Originally published by Narrow Road Capital
January brought mixed results for risk assets with gains and losses for equities and credit relatively small. Chinese (2.4%) and American (1.8%) equities rose, whilst Japanese (-0.4%), Australian (-0.8%) and European (-1.8%) equities fell. US high yield credit made gains, whilst investment grade credit pulled back a little in the face of record January issuance. Copper (8.7%), iron ore (6%) and gold (5.5%) had strong price increases but US oil (-1.8%) and natural gas (-15.6%) fell back. All eyes are on the Trump administration as it implements very different policies from what the previous administration and some pundits had expected. 2017 shapes up as being a very interesting year.
Economics
US GDP came in at 1.9% for the fourth quarter and 1.6% for last year, just beaten by the Eurozone which recorded 1.7% growth for 2016. This continues the trend of a very weak recovery with Obama finishing up without a year of GDP growth exceeding 3%. The dour past might be about change though, some US economic indicators begin 2017 in much better shape than a year ago. Conversely, the key indicators tracked by the conference board say that the US economy is in much worse shape than the official measures present.
The US isn’t alone in this experience; global growth for 2016 is expected to report at miserly levels whilst growth in debt increases much faster. Low interest rates make debt servicing far more comfortable than it would otherwise be, but the early signs of inflation in the US and Germany could mean that interest rates will be rising. Pleasingly, the debt to GDP ratio in the Euro area fell last year. That’s despite the problems with excessive budget deficits as eight EU countries received a warning about their fiscal position. In a break from a previously staunch position, Mario Draghi left open the door to nations leaving the Euro zone, providing they settle their bills before they leave.
The debate over the failures of quantitative easing and academic economics continues. Some are dismissing economics altogether, but others are asking whether it is just econometrics that has failed. A report from the Bank for International Settlements concluded that quantitative easing has reduced volatility but has not spurred growth.
High Yield Debt
US high yield debt is now back on the bad side of valuations. The credit spread for high yield bonds peaked at 8.87% in February 2016 but is now a miserly 3.96%. The junkiest bonds, those rated CCC and below, are particularly overpriced with little room for upside. One of the forgotten rules at this point of the cycle is that you don’t have to have defaults to take losses on a high yield portfolio. A return to average credit spreads can wipe-out several years of coupons. None of this is stopping hedge funds from loading up, distressed energy companies are a particular favourite. The $90 billion of US commercial mortgage debt maturing this year and debt from retailers are other hot spots.
Matt Levine wrote an excellent piece detailing the recent fightback by bondholders against awful covenants. A proposed change would have allowed companies to default on their bonds but avoid the early redemption premium. Matt noted that such a fightback is very unusual, as bond buyers rarely read the bond documents at issue. If they do read them and find something they don’t like, they rarely charge the issuer a high rate for the onerous terms or refuse to buy. This is a cyclical process though, once a crisis hits bond buyers demand strong covenants again before forgetting their importance as the cycle progresses.
I’ve found the same behaviours, I once called the issuer‘s lawyers after they had included an irrelevant section from a previous bond. They were shocked that anyone was reading their work! My response to bad terms, such as those that are commonplace in the Australian listed note market, is to not participate at all. Private debt, syndicated loans and securitisation offer much stronger covenants and better yields. Giving up some liquidity for higher returns and lower risk is the closest thing to a free lunch in the current environment. Keep in mind that the more illiquid a deal is likely to be, the more leverage the investor has to set covenants in their preferred way. If you are in the business of selecting debt managers, asking about their approach to covenants as part of manager due diligence is a great way to separate the wheat from the chaff.
Asset Management
Asset managers and capital allocators might be set for a tough 2017 as global stocks are near all-time highs, volatility is near all-time lows and there’s record bullish positioning in many markets. The bond bull market is the third longest in over 700 years and risk free rates are the lowest in sovereign debt history. This isn’t a good setup for good returns.
