Tuesday, October 31, 2017

Does Canada Have All The Answers?

On Thursday, The Brookings Institution will host an event in Washington, Fixing the U.S. retirement system – does Canada have the answers?:
In recent years, Canada has significantly expanded and improved its retirement income and pension system. The Canada Pension Plan (CPP), which provides Canadians with income security in the case of retirement or disability, has been expanded, and its defined benefit plans for government employees has managed to avoid many of the funding problems plaguing comparable U.S. plans. The country is also making advances in expanding coverage to moderate-and-lower income Canadians. But there’s still work to be done, particularly in improving efforts to target policies to low-to-moderate income workers.

How was Canada able to achieve this expansion, and is there anything in the Canadian experience that Americans can use to advance retirement system reforms in the United States? On November 2, the Retirement Security Project at Brookings will host an event with senior Canadian officials and American experts to discuss the Canadian system and its relevance to American policy debates. The event will be live webcast.
You can register for this event or webcast if you cannot attend here.

First, let me thank Hugh O'Reilly, President and CEO of OPTrust, for bringing this up to my attention on LinkedIn. Hugh will be attending this event and so will Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP).

I didn't receive my invitation for this event but registered to the webcast here.

Unfortunately, I don't see the US moving to the Canadian pension model anytime soon but if it did partially or fully privatize Social Security to adopt a similar CPP-CPPIB approach, it needs to ensure a few things first:
  • Get the mission statement right: What is the purpose of this new retirement system and how will the mission statement govern all activities at this new fund?
  • Get the governance right: Make sure the board overseeing this new pension plan is experienced, informed on all aspects (not just investments but HR, IT, etc.) and most importantly, independent. This board can then hire a CEO who will hire his or her senior team to carry out the day-to-day operations of this new pension. Most importantly, there can be no government interference whatsoever, and they need to get the compensation right to hire qualified staff able to bring assets internally and manage money at a fraction of the cost of outsourcing to external managers.
  • Get the risk-sharing right: If you look at the best pension plans in Canada, they have all adopted a shared-risk model which means higher contributions, partial or full removal of inflation-adjustments when the plan experiences a deficit or both. Investment returns alone will not be able to restore a plan's fully-funded status no matter how good the investment managers are. 
Now, there are a lot of other things that US plans need to get right, like lower their discount rate to estimate future liabilities which is still unreasonably high for many plans.

The biggest impediment for US plans to adopt the Canadian model is governance. I just don't see US public pensions doling out Canadian-style compensation packages to their public pension fund managers. It's never going to happen and there are powerful vested interests (unions, funds, etc) who want to maintain the status quo even if the long-term results are mediocre at best, especially compared to Canada's large, well-governed DB plans.

And by long-term results, I don't just mean performance, I mean funded status which Hugh O'Reilly and Jim Keohane emphasized in a joint op-ed they wrote last year. Long-term results matter but what ultimately matters most is a plan's funded status.

Now, it should be noted that Canada's large pensions have certain degrees of freedoms that their US counterparts don't have. They are piling on the leverage nowadays to take advantage of their pristine balance sheets which are a direct result of good governance, excellent risk management and to be truthful, a long bull market and investment policies that allow them to leverage their portfolio to improve overall risk-adjusted returns.

I also don't want to leave the impression that Canada's large pensions are perfect on the governance front and they can't learn anything from their US counterparts. This is pure nonsense.

Back in 2007, I did a study for the Treasury Board and can tell you in detail where Canada's large pensions can learn from the CalSTRS and CalPERS of this world. Things like better and more transparent benchmarks for private markets and better communication like public board meetings which are then on YouTube for everyone to see.

Canadians love boasting of how great they are in many activities, like education, healthcare, pensions, and hockey. My motto is simple: we can always be better.

So, does Canada have all the answers? Of course not but it has a lot of great insights and the establishment of a national pension hub will offer even more worthwhile insights on improving our pension system.

Can the US improve its retirement system based on Canada's experience? You bet and so can the UK which has one of the worst systems in the developed world.

I tell you, the UK needs to forget Mark Carney and hire Mark Machin to run a new national pension system akin to CPP and CPPIB. Every country needs to adopt the Canadian model but before doing this, they need to get the governance right.

Below, Mark Machin, CEO of the Canada Pension Plan Investment Board, discusses how they are navigating the global economy. You can watch this interview here. Listen carefully to Mark, we are lucky to have him manage the CPPIB.

And Healthcare of Ontario Pension Plan CEO Jim Keohane talks about why Canadian stocks, including energy, have a good long-term investment case. Keohane also tells BNN why HOOPP's loan to Home Capital was a "win-win" for both parties. You can watch this interview here.

Jim is humble, HOOPP made a killing on the Home Capital line of credit deal and it will likely outperform all its large peers this year for the simple reason that it fully hedges its currency exposure while others don't hedge (see here for a more detailed discussion). Next year will be a different story as I expect the loonie to get crushed.

Lastly, take the time to watch a great discussion on lessons from the Canadian pension fund model which took place last year featuring OTPP's CEO Ron Mock and the Caisse's CEO, Michael Sabia.

Canada doesn't have all the answers but it sure has top-notch pension fund managers who can offer great insights to US and other pension funds around the world.



Monday, October 30, 2017

Is Passive Investing Taking Over?

Eric Platt of the Financial Times reports, Vanguard’s Jack Bogle predicts passive investing takeover:
Passive investing could eventually account for 90 per cent of the equity market, according to Jack Bogle, founder of Vanguard and pioneer of the index-based investing that has upended the asset management industry.

Passive investment of stocks through mutual or exchange traded funds that simply track an index — and charge investors much smaller fees — accounts for 47 per cent of the assets managed by the US fund industry, posing a severe challenge to active managers who take higher fees with the promise of beating the returns of major indices.

“As a long-term investment strategy, I don’t think the index fund has any competition at all,” Mr Bogle told an audience at the Ivy League clubhouse for Cornell University in Midtown Manhattan this week.

“There must be some limit somewhere with how much indexing there can be without [reducing] the efficiencies of the market,” he said. “[But] if I had to guess, I’d put [the limit] in the area of 70 or 80 or 90 per cent — very large — because there will always . . . be people looking for values, price discovery and all that kind of thing.”

Passive equity management is expected to overtake funds managed by active advisers by January 2018, analysts with Bernstein forecast earlier this year.

However, after lacklustre performance last year, returns have improved for active stock pickers. Nearly 57 per cent of large-cap US equity fund managers beat the S&P 500 over the past year, according to S&P Dow Jones Indices.

Alina Lamy, a senior analyst with Morningstar, said that the battle was “not completely lost” for active managers, but that investors were paying far more attention to fund fees.

