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Monday, March 02, 2015 8:54 PM


Bill Gross: Too Much Debt, Too Many Zombie Corporations, Low Interest Rates Destroy Pension System


In an Bloomberg Television interview Bill Gross of Janus Capital spoke with Bloomberg Television's Trish Regan about the outlook for Federal Reserve policy, the U.S. economy and his objectives at Janus Capital.

Key Quotes

  • "Not even thin gruel is being offered to our modern-day Oliver Twist investors. You have to pay to come to the dinner table and then sit there staring at an empty plate."
  • "The interest rate can't be raised substantially even over the next two to three years."
  • "The US has escaped the liquidity trap that euroland and Japan are in. But, not necessarily for all time."
  • "[Low interest rates] keeps zombie corporations alive because they can borrow at 3 and 4 percent, as opposed to the 8 or 9 percent. It destroys business models. It's destroying the pension industry and in the insurance industry."
  • "ultimately, [low interest rates] destroy the capitalistic model at the margin. Instead of investing in the real economy, [corporations] can now simply borrow at close to 0 percent and buy their own stocks, which yield 2 or 3 percent on a dividend basis and provide a return of 6 or 7 percent on an earnings to price ratio basis."



Transcript

TRISH REGAN: Well, fresh off the presses, famed bond investor Bill Gross' monthly investment outlook, where he says the reality of today is that -- and I quote, "Not even thin gruel is being offered to our modern-day Oliver Twist investors. You have to pay to come to the dinner table and then sit there staring at an empty plate."

In other words, you're paying Germany, for example, to hold your money right now. Well, what does this mean for the health of the investing world? What does it mean for the Fed? What does it mean for pension plans? What does it mean for you?

BILL GROSS: Thank you, Trish.

REGAN: If you can work Dickens into an investment letter, along with a few references to the Westminster Dog Show, my hat goes off to you.

GROSS: Here's another one. You know, back in the Depression, in the 1930s, humorous Will Rogers said that he wasn't so much concerned about the return on his money, but the return of his money. And in today's financial markets, we're, as you mentioned, $2 trillion of euroland paper trades at negative yields, some as much as minus 75 basis points, I think Will Rogers would have to be concerned about both.

A negative yield assures the investor that not only is the return on his money or her money unsatisfactory, but the return of her money will be left (INAUDIBLE) paid.

REGAN: You know, it's pretty crazy. And you've got investors, Bill, out there that are getting somewhat desperate, right, for yield, because, as you rightly point out, there's just none out there.

So theoretically, let me ask you, could that change? Should it change?

Do we anticipate that Yellen will raise rates in June?

GROSS: Well, I think that's part of the problem, although it's one that can't be easily diagnosed in terms of historical models. And to the extent that the interest rates at -- at zero bound in the United States, you know, promote higher stock prices, higher bond prices, you know, some of that trickles down to the real economy and, you know, promotes growth.

But to be fair, not much has.

You know, what has been promoted has been, you know, potential bubbles in stock markets and in bond markets. And I think the Fed is willing, at this point, to at least acknowledge that by raising interest rates 25 basis points in June.

I also think -- and this is important, Trish, that the interest rate can't be raised substantially even over the next two to three years. I mean the market is anticipating the -- a 2 percent Fed funds rate in 2018, late 2018. And I -- I think the reason that they continue is that the U.S. economy and the global economy to which the U.S. dollar and the U.S. interest rate basically serves, is -- is too levered, too highly levered. There's too much debt and ultimately 2 percent is probably the top in terms of this Fed cycle.

REGAN: Let me ask you, though, how, Bill, does Yellen and company get off of the zero interest rate policy at a time when the U.S. dollar is showing so much strength?

You talk about, you know, the currency war, effectively, that we're seeing right now, but nobody wants to call it that.

But how can the Fed move when the dollar has already rallied as much as it has against other currencies?

GROSS: Well, I think that's a really good point and -- and I agree with it. Obviously, I put that it my investment outlook.

You know what, a stronger dollar does promote, you know, some negatives. It promotes not only lower exports and -- and lower growth in terms of manufacturing, but it promotes a -- an infusion of deflation as opposed to inflation, which is exactly opposite the -- what the Fed wants to do.

Today's number, Trish, the Personal Consumption Index, you know, on a year-over-year basis, was at 1.1 percent and going lower. And their target is 2 percent.

So ultimately, that's, again, one of the reasons why, you know, if they get off the dime in June or if they get off the dime in September, that they basically have to go very slowly, because ultimately, a stronger dollar promotes lower growth in the United States as opposed to higher growth.

REGAN: You mentioned this lack of inflation, 1.1 percent versus what they would like to see, 2 percent.

