Pension Funds Flight to Safety Skews Market?
Take some pity on the pension fund managers of northern Europe.
They're not facing deep cuts in their own pensions like retirees in Greece, but they are struggling to cope with an unprecedented drop in interest rates as investors flee weak euro zone countries and pile into safe-haven bonds.
Spooked by the euro crisis, investors are so concerned about the return of their money, rather than the return on their money, that Denmark has become the latest country to be paid for issuing debt.
A sale on Tuesday of 2-year notes produced a negative yield of 0.08 percent. Denmark, which is not a member of the euro, last month sold inflation-linked paper at a negative yield, but this was a first for an auction of debt bearing a nominal coupon.
Investors paid Switzerland, too, for the privilege of buying its debt on Tuesday. The governments of Germany and the United States have also been able to fund themselves with short-term paper for free.
While the likes of Spain and Italy can only marvel at the Danish government's good fortune, the market dislocation is giving the pension industry a headache. Falling interest rates pump up the present-day cost of meeting pension promises, forcing pension funds to buy ever more bonds to meet these future liabilities.
The feedback loop is another illustration of how the euro zone debt and banking crisis has exposed interlinkages that the architects of monetary union never anticipated. The mutual dependency of heavily indebted governments and their equally indebted banks is the most powerful example.
Alarmed by the unfolding risks, Denmark this month joined Sweden in trying to slow the stampede by allowing the country's pension funds to increase the discount rate they use to calculate their liabilities.
"You don't want your pension system chasing yields all the way down to zero because that would basically bankrupt everyone," said Steen Jakobsen, chief economist at Saxo Bank in Copenhagen.
Finland and the Netherlands have taken similar steps so that pension managers are not compelled to sell equities in order to devote an ever-greater share of their portfolios to long-term fixed-income securities.
SAYONARA, EUROPEAN GROWTH?
Governments intervene in markets at their peril.
But Juan Yermo, the Organisation for Economic Cooperation and Development's leading pensions expert, said the four countries were justified in concluding that bonds are temporarily mispriced because of the euro zone crisis.
"Regulators are there to provide long-term countercyclical thinking, so basically they're doing the right thing," Yermo said. "If you were to apply the strict methodology of risk-based solvency requirements, many of these funds would be under water and would be forced to be even more conservative than they are."
Yet what if the markets are right? Leaving the euro zone's woes to one side, what if economic growth in Europe has moved to a permanently lower trajectory because of weak productivity and ageing populations?
What if, in short, Europe is about to follow Japan on a long path of economic stagnation where low interest rates are the norm? Twenty years after Japan's own bubble burst, ushering in a banking crisis, its 10-year government bonds yield just over 0.8 percent.
"This is a scenario that is somewhere in the back of the minds of policymakers. It is a possibility. It is not something that can be discounted," Yermo said. "Clearly, in terms of growth prospects, ageing should certainly bring down growth rates compared to what we've had in the past."
The economic backdrop is certainly not propitious.
Southern Europe would need to double its 0.7 percent annual productivity growth of the past 20 years or see GDP growth per head decline, the McKinsey Global Institute said in a report last week.
JP Morgan puts Spain's growth potential at just 2 percent a year. Goldman Sachs says countries on the fringe of the euro area have moved from a structural upturn preceding the crisis to a ‘structural slump' in its aftermath.
"The combined level of output in the peripheral economies (Greece, Ireland, Portugal, Italy and Spain) is 7 percent below its 2008 peak. Our downbeat message implies that a significant part of this output loss will persist into the medium term," Goldman economist Andrew Benito said in a note to clients.
WHERE TO PUT YOUR MONEY
Such an outlook seems tailor-made for bonds. But the danger, identified by the four northern European regulators, is of another feedback loop whereby rigid pension rules deter investments in riskier assets and thus, at the margin, make slower growth likely.
"The interest rates we have today are clearly out of line with long-term expectations so any regulatory adjustment that allows pension funds not to over-react is positive," Yermo said.
"It's going to allow them to think a little bit more long term and that's clearly positive for equities, for real estate, for infrastructure and for all the alternative asset classes that may carry a risk premium or a liquidity premium over the longer term."
The OECD's latest Pensions Outlook report, released last week, lamented that funded private pension schemes had an inflation-adjusted rate of return of a paltry 0.1 percent a year on average between 2001 and 2010.
That arguably constitutes yet another "doom loop" discouraging fund managers from switching out of bonds, which have vastly outperformed equities over the past decade.
But Jonathan Stubbs, European equities strategist at Citi in London, said the continent's shares were cheaper now, measured against the book value of companies, than they were in late 2008 after the collapse of Lehman Brothers.
And British and German equities have not been this cheap, relative to their domestic 10-year bond yields, in the last 100 years, Stubbs said. In short, a lot of bad news was already priced in.
"Valuations should be a reasonable support to share prices at these levels unless there is a global recession coming," he said on a conference call on Monday.
Jakobsen at Saxo Bank also expects equities, after a dismal decade, to outperform bonds as markets revert to mean.
As such, the moves by northern Europe's pension regulators, even if they are a forced response to the unanticipated repercussions of the euro crisis, could prove to be prescient.
"The bet is that, first and foremost, companies are able to go through even a low-growth environment better than governments," Jakobsen said.
There is no question about it, fear of systemic risk is driving bond yields of preferred nations to insanely low historic levels. The market right now is pricing in a long stagnation or deflationary cycle.
Why is the market pricing in such low growth or worse, deflation? I personally believe it all has to do with the policy mistakes being perpetrated in Europe. Mindless austerity has exacerbated an unemployment crisis and with joblessness on the rise, there is no growth and the risk of a protracted deflationary cycle grows.
There are other factors driving bond yields lower in Europe. The Telegraph reports new rules to be introduced by the EU could have "catastrophic" consequences to British company pension schemes. The Solvency II rules to "harmonise" schemes would affect all private sector companies offering defined benefit (DB) schemes in Britain and rest of Europe.
But the overwhelming factor driving bond yields lower is the uncertainty in the eurozone and the lack of direction on how they will tackle this crisis in an effective and permanent manner.
The market wasn't enamored with the Fed's decision not to pursue more quantitative easing yesterday but I agree with those who think this is a good thing. I also think that many pensions who remain overweight bonds are going to get a nasty surprise in the near future. Michael Gayed is right, most funds who are too conservatively positioned, will be chasing the reflationary melt-up.
Importantly, the biggest risk going forward is a market melt-up unlike anything you've ever seen before. This might sound crazy now, but when it happens, it will be violent and a lot of euro bears and market skeptics will be caught off-guard.
I remain long US banks and see many excellent opportunities in coal, copper, nat gas, oil and oil servicing companies, and solars. And for all you bond lovers, check out some high dividend paying stocks like Cliffs Natural Resources (CLF) and Conocophillips (COP). Ken Fisher and Warren Buffet didn't become top investors by following the herd.
We are at a point now where the men are going to be separated from the mice. Sure, eurozone leaders might screw it up and the world could come crashing down, but my money is betting that the power elite will do everything and anything to reflate risk assets and avert a long-term deflationary cycle. In such an environment, at the very least, investors must take some intelligent risk.
Below, Bloomberg reports that Chairman Ben Bernanke is signaling the Federal Reserve will probably add to its record stimulus should the economy fail to make sufficient progress in creating jobs for 12.7 million unemployed Americans.