The New Normal

by Andrew Baume on 8 March 2015 · 3 comments

With the Intergenerational Report now released, the meme of “intergenerational theft” is spreading. Bill Mitchell has already shredded the core assumptions of the report, and now first time guest author Andrew Baume brings to the Mule brings the perspective of a financial markets practitioner to our possible future wealth. In broad strokes, he concludes

  • post-paid retirement is now the exception not the rule
  • the balance sheet that supports your retirement is now your own
  • absence of inflation is the enemy

Many older Australians have ridden the magic carpet of high levels of inflation which brought asset valuations to today’s levels. This has been particularly felt in the property market which has been the foundation for most of the “unearned” growth in asset base for anyone aged 50 or older. Property has been the asset which we have been most comfortable to leverage at incredibly high multiples.

Downsizing has liberated much of this unearned wealth and turned it into retirement income. This transfer is much like Potential Energy being transferred into Kinetic Energy. As with physics there is no perpetual motion machine so the transfer is permanent for those who do it. It is however also true they do continue to store some of the liberated KE but not into the illiquid high ticket indivisible item that the large family home generally represents. It is usually reinvested into different asset classes.

Although investing is a core competence for some, (certainly not this author!) normal people with money have found good clips of that money fall into their lap by having lived somewhere or having contributed to super. They have been comfortable in property because it “always goes up” and over their lives they have traded it as little as twice. Reinvesting the nest egg is a massive step.

Some commentators have made very strong cases for being heavily invested in risk assets post retirement whilst others have argued that timing of shocks can have a massive and unexpected effect on post retirement incomes. Both are right of course but the big impact that seems less understood it the massive shift in post-retirement income from post-paid to pre-paid and how that has fundamentally changed the return equation.

Rates of Return
Once pre-paid retirement hits its straps the clamour for return creates a dynamic associated to the paradox of thrift. As the population ages and demographic analysis promotes the concept that the welfare safety net needs to be drawn tighter, government services are reduced. The need to build a safety net for ourselves drives our return expectations lower and lower as the “best” assets (like bonds and bank shares) are bid upwards and the marginal assets assets (including higher leveraged companies and marginal property assets) benefit from that bid due to a crowding in effect. The impact of this trend has been seen most clearly in the global bond markets.

30 years ago when I started as a foreign exchange and interest rates trader the US 30 year bond was the bellwether for the health of the financial system. It was highly volatile and its movements reflected the broad market’s view of the capacity for the US to manage its (and therefore the world’s) economy. It seemed strange to me at the time that an instrument that was the projected average fed funds rate over the next 30 years would have any movement at all that related to the near term health of the economy.

Its volatility existed because in 1985 most retirement incomes were funded by the issue of that bond and others like it (by other governmental authorities) or by corporate debt in the case of corporate pension providers. Most defined benefit schemes were not close to fully funded so debt financed the pension provider’s obligations.

US 30 year Treasuries

Chart 1 – US 30 year Treasury yield
Source: Bloomberg

I wish I was smart enough to have bought a zero coupon 30 year US Government bond back then. It would have smacked me in tax over the 30 years, but I would be getting back 17.5 times the money invested this month. As a comparison the US stock index the S&P 500 is up by a factor of 11.7 times (unfair direct comparison because it is not tax adjusted).

These returns happened because the bond market was pricing way too much inflation and the equity market benefitted by there being just enough.

The dynamic in 2015 is the almost total reverse. Equity markets have lofty valuations underpinned by mediocre revenue growth, capital buy backs (as the companies can’t use the capital themselves) and bond yields that are ridiculously low as pre-paid retirement drives yields lower and lower in concert with global government policy of zero rates and Quantitative Easing (QE).

There is little doubt that it is appropriate for governments around the world to try to influence capital to take risk in the current environment. The paradox of thrift has driven risk aversion even further than the salutary lessons of the global financial crisis.

The investment profile of most companies has gone defensive with little entrepreneurialism and widespread equity buy backs. This lack of capital formation sees equity markets continue to rally on flows not earning. Consequently investors have gone massively short volatility –and has done so with one overriding reason near total absence of inflation expectation.

