Gold

Should we trust ratings agencies on US state credit?

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The Financial Crisis Inquiry Commission concluded in 2011 that “the global financial crisis could not have happened without the ‘Big Three’ agencies – Moody’s, Standard & Poor’s and Fitch which allowed the ongoing trading of bad debt which they gave their highest ratings to despite over three trillion dollars of mortgage loans to homebuyers with bad credit and undocumented incomes.” The table above tabulates the deterioration in US corporate credit ratings since 2006. The ratings agencies have applied their trade far more diligently.

As written earlier in the week, US state public pensions are running into horrific headwinds. Unfunded pension liabilities are running at over double the level of 2008. With asset bubbles in stocks, bonds and property it is hard to see how plugging the gap (running at over 2x (California is 6x) the total tax take of individual states) in the event of a market correction is remotely realistic. However taking a look at the progression of US states’ credit ratings one would think that there is nothing to worry about. Even during GFC, very few states took a hit. See below.

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Looking at the trends of many states since 2000, many have run surpluses so the credit ratings do not appear extreme. It is interesting to flip through the charts of each state and see the trajectory of revenue collection. A mixed bag is putting it lightly. Whether the rebuild after Hurricane Katrina in 2005, since 2008 revenue collection in Louisiana has drifted.

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Looking through S&P’s own research at the end of last year it included an obvious reference.

U.S. state and local governments can use pension obligation bonds (POBs) to address the unfunded portion of their pension liabilities. In certain cases, POBs can be an affordable tool to lower unfunded pension liabilities. But along with the issuance of POBs comes risk. The circumstances that surround an issuance of POBs, as well as the new debt itself, could have implications for the issuer’s creditworthiness. S&P Global Ratings views POB issuance in environments of fiscal distress or as a mechanism for short-term budget relief as a negative credit factor.”

Perhaps the agencies have learnt a painful lesson and trying to stay as close to being behind the curve as possible. It doesn’t seem like public pensions are being factored at levels other than their actuarial values. Marked-to-market values would undoubtedly impact these credit ratings.

As mentioned in the previous piece on public pensions, a state like Alaska has public pension unfunded liabilities equal to $145,000 per household, treble the 2008 figure. It is 3.5x annual tax collections. The state’s per capita operating budget of $13,728 per person is way above the national average of $6,826 per person. Alaska relies on oil taxes to finance most of its operating budget, so a sudden drop in oil prices caused tax revenues to sharply decline. The EIA’s outlook doesn’t look promising in restoring those fortunes in any scenario. So S&P may have cut Alaska two places from AAA in 2015 to AA in 2017.

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While pension liabilities aren’t all due at once, the last 8 years have shown how quickly they can fester. It wasn’t so long ago that several Rhode Island public pension funds reluctantly agreed to a 40% haircut, later retirement ages and higher contributions with a larger component shifted from defined benefits to defined contributions raising the risk of market forces exerting negative outcomes on the pension fund.

In 2017, despite a ‘robust’ economy, 22 states faced revenue shortfalls. More states faced mid-year revenue shortfalls in the last fiscal year than in any year since 2010, according to the National Association of State Budget Officers.

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Pew Charitable Trust (PCT) notes in FY2015 federal dollars as a share of state revenue increased in a majority of states (29). Health care grants have been the main driver of this. FY2015 was the 3rd highest percentage of federal grants to states since 1961.

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By state we can see which states got the heftiest federal grants. Most states with higher federal shares expanded their Medicaid programs under Obamacare (ACA) and got their first full year of grants under the expanded program in FY2015.

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PCT also wrote “At the close of fiscal year 2017, total balances in states’ general fund budgets—including rainy day funds—could run government operations for a median of 29.3 days, still less than the median of 41.3 days in fiscal 2007…North Dakota recorded the largest drop in the number of days’ worth of expenses held in reserves after drawing down almost its entire savings to cover a budget gap caused by low oil prices. It held just 5.4 days’ worth of expenditures in its rainy day fund at the end of fiscal 2017 compared with 69.4 days in the preceding year… 11 states anticipate withdrawing from rainy day funds under budget plans enacted for fiscal 2018

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Looking at the revenue trends of certain states, the level of collection has been either flat or on the wane since 2010 for around 26 states. As an aside, 23 of them voted for Trump in the 2016 presidential election. The three that didn’t were Maine, NJ and Illinois.

