Thursday, August 31, 2017

New Math Hits Minnesota's Pensions?

Martin Z. Braun of Bloomberg reports, New Math Deals Minnesota’s Pensions the Biggest Hit in the U.S. (h/t, Suzanne Bishopric):
Minnesota’s debt to its workers’ retirement system has soared by $33.4 billion, or $6,000 for every resident, courtesy of accounting rules.

The jump caused the finances of Minnesota’s pensions to erode more than any other state’s last year as accounting standards seek to prevent governments from using overly optimistic assumptions to minimize what they owe public employees decades from now. Because of changes in actuarial math, Minnesota in 2016 reported having just 53 percent of what it needed to cover promised benefits, down from 80 percent a year earlier, transforming it from one of the best funded state systems to the seventh worst, according to data compiled by Bloomberg.

“It’s a crisis," said Susan Lenczewski, executive director of the state’s Legislative Commission on Pensions and Retirement.

The latest reckoning won’t force Minnesota to pump more taxpayer money into its pensions, nor does it put retirees’ pension checks in any jeopardy. But it underscores the long-term financial pressure facing governments such as Minnesota, New Jersey and Illinois that have been left with massive shortfalls after years of failing to make adequate contributions to their retirement systems.

The Governmental Accounting Standards Board’s rules, ushered in after the last recession, were intended to address concern that state and city pensions were understating the scale of their obligations by counting on steady investment gains even after they run out of cash -- and no longer have money to invest. Pensions use the expected rate of return on their investments to calculate in today’s dollars, or discount, the value of pension checks that won’t be paid out for decades.

The guidelines require governments to calculate when their pensions will be depleted and use the yield on a 20-year municipal bond index to determine costs after they run out of money.

The Minnesota’s teachers’ pension fund, which had $19.4 billion in assets as of June 30, 2016, is expected to go broke in 2052. As a result of the latest rules the pension has started using a rate of 4.7 percent to discount its liabilities, down from the 8 percent used previously. As a result, its liabilities increased by $16.7 billion.

The worsening outlook for Minnesota is in line with what happened nationally. Pension-funding ratios declined in 43 states in the 2016 fiscal year, according to data compiled by Bloomberg. New Jersey had the worst-funded system, with about 31 percent of the assets it needs, followed by Kentucky with 31.4 percent. The median state pension had a 71 percent funding ratio, down from 74.5 percent in 2015.

While record-setting stock prices boosted the median public pension return to 12.4 percent in 2017, the most in three years, that won’t be enough to dig them out of the hole.

Only eight state pension plans, in Minnesota, New Jersey, Kentucky and Texas, used a discount rate “significantly lower" than their traditional discount rate to value liabilities, according to July report by the Center for Retirement Research at Boston College.

“Because of that huge drop in the discount rate under GASB reporting, their liabilities skyrocket," said Todd Tauzer, an S&P Global Ratings analyst. “That’s why you see that huge change compared to other states.”

Public finance scholars at George Mason University’s Mercatus Center have found “considerable variance" in how states were applying the new standards. In Illinois, for example, despite the state’s poor history of funding its plans, actuaries project they won’t run of money until 2072.

In Minnesota lackluster returns and years of shortchanging have taken a toll. The state’s pensions lost 0.1 percent in fiscal 2016.

But other factors also helped boost Minnesota’s liabilities: Eight of Minnesota’s nine pensions reduced their assumed rate of return on their investments to 7.5 percent from 7.9 percent, while three began factoring in longer life expectancy.

Minnesota funds its pensions based on a statutory rate that’s lower than what’s need to improve their funding status. School districts and teachers contribute about 85 percent of what’s required to the teacher’s pension, according to S&P Global Ratings.

“It’s woefully insufficient for the liabilities," said Lenczewski, the director of Minnesota’s legislative commission on pensions. “You just watch this giant thing decline in funding status."
In my last comment, I looked at whether Kentucky's pensions are finished, and stated that years of neglect, incompetence, cover-ups, corruption and lack of governance have irrevocably jeopardized the future of public pension plans in that state.

But while Kentucky, Illinois, and New Jersey have well-known public pension problems, other states are also on the verge of seeing their pensions collapse, either because of years of neglect or more likely, because the new pension math (new GASB rules) is forcing them to use a much lower discount rate to determine their future liabilities.

I have already discussed whether these new regulations will sink pensions here and here, and while some critics claim these new rules are too stringent, there's no denying using a 7% or 8% assumed rate-of-return to determine future liabilities is way too lax and rosy, significantly understating the true debt profile of US public pensions.

Remember, pensions are all about managing assets AND liabilities. If liabilities are skyrocketing because interest rates have declined and will stay at ultra-low record levels for years, then to be using a rosy assumed investment rate to discount future liabilities is simply not acceptable and borderline fraud.

And since the duration of liabilities is a lot bigger than the duration of assets, then no matter how well investments do, pension deficits will keep widening as interest rates decline. This effectively is the death knell for chronically underfunded US public pension plans.

Also, lowering the discount rate means liabilities will explode up, and this has all sorts of policy implications because it effectively means more and more of the public budget will need to go to service these pensions, cutting municipal and state services elsewhere.

And if the situation gets really bad, taxpayers will be called upon to shore these chronically underfunded public pensions, something which isn't politically palatable in today's economy where many private sector taxpayers are stretched, trying to save a buck for their own retirement.

More worrisome, from Kentucky to New Jersey, to Illinois to Minnesota, America's public pensions are crumbling and they're not bulletproof. If one by one, large US public pensions collapse, they could potentially fuel the next crisis.

One thing is for sure, America and the world hasn't properly addressed the ongoing pension crisis which is deflationary as more and more workers retire with little to no savings and are at risk of succumbing to pension poverty.

This is why I'm highly skeptical that central banks should adopt zero rates now. No doubt, we need inflation but this policy might aggravate an already dire pension situation and lead to more deflation.

I don't know, what do you think? Every time I write on these pensions at risk of collapse, it depresses me because I know some poor worker or retiree is going to get a rude awakening in the future when their chronically underfunded pension has no choice but to increase the contribution rate and/ or cut benefits to shore up their plan.

Below, an older clip (2015) where Bill Hudson of WCCO CBS reports Minnesota Teamsters have been told to brace for huge cuts in their monthly pension benefits.

Unfortunately, Minnesota's new pension math and years of neglect will mean hundreds of thousands of public-sector retirees will likely join their ranks in the future.

Update: Bernard Dussault,  Canada's former Chief Actuary, shared this with me after reading this comment:
As you may already well know, my proposed financing policy for defined benefit (DB) pension plans holds that solvency valuations (i.e. assuming a rate of return based on interest only bearing investment vehicles as opposed to the return realistically expected on the concerned actual pension fund) are not appropriate because they unduly increase any emerging actuarial surplus or debt of a DB pension plan.

Nevertheless, while assuming a realistic rate of return as opposed to a solvency rate would decrease the concerned USA DB pension plans' released debts, any resulting surplus would not appear realistic to me if the assumed long-term real rate of return were higher than 4% for a plan providing indexed pensions.
I thank Bernard for sharing his wise insights on this subject.

Wednesday, August 30, 2017

Are Kentucky's Pensions Finished?

Daniel Desrochers of the Lexington Herald Leader reports, ‘It affects everything.’ What’s at stake as Kentucky’s pension war begins:
Trenches have been dug, heels are firmly planted, fingers are locked and loaded, ready to point at the most convenient scapegoat — the war over Kentucky’s public pensions has begun.

