Debt

Add the Dutch to the $15.8tn pension shortfall

Negligence. No other word for it. Unrealistic assumptions coupled with a race to the bottom on interest products has meant the top 20 nations have a $15.8 trillion unfunded liability in pensions. CM wrote of the crisis awaiting US public pensions a while back.

It seems the Dutch are the latest bunch of pensioners to reach for the pitchforks at the prospect of having their retirement severely cut back. Shaktie Rambaran Mishre, chair of the Dutch pension federation (representing 197 pension funds and their members), said contributions might have to rise by up to 30% over the next few years to ward off the prospect of having to cut the pensions of 2 million retirees. That will go down a treat.

Zerohedge noted the lower Dutch risk-free rate is not low enough, and as a result about 70 employer-run pension funds with 12.1m members had funding ratios below the statutory minimum at the end of September, according to the Dutch central bank. And here lies the rub: if funds have ratios below the legal minimum for five consecutive years or have no prospect of recovering to a more healthy level, they must cut their payouts.

Can you imagine all of the Dutch who were looking forward to taking a round the world cruise to celebrate 40 years of hard work to face the reality that they’ll only be able to take a cruise down the Amsterdam canals.

This is an utter disgrace. You’d have to be asleep at the wheel as a regulator not to recognize expected returns on funds were so unrealistic as to beggar belief. Actuarial accounting lets you get away with it.

Yet the evil pensions funds will be the villains even though the supervisor left these children alone with a box of matches. Just watch them come home and act surprised that the house has burnt down.

We’re getting a taste of the remedy from the State of Illinois. It is issuing bonds specifically to help plug the gap. Rhode Island has gone the other way – take a 40% haircut or risk having nothing. Way to go!

It is worth factoring the longer term risk of the fall in consumption that this will ultimately have if even a slither or $16tn is no longer recycled into the economy.

Another Chinese bank bailed out

Harbin Bank, a 622 billion yuan (US$90bn in assets) juggernaut in the country’s north became the fifth bank – after Baoshang Bank, Bank of Jinzhou, Heng Feng Bank, and Henan Yichuan Rural Commercial Bank – to be bailed out by the Chinese state.  As can be seen above, the trend of confidence shown by the markets over recent years is waning – fast.

According to Zerohedge, “as was the case with at least one previous bank “rescue”, Harbin Bank was connected to a former oligarch who disappeared not that long ago amid allegations of massive fraud..”

ZH goes on, “Another curious fact: a little over a year ago, Harbin Bank, which in March 2018 had abandoned plans to list its shares in China, announced it would raise over $2 billion in perpetual bonds to replenish its capital after regulators in early 2018 allowed lenders to sell such instruments to bolster their balance sheets. Incidentally, a perpetual bonds is effectively the same thing as equity, but for some bizarre reason sells much better in China where the investing population is apparently stupid enough to be fooled by the clever change in designation. As such, Harbin Bank was the first Chinese lender to announce its intention to sell perpetual bonds to increase its Additional Tier 1 (AT1) capital. We now know what prompted the bank’s rush.”

According to Bloomberg,

Chinese banks reported 2.2 trillion yuan (US$315bn) of non-performing loans at the end of June, which, according to the China Banking and Insurance Regulatory Commission (CBIRC) is the highest level in over 15 years…Troubles facing Guangdong Nanyue’s biggest shareholders may also add to its woes. Neoglory Holding Group Co., which is going through a court-led bankruptcy restructuring after defaulting on its bonds, is the largest shareholder of Guangdong Nanyue with a 16.52% stake, followed by Gionee Communication Equipment Co., which is in liquidation, according to a report published by China Lianhe Credit Rating in June. The two hold a combined 25.4% stake in the lender.

Note in recent times, Baoshang Bank was taken over by the government in May and the Bank of Jinzhou was rescued in July.

We shouldn’t forget “special mention” loans which are not classified as NPLs but potentially at risk of becoming so (equivalent to being 90+ days in arrears), rose to 3.63 trillion yuan (US$521bn), accounting for 3.3% of the total loan volume for commercial banks according to the CBIRC.

Nothing to see here? This doesn’t even include the issues of the shadow bank lending market. The one thing to be sure of is that is likely far worse than the official figures. Peer-to-peer lending ran at around $1 trillion but shonky practices has meant more than 80% of China’s 6,200 P2P platforms ended up shutting or faced serious difficulties. Only 50 were expected to pass scrutiny to continue to operate but the government, keen to revive the slowing economy, has looked to ease restrictions again.

The irresponsibility of socially responsible investing

United Nations Sustainable Development Logo

Socially Responsible Investment (SRI) has been heavily pushed by members of the Australian Council of Superannuation Investors (ACSI) for a while now. Apart from cynically cashing in on the generally higher fees generated by these “woke” funds, the returns have been nothing much to write home about. As Milton Friedman once said, “One of the great mistakes is to judge policies and programs by their intentions rather than their results.

If we look at YTD, 1 or 10-year performance all of the SRI portfolios as indicated by published performance (listed on their websites) of local ACSI members, they have “underperformed” the benchmark index. One outperformed in the 5-year category. Hardly anything to crow about. So as much as they might feel warm and fuzzy for turning these funds into virtue-signalling investment vehicles, the outcomes for the monies entrusted to them is far from ideal. While investors should bear ultimate responsibility for where they deploy retirement funds, do they realise how much money they are torching by believing in this nonsense?

