U.S. Pension Assets Up, But So, Too, Are Liabilities

With the aging of America comes increased pension fund liabilities, a topic which has been top of mind for fund managers. A recent Milliman study shows the double-edged sword of such plans, which have higher funding ratios but also increased liabilities. The reach for yield in a low-interest rate environment has, in part, caused funding ratios to move lower as the deficit between growing liabilities and available assets climbs to a new study high.

Good news in Millman study is that aggregate funding ratios and pension assets are up, the bad news is that liabilities are up, too

The good news in the Milliman Public Pension Funding Study is that the estimated aggregate funded ratio is up to 70.7%, up from 67.7% on a year over year basis. Total assets in the nation's largest public pension plans rose from $3.19 trillion, and as of June 30, 2017, to a combined $3.44 trillion, a feat that Milliman attributes to "strong market performance in late 2016 and early 2017."

The gains come as many pension plans are lowering their return assumptions. The Employees Retirement System of Texas, for instance, lowered its return assumption from 8% to 7.5% in the headwind of some on the board who advocated for a 7% return assumption.

Lowering of returns expectations comes as the median average returns assumption in the Milliman report is 6.71%, off 79 basis points from the 7.50% median discount rate used by the plans. All but six of the plans in the Millman study have a lower independently determined rate.  One-third of the 100 largest plans reduced return assumptions, with 66 of the 100 plans lowering them at least once since 2012.

The lowered returns expectations come as total pension liabilities are rising, up to $4.72 trillion in 2016 from $4.42 trillion. The 2017 number is expected to clock in at $4.87 trillion. The 26 million members who rely on the plans for retirement each have a $224,000 cost assumptions. Nine of the plans have higher funded ratios in excess of 90%, 59 have funded ratios between 60% and 90% while 32 plans have ratios below 60%.

In the 2017 study, the aggregate reported funded status hit a record deficit of $1.53 trillion, down from a low of $1.02 trillion in 2015 and also higher than the 2018 study estimate of a $1.43 trillion deficit.

"In this low-interest-rate environment, market expectations on investment returns have been falling faster than plan sponsors can reassess rates," Becky Sielman, author of the report, said in a statement.  "And the gap that creates between sponsor-reported and our recalibrated market-based liabilities is widening, which is all the more reason plans should continue to monitor emerging investment return expectations and adjust their assumptions as needed."

Risk exposure has not been increasing

When pension funds look at their investment horizon, the impact low-interest rates and the resulting search for yield is apparent. US Fixed Income accounts for 21.8% of the average 2017 asset allocation, while US equities gobble up 28.3% while non-US equities occupy 19.1% of the portfolio. Other assets tied to the performance driver of economic strength include real estate, which has an 8.8% exposure while Private Equity has a 9.9% exposure. Hedge funds, initially designed to hedge during periods of market turbulence, have a 5.1% exposure.

Over the past five years there has been very little change in the overall allocation mix, the report noted. Pointing to a reach for yield that hasn't resulted in a correlated rise in risk factors, the report noted that over the past four years "there has not been a material move towards riskier investments."

Since 2013, equities generally made up near half the total portfolio, while private equity and real estate clock in at near one quarter along with fixed income.

Today’s Three Important Megatrends

When Peter Berezin, Chief Global Strategist at BCA Research, looks at three largely non-consensus megatrends shaping society, he doesn't engage in "happy talk," as he describes it. He sees global migration with open borders for skilled workers benefiting the developed world, but also notes that if the delicate issue is not properly managed rising economic stability. He considers social fragmentation that is rife across the developed world brandishing a populist flag and sees the unanswered rage as threatening democracy itself, which millennials don't seem to particularly care for anyway. Then he looks at aging trends across the developed world and doesn't think deflation, but rather inflation.

This isn't likely to be good for the business climate.

Providing open borders for skilled workers benefits an economy, but not unskilled workers

There are many trends that appear to unite a rage that is spreading around the developed world, with immigration being a key hot button.

If properly managed, however, open immigration can benefit a society.

Pointing to several studies that concluded the removal of all restrictions on labor mobility would more than double global GDP in advanced economies, Berezin notes a double-edged sword. Migration is a net economic positive in the developed world when they are educated and have useful skills. "The problem is that many migrants today are poorly skilled," he writes, a trend that has been documented in Germany to various degrees.

Looking at the issue from an unemotional, economic angle, Berezin recognizes the political powder keg. He observes that opening up borders to labor can hurt the existing unskilled labor force, forcing wages lower. Allowing for unfettered migration for the most skilled workers, however, further creates a global society of haves and have nots, which likely isn't expected to end well for capitalism in the long run.

Social fragmentation and class division hurts all

There is a trend of social fragmentation that can be seen, in part, through the eyes of open borders. Such measures create a further economic divide between the skilled and educated and the unskilled.

Further societal fragmentation and a deep, darker divide among social classes, which has a multi-facetted performance driver. He notes on the left the harang for income inequality is fraying society while on the right calls that "cultural elites" no longer instill middle-class values has resulted in "underclass" behavior being normalized.

It is not just open borders that divide society, but technology, a cause for recent Congressional hearings, that is exacerbating social fragmentation.

The internet is not expanding people's minds through divergent thoughts but rather "has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe."

The problem with social fragmentation is that a lack of a common value system, when divergent demographics no longer see eye to eye, is that established institutions lose legitimacy. Berezin notes that that has resulted in a collapse of trust in the media, particularly among right-leaning voters, and "most worrying, support for democracy itself has dwindled around the world."

