutch central bank also imposed a rigorous method for measuring the current value of all pensions due in the future. Pensions are not supposed to be risky, so the Dutch measure them the same way the market prices very safe bonds, like Treasuries — that is, by discounting the future payments to today’s dollars with a very low interest rate. This method shows that a stable lifelong benefit is very valuable, and therefore very expensive to fund.

Notably, the Dutch central bank prohibited the measurement method that virtually all American states and cities use, which is based on the hope that strong market gains on pension investments will make the benefits cheaper. A significant downside to this method is that it lets pension systems take advantage of market gains today, but pushes the risk of losses into the future, for others to cope with. “We had lengthy discussions about this in the Netherlands,” said Theo Kocken, an economist who teaches at the Free University in Amsterdam and is the founder of Cardano, a risk analysis firm. “But all economists now agree. The expected-return approach is a huge economic offense, hurting younger generations.”

He explained that in the Netherlands, regulators believe that basing the cost of benefits today on possible investment gains tomorrow is the same as robbing tomorrow’s workers to pay for today’s excesses.

Most public pension officials in the United States reject this view, saying governments can wait out bear markets because governments, unlike companies, don’t go out of business.

For years, economists have been calling on American cities and states to measure pensions the Dutch way. And, in fact, California’s big state pension system, Calpers, sometimes calculates a city’s total obligation by that method. When Stockton went bankrupt, for instance, Calpers recalculated and found that the city owed it $1.6 billion. Of course, Stockton is insolvent and does not have an extra $1.6 billion, but Christopher Klein, a bankruptcy judge, has said that federal bankruptcy law permits it to walk away from the debt. Calpers disagrees, setting up a clash that seems destined for the United States Supreme Court.

But most of the time, when someone in the United States calls for Dutch-style measurements, pension officials suspect a ploy to show public pensions in the worst possible light, to make them easier to abolish.

“They want to create a false report, to create a crisis,” said Barry Kasinitz, director of government affairs for the International Association of Fire Fighters, after members of Congress introduced a bill to require the Dutch method.

The Dutch say their approach is, in fact, supposed to prevent a crisis — the crisis that will ensue if the boomer generation retires without fully funded benefits. Their $1.05 minimum is really just a minimum; pension funds are encouraged to keep an even bigger surplus, to help them weather market shocks. The Dutch sailed into the global collapse of 2008 with $1.45 for every dollar of benefits owed, far more than they appeared to need. But when the dust settled, they were down to just 90 cents. The damage was so bad that the central bank gave them a breather: They had five years to get back to the $1.05 minimum, instead of the usual three.

American public plans emerged from the crisis in worse shape, on the whole, and many allowed themselves 30 years to recover. But 30 years is so long that the boomer generation will have retired by then, and the losses will have been pushed far into the future for others to repay.

It’s a recipe for disaster if the employer happens to be a city like Detroit. The city’s pension system used a 30-year schedule to cover losses but reset it at “Year 1” every year, a tactic employed in a surprising number of places. In Detroit, it meant the city never replaced the money that the pension system lost. When Detroit finally declared bankruptcy last year, an outside review found a $3.5 billion shortfall, one of the biggest claims of the bankruptcy. Manipulating the 30-year funding schedule had helped to hide it.

“This happening in the Netherlands is totally out of the question,” Mr. Kocken said.

While the Netherlands has a stellar reputation for saving, that doesn’t mean pensions have been without controversy there; in fact, a loud, intergenerational debate is occurring about how to manage pensions. The financial crisis raised new calls for reform, Mr. Ambachtsheer said. Retirees were shocked and angry to have their pensions cut by an average of 2 percent after the crash. That had never happened before, and many had no idea that cuts were even possible. A new political party, 50Plus, sprang up to defend the interests of older citizens and won two seats in the national Parliament.

But something else happened: Dutch young people found their voice. No matter their employment sector, they could see that their pension money was commingled with retirees’ money, then invested that way by the outside asset management firms. In the wake of the financial crisis, they realized that they and the retirees had fundamentally opposing interests. The young people were eager to keep taking investment risk, to take advantage of their long time horizon. But the retirees now wanted absolute safety, which meant investing in risk-free, cashlike assets. If all the money remained pooled, young people said, the aggressive investment returns they wanted would be diluted by the pittance that cashlike assets pay.