“Bogle . . . is the greatest advocate for passive and this is the principle he founded his company on,” she said. “They started it all and they are still ruling it.”

Mr Bogle, who billionaire Warren Buffett credits with doing more for American investors than anyone else, also cautioned that Vanguard is growing too large. Vanguard, whose corporate headquarters are just outside Philadelphia, manages about $4.7tn. It trails only rival BlackRock, which has almost $6tn of assets.

“We’re now closing in on $5tn and I worry about that,” he said. “Running a large company is a very difficult thing . . . It gets harder and harder as you get bigger and bigger. I’ve spent a lot of time trying to rectify that concept.”

The octogenarian added that he was worried about the risk of high concentrations on liquidity and marketability of some of Vanguard’s funds, particularly those in the $3.8tn municipal bond market. Of the $323bn ploughed into taxable bond funds over the past year, 60 per cent was directed to passive funds, according to data provider Morningstar.

There is also a “significant” risk in the form of possible regulation of the industry, although he said he did not believe it was fair to classify the largest fund managers as systemically important financial institutions.

“We run basically an old oligopoly, Vanguard, BlackRock and State Street,” he said. “State Street is the smallest part of that group. An oligopoly is not necessarily bad but it is subject to challenge by regulators, and particularly European regulators . . . It’s hard to predict where that might go.”

Mr Bogle is not involved in the management of Vanguard; he retired from the company’s top post in 1996. A spokesperson for the asset manager said the company’s growth had “been a force for good” in the industry.

“Growth is not a goal for Vanguard but an outcome of delivering clients superior investment performance and quality service at a low cost,” the spokesperson said. “Vanguard has grown responsibly and governed our growth by being prudent in our product development, offering only funds that meet an enduring long-term need.”
Interestingly, back in May, Jack Bogle was warning index fund investors at the Berkshire Hathaway annual meeting that if everybody indexed, it would be catastrophic:
The tragedy of the commons is a fanciful term from economics that describes an action whose benefits accrue mainly to the entity committing it and whose costs are diffused. A typical example would involve a manufacturer polluting the air or water, but the expression can also apply to owners of index funds in the commons that are the financial markets.

What makes indexing a tragedy of the commons is that the benefit — higher long-term returns due to lower costs — only accrues as long as there is an active, functioning market underlying whatever index a fund is trying to capture the performance of. While investors and managers of index funds reap the rewards, the expense of maintaining that healthy market is borne by shareholders in actively managed funds and traders who buy and sell individual stocks.

The market cannot exist without those participants engaging in research, analysis and the transactions that result from them, as well as regulation of the market itself and the businesses whose stocks form it. Index fund shareholders largely avoid the costs involved, so the more investors index, the greater the costs for the ones who don’t, increasing the incentives to index.

John Bogle, the founder of the Vanguard Group and the person who ignited the trend toward index investing four decades ago, acknowledged recently that this circle could turn vicious eventually and cause downright tragic events in the stock market.

“If everybody indexed, the only word you could use is chaos, catastrophe,” Bogle told Yahoo Finance at the Berkshire Hathaway annual meeting last month. “The markets would fail,” he added.

Bogle noted that trading would dry up if the stock market comprised only indexers and there were no active investors setting prices on individual issues. Everyone would just buy or sell the market.

The market is not entirely owned by indexers, of course, and it never will be, and Bogle pointed out that as indexing increases to a certain point, it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. But past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place.

Bogle did not elaborate in the interview, but as indexing comprised an ever-larger proportion of trading, the limited trading of the few remaining active market participants would cause exaggerated price swings in individual stocks and perhaps the whole market.

Bogle stressed that there is a long way to go before indexing reaches a level at which market stability begins to crumble. About one-quarter of U.S. stock ownership is done through indexing, he told Yahoo. According to investment researcher Morningstar, 46.7% of assets invested in U.S. stocks via exchange-traded funds or mutual funds was indexed in April, compared with 36.3% three years earlier.

One development could mitigate much of the advantage that index funds enjoy and slow the rush to own them, but you’re probably not going to like it. When the market suffers a prolonged decline, active managers can gain an edge over indexers by moving large portions of assets into cash or into defensive sectors such as utilities and consumer staples.

Shareholders of index funds could then suffer more than owners of actively managed funds, and they could take their losses harder due to the perceived security they feel precisely because they merely own the market and aren’t trying to beat it. That might make active investors feel a bit of schadenfreude for indexers who have been free-riding at their expense, but the feeling probably wouldn’t last. The greater price swings that could ensue in a heavily indexed, less-active market are likely to exacerbate losses for everyone.

Until the next bear market, the indexing trend is likely to accelerate. As with any tragedy of the commons, indexing is the sensible thing for each individual to do, but each individual should remember that many sensible ideas, especially in investing, make less sense as more people put them into practice. When the stock market turns down again, index fund owners will have to become their own active manager and make sure they’re well diversified, with limited exposure to risk, chaos, and catastrophe.
I believe it's as good as it gets for stocks, and with markets on the edge of a cliff, there will be important headwinds impacting passive and active funds (active funds have beta too but should on the whole fare better than passive funds in a bear market).

Still, there's no question passive will take over active investing in the next two years and Vanguard will be growing by leaps and bounds, likely even taking over BlackRock as the world's largest asset manager.

But don't count BlackRock out just yet from the number one spot. Last week, BlackRock and Blackstone Group announced they are are planning to open offices in Saudi Arabia, encouraged by the investment opportunities offered by the kingdom.

Speaking of Blackstone, its CEO, Steve Schwarzman, told Bloomberg that it may double its assets to $800 billion over the next five years as it looks to cement its leadership in private markets and even get into infrastructure, a very long-term asset class which is highly scalable. In terms of succession planning at Blackstone, my money is on Jon Gray, the firm's real estate superstar investor.

Now, the name of the game at public and private market funds and pretty much all funds is asset gathering. The more assets you bring in, the more fees you collect in perpetuity if you're doing a good job.

Go back to read my comment on the coming renaissance of macro investing where I wrote this:
[...] I don't buy the nonsense of the "end of the petrodollars". This is pure nonsense and all this talk of alternative exchanges that will threaten the preeminence of the US dollar or US exchanges is beyond ridiculous.

I suggest Mr. Curran and all of you who buy into this nonsense read Yannis Varoufakis's first book, The Global Minotaur. Let me be clear, I'm no fan of Varoufakis and his pompous leftist nonsense but this book is a must-read to understand why the US is gaining global strength as its national debt mushrooms.

In short, the US runs a current account deficit for years but it benefits from a capital account surplus as all those countries running current account surpluses (China, Germany, Japan, etc) recycle their profits back into the US financial system, buying up stocks, bonds, real estate and other investments as well as subsidizing the US military-industrial complex.

