BondSquawk

August 9, 2010

Gluskin Sheff’s chief economist, David Rosenberg in his morning missive, “Breakfast with Dave” covers that deflation for the U.S. economy has made its way into the mainstream media.  It was only several months ago that the “in-thing” to do was to expect a recovery and the Federal Reserve will be taking measures to fight against the exact opposite in higher inflation expectations.  As Bondsquawkers know, we gone head to head with the consensus view and talked about how deflation is the bigger issue given the tremendous amount of slack in resources, namely asset prices and labor.  In addition, we have questioned the validity of this “recovery” since inventory replenishment and federal stimulus measures masked the growth activity from earlier this year.  Now with those factors waning, the economy should be headed for a slowdown as long as job growth remains subdued and as households repair their balance sheet that is filled with an abundance debt.  The bond market certainly “gets it” (the same can be said about the dollar) as far as what is in store in the months ahead.

We could go on and on about how early we were on the deflation call — this was central to our debate with Jim Grant at the Grants conference back in April when deflation was considered by many to be a controversial and completely out-of-the-mainstream view. Not to mention that back then the yield on the 10-year note was nearly 4% and a growing chorus of economists were calling for 5%+.

The economy and the stock market were so hot by then that the Fed was on the precipice of shrinking its balance sheet, everyone was debating when the first tightening was going to come and the White House was busy gloating about the success of the fiscal boosts (to the point where Larry Summers boasted that “the economy appears to be moving towards escape velocity” — two weeks before the stock market peaked). Talk about the proverbial kiss of death.

The yield on the 2-year note is at a record low of 0.5% — down 5bps last week — and the 10-year note is at a 15-month low of 2.82% after last week’s 9bp rally. We had said for some time that while it was a financial panic that led to the downdraft in yields back to these levels in late 2008 and early 2009, the next time we revisit these levels in the near future it would be an “economic event” as opposed to a “financial event.” And, here we are (note, this huge bond rally has taken place even with the U.S. dollar sinking to a 15-year low against the Japanese yen — so much for a weaker greenback triggering higher yields).

Look at what the bond market is doing for the economy; it is driving mortgage rates down to new all-time lows of 4.5%. The rally in Treasuries, which for some reason so many market pundits resist, has also played a crucial role in revitalizing the corporate financial backdrop. The 100 basis point decline in AAA-rated company bonds in the past 12 months, to a 40-year low of 4.72%, didn’t happen all on its own. The downdraft in government bond yields — a welcome downdraft — has played a vital part in dramatically cutting into debt-service expense across the business sector. The yield on the 5-year TIPS is close to zero, which is another indication that inflation concerns right now have been completely swept under the rug. Globally, we also saw the 10-year JGB yield dip below 1% while the German bund retreated 16 bps back to 2.5%.

And, over the weekend, the same media types that four months ago were lamenting over inflation are now filled with deflation commentary — check out these articles from the weekend press:

• Time to Print, Print, Print (page 15 of Barron’s)

• A Lover of Treasurys Bets on Deflation (page B1 of the weekend WSJ)

• How to Beat Deflation (page B7 of the weekend WSJ)

• Japanese-style Inflation Fears Bode Well for U.S. Bonds (page 15 of the weekend FT)

• Afraid of Deflation? Try Some Medicine (Page 6 of the Sunday NYT business section)

• Fed Must Beware of Public’s Deflationary Mindset (page C1 of Monday’s Wall Street Journal)

As contrarians, we much preferred it when the crowd was still crowing about inflation and there was dearth of deflation talk. Now it has become commonplace and that indeed has us concerned that much of the deflation view is priced in to the market (consider that the Fed funds futures contract has pushed out the date of the expected first Fed tightening to August of next year).

We are not yet prepared to abandon our long-standing deflation views but we are nervous that this is now becoming a mainstream forecast and let’s face it, yields across the Treasury curve have rallied to levels that virtually nobody saw coming this year.

When you look at the variety of “top 10 surprise lists” that were published at the start of 2010, who was saying back then that the best-returning security would be the 30-year zero coupon bond? Were there any strategists back then forecasting that heading into the eighth month of the year that bonds would be outperforming stocks?

Then again, if there is a part of the curve that has lagged behind, not yet hit new lows in yield, and that represents true inflation expectations, it is the long bond at 4.00%. There is probably more juice here than anywhere else along the maturity spectrum if the economy continues to weaken and along with that, the forces of deflation gather steam. As an aside, it was interesting to see gold trade back up to a three-week high of $1,200/oz even as the CRB index closed the week with a 1.1% loss (biggest decline since June 29). This goes to show that it is also an effective hedge against deflation (as was the case in the 1930s when the sterling price of gold doubled).