“Now the question is, ‘How do you resolve this dilemma?’ ” Mr. Ambachtsheer said. “Everybody wants safety and everybody wants an affordable system, and you can’t have both. It’s become a major public debate in the Netherlands.”

It’s a debate that is rarely, if ever, heard in the United States.
It's about time the media in the United States starts looking more closely at pensions and what is working around the world. You can read a primer on the Dutch pension system here.

This article highlights a lot of issues I've discussed in my blog. Just last week, I went over the brutal truth on defined-contribution (DC) plans stating the following:
The brutal truth on defined-contribution plans is they're more costly and not properly diversified across public and private assets. More importantly, they will exacerbate pension poverty which is why we have to enhance the Canada Pension Plan (CPP) for all Canadians allowing more people to retire in dignity and security. These people will have a guaranteed income during their golden years and thus contribute more to sales taxes, reducing public debt.  

In my ideal world, you won't have the bcIMC, Caisse, OTPP, PSP, AIMCo, HOOPP or Bombardier, CN, Bell, Air Canada pension plans. You will only have large, well-governed public defined-benefit plans managing the assets and liabilities of all Canadians regardless of whether they work in the public or private sector. If we achieve such a monumental undertaking, we will significantly lower investment and administrative costs and do away with the issue of pension portability once and for all because people will move across public and private sector jobs knowing their pensions are safe and secure, backed by the full faith and credit of the federal government.
The Dutch got it right, rejecting DC plans and embracing defined-benefit (DB) plans for as many of their citizens as possible. More importantly, they take the funding of their pension plans seriously and the Dutch central bank stringently monitors and enforces funding ratios.

There are no contribution holidays for pensions in the Netherlands and no pension smoothing. Either they have attained their funded status -- 105% is what is considered fully funded -- or they're in trouble and have three years to correct their deficit, not 25 or 30 years. Some think such tight funding rules are too onerous but I submit that they make the difference between well-managed pension plans and mediocre ones which rely on a rate-of-return fantasy and hopium to attain their fully-funded status. And following the 2008 crisis, the large Dutch pension powerhousess moved back to basics.

Having said this, the Dutch pension system is far from perfect. The 2008-2009 crisis proved to be a real stress test for Dutch pensions and some argue the system needs more flexibility to address the inter-generational impact on the funding gap:
The financial crisis of 2008-09 has provided a stress test for the Dutch pension system. It appears that the more flexible defined benefit structure adopted by most plans earlier in the decade, which relies on indexation adjustments to restore solvency, may not be sufficient for the funds to recover fully. In response, policymakers should try to find approaches to compensate for the funding deficits in ways that best distribute risk among participating generations. In addition to the funding increases or nominal benefit cuts that may be needed in the wake of the crisis, policymakers should think more broadly about improving the design of pension funds going forward – through, for example, introducing age differentiation – to more effectively and fairly distribute risk by generations.
While there are kinks in their pension system, there is no denying the Dutch take their pensions seriously and it's an important political topic, just like healthcare and education.

There are three pillars to a just and healthy democracy: universal healthcare, education and pensions. In Canada, we got the first two right but have yet to bolster our pension system. We have some of the best DB plans in the world but we haven't built on their success, covering all Canadians. Once we do, we will surpass the Dutch in coverage and have the best pension system in the world.

As far as the United States, their looming pension disaster is only going to get worse and they have yet to introduce much needed reforms on pensions, especially reforms on their governance. Until they get the governance right, their public pensions are doomed, exacerbating America's new retirement reality. It's high time the U.S. goes Dutch or Canadian on pensions.

Below, as cities and states across the U.S. grapple with their pension programs, PBS travels to one country -- The Netherlands -- that seems to have its pension problem solved. Ninety percent of Dutch workers get pensions, and retirees can expect roughly 70% of their working income paid to them for the rest of their lives.