Between a rock and a hard place
Investors are unsure whether the current market rally can outlive central bank action, argue Nicholas Lyster and Amin Rajan
F Scott Fitzgerald said that “the test of a first rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” This advice applies to pension plans now more than ever.
The euro-zone has not broken up. America has not fallen off the fiscal cliff. China’s economy has not crash landed. The world has not suffered an oil spike. The dire predictions about the recent past have been confounded. Markets have rallied due to receding worries as much as decisive action by central banks on both sides of the Atlantic.
The quantitative easing (QE) programme of the US Federal Reserve has kick-started the recovery and created some 2m jobs in the US since its 2009 inception. Likewise, bold moves by the European Central Bank (ECB) have averted the demise of the euro and given governments time to enact reforms to reduce their unsustainable levels of debt.
The sentiment that the crisis may be over has itself served to ease it. Yet, fear continues to lurk in the background.
This is evident from the June market turmoil, following a hint from Chairman Bernanke that the Fed may taper its monthly purchases of assets, if the US economy continues to improve.
The reaction was violent: all asset values (including gold) fell sharply at the prospect of the Fed’s fuel drying up. The resulting 95 basis point hike in the yield on 10-year US Treasuries hit the recovery in the US housing market: mortgage applications, housing starts, and permits were all down in June. No wonder Bernanke and his central bank colleagues immediately took to podiums and airwaves to restore calm.
Markets will remain jittery until progress is evident on the debt front, according to the 2013 Principal Global Investors/CREATE-Research survey, Investing in a Debt Fuelled World*.
It shows that many questions continue to dog investors, despite the feeling that the worst is over:
• Will there be an accord on deficit reduction in the US? Will the Federal Reserve’s exit strategy turn what is now a stabilising force into a destabilising force?
• Will the ECB actions merely prop up weak banks in the euro-zone? Will its member governments have the will to persist with unpopular measures against a populist tide?
Accordingly, politics, more than economics, will drive the markets. Investors are braced for market-moving events that may potentially result in big gains or big losses. They’re damned if they take risk, and damned if they don’t.
The dilemma is more acute with the revival of a long-forgotten phenomenon: financial repression, caused when central banks keep the rates artificially low for a long time so as to help governments finance their debts. A combination of low rates and rising inflation will steadily vaporise public debt and erode the purchasing power of the underpinning assets.
Pension investors fear being on the losing side in this arbitrary redistribution of wealth that could last for at least a decade, if the past is any guide. Throughout history, governments have taken the line of least resistance and vapourised their debts. Inflation is a subtle means of reneging on their debt obligations.
The deleveraging now in progress in Europe and America is part of a bigger narrative that goes beyond cutting the public debt.
When banking losses were socialised after the Lehman crisis, what started as a financial problem turned into a structural one. Big government deficits dented confidence and hit growth. The resulting cuts in public expenditure made matters worse.
Had growth been maintained at its average level between 1990 and 2007, GDP would have been some 15% higher by 2013, as would be tax revenues. Austerity, or reforms of public finances, has proved self-defeating in the short term. Yet, without them, investors fear financial repression. So, governments will use a mix of five factors to drive down their debts.
In Europe, the main thrust will be led by cuts in public spending, low interest rates and reform of public finances. In the US, it will be led by economic growth, low interest rates and rising inflation.
The fundamentals of the US economy look good due to a pick-up in the housing market, job market and shale gas production. With its budget deficit already on a downward path, the US economy will soon be reaching ‘escape velocity’. It holds surprises on the upside.
In contrast, Europe will remain caught in a vicious cycle, triggered by two contentious issues – austerity and reforms. Both are taking their toll on growth, jobs and tax revenues. Only Germany, the Netherlands and Sweden have avoided them. Europe’s will be a jagged recovery, fraught with policy errors and negative surprises.
After the 2008 crisis, emerging markets lifted the global economy. After the steep downturn in 2011, that locomotive role has fallen on the US. At around 2.5%, though, its economic growth will not be stellar enough to make a big dent in its own budget deficit.
That the US managed to avoid a double-dip recession despite the political hiatus around the debt ceiling and ‘fiscal cliff’ speaks of its inherent resilience. That it has yet to produce a long-term plan to reform its finances speaks of its continuing political paralysis.