The first strike came Monday, when a state-paid consulting group, PFM, issued a report recommending drastic changes to the pension plans that cover most of Kentucky’s public employees — retired, active and future.

Read more here: http://www.kentucky.com/news/politics-government/article170086847.html#storylink=cpy

Lawmakers were quick to point out that the recommendation was just that — a recommendation.

“There’s good ideas in there. I will say there’s a lot of good ideas, some of them may be implemented, some of them may not be,” Gov. Matt Bevin said in a Facebook Live video hours after the report. “There’s some that, quite frankly, I don’t think there will be an appetite for, even though they may be financially appropriate for us to pursue.”

Legislators, the people who will vote on any pension overhaul, have expressed similar reservations about the report, which contained proposals that outraged every subset of government employees in the state.

“The PFM report should be, and I think to a large degree was, not political and now you’re going to introduce politics in the process,” said state Rep. James Kay, D-Versailles. “And there are going to be winners and losers.”

So far, government workers have largely been kept in the dark about what action the legislature might take.

Members of the House of Representatives held a closed-door meeting Tuesday afternoon to discuss the PFM report, shutting the public out of their first discussion about potential changes that might directly affect the pocketbooks of about 500,000 Kentuckians.

Lawmakers said the meeting largely consisted of asking the consultants and state budget director John Chilton questions about the report. Among other things, it recommended raising retirement ages, freezing the pensions of most state and local government workers and pushing them into 401(k)-style retirement plans.

Going forward, a variety of interest groups are poised to battle for the votes of lawmakers.

“I think we’re all hearing from folks,” said House Speaker Jeff Hoover, R-Jamestown. “Look, we’re all concerned about it, it affects every Kentuckian. I said yesterday that this issue is not just about retired workers or retirees, it’s not just about current state workers or current teachers. It affects everything with regard to the state budget and it affects every Kentuckian.”

Facebook pages for state government workers and retirees lit up with reaction Monday night to the consultant’s report and Bevin’s video chat. All of the groups have asked members to make their presence felt in Frankfort.

“We are currently in a fight to preserve the retirement benefits so many have been promised and spent a lifetime of service earning,” the Kentucky Fraternal Order of Police said on Facebook. “Please tell your state legislators to protect our pensions.”

The Kentucky Government Retirees group posted a request Tuesday for lawyers to offer suggestions about “how to proceed with evaluating and securing suitable legal counsel.” The group has pledged to fight a recommendation that would take away cost-of-living adjustments given to retirees from 1996 to 2012, a change that would reduce the monthly checks for many in the state (click on image).


Read more here: http://www.kentucky.com/news/politics-government/article170086847.html#storylink=cpy
Meaghan Killroy of Pensions & Investments also reports, Kentucky hires PFM Group to analyze state pension plans:
Kentucky's finance and administration cabinet, Frankfort, hired PFM Group to provide a performance and best practices analysis of the state's retirement plans.

PFM will analyze the plans’ overall solvency and liquidity, outstanding obligations, reasons for the plans’ current financial status, and best practices and future actions to shore up the plans, said a news release from the governor’s office on Monday.

The firm’s final report is due Dec. 31, said a spokeswoman in the finance and administration cabinet in an e-mail.

An RFP was issued in May.

PFM Group will provide the state with financial and other information relating to the current and projected financial situation on its retirement plans and advising the state on various paths forward. “Reforming the state’s ailing pension systems is one of this administration’s top priorities,” said Gov. Matt Bevin in the release. “The findings that will come from this pension fund audit will accurately identify our actual pension liabilities. It is our intention to shine the antiseptic light of transparency on the country’s worst funded pension system and financially secure the pension system for generations to come. Kentucky taxpayers, retirees and current employees deserve nothing less.”

The $18 billion Kentucky Teachers' Retirement System, $15 billion Kentucky Retirement Systems and $94 million Kentucky Judicial Form Retirement System, all based in Frankfort, face roughly $35 billion in unfunded liabilities combined.
Lastly, Tom Loftus of the Courier Journal looks at 7 controversial recommendations to solve Kentucky's pension crisis:
The PFM Consulting Group says that the many changes in recommended Monday for Kentucky's pension systems would eventually save the state more than $1 billion a year.

That's if all of them are adopted.

And some of the recommendations have been controversial.

Of course, it remains to be seen what the final result will be when a special legislative session — which Gov. Matt Bevin has said he will call this fall — convenes. The governor insisted on Facebook Live Monday night that any plan would be done in consultation with state workers and would protect benefits they have accrued thus far.

Of course, PFM's recommendations address other issues besides benefits (assumptions used by the retirement plans, investment practices of retirement systems, the basic approach the state takes to funding the plans, etc.)

But here are some of its more controversial recommendations:

1. Repeal retirees' cost of living adjustments


PFM recommends state and local government retirees give up the portion of their future benefit payments resulting from cost of living increases granted to Kentucky Retirement Systems members between 1996 and 2012. That would mean a reduction in benefit checks for anyone who retired before 2012, with some reductions of 25 percent or more.

2. Suspend teachers' cost of living adjustments

Recommends suspending future cost of living adjustments for teachers until the Teachers’ Retirement System is 90 percent funded, which is certain not to happen for many years. Teachers currently get cost of living increases, partly because — unlike most other public employee retirees — they do not get Social Security benefits, which do include an annual cost of living adjustment.

3. Create new 401(k) plans for most state and local government workers

Recommends freezing benefits earned so far and moving current workers into a 401(k)-style defined contribution plan for the rest of their careers. This proposal includes an optional “buyout” provision to encourage workers to move fully into the 401(k)-style plan. The new 401(k)-type plan would require an employee contribution of 3 percent of salary and a guaranteed base employer contribution of 2 percent of salary. Employers would also match 50 percent of additional employee contributions up to 6 percent of salary. Employees in hazardous duty jobs, such as police and firefighters, would not be shifted to the new 401(k) plans.

4. Increase retirement age for current workers

The consultant recommends increasing the age for retirement with non-reduced benefits to 65 for non-hazardous workers and teachers and to 60 for hazardous duty employees.

5. Drop some teacher benefits

Recommends ending certain benefits of teachers, including one that lets teachers use accumulated unused sick days to enhance their benefits.

6. Move new teachers into 401(k) plan

Recommends moving new teachers into a 401(k)-type plan with Social Security. This move into Social Security would increase the cost to employers. PFM says school boards could pick up this new Social Security cost.

7. Don't separate County Employees Retirement System

Does not recommend separating the County Employee Retirement System plans from the Kentucky Retirement Systems. CERS funds pensions for county and city employees as well as non-teaching school district employees, from the Kentucky Retirement Systems.

The Kentucky League of Cities and Kentucky Association of Counties want to pull CERS from the KRS umbrella, which includes other pension plans that aren't as well-funded.
I predicted this mess five years ago when I wrote all about Kentucky fried pensions. Chris Tobe took my blog title to make a book out of the corruption and cover-up going on at Kentucky's pensions.

One by one, the dominoes are falling on US public pensions and those with the weakest governance are being exposed. There is no place to hide, the situation is so grim that officials have to face the music and relay the terrible news to the plans' beneficiaries.

Some of the recommendations make sense but others are definitely a step in the wrong direction, one that will make everyone worse off, including the state of Kentucky.