Optically US states seem to be able to justify the credit ratings above. Debt levels aren’t high for most. Average state debt is around 4% of annual income. Deficits do not seem out of control. However marking-to-market the extent of public pension unfunded liabilities makes current debt levels look mere rounding errors.

Considering stock, bond and property bubbles are cruising at unsustainably high levels, any market routs will only make the current state of unfunded liabilities blow out to even worse levels. The knock on effects for pensioners such as those taking a 40% haircut in Rhode Island at this stage in the cycle can only feasibly brace themselves for further declines. This is a ticking time bomb. More states will need to address the public pension crisis.

A national government shelling out c.$500bn in interest payments on its own debt in a rising rate environment coupled with a central bank paring back its balance sheet limits the options on the table. Moral hazard is back on the table folks. Is it any wonder that Blackstone has increased its short positions to $22 billion?

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Truly sickening US Public Pensions data

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Following on from the earlier post and our 2016 report on the black hole in US state public pension unfunded liabilities, we have updated the figures to 2016. It is hard to know where to start without chills. The current state of US public pension funds represents the love child of Kathy Bates in Misery and Freddie Krueger. Actuarial accounting allows for pension funds to appear far prettier than they are in reality. For instance the actuarial deficit in public pension funds is a ‘mere’ $1.47 trillion. However using realistic returns data (marking-to-market(M-2-M)) that explodes to $6.74 trillion, 4.6-fold higher.  This is a traffic accident waiting to happen. US Pension Tracker illustrates the changes in the charts presented.

Before we get stuck in, we note that the gross pension deficits do not arrive at once. Naturally it is a balance of contributions from existing employees and achieving long term growth rates that can fund retirees while sustaining future obligations. CM notes that the problems could well get worse with such huge unfunded liabilities coinciding with bubbles in most asset classes. Unlike private sector pension funds, the states have an unwritten obligation to step up and fill the gap. However as we will soon see, M-2-M unfunded liabilities outstrip state government expenditures by huge amounts.

From a layman’s perspective, either taxes go up, public services get culled or pensioners are asked politely to take a substantial haircut to their retirement. Apart from the drastic changes that would be required in lifestyles, the economic slowdown that would ensue would have knock on effects with state revenue collection further exacerbating a terrible situation.

CM will use California as the benchmark. Our studies compare 2016 with 2008.

The chart above shows the M-2-M 2016 unfunded liability per household. In California’s case, the 2016 figure is $122,121. In 2008 this figure was only $36,159. In 8 years the gap has ballooned 3.38x. Every single state in America with the exception of Arizona has seen a deterioration.

The following chart shows the growth rate in M-2-M pension liabilities to total state expenditure. In California’s case that equates to 3.2x in those 8 years.

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Sadly it gets worse when we look at the impact on current total state expenditures these deficits comprise. For California the gap is c.6x what the state spends on constituents.

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Then taking it further,  in the last 8 years California has seen a 2.62-fold jump in the gap between liabilities and state total expenditures.

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This is a ticking time bomb. Moreover it is only the pensions for the public sector. We have already seen raids on particular state pension funds with some looking to retire early merely to cash out before there is nothing left. Take this example in Illinois.

Sadly the Illinois Police Pension is rapidly approaching the point of being unable to service its pension members and a taxpayer bailout looks unlikely given the State of Illinois’ mulling bankruptcy. Local Government Information Services (LGIS) writes, At the end of 2020, LGIS estimates that the Policemen’s Annuity and Benefit Fund of Chicago will have less than $150 million in assets to pay $928 million promised to 14,133 retirees the following yearFund assets will fall from $3.2 billion at the end of 2015 to $1.4 billion at the end of 2018, $751 million at the end of 2019, and $143 million at the end of 2020, according to LGIS…LGIS analyzed 12 years of the fund’s mandated financial filings with the Illinois Department of Insurance (DOI), which regulates public pension funds. It found that– without taxpayer subsidies and the ability to use active employee contributions to pay current retirees, a practice that is illegal in the private sector– the fund would have already run completely dry, in 2015…The Chicago police pension fund held $3.2 billion in assets in 2003. It shelled out $3.8 billion more in benefits to retired police officers than it generated in investment returns between 2003 and 2015…Over that span, the fund paid out $6.9 billion and earned $3.0 billion, paying an additional $134 million in fees to investment managers.”