Aging is inflationary, not deflationary

Looking at demographic trends, younger "millennials" don't think living under a democratic form of government is essential.

The youth trend could see a reversal of several trends, including the one that keeps urban areas vital. If the trend towards less crime is reversed -- as it has in Chicago -- young people could leave urban areas in droves.

While the trend for a population has at times been associated with deflation, Berezin thinks the opposite might occur. Spending increases as population ages.

He notes an approaching "inflection point" where aging trends morph from being deflationary to inflationary. This is largely due to the global trend of the "support ratio -- the ratio of workers to consumers – peaking after a forty-year climb. Ultimately this could lead not to deflation, but inflation.

The market’s ‘fear gauge’ says it’s time to worry

As all experienced investors know, October is a month to be wary of. That's because – as history has already shown – it's a time when stock markets like a good crash.

Except that this is 2017, and equities are playing a different game. They don't want to fall any more. Maybe overall price levels will drop a couple of per cent once in a while, but that's about it.

Right now, America's S&P 500 index appears to be leading global share indices into a nirvana of ever-rising corporate worth.

Regardless of any adverse news, it seems as though investors are no longer concerned they might lose money according to the stock market's 'fear gauge'.

And this is when we really should start worrying…

Asset price inflation

Why do stocks keep climbing?

Following the Great Financial Crisis (GFC) that began almost a decade ago – and was made worse by some 'clever' derivative instruments that went horribly wrong as I wrote about here – the world's top money men resolved to prevent another panic on their watch.

Deflation, i.e. a fall in prices, became the bogeyman. Central bankers, however, decided they could both 'solve' the GFC whilst simultaneously preventing another by creating oodles of extra cash.

After all, throw enough money at anything and eventually its price must rise. 

So the people running the US Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England did just that.

They gave it a pseudo-technical term: quantitative easing (or QE) but in essence, they simply cranked up the money-printing presses.

Central bankers can't, of course, actually resolve any real problems this way, as I examine lower down. In fact, they didn't even put their monetary sticking plasters in the right place.

Rather than raising high street prices, they ended up hiking the cost of assets such as property and stocks. Which is why if you don't already own your own house you probably can't afford to buy one and why the S&P 500 index just keeps on rising.

Not on much bigger profits – that's definitely not happened – but on increasingly over-extended valuations.

Put another way, investors are happy to pay ever-higher prices for exactly the same companies as before, just because interest rates are so low.

The 'fear index' tells the story

The bottom line is that the investment fret factor scarcely still exists. The US equity market has become hugely complacent about the risks of owning shares.

I'm not saying this simply because of the surge in the S&P 500.

You can also look at the VIX, otherwise known as the US market's 'fear gauge'.

Apologies for the nerdy stuff: VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index.

It's constructed using implied volatilities – the chances of price moves – of a wide range of S&P 500 index options. Specifically it shows the market's 30-day volatility forecast.

In simpler terms, the VIX measures the anticipated risk of being invested in America's equity market.

High volatility is seen as bad, low is good.

Over the last 20 years the VIX has traded between 80 (expected very risky, like nine years ago in mid-GFC) and just below 10 (expected very low risk).

By now you've probably worked out where the VIX is currently standing.

For most of 2017, it's been around the 10 area. In other words, it's already tested the troughs of the last decade but now the VIX has dropped to levels seen in March 2007…in fact, just before the GFC! Here's the 10-year VIX picture:

Can you believe it? 

Calling this extreme complacency is an understatement. Once again it seems that many shareholders simply haven't a clue how much risk they're taking.

For one thing, US equities may already be in bubble territory. That would spell big danger, even without all the bad news around and geo-political tensions are arguably their highest levels for years.

And remember what I said about those central bankers not solving the GFC? Well, their efforts have made things much worse.

Indeed, to drag itself out of a debt/deflation downward spiral, the world created lot of extra borrowing. Worse, even more debt exists than we previously thought.

The Bank of International Settlements is often called 'the bank for central banks'. After my earlier comments about central bankers, that might not sound too promising. However, I'd rate the BIS as one of the good guys. The bank is great at number crunching. And it doesn't pull any punches. So when the BIS speak, I listen.

And last month the bank gave a very scary warning:

"Global debt may be under-reported by around $13 trillion because traditional accounting practices don't include foreign exchange derivatives that are used to hedge international trade and foreign currency bonds", reports Reuters.

Aargh! More jargon. But you don't need to be an accountant to see the word 'derivative'. Financial weapons of mass destruction, as Warren Buffett once called them can be lethal in the wrong hands.

"Bank for International Settlements researchers said it's hard to assess the risk this 'missing' debt poses", says Reuters. "But the main worry [is] a liquidity crunch like the one that seized FX swap and forwards markets during the financial crisis".

And all the while, the VIX is saying there's less need to panic than ever.
In truth, I find it hard to envisage $13 trillion, and then I looked at the latest BIS chart on overall global debt (see below). The bank's 2017 worldwide estimate is now a completely mindboggling $217 trillion.

That's no less than 327% of world GDP!

The scope for something to go wrong has to be…well, I'll leave it to you to finish the sentence. Yet to repeat, S&P 500 investors are still at their most complacent.

So, the burning question now is; what next?

Well, if you are looking for an opportunity to take advantage of all of this uncertainty, my colleagues Jim Rickards and Tom Tragett might be able to help you.

You see, they've examined the outlook for markets over the coming months and spotlighted many of the risks, as well as looked at what to avoid. Finally, they've found a Big Trade for 2018 that they believe will be even bigger than any move in gold – the traditional safe haven in troubled times.

Fabrizio