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Guest Post: Will Rising Markets Save Pensions?

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Submitted by Leo Kolivakis, publisher of Pension Pulse.


The WSJ reports that shortfall triples at U.S. pension guaranty agency:

The federal agency that backstops corporate pension plans reported that its deficit tripled in the last six months, to $33.5 billion. Despite the shortfall, the agency said it has enough assets to pay benefits for many years, even if the holder of one of the largest retirement programs, General Motors Corp., were to file for bankruptcy.

The news came as the Pension Benefit Guaranty Corp.’s former director invoked the Fifth Amendment in response to lawmakers’ questions about possible mismanagement under the Bush administration. The PBGC’s inspector general last week issued a report saying that the former director had violated prohibitions on contacting bidders that were seeking investment contracts.

The former director, Charles Millard, has denied allegations that he had inappropriate contacts with several Wall Street firms that won contracts to advise the agency, and said his actions were approved by agency counsel. But his attorney, Stanley Brand, said in a statement that it was best if Mr. Millard didn’t testify at a Senate hearing Wednesday, in what he described as a “biased and hostile environment.”

The PBGC deficit stood at $11 billion, compared with its long-term obligations, as of Sept. 30. The agency attributed the deterioration of its finances since then to the assumption of pension-plan obligations from insolvent companies, as well as investment losses and the current low interest-rate environment.

The PBGC also warned that distressed companies are likely to terminate more pension plans, leading the agency to take on more of those obligations.

“The amount of underfunding in pension plans sponsored by financially weaker employers is very substantial,” acting director Vincent Snowbarger said in testimony before the Senate Special Committee on Aging.

The PBGC estimates that pensions for all companies in the auto sector are $77 billion short of the money they need to meet their obligations, of which $42 billion would be guaranteed by the agency. By law, PBGC limits the amount of benefits it will pay to retired workers.

According to the most recent public information available, the pension plans of GM and Chrysler LLC are underfunded by $29 billion. A congressional oversight official, Barbara Bovbjerg, said the Chrysler and GM pension plans pose “considerable financial uncertainty” for PBGC.

But many experts say that the problems of GM’s huge pension plan are not as serious as they appear. That’s because GM’s plan actually was relatively well-funded before last year’s market downturn. Assuming financial markets strengthen, it likely would return to health.

Indeed, financial markets have strengthened since March as Libor drops as Bank of America adds to recovery signs:

The cost of borrowing in dollars between banks for three months dropped for a 36th day amid signs the recovery in the banking industry is quickening.

The London interbank offered rate, or Libor, for such loans decreased three basis points to 0.72 percent, bringing its drop the past four days to almost 14 basis points, the British Bankers’ Association said. The rate was 1.43 percent at the end of 2008. Libor is used to set borrowing costs on about $360 trillion of financial products globally, according to the BBA.

Bank of America Corp., the biggest U.S. bank by assets, raised about $13.5 billion in a sale of common stock, seizing on a 40 percent jump in its shares in the past month to increase capital. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said yesterday the lender aims to be able to repay U.S. aid and exit the Troubled Asset Relief Program “in the next few weeks.”

“On the whole, we are seeing more normalization and there seems to be more lending between the banks,” said Sean Maloney, a fixed-income strategist in London at Nomura International Plc. “With the degree of support from policy makers, it seems unlikely we’ll have another blow out.”

But not everyone is convinced the good times are back. Michael Mackenzie writes this FT comment on the declining Libor:

On Wednesday, dollar Libor for the benchmark three-month sector set at 0.71625 per cent, extending its run of declines for 36 straight days. A comparison of Libor with the Fed funds rate shows that the gap between these two rates is at its lowest level since February 2008. Traders forecast further improvement on Thursday. The mood is a world away from the stressful peaks of Bear Stearns’ rescue last March and the failure of Lehman Brothers in September when Libor took a rocket ship to the moon.

Further evidence that the banking system is stabilising is seen by activity in financial commercial paper. Lending for three months is back above that of the one-month sector for the first time since late January when the Federal Reserve’s support temporarily boosted 90-day paper. Quantitative easing and the smooth completion of the stress tests for banks has eased tension. That has helped nurture the recovery in risky assets.

For the banking system, however, there are still signs of dislocation. Swap spreads, the difference between government bond yields and money market rates and a measure of bank credit quality, remain some way from looking normal. Liquidity also remains questionable as banks seek stronger balance sheets and raise capital to pay back government support.

The steady declines in three-month Libor have also reduced the Ted spread, which compares the bank lending rate with that of three-month Treasury bills. After surging to record levels, the much lower Ted spread is another good sign. But with bills only yielding 0.18 per cent, it’s clear there remains an aversion to lending money at the much higher unsecured rate of three-month Libor.

And speaking with Brian Milner of the Globe and Mail, David Rosenberg, Merrill Lynch’s chief North American economist, thinks people are still in denial:

You remain convinced that the U.S. is nowhere close to being out of the woods. Why is that?