The second book I want you all to read is John Perkins's The New Confessions of an Economic Hitman, an expanded edition of his classic bestseller. You will learn the world doesn't work according to some nice, tidy economic model full of complicated equations. Behind the scenes, there are a lot of dirty things going on.

Importantly, and this is my point, the US dominates global finance and the global economy, which is why I scoff at the idea of China, Russia or any other country is gaining on it and threatens to displace it or displace the greenback as the world's reserve currency.
By the way, over the weekend, I read about how the CIA offered gangsters $150,000 to assassinate Fidel Castro to the horror of Robert Kennedy. The same thing is going on nowadays but it's a lot more sophisticated and more effective.

Anyway, the point I wanted to make is petro profits and all profits made outside the US are recycled right back into Treasuries to fund the growing US debt, the military-industrial complex and Wall Street which loves collecting big fees to manage sovereign wealth fund and pension assets.

And those global investors are increasingly investing in private markets - real estate, private equity, and infrastructure -- where they see the highest annualized returns over the next ten years (click on image):



Nonetheless, as shown above, over the next ten years, no asset class except private equity is expected to return more than 8% annualized, which is bad news for pensions. And most of private equity's returns will come from leverage and asset-stripping.

Maybe that's why some are calling it the twilight  for the buyout barbarians while others are defending the industry at all cost.

All I know is that while passive is gaining on active funds in public markets, private markets are gaining on public markets, which is music to Steve Schwarzman's and Howards Marks' ears (fees are much juicier in private markets which are only active investing by nature).

So take everything you read on passive gaining on active funds with a pinch of salt. You need to dig a little deeper to really get a full picture of what's going on out there.

Below, Jack Bogle discusses whether Vanguard's size is a worry. Interestingly, he is cognizant that size can impact performance and sounds more cautious here.

Second, Blackstone's co-founder and CEO Steve Schwarzman told Bloomberg that it may double its assets to $800 billion over the next five years as it looks to cement its leadership in private markets. Blackstone received a commitment of as much as $20 billion for infrastructure deals from the kingdom’s Public Investment Fund.

Third, Howard Marks says stock, bond markets not likely to deliver great returns over next decade, stating "I think that if you look objectively at the market, you see cautionary signs." Marks is talking up his business and industry because if deflation strikes the US, boring old bonds might outperform all asset classes on a risk-adjusted basis over the next decade.

Lastly, BlackRock's CEO Larry Fink thinks investors should expect just 4% returns over the next 10 years. However, Fink also said we will see another leg up in this market and weighs in on what he thinks is driving stocks to record levels.

You already know my thoughts, it's as good as it gets for stocks, so book your profits and plow your money in boring old US long bonds (TLT) if you want to sleep well at night.







Friday, October 27, 2017

As Good As It Gets?

Evelyn Cheng of CNBC reports, Tech shares are this bull market’s most important stocks right now:
Technology is the most important industry for stocks today, indicating that blowout earnings from giants such as Microsoft could be good for the market.

Shares of Google parent Alphabet, Microsoft and Intel soared nearly 6 percent or more in Friday trading after reporting solid quarterly earnings that came in well above Wall Street's expectations. The stocks are among the largest in the S&P 500 by market capitalization. In fact, the technology sector overall has the largest weighting in the index at 23.2 percent, according to a Sept. 29 fact sheet.

The high weighting and strong performance heading into earnings season have tied the S&P 500's performance closely to that of technology stocks, especially over the last three months. During that time period, tech had the highest correlation to the S&P at 0.87, according to Kensho, a quantitative analytics tool used by hedge funds.


The closer a correlation is to 1, the more in sync two parts of the market are. The closer a correlation to zero, the more independent two parts of the market are. Telecommunications had the lowest correlation with the S&P over the last three months at 0.3.

"Frankly, it makes sense the correlation has risen here recently" between tech stocks and the S&P, said David Lebovitz, vice president and a global market strategist on the JPMorgan Asset Management Global Market Insights Strategy Team. "What you're seeing here as breadth has narrowed over the last couple of weeks, investors have [bought stocks of companies] growing both revenue and earnings as people get a little skittish."

The eight-year-old bull market is the second-longest in history, and many investors worry that a sharp drop in stocks is due soon. A bull market is a period without a drop of 20 percent or more in stocks from a recent high.

Lebovitz also pointed out that in a sluggish growth environment, stocks such as technology tend to perform better. The International Monetary Fund's latest global growth outlook this month forecasts a modest rise of 3.6 percent this year.

The relationship between tech stocks and the S&P has not always been this close. Over the last six months, tech has tied with consumer discretionary for the highest correlation with the S&P at 0.82, according to Kensho.

Over the last two years, tech falls to third place behind industrials and consumer discretionary, the analysis showed.

However, consumer discretionary is almost a play on tech as well since e-commerce giant Amazon.com is the largest stock in the sector. Shares of the company leaped 11 percent to all-time highs Friday after reporting a quarterly earnings beat and strong sales growth in its cloud business, Amazon Web Services.

Big tech earnings aren't over yet. Apple, which has the largest market capitalization in the S&P at $821 billion, is scheduled to report quarterly results on Nov. 2. Facebook, the fourth-largest S&P stock by market capitalization, is set to post results a day before.

Going back further into history, the S&P 500 is almost always up when tech stocks are up.

Since the current bull market began in March 2009, whenever the Technology Select Sector SPDR ETF (XLK) has gained more than 2 percent in a month, the S&P 500 has risen 96 percent of the time with an average return of 3.2 percent, according to Kensho.

On the other hand, the S&P has almost no chance of gains without tech stocks rising. When the tech ETF falls more than 2 percent in a month, the S&P falls 92 percent of the time with an average decline of nearly 3 percent, according to Kensho. The study looked at 37 such instances since the beginning of this bull market going back to 2009.

The S&P 500 traded Friday nearly half a percent higher within a quarter of a percent of its all-time high. The tech ETF rose more than 2 percent to a record high as technology stocks led S&P gains, while five sectors traded lower.

To be sure, some analysts worry that technology stocks are rising too quickly as investors chase performance. It's not a healthy sign for the market if only technology-related stocks are rising. In 2015, only Amazon and Netflix doubled, while Alphabet and Facebook were up double digits. But the S&P 500 was barely changed on the year.

"As tech becomes a larger and larger component of the S&P 500, its contribution to risk is larger as well," Lebovitz said.
Chase, chase, CHASE those high flying tech stocks higher or risk severely underperforming in this schizoid market.

It's Friday, by now everyone knows Jeff Bezos has surpassed Bill Gates to become the richest person in the world again as shares of Amazon (AMZN) are up close to 14% to over $1,100 a share as the company reported a monster blowout earnings report.