The active management versus passive management debate rages on. Active continues to be the majority but is losing market share at a decent rate. The discussion could be better framed as high fees versus low fees as many investors are choosing index funds and ETFs just to get away from high fees. Low fee asset managers like Vanguard are seeing huge inflows, the result being that big asset managers are struggling to grow their profits. Bloomberg highlighted the power of Vanguard and its ability to call out excessive executive remuneration, but the incongruent position where it won’t disclose what it pays its senior managers.
The shift to lower fee managers is still taking an awfully long time to play out though. Hedge funds were beaten by index funds for the seventh year in a row in 2016, and saw redemptions of $106 billion for the year. However, hedge fund assets crossed the $3 trillion mark during 2016 as positive returns more than offset redemptions. Investors continue to ignore the basic maths of hedge funds – it takes less than 20 years for the manager to have more money than you if you pay them a 2% management fee and a 20% performance fee. What’s worse is that some hedge funds are charging more than double the 2% and 20% fees by passing on dubious costs to investors.
China
The quarterly GDP print for China was 6.8%, above expectations but below the results of recent years. The growth was very much state led, old economy growth, as seen in the continued high prices being paid for iron ore. This might be coming to end with iron ore stockpiles at record highs. Commentary by key leaders has opened the door to managing GDP figures lower with a target of around 6.5% GDP growth for 2017. China hasn’t been immune from the global trade slowdown, with its exports falling by more than its imports in 2016.
As always, GDP growth must be read alongside debt to GDP growth for the whole picture. With one version of that ratio going from 254% to 277% during 2016 China continues to be on an unsustainable path. Another article pointed out that this looks just like Japan, Spain and Thailand before they had problems. Banks have been warned again to slow down lending particularly to residential property.
Early stage warnings signs of a credit crunch are starting to show up. Bond defaults doubled in 2016, but remain low as a percentage of all bonds. Unlike the past, not all defaults are being cured and some pretty severe losses are being taken. Key interest rates are rising causing bond sales to be cancelled. A spike in funding costs and a liquidity crunch saw the PBOC inject liquidity and cut the reserve ratio for banks. Stressed companies are turning to asset backed funding to raise debt. Residential property prices have peaked and the public reporting of some property price indices has been stopped.
None of this guarantees a credit crunch in the short term, it could be another head fake like those in recent years. The wall of junk debt maturities in 2017 and 2018 will provide a test to the system. Wealth management products, entrusted loans and Dai Chi repo games are all areas of concern.
December saw FX outflows at virtually nil, a break from the roughly $1 trillion of cumulative outflows over the last 18 months. The strong outflows have seen China dumping US government bonds with Japan now the number one holder. Banks have been told they must balance their FX trades with transactions as small as US$5,000 being analysed and sometimes rejected. Overnight interest rates hit 100% as the government sought to break currency shorts. Chinese buyers are having trouble settling global real estate purchases as currency conversion requests are rejected.
Emerging Markets
Emerging markets are offering plenty of problems and potholes for investors to deal with. Mozambique defaulted on a $60 million interest payment. Turkey’s currency is collapsing as outflows surge. Non-performing loans are spiking in Nigeria. Saudi Arabia has hired PWC to find $20 billion of savings across housing, transport, health and education. B- rated Egypt sold $4 billion of US dollar bonds after getting a $12 billion loan facility from IMF in November. The next big test for Venezuela is $3 billion of debt repayments due in April.
Puerto Rico has an extended list of problems to work through and bondholders don’t yet seem to have gotten the memo. The government’s report has the territory only able to meet 21% of debt payments due in 2019, indicating that the territory wants bondholders to take a 79% haircut. Disparate groups of bondholders are jockeying for position with each group asserting that its debt has priority. As well as $70 billion in debt, Puerto Rico has a $48.8 billion hole in its pensions which are only 1.6% funded.
Greece has yet to implement two-thirds of the reforms needed to access the next round of its bailouts funding. The IMF and the EU are further apart than ever in their plans on how to help Greece deal with its excessive debt.