In particular, scraping a defined-benefit plan to replace it with a defined-contribution plan is a really horrible idea. It shifts retirement risk entirely onto workers and leaves them all exposed to pension poverty down the road. That's the brutal truth on DC pensions, they're far, far inferior to large, well-governed DB plans.

The public-sector unions and retirees should fight tooth and nail to maintain DB plans but they will need to share some of the risks attached to these plans in order to see them regain fully-funded status.

The biggest problem is lack of governance. You can almagate all these plans at the state level, increase the retirement age for some and even introduce some form of shared-risk but if you don't get the governance right, Kentucky's defined-benefit plans won't survive and this will impact the state in a very negative way (both in terms of attracting qualified people to the public sector and in terms of economic activity).

Hurricane Harvey devastated Houston and other cities in Texas but they will rebuild that great state. Kentucky's pension hurricane has been going on for years and very few were paying attention, let alone sounding the alarm.

And now, I'm afraid to say, Kentucky's pensions are finished, irrevocably changed and the future of public defined-benefit plans in that state is grim at best. Welcome to America's new pension normal.

Below, a quick look at the figures behind Kentucky's pension shortfall. Like I said, the situation is grim, there's nothing much they can do to bring these pensions back from the abyss and everyone will lose as they crumble. Unfortunately, there are many other state pensions which will suffer the same fate.

Update: Tom Loftus of courier-journal reports, Kentucky pension crisis: Are 401(k) plans the solution?. I note the following passage:
Keith Brainard, research director for the National Association of State Retirement Administrators, said risk doesn't disappear under a 401(k) plan.

"These proposals shift that risk from the state and its public employers and taxpayers and put it all on the workers. In fact, there’s going to be more risk because they are no longer in a group that can manage the risk much better," he said.

Whether the moves actually will save the state money is a question being hotly debated.

Jason Bailey, executive director of the Kentucky Center for Economic Policy, of Berea, said, “Moving employees into 401(k)-type plans is actually more expensive … and harms retirees while making it much more difficult to attract and retain a skilled workforce.”
I will keep hammering the point that moving public sector employees to a 401(k) plan shifts retirement risk entirely onto employees, leaves them exposed to the vagaries of public markets, and ultimately many of them will succumb to pension poverty just like private sector employees with DC plans. Moreover, the long-term effects to the state of Kentucky are not good, they will raise social welfare costs and cut economic growth as more people retire with little to no savings.

Tuesday, August 29, 2017

Should Central Banks Go Negative Now?

Tim Wallace of The Telegraph reports, Prepare for negative interest rates in the next recession, says top economist:
Negative interest rates will be needed in the next major recession or financial crisis, and central banks should do more to prepare the ground for such policies, according to leading economist Kenneth Rogoff.

Quantitative easing is not as effective a tonic as cutting rates to below zero, he believes. Central banks around the world turned to money creation in the credit crunch to stimulate the economy when interest rates were already at rock bottom.

In a new paper published in the Journal of Economic Perspectives the professor of economics at Harvard ­University argues that central banks should start preparing now to find ways to cut rates to below zero so they are not caught out when the next ­recession strikes (click on image).


Traditionally economists have assumed that cutting rates into negative territory would risk pushing savers to take their money out of banks and stuff the cash – metaphorically or possibly literally – under their mattress. As electronic transfers become the standard way of paying for purchases, Mr Rogoff believes this is a diminishing risk.

“It makes sense not to wait until the next financial crisis to develop plans and, in any event, it is time for economists to stop pretending that implementing effective negative rates is as difficult today as it seemed in Keynes’ time,” he said.

“The growth of electronic payment systems and the increasing marginalisation of cash in legal transactions creates a much smoother path to negative rate policy today than even two decades ago.”

Countries can scrap larger denomination notes to reduce the likelihood of cash being held in substantial quantities, he suggests. This is also a potentially practical idea because cash tends now to be used largely for only small transactions. law enforcement officials may also back the idea to cut down on money laundering and tax evasion.

The key consequence from an ­economic point of view is that forcing savers to keep cash in an electronic ­format would make it easier to levy a negative interest rate.

“With today’s ultra-low policy interest rates – inching up in the United States and still slightly negative in the eurozone and Japan – it is sobering to ask what major central banks will do should another major prolonged global recession come any time soon,” he said, noting that the Fed cut rates by an average of 5.5 percentage points in the nine recessions since the mid-1950s, something which is impossible at the current low rate of interest, unless negative rates become an option.

That would be substantially better than trying to use QE or forward guidance as central bankers have attempted in recent years.

“Alternative monetary policy instruments such as forward guidance and quantitative easing offer some theoretical promise for addressing the zero bound,” he said, in the paper which is titled ‘Dealing with Monetary Paralysis at the Zero Bound’.

“But these policies have now been deployed for some years – in the case of Japan, for more than two decades – and at least so far, they have not convincingly shown an ability to decisively overcome the problems posed by the zero bound.”
Anyone who has ever taken a graduate level macroeconomics course knows exactly who Ken Rogoff is. He's one of the most respected economists teaching at Harvard and the former Chief Economist and Director of Research at the International Monetary Fund.

Rogoff also co-authored This Time Is Different: Eight Centuries of Financial Folly along with Carmen Reinhart, one of the most cited books explaining the 2008 financial crisis by presenting  a comprehensive look at the varieties of financial crises.

Now, let's put our macroeconomic hats on and think about what Ken Rogoff is proposing here. He's telling central banks to lay the groundwork and prepare for negative interest rates. In fact, he's saying "don't wait for the next financial crisis, do it now."

Moreover, he claims alternative monetary policy instruments such as forward guidance and quantitative easing have helped at the margin but ultimately, only negative interest rates will resuscitate this debt-laden deflationary economy.

Last week, I discussed Ray Dalio's warning on the dangerous divide where I went over six 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. 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 six structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

I will add a seventh obvious one here, globalization, which basically means capital is free to find the best opportunities around the world but labor isn't as mobile. We often here of "offshoring" of manufacturing and increasingly service sector low paying jobs to countries like China and India but elsewhere too.

Importantly, the main point I'm emphasizing here is all these factors exacerbate inequality and therefore exacerbate deflation.

And as I've stated many times in this blog, institutional and retail investors need to prepare for a prolonged period of debt deflation because it will eviscerate risk assets across public and private markets for a very long time.

I'm not joking here, I'm dead serious which is why I can look at the portfolio of Japan's GPIF or Norway's Government Pension Fund Global and tell you they both have a giant beta problem and are ill-prepared for the deflationary tsunami I'm warning of.

To be fair, with exception of HOOPP and OTPP which have a relatively high allocation to government bonds, most public and private pensions are ill-prepared for the deflationary tsunami I've been warning of. When it hits them and they erroneously think it's a cyclical correction and then see it's more secular in nature, it will hurt them for many years.

Anyway, I don't want to dwell on this too long because people roll their eyes when I warn of deflation but I remind them that my duration calls have been right on the money and tell them not to be surprised when the yield on the 10-year US Treasury note plunges below 1% and possibly much lower in the years ahead.

Forget Kim Jong-un who has already launched more missiles this year than his father did in his lifetime. The reason I'm recommending US long bonds (TLT) as the ultimate diversifier has nothing to do with North Korea.

My number one macro concern remains a slowing US economy at a time when the rest of the world is still in the grips of deflation. If deflation comes to America, Kim Jong-un will be a walk in the park.