Don't feel too bad for Bill Gates, Larry Page and Sergey Brin, however, as shares of Microsoft (MSFT) and Google (GOOGL) are up 7% and 5% respectively on their red hot cloud computing business, sending the Technology Select Sector SPDR ETF (XLK) up to record levels:


Good times! Nothing can stop these tech stocks from hitting the moon, especially since all those elite hedge funds own them in what is proving to be the most concentrated defensive trade out there.

Defensive? Yes, at this point of the cycle when a few large tech stocks account for the bulk of the overall market's moves, it's not a good sign.

I know, there were other great earnings reports from Caterpillar (CAT) and even IBM (IBM) but I hate to be the bearer of bads news, this is as good as it gets for stocks, so book your profits and run for the hills.

Here are a few articles for you to read over the weekend as you contemplate whether it's as good as it gets for stocks or bonds (click on links):
Interestingly, this week, Jeffrey Gundlach and Ray Dalio came out to warn that the bond bear market is just beginning.

I say "BULLOCKS!!" but will admit US and global growth have been a lot more robust than I predicted earlier this year. Still, the US Q3 GDP report wasn't as good as the headline number suggests.

Pay attention to this chart below which measures stock market bulishness among all investors (h/t, Mathieu St. Jean):


Last week, I told you this market is on the edge of a cliff. It might keep going, and even might melt up, but make no mistake, downside risks are rising fast as expectations and valuations are stretched.

My main macro calls remain unchanged:
  • Long US long bonds (TLT)
  • Long the US dollar (UUP)
  • Short oil (OIL), energy (XLE), Metals and Mining (XME), emerging markets (EEM), commodities, commodity currencies and stock indexes.
What about trading biotechs (XBI)? I would be very careful here as the index is ready to roll over:


There are individual names I track and sometimes trade for a quickie but I'm not deluding myself here, the big beta tide is about to recede and it will be painful for all sectors. Even the best traders can get killed in these markets.


Honestly, my best advice for the weekend is to sit back, relax, make some popcorn, open up a nice bottle of wine, and enjoy a good old movie featuring Jack Nicholson and Helen Hunt.

Thursday, October 26, 2017

Canada's National Pension Hub?

At the beginning of the month, the Global Risk Insitute put out a press release, National Pension Hub to develop insights into challenges facing Canada's pension industry:
The Global Risk Institute in Financial Services (GRI) today announced the creation of a National Pension Hub (NPH) that will serve as a Canadian centre for pension knowledge and research. The purpose of the NPH is to provide pension and income security research that, among other things, will lead to innovative solutions to pension design, governance and investment challenges.

To date, more than a dozen organizations have joined the NPH, including major pension plans, accounting firms, consultancies and public corporations, as well as a number of individual opinion leaders in the field of pensions. Additional members are being recruited, including governments and companies associated with pension plans. The NPH will be administered by the GRI.

“The diversity of our membership in the National Pension Hub is one of our key strengths,” said Barbara Zvan, Chair of the NPH, and Chief Risk & Strategy Officer at Ontario Teachers’ Pension Plan. “It will help us produce innovative ideas and research that reflect a wide range of interests and perspectives.”

The pension industry has been grappling with a number of evolving challenges over the past decade including an aging population with a longer life expectancy, finite resources to invest in, more complex regulations, greater market volatility, and the need to generate strong returns in a slower growth economy. The NPH will provide a pipeline of objective research on pensions and income security that will help pension plan providers, investment managers, policy makers, and government administrators address these and other challenges.

In particular, the NPH will be an incubator for outcome-based research that addresses three primary objectives:
  • Provide Innovative solutions to retirement saving challenges;
  • Create sustainable capacity for academic research; and,
  • Serve as an unbiased source for policy consultation.
“We plan to build a deep reservoir of pension knowledge and research that will inform pension industry stakeholders, encourage debate on pension policy, and lead to consensus on critical issues,” said Richard Nesbitt, CEO of GRI. “At GRI, we’ve developed a proven model of how to create value from research by working with academic and industry leaders. We want to apply this model of thought leadership to the pension industry.”

The NPH’s first meeting will take place at the beginning of November, at which time it will set its initial research topics and projects. Most projects will have a two-year time horizon with initisl ports delivered after the first year.

The member organizations of the NPH at its launch date are: AIMCo, bcIMC, CDPQ, CPPIB, CN Rail, Deloitte University, IMCO, KPMG, McKinsey, Mercer, OMERS, OTPP, Public Sector Pension Investment Board (PSP Investments), PwC and the GRI. Individual members who are pension experts include Hugh Mackenzie and Bob Baldwin.

About GRI: The Global Risk Institute is the leading forum for ideas, engagement and building capacity for the management of risks in financial services. We are a non-profit, public and private partnership with 32 government and corporate members from asset management, banking, insurance and pension management. The institute’s goal is to develop fresh perspectives on emerging risks, to engage members, and to enhance risk-management skills. Our activities support academics, corporations, policy makers and regulators. We take a global view of the risks facing the financial services industry from our base in Toronto, Canada.
Yesterday, I had a chance to speak with Barbara Zvan, Ontario Teachers' Chief Risk & Strategy Officer and Chair of the NPH, and Richard Nesbitt, CEO of GRI. I want to begin by thanking them for taking some time to talk to me about this national penson hub.

The conversation was brief and to the point. The GRI was founded in 2011 as a result of an idea conceived by Mark Carney, Governor of the Bank of England and Jim Flaherty, former Canadian Minister of Finance. There were sixteen founding financial institutions, with the Governments of Canada, Ontario, TD Bank Group and Manulife Financial acting as the core architects.

A little over a year ago, the GRI approached Canada's pension industry to see if they can work closely to promote academic research pertaining to pensions.

There are now 14 members taking part in this endeavor, and the GRI coordinates this, collecting membership fees which will be used to fund academic research in Canada on all sorts of pension-related topics.

For example, Barbara Zvan mentioned research topics related to:
  • Longevity risk (see here and here)
  • Asset Allocation
  • Risks in private markets (see here and here)
  • Modelling discount rates to determine future liabilities
  • The use of leverage at pensions (see here and here)
The topics will be divided between assets (investing) and liabilities. They have already approached academic institutions in Ontario, British Columbia and Quebec and are approaching more.

They are currently looking at 20 topics which are being distilled down to 5 topics and they will soon meet to discuss where they want to focus their intitial research effort.

Members are now large Canadian pensions but eventually, they will expand and look for US, European and Asian members down the road. Any pension can join the national pension hub and receive the research and be part of this community but the focus will initially be on Canada.

Barb and Richard told me the research is academic and they are not trying to promote DB over DC plans, but there will be importing links to policies and papers that highlight the main findings for a general audience.

Barb added, "the NPH will complement the work done at University of Toronto's Rotman ICPM and C.D. Howe's Pension series."