Moreover, we can take solace in the widespread acclaim that Jan Hatzius at Goldman Sachs is now receiving for being the prominent pessimist on Wall Street. The front section of the Saturday NYT (page A3) says: “A prominent pessimist, chief economist for Goldman Sachs, lowered his forecast of economic growth for 2011 to 1.9%, from 2.5%.”

What a country! You are labelled a “prominent pessimist” with a 1.9% growth forecast. This guy would be a hero through much of Europe not to mention Japan. In the U.S.A., he is labelled a “pessimist.” Well, having worked on Wall Street for close to seven years and having been early on the 2008-09 recession call, we know what being pessimistic (more like realistic, but who knew back then when securitization was a license to print money) is all about. So, we take some solace at least that even though there is “talk” now about deflation, it really has not comprised anyone’s official forecast, and that “double dip” risks continue to be readily dismissed.

When Jan Hatzius, who by the way is a first-rate economist, cuts that 1.9% to something closer to 0% for 2011 GDP growth, we will know that the degree of pessimism has reached its climax. In our view, what the NYT dubs a “pessimistic” growth forecast is really the best-case scenario for the economy in the coming year.

To be sure, there is growing chatter that the Fed is once again going to come to the rescue and Barron’s hints strongly at a coming $2 trillion quantitative easing program. The rumour mill is filled with talk of how the Administration is cooking up a new scheme, through the channels of Fannie and Freddie, to forgive part of the mortgage loans for distressed homeowners who are “upside down” (ie, negative net equity in their home) — a huge fiscal expansion that could bypass Congressional approval.

Atlanta Fed President Lockhart summed it all up in a sermon he delivered back on June 30:

“To sum up, I don’t see inflation as much of a current worry. If anything, there is a small risk of deflation that must be monitored. Limited inflation allows focused attention to recovery and growth, which I’d like to turn to now.

Here’s a key point about these contributors to recovery — each could be transitory. The economy has not yet arrived at a state where healthy and sustainable final demand is underpinning growth.

I make this point not to predict a reversal of the progress made but just as a cautionary reminder to avoid counting chickens too early. There are sectors that remain in a very depressed condition — housing, for example.

So, to pull this together, a recovery of the national economy is proceeding but not yet with solid and sustainable underpinnings. Inflation appears restrained. The outlook from here is beset by somewhat more than normal uncertainty.”

These are very disturbing conclusions. Twice he mentions the fact that without policy stimulus, there are no sustainable underpinnings to the fragile economic recovery. No wonder the Nation Bureau of Economic Research (NBER) has yet to declare the downturn to be over — if the private sector requires stimulation from the public sector, then the economy must still be in a recessionary state. It’s no different than taking some aspirin to break the fever, but you only know if you are no longer sick when your temperature is normal when you are off the medication. Mr. Lockhart goes much further and intimates that not only is public policy needed to stimulate economic activity, but that it is required to sustain growth.

Friends, when the private sector needs the public sector for growth to be sustained — not just stimulated, which is par for the course in fighting recessions in a classic post-war Keynesian fashion — then you know that we actually have on our hands is a depression. Let’s not keep our head in the sand and stay in denial mode. When you have a Federal Reserve official lamenting about how the economy still to this date has no “sustainable underpinnings” after the central bank has taken rates to zero, tripled the size of its balance sheet and the government has bailed out banks and homeowners and embarked on an array of spending incentives that has taken the deficit to a record 10% of GDP (outside of WWII) then you know that we have a totally different experience on our hands.

Nearly half of the 14.6 million unemployed have been out of work for over six months (according to the NYT, “a level not seen since the Depression”); and 1.4 million have been jobless for more than 99 weeks, at which point jobless benefits run out. Professor Robert Gordon, one of the gurus at the NBER, told the NYT that “[t]he situation is devastating. We are legitimately beginning to draw analogies to the Great Depression, in the sense that there is a growing hopelessness among job seekers.”

In this light, maybe the fact that there is some growing acknowledgment of deflation risks and that a cut to a GDP growth forecast by a “prominent pessimist” to +1.9% is perhaps just the beginning stage of ‘acceptance’ as opposed to our view being totally priced in at the current time. Though after reading Welcome to the Recovery on the op-ed page of last Tuesday’s NYT by Timothy Geithner, there does seem to be “denial” at the highest level of policymaking in Washington (Frank Rich in his excellent op-ed piece in the Sunday NYT rather appropriately called Mr. Geithner “tragically tone-deaf”).