We had three shocks in succession [in the U.S.]. We had a housing shock, followed by a credit shock, followed by an employment shock. Although credit conditions aren’t back to normal … there’s no doubt that they are measurably better than they were just three to six months ago. But the other two shocks are lingering and still very significant.

You were predicting by 2005 that U.S. housing would take a serious tumble.

I had this bad gut feeling about home prices. I was early on the call. But you could see the cracks. We know that house price deflations don’t end well. But this proved to be far worse than anything we saw in the 1990s.

Because you were an early bear at the table, plenty of smart portfolio managers dismissed what you had to say. Won’t that happen again, now that the market seems to be bottoming out?

I know that people will say, well, there’s the boy who cried wolf. And all I can say to that is: Remember, the wolf showed up at the end of the story.

I take it that U.S. housing remains the No. 1 concern.

It’s hard to imagine that anything is going to stabilize until we put a floor under home prices. They are still declining to varying extents in most parts of the States.

What’s critical in forecasting [the economic recovery] is trying to assess how a $20-trillion shock, which by the way is a 30-per-cent hit to the [U.S.] household balance sheet [on a par with what occurred in the 1930s], is going to influence the future.

This is very difficult to forecast. And there are long and insidious lags between a shock to the household balance sheet and the peak impact on consumer spending.

Why is that?

It takes time for households to determine if this is a permanent or temporary loss of wealth. If it’s a temporary loss, there will be no impact on spending or the savings rate. If it’s deemed to be permanent, then the impact is going to be significant, but it will happen quarters or years down the road. It takes a while for people to process.

So those predicting a turnaround by the end of this year are overly optimistic?

In a normal recession, we’re off to the races by this stage of the cycle. But when you go back and take a look at other countries in other periods that also endured a credit contraction and asset deflation of this magnitude, the decline in GDP typically lasts two years, not 10 months.

And it takes six years for home prices to bottom out, and the unemployment rate typically rises over a four-year interval. There will be a time and place when we actually do put in that bottom. To think that it’s going be this year is a little early.

You also point out that the average age of the consumer is also a big factor in crimping a consumer-led recovery.

We have the first consumer recession in the United States where the median age of the boomer is 52. The last time we had a [mild] consumer recession in 1990, the median boomer age was 34. They were still buying refrigerators and cars and microwave ovens.

What’s happening right now is that the boomer is going to his or her financial adviser and seeing two pieces of paper that scare them to death – their net worth statement and life expectancy table.

Let’s turn to the other big shock, labour. You don’t like what you see when you delve deep into the U.S. data, do you?

There are very disturbing trends. In lockstep with letting people go, companies have also been cutting people’s hours at almost a record rate. The 33.2-hour [U.S. average] workweek is at a record low.

People don’t look at that. But that is also a component of income. We have lost eight million full-time jobs in this recession.

In a normal recession, we’ll lose 2.5 million. But not everybody was let go. Six million were. Two million were pushed into part-time work. The number of people working part-time and not by choice is up almost 80 per cent year over year. We have never seen a growth rate like that.

What does the dramatic increase portend?

The biggest effect is on income, which drives spending, which ultimately drives profits.

So I guess we should forget about consumer-related stocks for a while.

I still hear this from clients today: ‘Don’t count the U.S. consumer out. It never pays to underestimate the shopping prowess of the U.S. consumer.’ I think people are still in denial. … This is a new paradigm of frugality.

There has been a definite shift in psychology. So when you have [housing] affordability at record highs and very little thrust on home sales, there’s valuable information there about the savings-spending relationship. It doesn’t make you feel too good, admittedly.

People’s attitudes towards credit, discretionary spending and home ownership have changed. This is going to take place over a period of years. To think that after eight months of a declining trend in consumer spending that this is over would be extremely hopeful.

So you would steer clear of consumer discretionary and housing stocks. What about U.S. financials?

What’s the future business model? I would not be putting a large multiple on trading revenues. But they got dramatically oversold, and the Obama team did an excellent job in selling the stress test. But it’s really hard to forecast the future in terms of what the structure’s going to look like, how regulated they’re going to be. What we do know is that the biggest client of the banks, which is the household sector, is going to be cutting back on credit. So it probably favours asset managers or those [other] parts of the financial sector that are geared toward savings.

Let’s turn to Canada. Why so bullish on your homeland?

If you have the view, as I do, that Asia will come back first, then the implications for basic materials and industrials that are geared to that part of the world should be positive, at least in relative terms.

A third of the Canadian economy is devoted to the U.S. But that doesn’t mean our market can’t outperform. In fact, I think that it will because of the additional torque that we get from the push in the commodities sector.

Any more reasons to feel upbeat?

You don’t have to do much more than take a cursory glance at the data to see that there are glaring differences [with the U.S.], that Canada is in much better shape.

How, ultimately, is that fiscal mess going to get cleaned up south of border? If you go back to the 1930s, you’ll see that it was through relentless increases in marginal tax rates. That’s going to work to our advantage.