I'm all for it, we have major pension issues in Canada that need to be addressed properly through more academic research and more common sense pension policies.

For example, in the wake of the Sears Canada bankruptcy, which is leaving 16,000 retirees unsure about the future of their under-funded pension plan, support is growing for new laws to better protect Canadian workers during corporate collapse:
CARP, a national non-profit advocacy group formerly known as the Canadian Association for Retired Persons, will be on Parliament Hill on Wednesday to meet with dozens of MPs as it lobbies for legislative change.

"What CARP is asking for is that unfunded pension liability be given 'super priority' status so it goes to the front of the line," said Wanda Morris, vice-president of CARP.

Pensioners hold no priority when it comes to dividing up assets during bankruptcy, and Morris said that typically in this country, defined benefit pensions are underfunded.

"There are about 16,000 [retirees] at Sears, but it just pales compared to the 1.3 million that potentially could be at risk. That's 1.3 million corporate pensioners with defined benefit pension plans," said Morris.
Then there are broader risks. This morning, Institutional Investors Release Declaration on Financial Risks Related to Climate Change:
Thirty Canadian and international financial institutions and pension funds representing approximately CAD $1.2 trillion of assets under management today issued a joint Declaration of Institutional Investors on Climate-Related Financial Risks, calling on publicly traded companies in Canada to commit to enhanced disclosure on their exposure to climate change risks, and the measures they are taking to manage them. The Declaration is supported in principle by 13 organizations.

The signatories of the declaration intend to work with publicly traded companies in Canada to help them mitigate their climate change risks. By signing the declaration, they are advocating for other economic and financial institutions to join forces in order to stimulate sustainable world economic growth, while reducing their environmental impact.

"This declaration, which was led by Finance Montréal's Responsible Investment work group, reflects the initiative shown by financial institutions. With more information at their disposal, investors will be able to better assess all the risks faced by their investment portfolios and design investment strategies that are adapted to the realities of climate change," said Louis Lévesque, Chief Executive Officer, Finance Montréal. "This is a positive development for the financial industry in Quebec and Canada, and keeps us aligned with global trends."

"I am proud to see the financial community rallying around this key issue. As institutional investors, we all have a role to play to promote increased transparency and better climate change disclosure practices from the companies we invest in," said André Bourbonnais, President and CEO, PSP Investments, and Responsible Investment Lead, Finance Montréal.

The declaration remains open to new signatories who wish to endorse it. The full text of the declaration, as well as a complete list of signatories, is available here.
Great job. Now, if we can only get President Trump on board.

Once again, I thank Barbara Zvan and Richard Nesbitt for speaking to me. If there is anything to add or change, I will edit this comment during the day.

Below, Barbara Zvan, OTPP's Chief Risk & Strategy Officer discusses the evolution of responsible investing and the role it plays in helping OTPP meet its fiduciary duty to its members.

I also embedded an interesting panel discussion on reforming the Canada Pension Plan and the Quebec Pension Plan featuring Bob Baldwin, Tammy Schirle and Pierre-Carl Michaud.


Wednesday, October 25, 2017

Bill Morneau's Pension Conflict?

Steven Chase and Robert Fife of the Globe and Mail report, Liberals defeat NDP motion to close conflict-of-interest loophole:
The Trudeau Liberals used their parliamentary majority Tuesday to defeat an NDP motion on closing a loophole that allowed Finance Minister Bill Morneau to retain close control over a significant stake in his family company even as he ran a department with power to affect the fortunes of Morneau Shepell.

The Liberals also continued to dodge questions on whether Mr. Morneau recused himself from internal discussions on Bill C-27, legislation that opposition parties say could be expected to benefit Morneau Shepell, one of four major firms in Canada's human-resources and pension-management sector.

As The Globe and Mail first reported last week, Mr. Morneau ran the Finance Department for nearly two years without putting his substantial assets into a blind trust – as Justin Trudeau did for his family fortune, a move that the Prime Minister holds up as the gold standard for avoiding conflicts of interest in federal politics. After days of defending his conduct, the Finance Minister last Thursday reversed course and pledged to sell his remaining one million shares in Morneau Shepell and put all other assets in a blind trust.
Read the rest of this article here. I think NDP ethics critic Nathan Cullen who sponsored this motion is spot on: "Every single Liberal voted against closing the ethics loophole," Mr. Cullen said. "Either they don't get it or they don't care."

Conveniently, Mr. Morneau was not in the Commons for Question Period but it's highly inappropriate for Canada's Finance Minister to take part in any discussions on Bill C-27 given he still has controlling interest in Morneau Shepell, one of four major firms in Canada's human-resources and pension-management sector.

Those of you who know me know that I'm a stickler for good governance and transparency. It's highly inappropriate for the CEO or senior manager of a major US or Canadian pension fund to invest in an outside fund and then magically get hired by that fund a few years later, especially if that officer had direct say in the investment decision.

Has it ever happened before? You bet. Lots of shady things have happened in the past that would never happen nowadays. Like what? Well, that is a topic for another day but let's just say I can write an interesting chapter on shady activity that used to take place at all of Canada's pensions including front-running F/X orders for personal accounts just like that HSBC currency trader who was just convicted of fraud and front-running.

Now, I'm not implying Bill Morneau is doing anything fraudulent or shady but the optics look terrible. This is the type of nonsense I would routinely see in Greece growing up, but we live in Canada, not Greece, Lebanon or Turkey.

All that Bill Morneau needed to do is follow Justin Trudeau (or Paul Martin, Jim Flaherty, etc.) and just put his assets in a blind trust from the get-go. The fact that he finally reversed course and pledged to sell his remaining one million shares in Morneau Shepell and put all other assets in a blind trust shows he understood the optics were all wrong.

And for the life of me, I simply cannot understand why the Liberals would quash a sensible NDP-sponsored motion which was fully supported by the Conservatives. And then people wonder why we call them limousine Liberals who are nothing but blatant hypocrites that love spending other people's hard-earned money.

I think our Prime Minister needs to take a break, come to Montreal now that the weather is nice and grab a coffee with me and my brother who was his high school classmate at Brébeuf and we'll talk some sense into him because Gerald Butts and the cronies in Ottawa are giving him terrible advice. Truly terrible advice.

And just for the record, I'm not impressed with Bill Morneau. Paul Martin impressed me, Jim Flaherty, God rest his soul, impressed me even though he was working under an authoritarian and arrogant leader peddling to Canada's powerful financial services industry every chance he got. Bill Morneau is weak and his newly unveiled economic plan will end up costing us dearly down the road.

Anyway, I'm extremely worried about Canada's economic future, I'm glad the Bank of Canada came back to its senses today after flirting with disaster earlier this year. Canada's growing debt risks are growing to the point where 4 in 10 Canadians cannot cover basic expenses without going deeper in debt.