Do we need to be worried about deflation?

Clearly, it's a concern overseas.

Is that a reality that we could be facing?

GROSS: Well, I don't think so in the United States. I mean for the most part, our -- our inflation indexes, outside of oil and outside of food prices, you know, basically reflect health care expenses and wages in the United States, which are going up by 2 percent themselves.

So the United States, it appears, has escaped this, you know, this trap, this liquidity trap that euroland and Japan are in. But, you know, not necessarily for all time.

And so do we have to be worried about it now?

No. But I think if the Fed truly wants to get to a 2 percent inflation rate, which, by the way, is the reason why they need to get there, is that in an ensuing recession or a slowdown, they need some room to lower rates.

And so, you know, if the Fed eventually gets to 2 percent inflation, then that's probably the sweet spot for Janet Yellen and the Fed.

REGAN: You say eventually 2 percent.

I mean how long is it going to take for that to unfold?

Do you think these are going to be very slow moves, Bill?

GROSS: I do. You know, I basically think, you know, 50 basis points a year. Right now, the forward market, as I mentioned, is anticipating a 2 percent Fed funds rate in late 2018.So that's three and a half years.

Whether or not that's the -- the proper path, the proper -- the slope and in terms of a -- a forward yield curve, no one really knows.But it gets back to, you know, what I've talked about in April of last year, you know, the new neutral rate, the new policy rate, which ultimately, in my view, has to be much lower than historically because of high leverage and because of demographic influences that basically promote lower structural growth.

REGAN: You know, Bill, Janet Yellen has indicated that she's going to stay patient. But here we are, what, six years into (INAUDIBLE). We've had multiple rounds of QE. And all we've got is this anemic growth.

In your view, has the Fed been too patient?

I mean do you worry at all that its policies have actually had the unintended consequence of causing people and companies to delay purchases because they know money is going to be cheap for the foreseeable future?

GROSS: Yes, I -- I think they went too far, Trish, and that's, you know, a -- a subjective assessment of history, I guess. But a zero percent interest rate, yes, induces positives in terms of higher bond prices and stock prices, but also some negatives.

You know, it keeps zombie corporations alive because they can borrow at 3 and 4 percent, as opposed to the 8 or 9 percent. It destroys business models. It's destroying the pension industry and in the insurance industry because, you know, basically, their liabilities can't be -- they can't be provided for by very low interest rates.

And ultimately, I think it destroys, you know, the capitalistic model at the margin. You talk about stocks and cheap money, they're basically corporations, instead of investing in the real economy, can now simply borrow at, you know, close to 0 percent and buy their own stocks, which yield 2 or 3 percent on a dividend basis and, you know, provide a return of 6 or 7 percent on an earnings to price ratio basis.

So, you know, there are a lot of negatives in terms of 0 bound interest rates. And I think one of the reasons why the Fed will move is to -- to sort of gradually move away from those negatives.

REGAN: Yes, because it's given birth to all this financial engineering, but you wonder these days whether investors are really valuing assets for what they're worth.

Let me -- let me ask you, with that in mind, do you ever worry that the Fed is just, perhaps, too forthcoming in its information, as well?

I mean they seem to want to tell us everything and anything that they're going to do.

And I just wonder whether investors have become overly reliant on that telegraphing from the Fed.

I mean do you ever long for the days when you actually had to wait and check the markets to see what the Fed had done, back before it was as transparent as it is now?

GROSS: Well, I don't long for that day, because it was -- it was very uncertain and you waited on a Thursday afternoon to -- or morning to see whether or not the Fed was, you know, changing its interest rates on a weekly basis.

But I think the Fed is moving away a little bit from this -- from this certainty, from Draghi's whatever it takes, from, you know, basically alerting the market as to, you know, how high interest rates are going to go and what level they should be at.

So, yes, I think that's a reflection of Stanley Fischer. He basically wants to move away from the certainty model.

We'll see a little of that movement. But I'd like at least to know a little bit about what the Fed is thinking in terms of, you know, new neutral interest rates, where they think, you know, the neutral interest rate should be relative to the Taylor Rule, which they used prior to the recession, to the Great Recession in 2008 and '09.

REGAN: You know, Bill, let me ask you, this is the first time you and I have talked on air here since you made your move to Janus. You were a founder of PIMCO. Your name was synonymous with that firm.

What's it like being some place new after having spent your career -- your entire career -- elsewhere (INAUDIBLE)?

GROSS: Well, it's certainly different. You know, PIMCO had 2,500 people. Janus Newport, you know, basically has seven or eight, although Janus Denver a much larger location and a much larger corporation, you know, has thousands of people, too.