Regulation
Regulators brought unwanted Christmas gifts to banks and brokers with a range of fines handed out recently. Credit Suisse (SIX:CSGN) and Deutsche Bank (DE:DBKGn) were hit with penalties of $5.3 billion and $7.2 billion respectively for mis-selling mortgage backed securities. The headline numbers are far bigger than the true position, Deutsche’s penalty comprises $4.1 billion in fines and $3.1 billion in “consumer relief”. Deutsche is seeking approval for the consumer relief component to be met by lending to Lone Star, who will undertake workouts on consumer loans. This could see Deutsche make a profit on what is meant to be a penalty.
Deutsche is also being scrutinised for helping Monte De Paschi hide €367 million in losses and will pay $629 million for organising Russian mirror trades. Moody’s will pay $864 million for its role in the subprime mortgage debacle. Citadel was fined $22.6 million for front running its retail clients, a case that exposed the ugly side of high frequency trading. Ten US fund managers have been fined up to $100,000 each in a pay to play scheme with pension funds. No word if any consequences will apply to those at the pension funds who received the “pay”. JP Morgan has been ordered to pay $164,000 plus legal fees to a former employee who they fired after he refused to sell inappropriate products. John Corzine got away with a $5 million penalty for using $1 billion in client funds to cover liquidity issues at MF Global.
A sleeper issue for banks has been the Libor litigation. The US supreme court has ruled that lawsuits against the banks can proceed, with the prospect that banks will be facing billions of dollars of compensation for investors and borrowers. The issue for banks is Libor manipulation was always going to hurt someone and help someone, with the losers suing and the winners keeping their gains. If Libor is inflated borrowers lose by paying higher interest rates on their debt. If Libor is deflated, investors lose by receiving less interest than should have occurred.
The various fines for Deutsche Bank will further reduce its meagre capital position. It looked like it wouldn’t have enough capital to be able to pay bonuses in cash or preference share dividends, but the ECB has given it a temporary leave pass. Deutsche Bank is one of the key European banks arguing against higher capital floors as part of the Basel 4 reforms. These negotiations appear to have broken down with the Americans and Germans at polar opposites.
The Dallas Pension Fiasco Is Just the Beginning
The recent blow-up of the Dallas Police and Fire Pension System was entirely predictable. Whilst it is tempting to blame unusual circumstances for the recent lock-up of redemptions and likely substantial reductions to pensions for those still in the fund, many other American pension funds are heading down the same road. The combination of overpriced financial markets, inadequate contributions and overly generous pension promises mean dozens of US local and state government pension plans will end up in the same situation. The simple maths and political factors at play mean what happened at GM, Chrysler, Detroit and now Dallas will happen nationwide in the coming decade. So, what’s happened in Dallas and why will it happen elsewhere?
Background to the Dallas Pension Fiasco
The Dallas pension scheme has been underfunded for many years with the situation accelerating recently. As the table below shows, as at 1 January 2016 the pension plan had $2.68 billion of assets (AVA) against $5.95 billion of liabilities (AAL), making the funding ratio (AVA/AAL) a mere 45.1%. Despite equity markets recovering strongly over the last seven years, the value of the assets has fallen at the same time as the value of the liabilities has grown rapidly. The story of how such a seemingly odd outcome could occur dates back to decisions made long before the financial crisis.
In the late 1990’s, returns in financial markets had been strong for years leading many to believe that exceptional returns would continue. In this environment, the board that ran the Dallas plan decided that more generous pension terms could be offered to employees and that these could be funded by the higher expected returns without needing greater contributions from the Dallas municipality and its taxpayers. Exceptionally generous terms were introduced including the now notorious DROP accounts and inflated assumptions for cost of living adjustments (COLA). These changes meant that pension liabilities were guaranteed to skyrocket in future years, whilst there was no guarantee that investment returns and inflation levels would also be high. Dallas police and fire personnel were being offered the equivalent of a free lunch and they took full advantage.