Yesterday, I warned of America's dangerous dual economy. The situation is far worse in Canada and when the next global deflationary shock hits us, watch out, deficits are going to mushroom, it will get very ugly, very quickly.

I've said it before and I'll say it again: Canada is one global deflationary shock away from a great depression which might last a decade and maybe even longer.

All you delusional Canucks buying the Canadian housing dream nonsense are cruising for a bruising because when the next crisis hits, it's game over for a long, long time.

Now, what about Bill C-27 and target benefit plans? Morneau Shepell does a good job comparing Defined Contribution (DC) plans versus Target Benefit Plans (TBPs) in this comment, Target benefit plans - Game-changer or non-starter?.

I will let you read the entire comment but the key passage is this:
WHAT IS A TBP?

The TBP concept is not new. It has existed for many years in the form of negotiated contribution Multi-Employer Pension Plans (MEPPs), which are especially popular in certain industries. What is new is the notion of TBPs in the single-employer environment.

In its most basic form, a TBP is a pension plan that aims to provide a defined benefit (DB), but with fixed contributions. To plan members, it is virtually indistinguishable from a regular DB plan except that accrued benefits are subject to reduction if the funding level falls below a given threshold. To avoid a reduction, TBPs are governed by more formal funding and benefit policies than one typically finds in defined benefit plans. In addition, conservative assumptions can be used in the setting of the target benefit with benefit improvements granted only if there is a significant funding surplus.

TBP assets are pooled for investment purposes and are managed in much the same way as in a DB plan although the TBP fund might be invested a little more conservatively to reduce the chances of a funding deficit.

One variation on the basic TBP allows for contributions to vary within a narrow range rather than being completely fixed. This is the idea behind the Shared Risk Pension Plan that was adopted recently by the New Brunswick Government (see the sidebar “The New Brunswick SRPP”).

REASONS TO CONSIDER TBPs

TBPs are promising because they eliminate the risk of rising costs inherent in DB plans while offering a better solution for most employees than most DC plans.

DB plans have long fallen out of favour in the private sector and are now under increasing attack in the public sector. Much has been written to explain why this is the case but for our purposes it suffices to say that the decline of DB plans is unlikely to be reversed. In the long run, the only DB plans that may survive are those sponsored by organizations with very deep pockets.

For their part, DC plans suffer from two fundamental defects. The first is the uncertainty of the benefits they generate, which complicates retirement planning (see Figure 1 for example). The second is that the members bear the risk, but all too often are not qualified to make their own investment decisions.


TBPs minimize many of these shortcomings. From the employer’s perspective, the following characteristics of a TBP are significant inducements to switch away from DB:
  • The contribution level is fixed, with no obligation to contribute more even if funding proves inadequate.
  • Accounting (in the ideal case) is based on contributions made, the same as in DC plans. Accounting in DB plans is an elaborate exercise that has produced some unpleasant surprises for employers in recent years. Pension expense has skyrocketed as bond yields have fallen and the situation has been exacerbated by investment losses during the financial crisis. This is the main reason DB plans became so unpalatable to the shareholders of private sector companies. The DC-type accounting that the accounting profession might decide to apply to TBP plans eliminates any such pension expense shocks.
  • Pension Adjustment (PA) calculations under a TBP should be easy, being simply the contribution made (assuming the Canada Revenue Agency (CRA) agrees with this treatment). This simplifies plan administration and may also provide more Registered Retirement Savings Plan (RRSP) contribution room for employees.
  • The target benefit in TBPs is monitored by means of going-concern funding valuations. Solvency valuations, which have been the source of such volatile funding in recent years as to threaten the very solvency of some companies, would not be required.
The sponsors of DC plans may also want to consider TBPs. The one big advantage they have over DC plans is that the assets are pooled and invested in much the same way as for DB plans. This means the TBP sponsor does not have to offer individual investment choice thus eliminating the onerous and sometimes futile task of trying to educate an entire workforce on investment basics.

While employees are unlikely to prefer TBPs over traditional DB plans, they will probably find them a better alternative than DC plans. There are some good reasons for employees to prefer TBPs:
  • While the target benefit is less certain than in a DB plan, it is more certain than the income one can derive from a DC plan.
  • The target benefit is paid for life so retirees do not have to worry about outliving their assets. They do have to worry about a potential benefit cut under a TBP but good funding and benefit policies reduce both the chances and the severity of such a cut.
  • Various studies indicate that plan administrators, with the advice of investment professionals, make better investment decisions than individual employees. TBPs therefore promise to stretch a dollar of contribution further than it would go in a DC plan.
  • For a DC retiree to secure a stable monthly income, she would have to buy a life annuity. The insurance company expenses and anti-selection charges, as well as the very conservative investments underlying the annuity reserves tend to reduce the amount of payout. TBPs avoid all of those problems.
  • Unions should appreciate the fact that TBPs promote solidarity. Unlike DC plans, all members in a TBP accrue the same pension for a given year of service.
PROBLEMS WITH TBPs

The biggest drawback to a TBP is that the payout can be reduced if the target benefit is less than 100% funded. This problem is more than theoretical as an estimated 25% of MEPPs have had to reduce benefits in the past decade.

As we will see, benefit reductions should be less likely in single-employer TBPs with the help of intelligent plan design features and the adoption of conservative investment, benefit and funding policies. The downside to conservatism, however, is lower target benefits and a greater transfer of wealth to the next generation, so some compromise is necessary. Hence, the prospect of benefit reductions in a TBP can never be entirely eliminated.

To appreciate the challenge of deriving a stable income from fixed contributions, consider Figure 1,1 which is taken from our last Vision. It shows that historically, a fixed rate of contributions would have generated retirement income that varies from a low of 15% of final average pay to as much as 55% depending on the year of retirement.

For the plan in Figure 1, the plan sponsor could have set the target benefit at 30% of final average pay and could probably have paid out the full basic pension consistently though there would have been some years when post-retirement indexing could not have been paid. Had the target been set at 40%, it certainly looks more attractive but it would mean forgoing indexing for prolonged periods and even basic benefits would have to be reduced in some years. Neither situation is perfect. The 30% target provides better security but in good times it may frustrate some retirees who feel they could have done better in a DC plan and who have no wish to be building up a reserve for the benefit of the next generation of plan members. On the other hand, a 40% target would lead to frequent disappointment.

Another challenge with TBPs is that employers may have to forgo plan provisions that incent certain behaviour, such as retiring earlier. Incentives come at a cost and members in a TBP will resent subsidizing others. Of course, subsidies exist in virtually every DB plan as well, but they do not tend to create problems there because the extra cost is perceived to be borne by the employer rather than coming at the expense of fellow plan members.
I'm not going to go over the pros and cons of target benefit plans (TBPs) here. They're a step in the right direction but far inferior to a large well-governed defined-benefit plan which is what Bill Morneau, Justin Trudeau and Canada's pension overlords enjoy.