I think that there’s going to be a lot of money flowing into the Canadian capital markets in the next several years. It’s very bullish for the Canadian dollar. … Over time, Canada is going to be viewed as a bastion of stability.

You also say that Canadian fortunes depend on whether China’s recovery story turns out to be real.

There’s no doubt that our economy is very closely hitched to the U.S. market. But our stock market is actually very significantly tied to what happens in China, because roughly half is resource-oriented.

There’s the old saying that in the land of the blind, the one-eyed man is king, and Canada is the one-eyed man, certainly relative to the U.S. If the story in China is the real deal, so much the better.

It is worth noting that the Baltic Dry Index, a measure of shipping costs for commodities, rose to a seven-month high in London on accelerating Chinese demand for iron ore.

This supports Mr. Rosenberg’s thesis that a pick-up in demand in China will help propel the Canadian stock market, which continues to push higher as commodities rally.

While I respect David Rosenberg, I strongly doubt Asia will lead us out of this global downturn and I don’t buy the bullish Canada story.

The way I read the markets is that risk appetite has increased as hedge funds put risk trades back on: long stocks, long corporate bonds, long commodities, long commodity stock indexes, long commodity currencies, long emerging markets.

It’s not fundamentals driving stocks higher; it’s the big hedge funds that are playing the momentum trades. Andy Kessler is right, it’s another sucker’s rally:

The stock market still has big hurdles to clear. You can have a jobless recovery, but you can’t have a profitless recovery. Consider: Earnings are subpar, Treasury’s last auction was a bust because of weak demand, the dollar is suspect, the stimulus is pork, the latest budget projects a $1.84 trillion deficit, the administration is berating investment firms and hedge funds saying “I don’t stand with them,” California is dead broke, health care may be nationalized, cap and trade will bump electric bills by 30% . . . Shall I go on?

Until these issues are resolved, I don’t see the stock market going much higher. I’m not disagreeing with the Fed’s policies — but I won’t buy into a rising stock market based on them. I’m bullish when I see productivity driving wealth.

For now, the market appears dependent on a hand cranking out dollars to help fund banks. I’d rather see rising expectations for corporate profits.

My only warning to portfolio managers who share this view is that this sucker’s rally still has legs so be careful thinking that it’s bound to break down anytime soon. In fact, it might go a lot higher from here.

Longer term, I agree with Paul Krugman, rising unemployment, which is expected continue after the recession ends, could lock the U.S. into a “depressed economy” for as long as five years:

Krugman said he would not be surprised if the U.S. recession, which began in December 2007, ended in August or September this year. Deteriorating labour markets, however, are likely to continue into 2011, meaning “the period of a depressed economy” could last until 2013 or 2014.

Krugman, who teaches at Princeton University, won the Nobel Memorial Prize in Economic Sciences last year for his analysis of how economies of scale can affect international trade patterns. He also writes columns for the New York Times newspaper.

The U.S. economy, the world’s largest, contracted a worse-than-expected 6.1 per cent annualized drop in the first quarter. Americans increased purchases of cars, furniture and appliances but businesses cut back spending and exports had their biggest drop in 40 years. The U.S. unemployment rate hit 8.9 per cent in April and many economists expect it to reach 10 per cent by year’s end.

Krugman said while economic indicators from around the world are improving, they suggest the pace of economic decline has only slowed.

“I share the optimism that the worst of this may be over,” he said, also noting a stabilization in financial markets.

“What’s really hard, however, is to say when does this go beyond stabilization to an actual recovery.”

It is also worth keeping in mind that rising stock markets will not save pensions. As interest rates fall to historic lows, future pension liabilities have soared. You need higher asset values and higher interest rates to reign in those ballooning pension deficits.

I just don’t see this happening over the next few years. And I find it particularly worrisome that the U.S. Pension Benefit Guaranty Corporation is in dire straights.

I agree with Mike Shedlock who asks: who foots the bill on this automotive disaster?:

If the PBGC will only pick up $4 billion out of the November $20 billion shortfall, how much will it pick up out of the current total of $77 billion in underfunded liabilities of which $42 billion is not funded at all?

This is not a pretty picture for GM employees, Chrysler employees, or US taxpayers.

This isn’t a pretty picture but for now, people are in denial. When reality settles back in, they’ll quickly realize the good times are over.

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2 comments

  1. "DoctoRx"

    I agree more with Rosenberg out of default, not that Kessler is wrong, rather that Canada has simply been better run as a financial entity than the US. It’s honest and had no signif housing bubble. Thus its currency should appreciate, all other things being equal.

    Re the stock market, it is not near major bear market valuation lows. These are likely one of these years, adjusted for inflation.

  2. ComparedToWhat?

    Cheers Leo.

    “Charles Millard… said his actions were approved by agency counsel.”

    Assuming Gonzales, Addington, Bybee, Yoo, Feith, and Haynes were otherwise occupied — let’s have the names of said counsel.

    A “biased and hostile environment”? That’s likely to last until every citizen who was over age 6 in 2008 has passed, and longer.

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