And it's a little bit different. There's more flexibility, basically, in what I'm doing, the -- the unconstrained funds that are run on a separate account basis and the mutual funds. There's a lot more flexibility. There's the ability to move as opposed to not move so much, as was the case in PIMCO.

So, you know, a little bit smaller, certainly, but a little bit more flexible and I enjoy that.

REGAN: You know, Bill, a lot of people would have said, look, I don't need to do this, I've got plenty of money, I've had plenty of success.

Why keep going?

Why get up and go to the office every day and do what you do at this point?

GROSS:Well, part of it, you know, my wife said she married me for better or worse, but not for lunch. And so...
(LAUGHTER) so lunchtime is spent in Newport Beach. But, also, you know, I wanted to show clients and to show the world, to the extent that they're interested, you know, that I can continue to produce a track record like I did at PIMCO.

You know, I won't have as much time. I won't have five to 10 to 15 years of leeway like I had at PIMCO in terms of proving that. But certainly for the next two, three or four years. You know, I'm a very competitive person and I like to post numbers that are better than the market and better than the competition. So it's a combination of both of those.

REGAN: Well, my congrats to you. Bill Gross, great to see you. Hope to see you again soon.

GROSS: Thank you, Trish.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

2:55 PM


Illinois Pension Plans 39% Funded; Taxpayers On the Hook for $105 Billion in Liabilities; It Will Get Worse!


This is my second column for the Illinois Policy Institute, where I am now a senior fellow.

The article was written well ahead of the Moody's downgrade of Chicago pensions last Friday, with a final edit made on Friday, and posted then on the IPI website.

Illinois Pension Plans 39% Funded

A "Special Pension Briefing" last November, shows the Illinois State Retirement Systems are in dismal shape.

Unfunded Liabilities

  • Teachers' Retirement System (TRS): $61.6 Billion
  • State Retirement Systems (SERS): $61.6 Billion
  • State Universities Retirement System (SURS): $21.6 Billion
  • Judicial Retirement System (JRS): $1.5 Billion
  • General Assembly Retirement System (GARS): $0.3 Billion

The above numbers show actuarial (smoothed) asset valuations, as does the following chart.

Summary of Liabilities and Unfunded Ratios



click on any chart for sharper image

Congratulations go to the Illinois General Assembly Retirement System (GARS) for having one of the worst, (if not the worst) pension plan in the entire nation. It is 16% funded.

No doubt, that increases the pressure of the General Assembly to put the burden of bailing out the system on the backs of Illinois taxpayers.

Smoothed Returns

The above chart shows "smoothed returns" that even out the 2007-2009 dip as well as the 2010-2014 blast higher. Illinois resorted to using "smoothed returns" minimize the effect of the 2007-2009 dip. But now, with the rally, Illinois wants to use actual market returns.

On a non-smoothed (market) basis the numbers are slightly better. Non-smoothed, the total deficit is $105 billion instead of $111 billion.

Liabilities Per Household

Let's be generous and assume the lower $105 billion number. The US Census Bureau shows there are 4,772,723 Illinois households.

The potential taxpayer burden to make up the deficit is $22,000 per household. That's not even the worst of it as the following chart shows.

Liability Trends - Not Smoothed



In spite of the massive stock market rally, Illinois liabilities increased every year since 2011.

Expectations



Zero Percent Chance of Success

Its bad enough that Illinois is $105 Billion to $111 billion in the hole and liabilities have increased in spite of a massive rally in both stocks and bonds.

Illinois plan expectations are icing on the "Zero Percent Chance of Success" Cake.

I discussed this at length in my post Beggar Thy Taxpayer: Currency Wars, QE Strain Life Insurers and Pension Plans; Negative Returns With 4-7% Promises.

Europe vs. US

In Europe, pension plans and retirement funds have promised 4% returns. Future promises in Germany are now down to 1.25%. However, yields on 10-year German bonds are 0.35%.

In Illinois, the plan assumption for TRS, the biggest system with the biggest unfunded liability, is 7.5%. There has been no meaningful reduction in plan promises over the years.

7.0% to 7.5% Assumptions Will Not Happen for Two Reasons

  1. US Treasury Yield Curve
  2. Stock Market Valuations

US Yield Curve



US Promises

In the US, pension funds have not made 1.25% promises or even 4% promises, but rather 7.0%+ promises with the 10-year bond yielding about 2%. Annuities promise 6% or so.

Illinois promises range from 7.0% to 7.5%. How you get 7.5% in a 2% world?

The correct answer is: you don't. But insurers and pension plans try, by taking risks. And the more risk they take, the higher and higher into bubble territory go stock market and junk bond valuations.