In the 2000’s the pension plan made some unusual investment decisions. A disproportionate amount of plan assets were invested in illiquid and exotic alternative investments. When the financial crisis struck these assets didn’t decline as much as the assets of other pension plans. However, this was merely a deferral of the inevitable write downs which came in the last two years after a change in management.
Recent Events
Throughout 2016 the pension board, the municipality and the State government bickered over who was responsible and who should pay to fix the mess. The State government blamed the municipality for the poor investment decisions. The municipality blamed the State government for creating a system that it could not control but was supposed to be responsible for. It also blamed the pension board for the overly generous changes they implemented. The pension board recognised the huge problem but offered only minor concessions arguing that plan participants were entitled to be paid in full in all circumstances. They asked the municipality for a one-off addition of $1.1 billion, equivalent to almost one year’s general fund revenue for the municipality.
As the funding ratio plummeted during 2016, plan participants became concerned that their generous pension entitlements might not be met. In other pension plans the employer might increase its contributions when these circumstances occurred, but in Dallas the municipality was already paying close to the legislative maximum. Police officers with high balances retired in record numbers, pulling out $500 million in four months in late 2016. Those who withdrew received 100% of what was owed, with those remaining seeing their position as measured by the funding ratio deteriorate further.
In November, when faced with $154 million of redemption requests and dwindling liquid assets, the pension board suspended redemptions. The funding ratio is now estimated to be around 36% with assets forecast to be exhausted in a decade. Litigation has begun with some plan participants suing to see their redemption requests honoured. The municipality has indicated it wants to claw back some of the generous benefits accrued since the changes in the 1990’s, though this is likely to only impact those who didn’t redeemed. The State has begun a criminal investigation. Everyone is looking to blame someone else, but not everyone has accepted that drastic pension cuts are inevitable.
The Interplay of Political Decisions and Financial Reality
The factors that led to Dallas pension fiasco are all too common. Politicians and their administrations often make decisions that are politically beneficial without taking into account financial reality. A generous pension scheme keeps workers and their unions onside, helping the politicians win re-election. However, the bill for the generosity is deferred beyond the current political generation, with unrealistic assumptions of future returns enabling the problem to be obscured. As financial markets tend to go up the escalator and down the elevator it is not until a market crash that the unrealistic return assumptions are exposed and the funding ratio collapses.
This is when a second political reality kicks in. In the case of Dallas, there are just under 10,000 participants in the pension plan compared to 1.258 million residents in the municipality. Plan participants therefore make up less than 1% of the population. If the Dallas municipality chose to fully fund the pension plan it would be require an enormous increase in taxes from the entire population in order to fund overly generous pensions for a very small minority of the population. For current politicians, it is far easier to blame the previous politicians and the pension board for the mess and see pensions for a select group cut by half or more than it is to sell a massive tax increase.
The legal position remains murky and it will take some time to clear up. The municipality is paying 37.5% of employee benefits into the pension plan, the maximum amount required by state law. Without a change in state legislation, it seems likely that the pension plan will have to bear almost all of the financial pain through pension reductions. If state legislation was changed to increase the burden on the municipality years of litigation could ensue with the potential for the municipality to declare bankruptcy as a strategic response. The appointment of an administrator during bankruptcy could see services reduced and/or taxes increased, but pension cuts would be all but a certainty.
Dallas Isn’t the First and Won’t be the Last
It’s tempting to see the generous pension structure and bad investment decisions in Dallas as making it a special case. Detroit was seen by many as a special case when it went into bankruptcy in 2013 as it had seen its population fall by 25% in a decade. This depopulation left a smaller population base trying to fund the debt and pensions obligations incurred when the population was much larger. Growing debt and pension obligations are signs of what is to come for many local and state governments who have been living beyond their means for decades.