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To highlight the pressure such states/cities could face, this is a frightening example of how the tax base can evaporate before one’s eyes putting even more pressure on bail outs.

This problem is going to get catastrophically worse with the state of bloated asset markets with puny returns. Looking at how it has been handled in the past Detroit, Michigan gives some flavor. It declared bankruptcy around this time three years ago. Its pension and healthcare obligations total north of US$10bn or 4x its annual budget. Accumulated deficits are 7x larger than collections. Dr. Wayne Winegarden of George Mason University wrote that in 2011 half of those occupying the city’s 305,000 properties didn’t pay tax. Almost 80,000 were unoccupied meaning no revenue in the door. Over the three years post the GFC Detroit’s population plunged from 1.8mn to 700,000 putting even more pressure on the shrinking tax base.

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Plunging credit quality more troubling than market rout

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The Dow plunged 1175 points (-4.6%) overnight. 4.6% is a lot and yes 4-digit drops optically look worse but off the higher base we get higher (record) point drops. One thing to contemplate in a rising bond yield market is corporate credit quality. Since 2006 the average credit ratings for US corporates issued by the big agencies have seen the number of top rated (to the left) fall while those with deteriorating grades (to the right) soar. That’s right, the 4 categories before “junk” have risen sharply. After many years of virtually free money many corporations have let the waistline grow. When refinancing comes around just how will credit ratings influence the new spreads of corporates who’ve shifted to the right?

The IMF highlighted in 2017  that US companies have added $7.8t in debt & other liabilities since 2010. The ability to cover interest payments is now at the weakest level since 2008 crisis.

This despite near full employment, record level equity markets and every other word of encouragement from our politicians.

However if this is the state of the corporate sector at arguably the sweet spot of the economic cycle CM shudders to think the state of potential bankruptcies that will come when the cycle truly takes a turn for the worse. This is a very bad sign.

My Button is bigger than yours

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Purile but effective. The message has gone around the world. How is it more people are worried about his language than the ability for a nation like the DPRK to possess a capability to strike the US? How many times have we seen the North Korean’s nuke technology end up  in the wrong hands – e.g. Syria. Spurn the US for its post war foreign policy but it’s a known devil.

Back to mine is bigger than yours – unorthodox message delivery but why is anyone in the least bit surprised? How can anyone feel outrage at something that has happened almost daily for nearly 12 months straight? One should be howling if he wasn’t doing it! Then one could truly call him an unhinged lunatic because one would be worried that he was unpredictable.

Let’s not forget that China has recently told the world what it thinks of the UN sanctions by continuing to trade oil with the rogue nation. Trump told Xi than no amount of theatre by hosting a dinner in the Forbidden City will give them any free passes like his predecessors. Let’s not forget the farewell message sent by China to Obama on his last state visit – no stairs, no red carpet and no senior delegates. He exited by the emergency stairs of Air Force One. What a humiliation.

It is reasonably unstatesmanlike to be sure but the message is pointed at China not Kim. Quit screwing around is the message. If China doesn’t take care of business with its ‘tenant’ the US will evict him for it.

For all those panicking that a nuke strike is on the horizon Korean CDS spreads are 52. At the first stage of the verbal exchange several months back they were mid 70s. Yawn.

Bitcoin Bubble explained in one picture

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First look at the price when the question is asked and then the percentage of responders thinking it’s a bubble. Reverse logic or Tulip Mania? Sort of reminds me when the Dutch traders in the 1600s were selling silver to the Japanese who valued it more than gold. How much silver can we safely carry they must have thought!

Credit: Stu

Ultra High Net Worth Individuals (by country)

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In an ever growing world of haves vs have nots, Elliman has released an interesting update on the statues of global wealth and where it is likely to head over the next decade. It suggests North America has 73,100 UNHWIs at an average of $100mn each or $7.31 trillion. To put that in perspective 73,100 North Americans have as much wealth as Japan & France’s annual output combined. Over the next decade they expect 22,700 to join the ranks.