This is well understood and established behavior. And it's precisely what the Fed has sponsored. At the end of 2012, even mainstream media recognized what was happening, as shown by the following quote from the CNBC article How the Fed Is Pushing Investors to Buy Junk Bonds

"The market is thirsting for yield and the Fed is pushing people to do things like this [buy junk]," said Lawrence G. McDonald, who as head of LGM Group specializes in junk-bond trading. "So big asset managers are reaching, reaching, reaching and companies know this and are issuing, issuing, issuing all this crap."

We have seen that effect in Illinois pension plans as well. In our own report, 401(k)s are better than politician-run pensions, we noted pension funds often invest in riskier assets to try and boost their returns.

"A look at the Illinois Teachers’ Retirement System, or TRS, portfolio, for example, reveals a portfolio of investments in junk bonds, real estate, derivatives and private equity. TRS has more than $1 billion invested in bonds that Moody’s Investors Service or S&P Ratings Services rate as junk."

Seven Year Negative Returns

As of January 31, 2015, Stock and bond prices are so stretched that GMO's 7-Year Asset Class Real Return Forecast shows negative real returns for seven years in US equities and bonds.



"The chart represents real return forecasts for several asset classes and not for any GMO fund or strategy. These forecasts are forward‐looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Forward‐looking statements speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update forward‐looking statements. Forward‐looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in forward‐looking statements. U.S. inflation is assumed to mean revert to long‐term inflation of 2.2% over 15 years."

As of December 31, 2014 GMO managed $116 billion in assets.

Broken Model

In the US, pension plans have aggressively shifted from investing in AAA rated bonds to equities and junk bonds because yields in US treasuries and AAA rated corporates are not high enough.

Denial that this has happened is nearly everywhere one looks. Of course the Fed, and most others, cannot and will not see a bubble until it bursts wide open.

Even if the air is let out slowly (something that has never happened in practice), negative real returns, and perhaps zero nominal returns for seven years are the only other plausible outcomes unless one expects an even bigger bubble coupled with even longer negative returns in the future.

Simply put, numerous US pension plans are in deep, deep trouble. Illinois is at the top of the list. Plan assumptions cannot and will not be met. It's far too late for token improvements.

Honest Discussion Needed

Not even massive tax hikes can save the system at this point. Businesses and taxpayers would flee. And Illinois is already struggling with corporate and individual flight.

The Illinois pension system is totally broken. It's time to have a truly honest discussion of what to do about it.

Postscript- Illinois Taxes - Loser Spoils

For a look at the Chicago downgrade, please see my post Chicago's Fiscal Freefall: Moody's Cuts Chicago Credit Rating to Two Steps Above Junk; Snake Oil and Swaps; It's All Junk Now.

My first article for IPI was Right-to-Work Sweeps Midwest, Heads for Passage in Wisconsin.

Both articles are up on the Illinois Policy Institute  website where you can also learn (assuming you did not know),Illinoisans pay high taxes compared to other Midwest families.

Loser Spoils

Inquiring minds may also be interested to learn via the IPI website, that former governor Quinn Will Receive Millions in Pension Payments
When he ceded his office to Gov. Bruce Rauner on Jan. 13, former Gov. Pat Quinn gave up a $180,000 salary as well.

But that same day marked the beginning of a lucrative consolation prize: monthly pension checks that will add up to $137,000 in Quinn’s first year of retirement, according to WUIS 91.9. The former governor will receive $3 million in pension payments over his lifetime should the Illinois Supreme Court strike down Senate Bill 1, a pension-reform law passed in 2013. Should it be upheld, Quinn would still receive over $2 million.

Over his public tenure, which included stints as the state treasurer and lieutenant governor, Quinn contributed a mere $190,000 toward his pension as of November 2014, according to the Chicago Sun-Times. This contribution is not sufficient to cover even the first 18 months of benefits he will collect.
In case you were wondering how Illinois plans became so underfunded, you now have a clear picture: in general, promising far more than can possibly be delivered.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

12:57 PM


Greece Accuses Spain and Portugal of Conspiracy; 3rd Greece Bailout Discussion Under Way for €30-50 Billion


Now that Germany has agreed to an extension, allegedly with no more money on the table, Spain confirms what we all knew would happen, Third Greek Bailout Under Discussion.

Euro zone countries are discussing a third bailout for Greece worth 30 billion to 50 billion euros, Spain's economy minister said on Monday, as Athens sought to quell fears it might run out of money before the end of March.

Speaking at an event in Pamplona, in northern Spain, Economy Minister Luis de Guindos said the new rescue plan would set more flexible conditions for Greece, which had no alternative other than European support.