Gordon Gekko said “greed is good”. If greed is good and it is fed by a healthy inflation expectation. Inflation has a musky quality, like a magnificent Burgundy it needs to have a little funk, but get too funky and it spoils everything. No funk and you have strawberry cordial. Current markets are strawberry cordial and they are thus by design at the government level reacting to fear still holding the upper hand in the zeitgeist. For the next generations’ sake let’s hope we get some fear back.

Most Baby-Boomers and older have experienced the best fortune inflation can bring you. Liabilities that are nominal in nature against real assets (property and equity) are able to bring massive compounding benefits. As wages grow to match inflation (and employees advance through the ranks) the liabilities whittle away into nothings. Those conditions allowed us to regurgitate the old saying “it’s not timing the market it’s time in the market”. History is a great indicator of history, but absent inflation and with an incredibly long period of defensiveness from a capital formation standpoint it seems ever more likely that the current and next phase of markets will look like little else that has gone before.

In the last two years the Australian Index has increased circa 18% which certainly gives the lie to this argument. That suggests that the drive to low returns is a long way from over, keeping the bid in the equity market strong. It is this authors’s contention that as over 9% of that growth has occurred since the RBA decided the Australian economy was fragile enough to require a rate cut to a level not seen in my lifetime, in fact we are solidly in the execution phase of this return compression. Those of us lucky enough to have money to invest should do so now in any asset with moderate leverage and a high yield.

Once the compression of yields is more complete, the market will roll down one of three clear but quite different paths:

  1. Inflation returns moderately and gradually and allows the central banks around the world to very very slowly unwind the extraordinary accommodation so that the dividend discount model is basically unchanged (i.e. dividends rise as fast as the need to raise rates to combat overstimulation). This path is technically known as Nirvana and we all get to retire rich.
  2. Inflation does not develop for some time meaning returns remain bid down and bond markets globally provide savers with approximately zero income driving investors into earning whatever they can from “real assets”. This is a great outcome for those already invested as they benefit from the compression in returns and their living expenses remain low. The paradox of thrift keeps returns low as fear remains in the system and lack of confidence provides negative feedback loop on inflation and fuels currency devaluation wars. This path is technically known as “the Baby Boomers stealing food from their children’s (and grandchildren’s) mouths.”
  3. Inflation takes some time to develop but when it does it takes a classical monetarist predicted path and smashes valuations very hard as rates back up markedly to try to not just reverse the accommodation but put the brakes on rampant price indiscipline. This path is technically known as “Timing the market has never been so important”

Interestingly path 3 is probably the best outcome for a youngster without much yet in the market. They may have leveraged a bit and after the valuations adjustment works through they get a higher wage and the absolute (not real) level of their assets recovers based on the higher cashflow brought by inflation. Anyone who doubts this should think about their own personal balance sheet in 1973.

The Balance Sheet
When retirement was provided by either a defined benefit scheme or government pension (especially pensions for the government) the issues of timing were completely irrelevant and the investment landscape was also largely irrelevant. Many firms’ pension schemes were “underfunded” and the government did not recognise future liability at all in the budget, only the current FY expense. Someone else’s balance sheet took all the variability. This all changed once governments realised that the unfunded liability would cripple them (admittedly rating agencies had a big role to play in helping them realise this). Post 1987 crash company balance sheets also began to recognize the potentially life threatening exposure that they were taking to equities via their pension schemes.

S&P estimates that the anticipation of quantitative easing in Europe squashed bond yields so much that the liabilities of defined-benefit pension plans rose by up to 18 percent last year. Its analysis looked at the top 50 European companies it rates that have defined-benefit pension plans and are “materially underfunded,” meaning, the plans have deficits of more than 10 percent of adjusted debt, and that debt is more than 1 billion euros. In 2013, liabilities outstripped obligations for that group by more than 30 percent on average.”

Source: Bloomberg

Moves to defined contribution and superannuation guarantees are not localized Australian issues. The world has shifted and as Chart 1 shows one key outcome has been that there is more money to be potentially invested for 30 year debt-like returns than there are creditworthy borrowers who want the money.