Europe has 49,650 UHNWI also at the magical $100mn mark (presumably the cut off for UHNWI or the equivalent of Japan.

Asia is growing like mad with $4.84 trillion split up by 46,000 or $105mn average. In a decade there are forecast to be 88,000 UHNWIs in Asia.

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I am not sure what the World Bank was smoking when coming up with the coming forecasts I’ve rthe next decade but the figures smel fishy.  Then it all comes down to this chart.

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1) Political uncertainty? Everywhere you look – Trump, Brexit, Catalonia, Australia, France, Germany, Austria, Czech Republic, The Netherlands, Hungary, Poland etc etc

2) Potential fall in asset values – looks a very high chance of that. Current asset bubbles are almost everywhere – bonds, equities, real estate etc

3) Rising taxes – maybe not the US or Canada (if you follow the scrutiny over Finance Minister Morneau), but elsewhere taxes and or costs of living for the masses are rising

4) Capital controls – China, India etc

5) Rising interest rates – well the US tax cuts should by rights send interest rates creeping higher. A recent report showed 57% of Aussies couldn’t afford an extra $100/month in mortgage – a given if banks are forced to raise lending rates due to higher funding costs (40% is wholesale finance – the mere fact the US is raising rates will only knock on to Aus and other markets).

Surely asset prices at record levels and all of the other risk factors seemingly bumping into one another…

So while UHNWIs probably weather almost any storm, perhaps it is worth reminding ourselves that the $100mn threshold might get lowered to $50m. It reminds me of a global mega cap PM who just before GFC had resplendent on his header “nothing under $50bn market cap”. Post GFC that became $25bn then eventually $14bn…at which point I suggested he change the header entirely.

I had an amusing discourse on LinkedIn about crypto currencies. The opposing view was that this is a new paradigm (just like before GFC) and it would continue to rise ( I assume he owns bit coins). He suggested it was like a promissory note in an electronic form so has a long history dating back millennia. I suggested that gold needs to be dug out of the ground – there is no other way. Crypto has huge risk factors because it is ultimately mined in cyber space. State actors or hackers can ruin a crypto overnight. There have already been hacking incidents that undermine the safety factor. It does’t take a conspiracy theory to conjure that up. To which he then argued if it all goes pear shaped, bitcoin was a more flexible currency. Even food would be better than gold. To which I suggested that a border guard who is offering passage is probably already being fed and given food is a perishable item that gold would probably buy a ticket to freedom more readily as human nature can adapt hunger far more easily in the fight for survival. I haven’t heard his response yet.

In closing isn’t it ironic that Bitcoin is now split into two. The oxymornically named Bitcoin Gold is set to be mined by more people with less powerful machines, therefore decentralizing the network further and opening it up to a wider user base. Presumably less powerful machines means fewer safeguards too although it will be sold as impervious to outsiders. Of course the idea is to widen the adoption rate to broaden appeal. Everyone I know who owns Bitcoin can never admit to its short comings. Whenever anything feels to be good to be true, it generally is. Crypto has all the hallmarks of a fiat currency if I am not mistaken? While central banks can print furiously, they will never compete with a hacker who can digitally create units out of thin air. Fool’s Gold perhaps? I’ll stick to the real stuff. I’ll take 5,000 years of history over 10 years any day of the week.

From Sesame to Elm Street

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ETF markets continue to surge in popularity. With low fees and basic packaging of the ETF product even Big Bird can understand what The Count is going on about. No wonder investors are snapping up these products faster than the Cookie Monster. However there is something chilling about the ETF market. In the lead up to and eventual crash of Lehmans et al CDOs, CDSs and other synthetic products were seen as the root of all evil. They were so complex that even Fields Medal winners in mathematics couldn’t make head nor tail of them. The ETF became the opposite – being too simplistic – and with that the product has brought huge complacency. To that end Sesame Street could well switch to Elm Street.

Today assets invested in ETF/Ps comprise over $3 trillion globally. Put simply the new funds flowing into ETFs vs. traditional mutual funds is at a 100:1 ratio and in terms of AUM is on par with total hedge fund assets which have been in existence for 3 times as long.