Meanwhile, in the same edition we saw Alan Greenspan state that the economy was in a “quasi recession” — hopefully Mr. Geithner realizes that President Obama’s approval rating is down to a record low of 41% and it’s not about how he is handling the war on terror as much as to what is happening to the labour market.

As for policy prescriptions, maybe it’s time to abandon all the fiscal quick fixes that have little multiplier impact at tremendous taxpayer cost. With 6.6 million unemployed now for at least six months and discouraged workers dropping out of the labour market at an alarming rate, perhaps we need more in the way of creative supply-side measures to bolster business investment and durable employment growth. For more on this file, have a look at the column on op-ed of the Saturday NYT (The Economy Needs a Bit of Ingenuity — page A15).

And Bill Gross couldn’t have put it any better either — to the Sunday NYT. To wit: “In the new-normal world, there are structural problems, which require structural solutions.”

By John Mauldin – Investors Insight

August 8, 2010

A report just out from the Center for Policy Analysis, by Courtney Collins and Andrew J. Rettenmaier (solid academic types from Mercer University and Texas A&M respectively), that indicates that state and local pension funds are drastically underfunded.

I first wrote about public pension problems in 2003, suggesting that pensions would soon be underfunded by $2 trillion, as a long-term secular bear market would dampen returns. Turns out that I am once again proven to be a wild-eyed optimist.  Quoting from the executive summary:

“Many state and local government pension plans’ liabilities are calculated using discount rates that are not commensurate with the risk they may pose to taxpayers. Accounting standards allow pension funds to calculate their liabilities using a discount rate comparable to the expected rate of return on the funds’ assets. This typically high discount rate tends to reduce the size of a pension plan’s accrued liabilities. However, pensioners have a durable legal claim to receive their benefits and consequently, it is more appropriate to use a lower discount rate in calculating the plans’ accrued liabilities.

“Due to the use of high discount rates, the liabilities of state and local government pension plans are underestimated. For example, recent reports by the Pew Center on the States and others indicate that assets will cover about 85 percent of the pension benefits owed to participants. But other studies that adopted lower discount rates have found liabilities may actually be 75 percent to 86 percent higher than reported. As a result, taxpayers’ role as insurer may be much greater than anticipated.”

You can read the whole report and see how your state is doing at http://www.ncpa.org/sub/dpd/index.php?Article_ID=19634

Turns out that, by the authors’ calculations, state and local pensions are underfunded by $3 trillion (with a T). Of course, some states are much worse off than others. The report has numerous graphs but the following one tells us a lot. It is the unfunded liabilities as a percentage of state GDP.

In the paper (less than 20 pages) they cite the work of Novy-Marx and Rauh and another paper by Biggs. They all use very different methodologies but come up with roughly the same $3 trillion underfunding.

First, understand that in most states the law will not allow for adjustment of pensions. Taxpayers are completely on the hook. That money WILL be found at the expense of either higher taxes or reduced services (such as health care, roads, or police).

Second, the hole is getting deeper each year. Most pensions assume they are going to get an 8% return on their investments. This in a time of a slow economy for years ahead (as I have shown elsewhere), very low bond yields, and a stock market that I think is still in a long-term secular bear market for another 6-7 years, which suggests a continuation of the current sideways, volatile market.

What if instead of getting an 8% return, total returns were 5%? That would mean the hole would be getting deeper by about $75 billion a year. And what if people lived longer, as is clearly the trend, as the actuaries keep changing the longevity tables every few years for the better? (Which for this 60-year old is a very good thing!)

Why use an 8% assumption? Because if you used more conservative numbers, as the academic studies suggest, you would have to make larger current contributions to the pensions, when state and local governments and schools are already in fiscal trouble. So what do the pension plans do? They hire “consultants” who tell them they can expect 8%, as shown by all the nice models and papers that back up their “advice.” Note that if you were a consultant who said you should use a 5% discount rate, you would not be hired. Hmmm, where have we seen that phenomenon before?

My friend Paul McCulley (of PIMCO, who I hope to see tonight) quipped that the ratings agencies were supplying fake IDs at a teenage drinking party, when it came to the subprime mortgage ratings. The pension consultants are providing a similar service to their clients, who are told what they want to hear, pay large fees for the privilige, and thereby increase the risk to taxpayers and reduce the current pain for politicians.

This is going to end in tears for many states and municipalities. I mean real tears. Pension funding in some states will be required by law to consume 25-30% or more of tax revenues. That is going to mean much higher taxes or reduced services. I would seriously consider checking how your state and locality are funded. You might not want to retire to a place that is on a collision course with serious pain. Just a thought.

John is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered in multiple states. John Mauldin is President of Millennium Wave Securities, LLC a FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). He is a frequent contributor to numerous publications, and guest on TV and radio shows as well as quoted widely in the press.