When asked whether governments will be able to make significant progress in reducing their debts over the next three years, once again a trans-Atlantic divide emerged in our respondents’ assessment.
Responses for Europe err on the side of pessimism. Responses for the US err on the side of cautious optimism. Behind these numbers lie a number of salient points.
First, it took 20 years to build up the excessive leverage that caused the 2008 crisis.
It is too much to expect it to be rolled back within five years. The visceral populist anger against banks has made it ever harder to drive reforms that affect the general public. Elections, too, have got in the way of serious debates on spiralling welfare costs in the face of ageing populations.
Second, central bank action has prevented a global disaster. But it is no substitute for reform. Long before then, adverse demographic trends were having dramatic effects on healthcare, welfare budgets, labour markets and national competitiveness in all the OECD countries. The pre-occupation with the financial crisis has diverted policy attention from the important to the urgent.
Third, central banks have their own detractors. The current QE programmes of the US Federal Reserve and Bank of Japan are the biggest monetary experiments in history – possible outcomes range from a big economic turnaround to a 10-year flat line.
They have already succeeded in their early intent: to stimulate demand for risky assets.
Whether they will create a lasting ‘wealth effect’ that ramps up growth and jobs remains an open question. The conventional monetary multipliers appear less potent.
The feel-good factor is returning. But fear will continue to lurk in the background until monetary stimulus is complemented by supply-side reforms.
Personalisation of risk
There is no free lunch with the QE programmes. They require exceptional foresight and luck.
They have stretched relative valuations in favour of risky assets to create the ‘wealth effect’ that will boost the real economy, create new jobs and expand the P/E multiples. The green shoots of this multiplier effect are evident: more in the US than Europe.
But opinions differ: 40% of our respondents see QE as a tonic for reviving growth; 35% see it as inflationary. The rest see it as deflationary.
These numbers mark an improvement on our 2012 survey. But their message is clear: barring a sudden improvement, investors see themselves in a new era in which their expectations about growth, inflation and returns have to be reassessed.
Investors expect bond yields to remain low at least until 2015. Low yields can fuel equity markets, but they can also presage deflationary outcomes. In any event, equity valuations are expected to revert to their fundamentals, as successive rounds of QE generate diminishing outcomes.
As a result, high returns will no longer be essential. Investors will adopt eclectic approaches to target multiple investment outcomes.
Two sets of data points from our survey make sombre reading. First, only 33% of DB plans worldwide have a funding level in excess of 100%. Under-funding remains widespread, despite rallies since 2011.
Second, the annual investment returns (net of fees) required for DB plans to stay open look decidedly unrealistic. The majority need to have returns in excess of 6.5% – a tall order based on the last decade’s experience. Today, it’s hard to get anything in excess of 5% without invoking the three dirty words in investment lexicon: leverage, shorting and derivatives.
Thus, the pension promise will have to be rewritten in this decade. The promise was easy to make but hard to keep. It will be downsized.
The closure of DB plans will accelerate in all the pension markets due to a double squeeze: low discount rates on the liability side and low returns on the asset side.
Schemes will be closed to new members as well as to existing ones. Capital injections will become inevitable in order to retain plan solvency. In return, member benefits will be scaled back.
Retirement age will continue to rise in line with life expectancy. Risk will be shared between sponsors and their employees, with the imminent rise of defined ambition plans.
In the private sector, the key aim will be progressive risk immunisation via liability-driven investing. In the public sector, it will be capital growth, enabled by taxpayer backstops.
These changes will be accompanied by an unprecedented switch to DC plans. They will hold the bulk of the global pension assets by the end of this decade.
Above all, pension plans will seek more effective ways of investing in this decade. Even in rock solid DB markets such as Canada, Japan and the Netherlands, the winds of change are evident.
The current debt deleveraging will rely on low real yield for the foreseeable future while politicians continue to kick reform further into touch.
When Chairman Bernanke’s ‘taper talk’ caused a nose-dive last June, the Richmond Fed President Jeffery Lacker came to his rescue with an alcoholic metaphor: “The Federal Reserve is not only leaving the punchbowl in place, we’re continuing to spike the punch.”
Markets rallied immediately. Pension investors are forced to walk a fine line between loose talk and prudent investing.
Nicholas Lyster is CEO of Principal Global Investors (Europe) and Amin Rajan is CEO of CREATE-Research
*Available from email@example.com