Prime Minister Alexis Tsipras used a televised address on Friday to deny his country would need another international program.

"Some have bet on a third bailout, on the possibility of a third bailout in June. I'm very sorry but once again we will disappoint them," Tsipras said.

Greece has acute and immediate funding problems to overcome, despite the four-month extension to its existing bailout it negotiated with the euro zone last month. To win that, Tsipras had to give up on key pledges made during his election campaign.

The extension averted an imminent banking meltdown. But Greece still faces a steep decline in revenues and is expected to run out of cash by the end of March, possibly sooner.
Options Limited

  1. Greece wants €1.9 billion in profits the ECB made on Greek debt. The ECB wants reforms first.
  2. Greece wants to issue more short-term bonds, having reached a €15 billion cap. The ECB says no.
  3. €7.2 billion remains of the €240 billion bailout programs. Dutch Finance Minister Jeroen Dijsselbloem wants reforms first.
  4. German Finance Minister Wolfgang Schaeuble says no further aid would be paid out until Athens fulfills all the conditions.

Conspiracy Against Greece?
Tsipras accused Madrid and Lisbon of leading a conservative conspiracy to topple his anti-austerity government because they feared the rise of the left in their own countries.

"By European standards, this was very unusual foul play. We don't do that in the Eurogroup, that's not appropriate," a spokesman for Schaeuble told a news conference in Berlin.
War of Words

Acrimony took a huge leap forward as Madrid hit back against Tsipras' conspiracy charges. The Guardian reports Alexis Tsipras Comes Under Fire from Spanish Prime Minister.
Greece’s anti-austerity government has denied that it sees Europe through the prism of “hostile and friendly countries” as the Spanish prime minister Mariano Rajoy hit back at accusations that Spain and Portugal had deliberately tried to topple the new leftist-led administration.

The war of words erupted when Greek premier Alexis Tsipras attacked the sabotage tactics that had, he said, been employed by Lisbon and Madrid in an effort to scupper the chances of a successful end to the negotiations over the eurozone’s extension of the Greek bailout programme.

He accused the Iberian partners of deliberately taking a hard line in the talks because they feared the rise of radical forces in their own countries.

We found opposing us an axis of powers ... led by the governments of Spain and Portugal which, for obvious political reasons, attempted to lead the entire negotiations to the brink,” Tsipras told party members on Saturday.

Their plan was, and is, to wear down, topple or bring our government to unconditional surrender before our work begins to bear fruit and before the Greek example affects other countries… And mainly before the elections in Spain.

Rajoy responded angrily on Sunday, saying that Spain had stood by Greece in solidarity by contributing to the debt-stricken country’s €240bn (£180bn) bailout.

“We are not responsible for the frustration generated by the radical Greek left that promised the Greeks something it couldn’t deliver on,” he said.
Conspiracy or Political Ignorance?

I disregard the conspiracy charges and instead plead political ignorance on behalf of Spain and Portugal.

In particular, Spanish Prime Minsiter Mariano Rajoy is making a big mistake. Spain can use debt relief. And the citizens of Spain want debt relief.

By taking a hard stance in favor of Berlin, Rajoy adds fuel to the rise of Podemos. Siding with Germany is the wrong thing to do if Rajoy wants to win reelection.

Playing with Fire

Tsipras is a close friend and political ally of Pablo Iglesias, the former political science lecturer who founded Spain’s anti-establishment Podemos movement.

Podemos is currently in the lead in Spanish polls. Elections are later this year.

Recall that the Podemos "Economic Manifesto" Calls for Debt Restructuring, Spain to Abandon the "Euro Trap".

"Spaniards should be aware that it is physically impossible that they can pursue policies that meet the national interest, within the euro as it is designed. The euro was conceived as a real trap, but nowhere is it written that people have to accept it ." said Iglesias.

Also consider Incredible Populist Positions in Podemos' "Economic Manifesto".

An anti-austerity, anti-euro party is leading in the polls. Podemos has an excellent chance of winning the election and putting together a coalition.

The next set of Spanish polls will be very interesting. It's possible the charges by Tsipras unite a rally behind Rajoy. But if not, it's all over for the current prime minister.

Addendum

Reuters reports Juncker says no talks in the euro zone for a third Greek bailout. Why Reuters would even bother posting a denial like that is the question on my mind.

Recall that Jean-Claude Juncker, former Luxembourg PM and former Head Euro-Zone Finance Minister is famous for saying "When it becomes serious, you have to lie".

If Reuters wants to provide accurate context, it should put in that reference every time it quotes Juncker. In short, there is nothing Juncker ever says that can be trusted.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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