As well as building up pension obligations many US governments have been accruing explicit debt. The two are intertwined, with some governments issuing debt to make payments into their pension plans, often to close the underfunding gap. This is very much a short-term measure, as whether it is pension contributions or debt repayments both will either require high taxes and/or lower spending on government services in the future in order for these payments to be met.
Pew Charitable Trusts research estimates a $1.5 trillion pension funding gap for the states alone, with Kentucky, New Jersey, Illinois, Pennsylvania and California going backwards at a rapid rate. Using a wider range of fiscal health measures the Mercatus Center has the five worst states as Kentucky, Illinois, New Jersey, Massachusetts and Connecticut. The table below shows the five state pension plans in Illinois, with an average funded ratio of just 37.6%.
For cities, Chicago is likely to be the next Detroit with the city and its school system both showing signs of financial distress. Chicago is trying to stem the bleeding with a grab bag of tax and other revenue increases but in the long term this makes the overall position worse.
Default is Almost Inevitable as the Weak get Weaker
The problem for Chicago and others trying to pay their debt and pension obligations by raising taxes is that this makes them unattractive destinations for businesses and workers. Growth covers many sins, as growth creates more jobs and drags more people into the area. This increases the tax base and lessens the burden from previous commitments on those already there. Well managed, low tax jurisdictions benefit from a positive feedback loop.
For states and municipalities in decline, their best taxpayers are the first to leave when the tax burden increases. Young college educated workers with professional jobs generate substantial income and sales tax revenue but require little in the way of education and healthcare expenditure. This cohort has many options for work elsewhere and can easily relocate. Chicago and Illinois are bleeding people, with the flight of millionaires particularly detrimental on revenues.
Those who own property are caught in a catch 22; property taxes and declining population have pushed property prices down, potentially creating negative equity. But staying means a bigger drain on the household budget as property taxes are the most efficient way to raise revenue and therefore become the tax increased the most. If too many people leave property prices plummet as they have in Detroit, making it even more difficult to collect property taxes as these are typically calculated as a percentage of the property valuation. Bankruptcy becomes inevitable as a poorer and older population base that remains simply cannot support the debt and pension obligations incurred when the population base was larger and wealthier.
Pensions Will be Reduced, but Bondholders Will Fare Worst
The playbook from the Detroit bankruptcy is likely to be used repeatedly in the coming decade. When a bankruptcy occurs and an administrator is appointed a very clear order of priority emerges. Firstly, services must be provided otherwise voters/taxpayers will leave or revolt. There may need to be cuts to balance the budget but if there is no police force, water or waste collection the city will cease to function.
Secondly, pensions will be reduced to match the available assets quarantined to meet pension obligations and the ability of the budget to provide some contribution. If the budget doesn’t have capacity or the legal obligation to contribute more to pension funding, pensioners should expect their payments to be cut to something like the funding percentage. For Dallas and the pension plans in Illinois this means payments cut by more than half.
Third in line are financial debtors. Bondholders and lenders don’t vote and they are seen as a bunch of faceless wealthy individuals and institutions who mostly reside out of state. They effectively rank behind pensioners, who are people who predominantly reside in the state and who vote, even though the two groups technically might rank equally. This makes state and local government debt a great candidate to short via buying CDS protection as the recovery rate for unsecured debt is usually awful in the event of default.
The Next Crisis Will Trigger an Avalanche
At the risk of being labelled a Meredith Whitney style boy who cried wolf I expect that the next financial crisis will trigger a wholesale revaluation of the creditworthiness of US state and local government debt. I have no crystal ball for when this will happen, but it is almost certain that the next decade will contain another substantial decline in asset prices. This will impact state and local governments and their pension obligations in two major ways.