This morning you saw the dip buyers move in after a night of unrest. All the large CTAs are buying stocks on every dip, and thus far this strategy has worked just fine for them.

But when the big "D" hits us, dip buyers and risk-takers like volatility sellers will get killed and they won't know where to turn.

This is why I strongly feel Alan Greenspan and others are out to lunch when they claim there is a bond bubble. They simply don't get the baffling mystery of inflation deflation.

Moreover, those asking when will the tech bubble burst are equally out to lunch. They're asking the wrong question. It's not when the tech bubble will burst, it's when will deflation come to America and obliterate all risks assets across public and private markets for a very, very long time.

Capiche? I'm glad TPG's David Bonderman made a $425 million windfall yesterday when Gilead (GILD) acquired Kite Pharmaceuticals (KITE) for $11.9 billion.

I'm not worried about the David Bondermans or the Ray Dalios of this world, they have amassed a fortune over the decades through their financial acumen and let's be honest, by squeezing public and private pensions dry on fees.

"But Leo, that's capitalism, you need to pay up for performance. Even Mark Wiseman told you that he'd love to hire David Bonderman but he can't afford to so he invests in his funds."

Oh PUHLEASE!!! As I stated unequivocally and quite eloquently in my comment on the pension prescription back in May, it's high time these elite hedge funds and private equity funds get down from their high pedestal and be part of the pension solution by drastically cutting their fees.

I know, this won't incentivize them to take more intelligent risks, but I'd rather see pensions allocate more to these alternative managers in return for drastic cuts in fees than the status quo which is doing absolutely nothing in terms of helping chronically underfunded pensions get back to fully-funded status.

All this brings me to Ken Rogoff's proposal for negative rates. Any time I evaluate a macro policy, I ask some basic questions:
  1. Will it promote aggregate demand? 
  2. Will it significantly reduce inequality?
  3. Will it spur more business investment and help productivity?
  4. How will it impact risk-taking behavior?
  5. How will it impact pensions? Will it exacerbate pension deficits?
That last one is a bit easy to answer. As rates plunge to negative territory, pension deficits will soar and many chronically underfunded pensions will not be able to meet their pension payments.

This means less money for pensioners which means less money for the economy, which isn't good for aggregate demand and is deflationary.

What about stocks and other risk assets? This is far from clear because if central banks actively look to go negative, it could send a jolt through markets but if it works in spurring economic activity, the correction will be followed by a sustained rally.

I don't know, negative rates aren't going to stop aging demographics, globalization, or technological change and they will decimate pensions, so I'm not sure if Rogoff's proposal has any merit from a policy perspective.

I could be wrong but I think we should prepare for QE infinity, not negative rates. If they occur, it will be a symptom of a deflationary crisis unlike anything we've ever seen before.

Once again, I don't have a monopoly of wisdom on this or other issues I cover on my blog. I'm sharing my thoughts and if you have anything to add, feel free to email me at LKolivakis@gmail.com.

Also worth reminding all of you reading this blog to please support my efforts by donating/ subscribing on the top right-hand side under my picture (web version on your smart phone). I truly appreciate all of you who have shown and continue to show your financial support.

Below, Kenneth Rogoff, Economics Professor at Harvard University, speaks on the future of cash & India's demonetisation drive (Parts 1 & 2).

Rogoff also spoke to Blomberg in India stating rates shouldn't be hiked and dismissed the rationale of quantitative easing by the US Federal Reserve.



Monday, August 28, 2017

Norway's Giant Beta Problem?

Michael Katz of Chief Investment Officer reports, Norway’s Sovereign Wealth Fund Returns 2.6% in Q2:
Norway’s $977.4 billion Government Pension Fund Global returned 2.6%, or 202 billion kroner ($25.53 billion), in Q2 of 2017.

The fund had a market value of 8.020 trillion kroner as of June 30, of which 65.1% was invested in equities, 32.4% in fixed income, and 2.5% in unlisted real estate. Equity investments returned 3.4%, while fixed-income investments returned 1.1% for the quarter. Investments in unlisted real estate returned 2.1%, and the total return on investments was 0.3% higher than the return on the benchmark index.

“The stock markets have performed particularly well so far this year, and the fund’s return in the two first quarters was 6.5[%]. This gives a total return of 499 billion kroner, which is the best half-year return measured in Norwegian kroner in the history of the fund,” said Trond Grande, deputy CEO of Norges Bank Investment Management.

However, Grande added that “we cannot expect such returns in the future. The record-high return is primarily due to the fact that the fund has become so large.”

The returns would have been even higher, however, the kroner appreciated against the main currencies during the quarter, which decreased the value of the fund by 32 billion kroner. In the second quarter, 16 billion kroner was withdrawn from the fund by the government.

While the fund said that the returns were driven by continued healthy growth in the global economy, it added that some macroeconomic data, especially for the US economy, were weaker than the market had anticipated. Growth expectations for emerging markets were mainly unchanged from the previous quarter, while those for developed markets improved, which was due to greater optimism in the euro area.

The strongest returns came from European equities, which returned 6.3%, and accounted for 36.6% of the fund’s equities at the end of Q2. The UK, which was the fund’s largest market in Europe with 9.7% of its equity investments, returned 3.3%, or 1.5% in local currency. North American stocks returned 0.7%, and comprised 38.6% of the equity portfolio. US stocks, which were the fund’s single-largest market with 36.4% of its equity investments, returned 0.8%, or 2.9% in local currency.

The health-care sector delivered the best return for the fund during the quarter, as health-care stocks returned 5.7%, spurred on by market expectations of stronger earnings in the sector. The fund said that the inability of the US Congress to significantly alter its health-care system’s regulatory framework was interpreted by the market as a continuation of stable operating conditions.

Industrials returned 4.9%, driven by an improved outlook for economic growth, particularly in Europe and emerging markets. Returns were strong in the industrial machinery sector, which was attributed to increased demand for construction machinery, and more stable demand for capital goods in the commodity industry.
It's been a long time since I covered Norway's giant pension/ sovereign wealth fund. Last week, I covered why Japan's GPIF is warning of index trackers run amok, where I stated this:
Japan's GPIF and CPPIB are long-term investors and they need to think more carefully about how they will construct their respective portfolios across public and private markets to ride through the coming pension storm.

In this regard, CPPIB is well ahead of GPIF but it's a lot smaller too. GPIF will have a very hard time finding solid active managers across public and private markets as the mystery of inflation-deflation unfolds.

Still, GPIF is moving as fast as possible to diversify into private markets. It recently announced it's plowing into real estate, asking asset managers around the world to submit proposals to run portions of the fund's real estate investment portfolio.

But make no mistake, GPIF's assets recently hit a record ¥144.9tn on the back on passive investments and the fund has massive beta exposure, far more than its large peers around the world. This is why the focus right now is on active managers in public and private markets.
I also coverd the great CPP/QPP divergence where I stated this:
[..] if you account for inflows and returns, and the new enhanced CPP, there is little doubt CPPIB will become a multi-trillion behemoth by 2090.

It seems crazy when you think of it but you should keep in mind by that time, world GDP will have grown significantly, increasing CPPIB's opportunity set across global public and private markets.

Also, keep in mind there are a few global pensions (Norway and Japan) that are already managing over a trillion each, and they aren't as well diversified across global public and private markets as CPPIB.