My biggest beef with TBPs is just like DC plans which are just brutal, they invest only in public markets, not private markets. Over the long run, this makes a huge difference to a well-run plan.

If it were up to me, CPPIB and other large, well-governed Canadian pensions would be managing the pensions of all Canadians. Period. No more issues with companies going bankrupt and taking pensions down with them. No more conflicts of interests with Morneau Shepell, Mercer or any other organization. There would be no need for them or a marginal one to consult and advise.

We waste so much valuable time and energy trying to get our pension policy right but we have everything we need right under our nose. The world's best defined-benefit pensions and a shared-risk model which shares the risk of the plan equally if the funded status deteriorates.

Below, Finance Minister Bill Morneau says he is meeting with the ethics commissioner Thursday to discuss how he can reassure Canadians about his personal wealth. Morneau is taking steps to end the controversy regarding his business assets.

My former colleague from my days at PSP, Fred Lecoq, recently emailed me to tell me I should get into politics. I told him I'm too honest and harsh for politics. He said "that's why they'd love you."

I’ll leave the politics to others but if Bill Morneau and Justin Trudeau ever want to meet me, I'll treat them to a coffee here in Montreal and bring Fred, my brother and others along so we can talk some sense into them and they can get back on track, dropping all the foolish nonsense that has derailed them. Everything off the record, of course. :)

Tuesday, October 24, 2017

America's Dangerous Dual Economy?

Abby Joseph Cohen, a senior investment strategist at Goldman Sachs, wrote a comment for Yahoo Finance, The last 8 years of labor market improvement have been disturbingly uneven:
The deep recession triggered by the financial crisis technically ended in the summer of 2009. Despite eight years of economic growth, the labor market improvements have been disturbingly uneven.

Several factors are contributing to the wide range of outcomes which, in turn, have led to stark contrasts in how different groups of consumers and business owners view the current economic environment. I’ll briefly discuss only three of the factors: education, technology and geography. This last category can also be described as “location, location, location” and hasn’t received adequate attention from policymakers.

Declines for high-school educated Americans

Even before the financial crisis, some workers and their families were falling behind, with an ever-widening gap in household incomes linked to level of education. In 2000, for example, the median household income in which the head of household had a high school diploma was about $50,000. A household headed by someone with a college degree was about $100,000. Since then, on an inflation-adjusted basis, the high school-educated family has experienced a decline of about 15% in household income to $43,000. The decline for a college-educated family was about 3% to $97,000.

Technology causing shifts in how workers do their jobs

Long-term structural changes have also had dramatic effects on individual earners and their families. Much has been written about the job losses in the manufacturing sector. Although some politicians point to the role of imports, by far the larger factor has been the use of technology and increased productivity of workers in this sector. Studies have suggested an 80/20 split, that is, 80% of the job losses can be attributed to enhanced productivity, and much of the remainder to global competition. Of course there are variations based on the specific industry within the manufacturing sector.

Throughout the economy, increased use of technology is causing shifts in how businesses interact with customers and how workers do their jobs. There have been pronounced changes in many sectors, including retailing, media and some professional services. The growth in STEM-specific jobs has outpaced the rest and wages, at about $95,000 per year, are roughly double those for the overall private economy. But only 7.2% of US workers are in STEM jobs.

Location, location, location 

Geography is a critical factor which is often overlooked. The attached chart clearly shows the wide gap in job creation by location in the US (click on image below). Since the peak of employment before the financial crisis, the overall economy has created jobs at an anemic pace. Between 2007 and 2014 the aggregate increase was 1.1%. But we need to look below the surface of the national averages. There have been sustained job losses in rural areas and in smaller towns and cities. But, the nation’s largest cities experienced a sharp 8% increase in jobs during this period. The areas surrounding these primary cities also benefited as being part of the regional ecosystem.

Courtesy: Abby Joseph Cohen

The success of communities can be linked to multiple factors. These include the presence of growing industries, higher levels of education, welcoming of newcomers, and the magnetic appeal of public infrastructure and cultural institutions. It is worth noting that broad policy tools, such as monetary and fiscal stimulus, may not be sufficiently targeted to help the communities that are currently struggling. Instead, the “business models” of the cities that are currently thriving show that long-term public investment in education, infrastructure (roads, schools, communication, etc.), and health care can pay long-term dividends in the form of job creation and wage growth.
A very interesting comment indeed from Abby Joseph Cohen, Goldman's former superstar permabull strategist during the tech bubble years. I wonder if she agrees with Greenlight Capital's David Einhorn who recently told clients that the market may have adopted an "alternative paradigm" for calculating the value of stocks.

It's a very bullish Tuesday on Wall Street. In early afternoon, the Dow is up over 200 points reaching another record-breaking high driven primarily by great earnings reports from Caterpillar (CAT) and 3M (MMM).

In the last four trading sessions, the Dow is up almost 500 points (click on image):


This is great news for Bill Koch and his expensive counterfeit wine collection and for his fellow billionaires which include tech innovators, indusrialists, entrepreneurs and a handful of banking, hedge fund and private equity titans who are reaping massive gains no thanks to global central banks continuing to pump massive liquidity in the system (click on chart):


Cohen doesn't discuss the financialization of the economy and how it has permanently and irrevocably exacerbated the wealth gap in the United States.

Many people do not understand the way the world works now and how critically important the FIRE (finance, insurance, real estate) industry is. For example, as I recently explained in the coming renaissance of macro investing, the US is becoming more powerful as its current account deficit and national debt widen because the rest of the world is recycling profits right back into Wall Street.

13D Research tweeted this chart on China's growing influence looking at its share of global trade (click on image):


People look at this and think "OMG! China is taking over the world!". But they're not understanding the full story.

Importantly, China, Japan, Germany all running current account surpluses necessarily means the US is running a capital account surplus. In other words, all these profits need to recycled right back into Wall Street so don't read too much on China's growing influence.

And with central banks pumping billions into the financial system using conventional and non-conventional tools, it's a virtual free-for-all for the lords of finance.

In fact, when people ask me which industry receives the most subsidies from governments in the developed world, I tell them it's not agriculture or aerospace, it's the financial sector via money for nothing from central banks that can print at will through a few keystrokes.

Bankers don't like to talk about this dirty little secret. They prefer the mirage that they're real tough capitalists who are innovators and take risks. They do take risks, mostly with other people's money, but when things go wrong, they socialize the losses (as we saw in 2008).

But even on Wall Street, traditional jobs are already being disrupted by technology, and the emergence of artificial intelligence will drastically reorder the role of most humans in finance, according to former Goldman Sachs Group Inc. Chief Technology Officer Michael Dubno.