However ETFs, despite increasing levels of sophistication, have brought about higher levels of market volatility. Studies have shown that a one standard deviation move of S&P500 ETF ownership carries 21% excess intraday volatility. Regulators are also realising that limit up/down rules are exacerbating risk pricing and are seeking to revise as early as October 2015. In less liquid markets excess volatility has proved to be 54% higher with ETFs than the actual underlying indices. A full report can be seen here.

With the continuation of asset bubbles in a TINA (there is no alternative) world, ETFs in my view will lead to massive disappointments down the line. Their downfall could well invite the revival of the research driven fund manager model again as robots show they’re not as infallible as first thought in managing the volatility. Don’t forget humans designed the algorithms.

There is also the added risk of whether some ETFs actually hold the physical of the indices or commodities they mimic. A gold ETF is a wonderfully good way to store wealth without resorting to one’s own bank vault but how many ETF owners have inspected the subterranean cage that supposedly holds the physical the ETF is backed by? Has it been lent out? Does it own a fraction of stated holdings? It could be any other commodity too. Of course the ETF providers bang on about the safety of the products but how many times have we gasped when fraud reared it’s ugly head right in front of us. Bernie Maddoff ring any bells?

Given the implied volatility on the downside we need to bear in mind the actions of central banks. The Bank of Japan (BoJ) is the proud owner of 60% of the ¥20 trillion+ domestic ETF market. While the BoJ says it isn’t finished expanding its world’s largest central bank balance sheet (now 100% of GDP), the US Fed is looking to reduce its balance sheet by over 40% in order to normalize. While one can applaud some level of common sense pervading sadly the consequences of defusing the timer on the bomb they created at a period when the US economy is showing signs of recession will only be an overhang on asset markets. Should the US market be put through the grinder, global markets will follow.

It is one thing for the Fed to be prudent. It is another for it to be trying to cover its tracks through higher interest rates in a market that looks optically pretty but hides serious life threatening illnesses. The Fed isn’t ahead of the curve at all. It is so far behind the 8-ball that its actions are more likely to accelerate rather than alleviate a crisis. Point to low unemployment or household asset appreciation as reasons to talk of a robust economy but things couldn’t be further from the truth. Wage growth is not the stuff of dreams and the faltering signs in auto, consumer and residential markets should give reason for concern.

Since GFC we have witnessed the worst global economic revival in history. The weakest growth despite record pump priming and balance sheet expansion. Money velocity is continually falling and the day Greenspan dispensed with M3 reporting one knew that things were bad and “nothing to see here” was the order of the day.

Record levels of debt (just shy of $220 trillion or 300% of GDP when adding private, corporate and government), slow growth, paltry interest rates and coordinated asset buying have not done anything other than blown more air into a bubble that should have been burst. GFC didn’t hit the reset button. Central banks just hit print to avoid the pain. We’ve doubled up on stupidity, forgot the idea of prudent and sensible growth through savings and just partied on. Ask any of your friends in finance what they “really” think and I can assure you that after a few drinks they’ll tell you they’re waiting for the exit trade. They know Armageddon is coming but just don’t know when

Whether we like it or not, the reset button will be hit. I often argue people should not worry about the return ON their money but the return OF it. Global markets can’t be bailed out again with massive cash infusion. That has been a recipe for disaster, only widening the gap between haves and have nots. Debt must be allowed to go bad, banks must be allowed to go bust and free markets must be freed from the shackles of state sponsored manipulation to set prices. It will be ugly but more of the same can kicking won’t work.

ETFs are a sign of the times. They represent the slapdash approach to life these days. Time saving apps if you will. However nothing beats hard nosed analysis to understand what awaits us. Poor old Big Bird will be the canary in the coal mine and Sesame Street will be renamed Elm Street as the Kruger’s move in to give us nightmares Janet Yellen assures us aren’t possible.

Perhaps that is the ultimate question. As you go to work each day do you honestly feel that things are peachy as the management town hall meetings would have you believe? Are your friends or colleagues all bulled up about the future? Perhaps that is easier to answer than an ETF.