Moreover, some Canadian insurance companies manage over a trillion now, so CPPIB isn't the only large Canadian fund that will grow to become a behemoth by 2090.

How will CPPIB manage this explosive growth over the decades? The exact same way it's managed it over the last ten years, carefully and diligently diversifying across global public and private markets.
I made a mistake, Norway's fund hasn't surpassed a trillion dollars yet but it's on its way. You can read all about Norway's Government Pension Fund Global here. Suffice it to say, it and Japan's pension whale are the biggest pension funds in the world.

They're also giant beta funds, meaning their performance is overwhelmingly determined by global public equity and fixed income markets. Norway's Fund is a lot more sophisticated than Japan's in terms of where it takes its beta exposure, but beta is beta, so the Fund is vulnerable to a severe correction in global public equity markets.

What I like about Norway is the Fund's transparency and governance. You should read this presentation to understand the Fund's mission, structure and governance.

Just like CPPIB, Norway's pension fund invests for the long-term but the two organizations have taken a different approach to investing as the former invests across global public and private markets whereas the latter invests almost exclusively in public markets.

One reason, I believe, is the governance structure. Without boring you with details, there are aspects of Norway's governance I like but there is a lot more government interference in this fund, capping the compensation they need to attract qualified people to properly invest in private markets or to do absolute return strategies across public and private markets internally.

Since the financial crisis, this reliance on public equities has significantly boosted the assets of Norway's pension fund but it also leaves it very exposed to a major correction or prolonged bear market.

True, one can argue that both public and private markets are way overvalued now and both risk getting clobbered in a bear market but private markets aren't marked-to-market and as such, they're not as volatile. Also, private markets have inefficiencies which can be exploited if the deal is priced right.

All this to say, I believe Norway and Japan's pension fund are going to run into some serious trouble over the next decade and significantly underperform their Canadian peers which are more diversified across public and private markets.

Japan is right to shift the focus on active management across public and private markets going forward, and I think Norway needs to do the exact same thing.

Also, if my fears of global deflation come true, Norway, just like Canada, is in for a whole lot of hurting  because oil prices will plunge and stay low for a very long time, significantly impacting revenues.

Of course, Trond Grande and the rest of the senior managers at Norway's Government Pension Fund Global are keenly aware of the risks I'm highlighting but apart from their Treasury holdings, I doubt they're hedged for a long period of global debt deflation.

Below, Gary Shilling, the president of A. Gary Shilling & Co., spoke to Business Insider CEO Henry Blodget about the stock market, which he views as expensive, citing the Shiller P/E ratio, which is roughly 40% above its historical norm. He doesn't necessarily see them falling apart, but says they're starting at a high level.

Shilling shares his thoughts on the end of the eight-year bull market, saying that some sort of exogenous shock could derail it, as well as tightening from the Fed. He also breaks down his forecast that the 10-year US Treasury will go to 1%, noting that we're more likely to see deflation than inflation, which is beneficial to his forecast.

Unlike others, Shilling has correctly predicted deflation over inflation and even written books on this subject. I personally think he's optimistic and doesn't see the global deflation tsunami headed our way, but I agree with him, the yield on the 10-year US Tresury note is headed much lower which is why I continue to recommend US long bonds (TLT) as the ultimate diversifier.

Friday, August 25, 2017

Canada's Growing Debt Risks?

Andy Blatchford of the Canadadian Press reports, Rising Household Debt Risks Canada's Long-Term Economic Health: Confidential Memo:
Even debt-free Canadians could eventually feel a pinch from someone else's maxed-out credit cards, suggests research presented to senior officials at the federal housing agency.

Canada Mortgage and Housing Corp. board members received an update in March on the country's credit and housing trends.

The presentation contained a warning: the steady climb of the household debt-to-GDP level had put Canada's long-term economic growth prospects at risk.

The document pointed to a study that argued household debt accumulation eventually hampers economic growth over the longer term, eclipsing the nearer-term benefits of consumption.

The strong expansion of household spending, encouraged by a prolonged period of historically low borrowing rates, has created concerns over Canadians' record-high debt loads.

It has also been a major driver of economic growth.

The Canadian Press obtained a copy of the CMHC presentation via the Access to Information Act. It was included in a "confidential" memo to deputy finance minister Paul Rochon.

Citing international research, the CMHC presentation points to an estimate that says a one percentage point increase in household debt-to-GDP tends to lower growth in a country's real gross domestic product by 0.1 percentage points at least three years later.

The calculation, published in a January study by the Bank for International Settlements, was based on an average produced from the data of 54 countries from 1990 to 2015.

"Our results suggest that debt boosts consumption and GDP growth in the short run, with the bulk of the impact of increased indebtedness passing through the real economy in the space of one year," said the BIS report.

"However, the long-run negative effects of debt eventually outweigh their short-term positive effects, with household debt accumulation ultimately proving to be a drag on growth."
Only Australia has faster debt growth

An accompanying chart in the CMHC presentation showed that between 2010 and 2016 Canada's household debt-to-GDP level rose by more than five percentage points. The household debt-to-GDP ratio increased from almost 93 per cent to just over 101 per cent at the end of 2016, Statistics Canada says.

A reduction of even 0.1 percentage points in the country's GDP can have an impact. For example, Canada saw year-over-year growth in real GDP last year of 1.3 per cent.

The chart listed eight developed countries and ranked Canada second, behind Australia, for having the biggest increase in household debt-to-GDP level over the six-year period.

BMO chief economist Doug Porter says he doesn't dispute the broader conclusion that a rising household debt-to-GDP level poses risks for growth.

But he's skeptical one can draw a direct line from the household debt-to-GDP directly to economic growth down the road. For one, he said interest rate levels must be factored in.

"I'd be very cautious about putting pinpoint accuracy on that," Porter said. "I think that's incredibly difficult to do."

However, Porter says the record levels of household debt piling up in Canada, like in many industrial-world economies, does suggest it will be tougher for the country to grow as quickly as it has in the past.

"The consumer spending and housing gains that we could reap from lower interest rates have basically been reaped," he said.

"And, if anything, interest rates are probably more likely to rise than fall from current levels. So, to me that suggests we just really can't count on the consumer to really pull the economy ahead as they have in recent years."
Interest rates are more likely to rise? I respect Doug Porter but all the bank economists have been saying the exact same thing, interest rates are likely to rise -- and they've all been wrong.

When I last spoke to my father's financial advisor at RBC roughly a month ago, I instructed her to sell everything and shove all his money in US long bonds (TLT). She told me the exact same thing all the big banks are saying: "RBC thinks rates are rising over the next year and I would advise you not to invest in US long bonds."

I told her the Canadian dollar is high and with all due respect to RBC, my view is we need to prepare for a US slowdown, and I am increasingly worried about global deflation spreading to North America which is why I want to buy US Treasurys now."

I wasn't rude but all the big banks keep saying the same thing, "everything is fine, US economy is humming along, and rates are going to rise." Basically, the optimistic global reflation nonsense.

In my last comment on why Ray Dalio is worried about the dangerous divide, I laid out yet again six 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. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
I keep referring to these six structural factors because people get all excited when the Dow hits record levels but are completely clueless when it comes to the bigger deflation picture. This is why I keep warning investors to temper their growth forecasts and to prepare for global deflation.

I discussed rising inequality as a major factor that will impact growth and keep rates at ultra-low levels for a very long time. The jobs crisis (high structural unemployment, not headline figures) and the global pension crisis will only exacerbate rising inequality as millions retire with little to no savings and ultimately succumb to pension poverty.