Firstly, asset prices will fall causing underfunded pensions to become even more obviously insolvent. Most US defined benefit pension funds are using 7.50% - 8.00% as their future return assumption. Using a 7.50% return assumption for a 60/40 stock/bond portfolio, with ten year US treasuries at 2.50%, implies equities will return 10.8% every year going forward. In a low growth, low inflation environment this might be achievable for several years, but an eventual market crash will destroy any outperformance from the good years. The continued use of such high return assumptions is unrealistic and is being used to kick the can further down the road. The largest US public pension fund, Calpers, has recognised this and is reducing its return expectations from 7.50% to 7.00% over three years. This still implies a 10% return on equities for a 60/40 portfolio.
Secondly, downturns cause a reassessment of all types of debt with the highest risk and most unsustainable debt unable to be renewed. State and local governments with a history of increasing indebtedness and no realistic plan for reducing their debts may become unable to borrow at any price. This will force them to seek bankruptcy or an equivalent restructuring process. Once this happens for one mainland state (Illinois looks likely to be the first) lenders will dramatically reprice the possibility that it could happen elsewhere. Those who think states cannot file for bankruptcy should watch the process occurring in Puerto Rico, it will be repeated elsewhere. Barring a federal bailout, an overly indebted state or territory has no alternative other than to default on its debts. Raising taxes or cutting services will see the city or state depopulated. Politicians and voters are strongly incentivised to default.
Conclusion
Chronic budget deficits, growing indebtedness, excessive pension return assumptions and pension underfunding all set the stage for a wave of state and local government pension and debt defaults in the coming decade. As Detroit has shown this century, once an area loses its competitiveness its financial viability spirals downward. As taxes increase and services are cut the wealthiest and highest income earners leave slashing government revenues and increasing the burden on the older and poorer population that remains.
The next substantial fall in asset prices will sharpen the focus on budget deficits and pension underfunding, with the most indebted and underfunded states likely to find they are unable to rollover their debts at any price. Remaining residents will be negatively impacted, pensioners will see their payments slashed and bondholders will recover little, if any, of their debt. As there is virtually no political will to take action to avoid these problems investors should position their portfolios in expectation that these events will happen.
Media Worth Consuming
Obama will go down as the coolest president ever, the best basketball player but also as President Debt for building the US government debt mountain by far more than his predecessors. It unclear whether Trump will take that title from him, Trump’s policies could make the deficit far worse but his team is working on substantial spending cuts. One of Obama’s final changes was to cut the mortgage insurance payments for higher risk FHA borrowers, but Trump has killed that off already. The FHA insurance scheme now covers more than $1 trillion in mortgages, some of which bear risk characteristics similar to the subprime loans of 2004-2007.
The US fast food industry is in the spotlight as it campaigns against minimum wage increases. Some claim that low wages force US taxpayers to subsidise the industry by $7 billion per year. Some Uber drivers are travelling long distances to wealthy areas to get fares and are sleeping in carparks overnight to reduce their commute. Uber is having a big impact on the value of taxi licences, one lender has a 51.5% arrears rate on their loans secured by taxi licences.
Despite the hopes of some that standard demand and supply concepts don’t apply with minimum wages, research has found there are negative impacts to increasing minimum wages including some businesses laying off workers and others closing altogether. The EU is proposing universal basic income and higher minimum wages for citizens of member nations. The evidence for universal basic income is weak, with some claiming it has never worked and never will. An alternative scheme is for the government to provide work in exchange for welfare. Another suggestion for helping low income earners is to make work abundant and decrease the cost of living. Working against this is government regulation which is estimated to cost each American $20,000 per year.
The Economist magazine has downgraded the US from “full democracy” to “flawed democracy” joining France, Italy and Japan at the sub-par level. A Dutch woman has had her application for a Swiss passport rejected after she annoyed locals by repeatedly protesting against Swiss traditions. Iceland has slashed drug usage amongst teens by making straight forward and inexpensive changes. An unemployed college graduate made $1,000 an hour writing fake news. Bernie Madoff corners the hot chocolate market in prison. The Bank of Canada has made a YouTube video to warn about the housing bubble. Americans responded to the financial crisis by having less children and more pets.