Companies that switched to “Liability Driven Investments” to fund their pension schemes more than 7 years ago are less vulnerable. These shortfalls will force many unprepared companies to play catch up in their asset allocations.

Variability is much harder to take in a personal balance sheet when external income is no longer being received (i.e. when you are retired). It seems that extreme variations in equity markets is an inevitable consequence of the current reach for yield unless world economic growth has a strong and sustained recovery that outweighs the downward pressure on valuations from the consequent increase in bond yields. In the case of Japan, time in the market has not been your friend:

Nikkei 225

Chart 2 – Japan’s Nikkei stockmarket index
Source: Bloomberg

I have actually been generous in this chart as the vertical axis starts well after the 38,915 peak in 1989. It is a dangerous assumption that markets will behave differently in the future than they have in the past, but perhaps this chart shows an economy operating a little like the new normal for the last 20 years. It is also interesting to note the massive rally over the past 12 months has been driven by QE.

Timing of that market would have been one of the most lucrative investments possible and funnily enough it was completely predictable and transparent.

The paradox of thrift has usually been applied to emerging economies where very few social services are supplied by the state. The aging of the population combined with the shift to pre-funded retirement in an environment where social services are being pared back is creating this phenomenon in the advanced economies. This is potentially the most egregious form of intergenerational theft.

The associated absence of inflation will also tend to remove the fantastic wealth building effect of unearned capital appreciation primarily through property. This source of wealth for over 50s may be replicated by modern young parents but the scale of success that older folk have had seems unlikely.

In all but the Nirvana case outlined above the outcome seems clear. The retirement age may stay where it is but the size of the pension relative to retirement income expectations will continue to deteriorate as pension growth does not keep pace with lifestyle. People will have little choice but to continue some form of labour-driven income generation into their late sixties and most likely their 70s. Our personal balance sheet which now bears the risk will demand it.

A set and forget equity portfolio may work but also lead us into a very active post retirement game of catch up. Those with no nest egg may struggle hard to get a retirement savings pool that allows them to leave employment until well into their 70s and further may be subject to violent valuation adjustments.

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{ 3 comments… read them below or add one }

1 Zebra March 13, 2015 at 5:39 pm

Hi Baumey, welcome to the Stable.
Before Douglas Copeland’s phenomenal book “Generation X” came out in 1992 I read another along the same lines called “13th Generation: Abort, Retry, Ignore, Fail” by Neil Howe (as in the 13th generation since the founding of the US). It was a little less zeitgeisty than “Generation X” and lacking a virally title so has been overshadowed by Copeland’s book. It was a much more thorough analysis though of how generations work, at least in the US. It basically said that they come in threes where the first generation pisses away the wealth of previous generations, the next one lives in abject poverty when it all goes pear shaped, and the third generation rebuilds wealth to start the cycle again. So think the Golden Age in US (think F.Scott Fitzgerald’s “The Great Gatsby”) followed by the Great Depression and then following WW2 The Baby Boomers. By that analysis we are living in the third generation again of Millenials who will have to rebuild the wealth to support Gen Y’s and Gen Xers. I think like a lot of historical analogies it breaks down a bit in recent times but worth reading anyway.

2 Stubborn Mule March 14, 2015 at 4:20 pm

@baumie the experience of the 1970s stagflation was a crisis for confidence in the Keynesian consensus, which was gradually replaced by a new confidence in the power of monetary rather than fiscal policy as the most effective tool for managing economic cycles and, in particular, taming inflation. This confidence reached its apex through the “great moderation”, but I believe what we are seeing is the equivalent crisis for confidence in monetary policy. The world is learning that in fact monetary policy cannot solve all problems.

3 Andrew Baume March 15, 2015 at 11:04 pm

@zebra I think the idealogues saying super is sacrosanct and young people should not buy a house is an interesting exposition of the generational insensitivity of older folk. I don’t know the answer but I am pretty sure a didactic response wont make the young feel any better about renting. @mule there is no dount at all in my mind that on the wings the price of money is much less relevant than its availability and velocity, but maybe in the belly you can fine tune exuberance/sluggishness via price.

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