This is why I keep harping on policymakers to get their pension policy right by bolstering large, well-governed public defined-benefit pensions. In Canada, there are excellent private DB plans (HOOPP, CN, Air Canada) but I think we need a large public plan backstopped by the federal government for all workers who want to retire in dignity and securty.

Rising debt levels also exacerbate inequality as people take on more and more debt to buy a house they probably can't afford, lease expensive cars, and buy nice furniture using some payment plan to keep monthly payments low (even if they're getting milked on rates over the life of the plan).

In fact, Pete Evans of CBC News reports, Average Canadian mortgage nears $200K, up 5% in a year:
Canadians owe more than ever before on their mortgages, but fewer and fewer borrowers are falling behind on their payments.

That's one of the major takeaways from a report published Tuesday from credit monitoring firm TransUnion, which looked at every active credit file across the country to gauge the financial health of borrowers and consumers.

TransUnion found that as of the end of June, the average Canadian mortgage had $198,781 left on it, a figure that has increased by almost five per cent in the previous 12 months. That's in part a factor of high housing prices, which have prompted people to borrow more than ever to finance a home.

But it's not just that people are borrowing more — more people are borrowing, too.

"The total number of active mortgage accounts grew annually to 6.0 million, an increase of 1.2 per cent from last year," TransUnion said.

While Canadians may be borrowing more to get into the real estate market, thus far they seem to be staying on top of their debts, as delinquency rates dropped to 0.56 per cent for the third quarter in a row.

Credit agencies consider a debt to be delinquent if the borrower is more than two months behind on payments. A delinquency rate of 0.56 per cent means barely one of every 200 mortgage holders was more than 60 days behind on their mortgage payment as of the end of June.

"Despite increases in mortgage debt, serious delinquency rates remain low with very little volatility observed over the past two years," Matt Fabian, TransUnion Canada's director of research and analysis, said in a release. "Consumers have so far been able to manage their mortgage obligations despite the increasing balance levels."

Overall consumer debt climbing

But mortgages aren't the only type of debt that's growing fast. The average Canadian owed $22,154 on top of any mortgage at the end of June, TransUnion said, a figure that has grown by 2.7 per cent in the previous 12 months.

The average credit card balance was at $2,840 at the end of June, and on average, people owed $19,087 against their car, if they owned one. Some 23.7 million Canadians have at least one credit card, and there are 3.3 million auto loans across the country.

The fastest growing type of debt, meanwhile, is installment loans, which are unsecured, high-interest, short-term loans, such as the ones often offered to buy home furnishings and other big ticket items. Among the 6.4 million Canadians who had one as of the end of June, the average balance was $20,466 — up 5.5 per cent in the past year.

The delinquency rate for that type of debt is also the highest at four per cent, TransUnion said.
Note, $200,000 is an average of all households who pay a mortgage. That number varies because people who entered the housing market in the last five years have a considerably higher mortgage. They're the ones most vulnerable to a significant housing downturn.

Now, using this tool and terms, a $200,000 mortgage translates into roughly $1,500 a month, which isn't the end of the world if you're a two-income household bringing in $120,000 a year.

However, if you start adding car expenses, food, clothing, gas, utility bills, cable and cell phone bills, car and house insurance, municipal and school taxes, trips, and more, you'll quickly realize you need to plan your expenses more carefully to make the mortgage payment every month and save money for your retirement.

More importantly, the median family income in Canada isn't $120,000, it's a lot less. As shown here, depending on where you live, the median is significantly lower.

This explains why Canadians are taking on more and more debt. Wage growth is muted so as the housing frenzy reached a bubble phase, Canadians worried they wouldn't be able to afford a house borrowed heavily from banks and subprime lenders to compete with foreign and domestic buyers.

Once they bought their house at overvalued levels, they had to pay a welcome tax and municipal taxes based on the municipal evaluation, which is based on current market prices.

This is another huge tax grab. In fact, a friend of mine shared this with me today:
For the first time ever, I contested my municipal evaluation.

The valuation applied by the City of Montreal was ridiculously overstated (by at least 15%). The whole process is a bit of a sham. You have to pay $500 to contest and it is not reimbursable if you win.

Of course, the City benefits by exaggerating valuations so their incentive to err on the exaggerated end is high. I won the challenge (hands down). They didn't even put up a fight which tells that I didn't go far enough.

Somebody should really do a study which compares how municipal taxes have increased over time on an inflation adjusted basis. What is ridiculous is that the municipalities used to offer services but now charge extra for everything. I bet that taxes have increased way beyond inflation.
He's probably right and don't forget, when house prices go down, your municipal taxes based on inflated prices (evaluations) won't go down, not unless there is a depression, and even that might not impact them.

This is what happened in Greece, as the country sunk into a deep depression, municipal taxes remained elevated (based on pre-crisis high evaluations) and people walked away from their homes, unable to pay the monthly payments and taxes (not to mention, renters weren't paying their rent, taking advantage of a lenient and farcical Greek justice system, so property owners really got screwed).

This brings me to another important point, a little disagreement I have with Garth Turner who publishes the very popular Greater Fool blog, all about the housing follies Canadians have succumbed to in their quest to own a nice house at all cost.

Garth has done great work, I often read his blog but we have a fundamental disagreement. You see, Garth buys the nonsense big banks are peddling, that rates are headed up, and he believes higher rates will kill the Canadian housing market for a long time. I believe debt deflation and soaring unemployment in an ultra-low rate environment will clobber the Canadian housing market for decades.

In fact, in a recent comment, After Mom, Garth stated this:
When a reporter asked me this week what major cities housing refugees from Vancouver or Toronto should explore to find “a bargain”, the answer was simple. None. There are no bargains just before real estate values decline. Only wealth traps. Especially for first-time buyers who cannot afford losses.

The reason is simple and it’s called B-20. The forgettable name is “Residential Mortgage Insurance Underwriting Practices and Procedures” and it emanates from the banks’ regulator, OSFI. Freaked out at the size and growth in mortgage debt, along with what looks like a rapid decline in the quality of that debt, OSFI has proposed tough new borrowing guidelines which it says, “will be issued in autumn 2017, and will come into effect shortly thereafter.”

It sure looks like a game-changer, as this pathetic blog heroically explains. The main consequence will be a stress test every person taking out or renewing a mortgage must pass, proving they can afford payments at current rate +2%. If financial circumstances have eroded or house equity faded, it’ll be current rate +3%. If you want a home loan from one of the Big Six, that’s the rule sometime after Thanksgiving.

Why is this happening?

Because (a) interest rates will be upped by the Bank of Canada another four to six times over the coming years, (b) mortgage debt is out of control and a third of borrowers say last month’s single quarter-point hike is already hurting them, and (c) down payment money from the Bank of Mom has completed screwed things up. Parental cash has purposefully skirted rules designed to protect people from borrowing too much. It’s love gone awry.
I seized on that last passage to post this comment:
“Why is this happening? Because (a) interest rates will be upped by the Bank of Canada another four to six times over the coming years”

Really? Want to bet on that? Garth, read my blog comments because you still think rising rates are what’s going to kill the great Canadian housing bubble. You and others who think rates are headed up have been wrong and continue to claim this. You don’t see the big global deflation tsunami headed our way and how high debt and higher unemployment will kill the housing market for decades, NOT rising rates. Agree with rest of your comments.
Garth responded:
Actually restricted credit, not higher rates, will be the true enemy of real estate. But the cost of money, nonetheless, will increase.
No doubt, tighter restrictions will hurt many trying to get a loan, and my biggest fear is those dual-income households drowning in debt, barely making their mortgage payments. Never mind what TransUnion says, if one member loses their job, mortgage delinquencies will rise significantly.