This is the ruthless logic of banks looking to cannibalize each other, where return-on-investment drives everything with little to no regard on how AI is profoundly disrupting all industries and the very fabric of society (we need more good moral philosophers, fewer programmers!).

And it's not just banks. Their big quant hedge fund clients taking over the world are also investing heavily in AI, trying to gain an 'edge' over rivals. Two Sigma has rapidly risen to the top of the quant hedge fund world and it has been hiring Ph.D.s and other AI experts just like everyone else.

The same thing is happening in Silicon Valley where tech giants are paying huge salaries for scarce AI talent, upward of $300,000 to $500,000 a year for Ph.D.s and people with less education fresh out of school. Pretty soon, we're going to be teaching embryos to code to give them an edge in life.

Go back to read my comment on why deflation is headed for the US where I outlined once again the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

By structural, I mean factors that will be with us for a very long time, as opposed to cyclical factors that are temporary by nature.

All these factors are deflationary because they shrink the economic pie for most, leaving more an more resources in the hands of the prosperous few, the so-called "winners" of this uneven economy.

Some very influential hedge fund elites are taking notice. Yesterday, Ray Dalio, Chairman and CIO at Bridgewater wrote one of his most profound and in my opinion, important comments on LinkedIn, Our Biggest Economic, Social, and Political Issue The Two Economies: The Top 40% and the Bottom 60%. It's not the first time Ray discussed the dangerous divide.

I will let you read his entire LinkedIn comment here as it is long but he explains in detail why you cannot base policy based on averages like average household income. He also explains why the polarity in economics and living standards is contributing to greater political polarity which in turn is fueling greater distrust in government, financial institutions, and the media, which is at or near 35-year lows.

Ray summarizes it all here and shares his policy concerns:
Average statistics camouflage what is happening in the economy, which could lead to dangerous miscalculations, most importantly by policy makers. For example, looking at average statistics could lead the Federal Reserve to judge the economy for the average man to be healthier than it really is and to misgauge the most important things that are going on with the economy, labor markets, inflation, capital formation, and productivity, rather than if the Fed were to use more granular statistics. That could lead the Fed to run an inappropriate monetary policy. Because the economic, social, and political consequences of an economic downturn would likely be severe, if I were running Fed policy, I would want to take this into consideration and keep an eye on the economy of the bottom 60%. By monitoring what is happening in the economies of both the bottom 60% and the top 40% (or, even better, more granular groups), policymakers and the rest of us can give consideration to the implications of this issue. Similarly, having this perspective will be very important for those who determine fiscal policies and for investors concerned with their wealth management. We expect the stress between the two economies to intensify over the next 5 to 10 years because of changes in demographics that make it likely that pension, healthcare, and debt promises will become increasingly difficult to meet (see “The Coming Big Squeeze”) and because the effects of technological changes on employment and the wealth gap are likely to intensify. For this reason, we will continue to report on the conditions of “the top 40%” and “the bottom 60%” separately (as well as on the averages), and we encourage you to monitor them too.
Of course, Ray Dalio's "big squeeze" neglects to mention the big squeeze on fees US pensions had to endure from his fund and other elite hedge funds and private equity funds over the last two decades despite seeing their funded status deteriorate. That's what catapulted them to the top 0.0000001% of the world's rich and famous.

Ray is right however on monetary and fiscal policy. Janet in wonderland or whoever is at the helm of the Fed needs to stop catering to big banks and their big hedge fund and private equity clients and start thinking very carefully about the next downturn and how it will primarily impact the bottom 99%, not just the bottom 60%.

I believe Yellen is starting to worry that deflation is headed for the US which is why she is openly discussing redeploying quantitative easing during the next downturn.

But again, even if the Fed preps for QE infinity, there are serious structural issues that need to be addressed and monetary policy alone will not relieve the major inequities that plague the US and increasingly global economy.

A few months ago, I was talking to my younger brother who is a psychiatrist like our father about rising inequality and he thinks it's only a matter of time before we introduce a basic minimum income for all in our economy like they are now doing in Finland and other Scandinavian countries, realizing that some people will never be able to be part of the labor market.

Even Facebook's Mark Zuckerberg sees the merits of a universal basic income. And he is right to worry because according to one recent study, financially vulnerable millennials could spell disaster for the US economy:
The unemployment rate dropped to 4.2% in September, its lowest since February 2001, and yet consumer loan defaults keep creeping up.

In fact, the divergence between the labor market on one hand, and consumer credit performance on the other is at a record (click on image). What figures?


UBS analysts led by Matthew Mish and Stephen Caprio set out to answer that question, and their findings highlight the financial difficulties many millennials are facing.

According to Mish and Caprio, there are two cohorts that have been left behind by the labor market: lower income households, and millennials.

"The most underappreciated factor explaining consumer stress is the two-speed recovery in US consumer finances," they said.

The two strategists dived into the Fed's latest Survey of Consumer Finances to calculate a bunch of metrics, including the the levels of debt to assets and income across different age cohorts. Those ratios are near record levels, with the millennial debt-to-income ratios in line with 2007 levels (click on image).


And that might not tell the whole story. The Fed survey suggests 38% of student loans are not making payment, while the structural shift from owning a home and paying a mortgage to renting means that more households are paying rent and making auto lease payments. In other words, they might have significant outgoings that aren't being captured in the debt figures.

"We believe this is particularly problematic when assessing the financial obligation ratios of US millennials and lower-income consumers," UBS said.

So what does this mean? Here's UBS:
"Longer term, the two-tier recovery in consumer finances suggests key segments of the US population (lower income, millennial households) are more financially vulnerable than aggregate consumer credit metrics imply. In turn, these groups will be more sensitive to fluctuations in labor market conditions and interest rates ceteris paribus."
That's a touch worrying, especially at a time when interest rates are going up.

For context, millennials hold 18% of debt outstanding, according to UBS, and make up 19% of annual consumer expenditures. Together, the two cohorts "left behind," lower-income households and millennials, make up about 15% to 20% of debt, and 27% to 33% of expenditure.

So if they're struggling, it has the potential to negatively impact the economy pretty significantly.
This research supports Ray Dalio's warning on the danger of looking at averages when making important policy decisions. It also supports my theory that things are nowhere near as strong as these record-breaking stock markets suggest.

Below, Ray Dalio, Bridgewater Associates founder, talks about Federal Reserve policy, interest rates and how an economic downturn would likely impact the US's dual economy (September 19, 2017).

And Goldman Sach's former Chief Technology Officer, Mike Dubno, talks about how traditional Wall Street jobs are already being disrupted by technology, and the emergence of artificial intelligence will drastically reorder the role of most humans in finance.