July 29, 2010

From Pacific Investment Management Company’s June 2010 Investment Outlook, Bill Gross talks about the “New Normal” and additional headwinds for the global economy.

I write this month to condemn the inventor of the electronic “seeing eye” toilet. Yes, that’s right, I’m talking toilets here, doo-doo-stuff, some of which I hopefully won’t step in myself over the next few paragraphs. I know there must be more substantive and less objectionable topics to bring before you, but I have a sense that many of you join me in spirit if not common experience and so I devote this month’s Outlook to another trivial snippet emphasizing our joint humanity and sense of loss due to the recent disappearance of the hand flusher.

I don’t know where it is located exactly, but there’s an electronic eye in the plumbing of public toilets these days that can sense when you get up and down (or is it down and up) and are finally finished with your “business,” if you get my drift. My doctor says a proctology exam is a necessary evil but cameras in toilets? Never having seen myself from this particular angle, it is particularly embarrassing to turn over the assignment to a camera and in effect say, “Snap away – see anything that doesn’t look right?” I figure if there’s an eye there, then there could also be a little voice that says, “Have a seat,” which of course I do, usually with much haste and a sense that I’d better get on with it before I attract a crowd.

It’s after the dirty deed is complete, however, that the real intrigue begins. Does it flush or doesn’t it? Only the computer chip knows for sure. Sometimes, though, after the paperwork has been filed, pants pulled up and an attempted getaway initiated – nothing happens. No flush. Well, what is one to do in such circumstances? You can’t just leave it there, you know. Sometimes when the toilet’s plugged and there’s no plunger like in European bathrooms, you can get out of there quick with conscience in tact, but only, of course, after checking to see that there’s no one else in the restroom who might be able to testify against you in court for being a non-flusher. With electronic eye toilets, however, the conscience is never clear and so you wave your hand in front of the camera, hoping to convince it by the breaking of light waves that someone really has used the toilet and that somehow it just forgot, or maybe the deposit was so minuscule that it just didn’t merit a flush. Hello in there! Having failed to trick it, however, the next step is to look for that little button in the back that you supposedly push in an emergency – sort of like a “break glass in case of fire” toilet equivalent. But think of all the billions of germs! At least with an old handle you could kick it with your shoe, hold up your arms like a doctor scrubbing for surgery and make an exit looking like you’re auditioning for a part on ER. Finally I suppose you head for the door, all the while listening for the flush, the flush, that beautiful sound of the flush. I could have done it myself, you know, with a lot less hassle. Which is why I support a retreat to the old days, (not the backyard outhouse), but the good old-fashioned hand flusher. One push, and presto – you’re good to go!

I really do have a serious message this month, an adjunct to the New Normal that will likely impact growth and financial markets for years to come. Our New Normal, to repeat ad nauseam, is predicated upon deleveraging, reregulation and deglobalization, all of which promote slower economic growth and lower inflation in developed economies while substantially bypassing emerging market countries that have more favorable initial conditions. In recent months, Mohamed El-Erian has added a developing corollary that emphasizes the lack of an appropriate policy response to what is a structural as opposed to a cyclical development, and you should read his frequently published op-eds for a more thorough analysis as well as those written by Jeffrey Sachs and others who are constructively suggesting a way back to the old normal.

That return journey will be all the more difficult to accomplish, however, because of demographics, an influence that much like gravity is hard to see but whose effect is all too powerful. Demographics – or in this case population growth – is so long term in its influence that economists and observers are inclined to explain the functioning of economic society without ever factoring in the essential part that it plays in growth. Production depends upon people, not only in the actual process, but because of the final demand that justifies its existence. The more and more consumers, the more and more need for things to be produced. I will go so far as to say that not only growth but capitalism itself may be in part dependent on a growing population. Our modern era of capitalism over the past several centuries has never known a period of time in which population declined or grew less than 1% a year. Currently, the globe is adding over 77 million people a year at a pace of 1.15% annually, but slowing. Still, that’s 77 million more mouths to feed, 77 million more pairs of shoes to make, 77 million more little economic units of demand – houses, furniture, cars, roads, oil – more, more, more. Capitalism, I would assert, thrives on more, more, and more, but not so well when there is less or an expectation of less. This is not the Malthusian thesis, which maintained that at some point the world would run out of food to satisfy a growing population; it is an assertion that capitalism depends upon final demand and that if there ever comes a time when population growth slows, then the world’s most efficient economic system will be tested. If anything, my thesis is anti-Malthusian in its assertion that there will always be enough production to satisfy a growing population, but perhaps not enough new people to sustain growing production.

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