Also worth noting, while Ontario and British Columbia's new levies and measures have had a short-term negative effect on home prices, unless they significantly expand housing supply, prices will keep climbing in the future.

Things are not great in Canada. People drowning in debt will typically cut discretionary spending like restaurants, movies, shopping for clothes, electronic gizmos, trips, etc.

There is only so much debt one can take on before they pass the point of no return --where essentially they will be condemned to debt servitude for pretty much the rest of their life.

I'm increasingly worried about Canada's growing debt problem. There is no doubt it will impact the economy longer term, and possibly even in the near term.

This is why I am long US long bonds (TLT), using the grossly inflated loonie to load up on US Treasurys. I am also long Canadian bonds and short the loonie.

And if my worst fears on global deflation come true, oil prices will plunge to record low levels, manufacturing and service sector unemployment will soar, and Canada will be in a crisis for many years. This is why Canada's growing debt problem is such a huge concern for policymakers.

Hope you enjoyed this comment. If you have anything to add, feel free to share your thoughts via email at LKolivakis@gmail.com.

Below, 680 NEWS senior business editor Mike Eppel reports on Canadian consumer loans. He's right, as long as Canadians can service this debt, they will be fine, but if that changes because of an internal or external shock, watch out, it will get very ugly, very fast.

Thursday, August 24, 2017

Ray Dalio on the Dangerous Divide?

Jeff Cox of CNBC reports, Ray Dalio: US most divided socially and economically since 1937:
Americans are divided socially and economically in ways that have not been seen since the worst days of the Great Depression and as the world was heading into another global conflict, hedge fund king Ray Dalio said Monday.

In an essay on LinkedIn, the head of Bridgewater Associates compared the current U.S. climate to 1937, as Adolf Hitler rallied Germans ahead of World War II and the U.S. plunged further into the economic abyss that had begun in 1929.

"It seems to me that we are now economically and socially divided and burdened in ways that are broadly analogous to 1937," Dalio wrote. "During such times conflicts [both internal and external] increase, populism emerges, democracies are threatened and wars can occur. I can't say how bad this time around will get. I'm watching how conflict is being handled as a guide, and I'm not encouraged."

The missive comes as U.S. markets appear to have hit a wall, political conflict in Washington has escalated, and thousands are protesting in the streets over historic monuments.

Dalio's view on how it all turns out is not optimistic.

"[D]emocracies are threatened when the principles that divide people are more strongly held than those that bind them and when divided people are more inclined to fight than work to resolve their differences," he said. "Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation."

Wall Street had been hoping that President Donald Trump's election would bring with it a new business-friendly era in Washington. Dalio was among those encouraged by the new administration's potential to impact growth, but has since soured on the president.

GDP has risen 1.9 percent this year and is on track to jump 3.8 percent in the third quarter, according to the Atlanta Fed. In addition, the 4.3 percent unemployment rate is the lowest in more than 16 years, and the stock market had hit a series of new records before edging lower recently.

Dalio, though, sees those benefits as skewed, with some doing "extraordinarily well and others are doing terribly, with gaps in wealth and income being the greatest since the 1930s."

He pointed to Gallup polling showing Trump's favorability among Republicans at 79 percent and just 7 percent among Democrats, while 40 percent back the president's impeachment, with sentiment again running along party lines.

"In other words, the majority of Americans appear to be strongly and intransigently in disagreement about our leadership and the direction of our country," Dalio wrote. "They appear more inclined to fight for what they believe than to try to figure out how to get beyond their disagreements to work productively based on shared principles."

Amid the conflicts, Dalio said his firm is "tactically reducing our risk" to the current problems "not being handled well." In a separate LinkedIn post recently, Dalio encouraged investors to buy gold amid global conflict.
Lucinda Shen of Fortune also reports, Ray Dalio Warns Markets: ‘Death Probably More Likely Than Reconciliation’:
President Donald Trump has drawn a rosy picture of the United States economy in recent months, but investor and hedge funder Ray Dalio isn't buying it.

On Monday, Dalio wrote in a LinkedIn post that recent economic figures mask deep divisions in wealth and political leaning. This threatens the balance of the U.S. economy, he added, and it doesn't look like those divides are going away—at least for now. Dalio is the founder of Bridgewater Associates, one of the world's largest hedge funds.

"Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation," Dalio wrote. He added how the country manages conflict "will have a greater effect on the economy, markets and our overall well-being than classic monetary and fiscal policies."

As a result, Dalio has positioned his own portfolio in preparation of worsening conflicts, he wrote.

The note comes a week after Trump said that "both sides" were responsible for the violence in Charlottesville, Va. In that incident, a car plowed into counter-protestors at a white supremacist rally, killing one and injuring several others. Several CEOs condemned Trump for failing to hold the "alt-right" responsible in the incident.

That same week, turmoil in the White House resulted in advisor Steve Bannon's departure. And before that, investors were rattled Trump's back-and-forth with North Korea over its nuclear missile testing.

Dalio isn't the only one urging caution when it comes to Washington: The S&P 500 Index has edged down about 1% since the start of August, while gold, a so-called safe haven asset, has risen nearly 1%.
Ray Dalio has been very active on LinkedIn this month, first warning that risks are rising while low risks are discounted and this week warning the principles that divide us might be greater than those that bind us together:
I believe that a) most realities happen over and over again in slightly different forms, b) good principles are effective ways of dealing with one's realities, and c) politics will probably play a greater role in affecting markets than we have experienced any time before in our lifetimes but in a manner that is broadly similar to 1937.

I'm essentially an economic mechanic who focuses on how reality works by studying the cause:effect relations and how they played out in history to help me bet on what's likely to occur. For reasons previously explained in "Populism..." it seems to me that we are now economically and socially divided and burdened in ways that are broadly analogous to 1937. During such times conflicts (both internal and external) increase, populism emerges, democracies are threatened and wars can occur. I can't say how bad this time around will get. I'm watching how conflict is being handled as a guide, and I'm not encouraged.

History has shown that democracies are healthy when the principles that bind people are stronger than those that divide them, when the rule of law governs disputes, and when compromises are made for the good of the whole—and that democracies are threatened when the principles that divide people are more strongly held than those that bind them and when divided people are more inclined to fight than work to resolve their differences. Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation.

Average numbers hide the depths of the divisions. For example, by looking at average figures, one might conclude that the United States economy is doing just fine, yet when one looks at the numbers that comprise those averages, it's clear that some are doing extraordinarily well and others are doing terribly, with gaps in wealth and income being the greatest since the 1930s.

Largely as a function of these economic differences and differences in the principles that people believe most deeply in, we are seeing large and increasingly firm political differences, which are apparent only by looking below the averages. For example, Donald Trump's approval rating of 35% is a result of 79% support among Republicans and 7% among Democrats (Gallup). Of those who approve of President Donald Trump, 61% say they can't think of anything Trump could do that would make them disapprove of his job as President, and 57% who disapprove of Trump say they are never going to change their minds on the President's job performance (Monmouth). Similarly 40% of those polled (PRRI) would favor Donald Trump’s impeachment, which consists of 72% of Democrats and 7% of Republicans, and most of them won't change their minds.

In other words, the majority of Americans appear to be strongly and intransigently in disagreement about our leadership and the direction of our country. They appear more inclined to fight for what they believe than to try to figure out how to get beyond their disagreements to work productively based on shared principles.

So, where does that leave us?

While I see no important economic risks on the horizon, I am concerned about growing internal and external conflict leading to impaired government efficiency (e.g. inabilities to pass legislation and set policies) and other conflicts.

I of course hope that the principles that bind us together are stronger than the ones that divide us. I believe that this is a time when it is especially important for us a) to be explicit about what our principles are in order to be clear about what we agree and disagree on, b) to practice the art of thoughtful disagreement, and c) to respect our ways of getting past our disagreements so we can start rowing in the same direction. I believe that how well this is done will have a greater effect on the economy, markets and our overall well-being than classic monetary and fiscal policies, so I continue to closely watch how conflict is handled while tactically reducing our risk to it not being handled well.
So, is Ray Dalio right? Are Americans divided socially and economically in ways that have not been seen since the worst days of the Great Depression?

What do you think, Captain Obvious?


One only has to turn on American television and flick back and forth from CNN to Fox News to see just how divided the country really is. And I hear outrageous comments on both channels, stuff that makes me cringe (they are both so blatantly biased, it's pathetic news coverage).

In fact, last night on CNN during Don Lemon's show (completely biased against Trump), some political commentator said: "Trump might be suffering from dementia." Really? I felt like asking her: "What are your qualifications to make such medical diagnoses based on Trump's speeches?".

Don't get me wrong, Trump is clearly unhinged at times and suffers from severe narcissistic personality disorder, and he manages to piss people off every other day with his tweets and ridiculous comments ("both sides are to blame"...umm, NO!), but to claim he has dementia on a live CNN show is beyond preposterous.

Now, I get it, a lot of Americans hate Trump and everything he represents. I can also tell you that a lot of Americans absolutely loathe Hillary Clinton and what she represents, which is why she lost the elections.

Don't talk to me about the electoral system and popular vote, the bottom line is she lost the elections and it was because a lot of Americans are sick and tired of establishment politics.

The problem is Trump isn't going to heal social divisions and he will exacerbate rising inequality with his tax cuts which will overwhelmingly favor the uber-wealthy.

In my comments on why Alan Greenspan is wrong on bonds and why so many people are baffled my the inflation deflation mystery, I outlined six 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. 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 six structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

One of them is rising inequality, which is something Ray Dalio alluded to. There are many views on how we can address rising inequality -- better education, higher corporate and personal income taxes for the top 1%, increase wealth and estate taxes, and more subsidies for the poor and working poor -- but these policies are not politically palatable to everyone.

Some people feel that cutting taxes for everyone will magically lift the poor and working poor out of poverty and bridge the great economic divide. Well, we tried that during the Reagan-Bush years and the rich got even richer (the great economist, John Kenneth Galbraith, famously said this about supply-side economics: "If you feed enough oats to the horse, some will pass through to feed the sparrows").

But under Obama, the exact same thing happened, the rich got even richer, which is why so many young people saddled with huge student loans had enough and were openly and passionately campaigning for Bernie Sanders to lead the Democratic party.

I don't want to dwell on this too long, but I agree with BCA's geopolitical strategist, Marko Papic, America is moving to the Left in the decades ahead and Europe will be moving slightly to the Right.

But there will be vehement opposition in America as the country moves to the Left in the decades ahead, and it can potentially disintegrate into a full-blown civil war again. I don't say this lightly, but there are some extreme lunatics on both sides of the political spectrum who have vowed to escalate the violence to reach their political objectives.

Sure, the Nazis and white supremacists at Charlottesville were to blame for the death of an innocent woman, and there weren't "bad people on both sides," only one repugnant side. But make no mistake, there is an increasingly violent anarcho-leftist group in America made up mostly of young people who will use violence and destruction of property to promote and achieve their political objectives.

And it's not just in America. I was watching Greek news last week where I saw thirty young leftist anarchists walk into a drug store in Athens with their black hoodies and masks, stealing food and medication in a matter of minutes as their colleagues stood outside patrolling for the police. It was surreal and highly organized.

"Leo, that would never happen in the States because store owners have guns". So do the bad guys and I assure you, lots of Greeks own guns too but if you see an organized mass doing this, good luck trying to stop them or kill them and risk being killed.

Anyway, back to Ray Dalio and Bridgewater. Yes, he likes gold (GLD) but he also increased his holdings of US long bonds (TLT), which is what I've been recommending everyone to do.

However, unlike Ray Dalio who doesn't see "any important economic risks on the horizon", I see a major risk, global deflation coming to America, clobbering risk assets across public and private markets for a very, very long time.

Stop worrying about when the tech bubble will burst, if my reading on the risks of global deflation spreading to the US is right, we will have a bear market unlike anything we've ever seen in the past, including the Great Depression. That's when the silence of the VIX will be no more and the lambs selling volatility will get slaughtered.

But I will tell you this much, I track stocks very closely, and there is still a party going on out there. This morning I shared a sample of stocks on my watch list with some traders (click on image):


Fun times, right? Sure, if you're Renaissaisance Technologies and other elite hedge funds playing the trading game but if you ask me, the risks aren't worth it at this time.

You will hear a lot of nonsense on CNBC like "the market is anticipating tax cuts" but I'm warning you, the market is NOT anticipating global deflation spreading to the US. Nobody is.

Below, take the time to watch Noam Chomsky's documentary, Requiem for the American Dream (with French subtitles). I don't agree with everything he states but it's important to watch this and think about where the world is heading and why the dangerous divide threatens our democracies.

It's also worth noting public pensions that have been getting squeezed on fees for decades have also contributed to rising inequality, propelling Ray Dalio and other elite hedge-fund and private equity managers to the list of the world's rich and famous.

Dalio and others have no idea how lucky they are to be "first-movers" in the golden age of alpha managers. There is no way someone starting a hedge fund or private equity fund now will ever achieve a fraction of the wealth these gurus managed to amass over the last thirty years (central banks' quantitative easing to mitigate the fallout from financial crisis also helped transfer unprecedented gains to the lords of finance).

Update: My friend, Jonathan Nitzan, professor of political economy at York University, shared this with me after reading this comment:
Dalio, like most other economists and financial analysts, lives in a bifurcated world of economics vs. politics. For him, economics is a machine (he calls himself a mechanic). This machine would have worked just fine (equilibrium) if it were not for the external political shocks that constantly bombard it (distortions). His main claim to fame (other than the money he manages and owns) is to argue that current political shocks are bigger than other analysts believe.

The idea that capital is not an economic category but a political entity to start with, that capitalization discounts not utility but sabotage, and that capitalism is not a mode of production and consumption but a mode of power is something he cannot possibly fathom (for more on this latter perspective, see our 2016 paper "CasP Model of the Stock Market" and the accompanying video here which is embedded below).
I thank Jonathan for sharing his wise insights with my readers. In fact, I would urge Ray Dalio to invite him over to Connecticut to discuss his ideas with Bridgewater's staff (Jonathan formerly worked as an Associate Editor, Emerging Markets at BCA Research and he really knows his stuff).