So why do these funds try to bully top-performing companies to conform to their irrelevant ideals which on the face of it do not appear to be working? If one reads through the fine print, many superannuation administrators pat themselves on the back that they are aligning portfolios to the United Nations Sustainable Development Goals (SDGs). If one wants to champion best in class ethics, the UN is the last place anyone should look. Just look at the unethical scandal that occurred at UNAIDS. 

It doesn’t take a rocket scientist to work out what these SDGs are – eliminating hunger, wiping out poverty, promoting gender equality, good health, clean water and sanitation, affordable clean energy etc. All wonderful things in and of themselves, but surely if the market agrees with them,  shouldn’t share prices reflect that?

Friedman spoke of free-market economics, “Well, first of all, tell me: Is there some society you know that doesn’t run on greed? You think Russia doesn’t run on greed? You think China doesn’t run on greed? What is greed? Of course, none of us are greedy, it’s only the other fellow who’s greedy. The world runs on individuals pursuing their separate interests. The great achievements of civilization have not come from government bureaus [including the UN]. Einstein didn’t construct his theory under order from a bureaucrat. Henry Ford didn’t revolutionize the automobile industry that way. In the only cases in which the masses have escaped from the kind of grinding poverty you’re talking about, the only cases in recorded history, are where they have had capitalism and largely free trade. If you want to know where the masses are worse off, worst off, it’s exactly in the kinds of societies that depart from that. So that the record of history is absolutely crystal clear, that there is no alternative way so far discovered of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by the free-enterprise system.

In Australia,  it would seem that many high performing companies, that aren’t ‘compliant as they should be‘, are being pressured to increase diversity, women on boards and all manner of meaningless benchmarks preached by the ACSI and its members.

Take the 30% Club which pushes to have 30% women on boards. While this started in the UK in 2010, it has spread across multiple jurisdictions including Australia. The 30% Club emphatically quotes from a McKinsey study,  “Companies in the top quartile for gender diversity on their executive teams are 21% more likely to experience above-average profitability than companies in the fourth quartile.” What this study doesn’t say is that the bottom quartile of companies maybe just poorly run, in spite of the genitalia of the board.

Don’t mistake the most important point to be made. If a board is best served by all women, you won’t hear a peep from investors if they can produce the best results. As soon as we start to try to enforce gender quotas, performance becomes predicated on chromosomes rather than capability. What next? Ensure fair representation of LGBT on boards? Religions? Races? Disabilities? Where does it stop when all that matters is ability that produces performance?

Take a look at the disaster that has befallen PG&E in recent times. In the interests of pandering to all these irrelevant SDGs, it can tell you the exact breakdown of the diversity of its workforce but can’t tell you the status of much of its infrastructure, some which have been directly responsible for the devastating wildfires in California. The company was forced into Chapter 11 bankruptcy. Did diversity help shareholders? If one’s house is on fire, do we worry about identity? Or who has the skillsets to put out the blaze the fastest? QED.

Yet our woke investors keep pushing these trends. IFM Investors waxes lyrical about its climate change, 30% Club and carbon disclosure project. Good for it. It has a choice. It should live by the sword and die by it. If that is what it wishes to focus on why not allow the free market to; a) decide whether superannuation holders want to deploy funds in such a manner and b) let corporates decide if SRI is good for their businesses.

Yet, the latest push by these socialist fund administrators is to ensure that companies conform to the ‘Modern Slavery Act.’ Are these people for real? Who are they to try to enforce federal law? Talk about self-imposed authority. It is a safe bet that 99%+ corporates listed on the ASX behave are compliant in this regard because if not the punitive outcomes will be severe.

Moreover, if some of these funds own stocks like Tesla in their international portfolios, perhaps they might consider such a hip and trendy investment has an indirect connection to child-slave labour in DR Congo where 70% of the world’s cobalt is mined to go into the Li-ion batteries.

There is one absolute truth in finance. In good times, any mug CEO can be successful. It is only when markets turn sour that the “quality” of decent management is truly appreciated in how they successfully manage to mitigate risk in an ugly downturn. In a difficult market climate, only the fittest survive and if companies have strayed off the reservation to appeal to investors, it will soon become self-evident in the results.

As we stare at the precipice of a potentially deep global recession, the previous paragraph will be all that matters. Because those corporates too busy hitting diversity targets, installing genderless bathrooms and ensuring they have double-checked all employees have complied with Earth Hour will be slaughtered when markets take a pounding.

These SDG focused funds will soon see that they are part of one giant herd and as performance starts to suffer in this crowded trade, the stampede toward the exit will reveal just how irresponsible the push to ram through such irrelevant metrics at the very companies who caved in was.

As a contrarian investor, the best investments will be in exactly those companies that shun(ned) this foolhardy exercise and forged a path in the spirit of Milton Friedman. Afterall they understood what it really means to be “free to choose.” So back up the truck in tobacco, mining and fossil fuel stocks on any pullback. After all, mean reversion will see these stocks outperform if nothing else.

Don’t forget Harvey Norman (HVN). How could it be that the company is worth 4x the combined value of Myer and David Jones, the latter two businesses focused on pleasing the United Nations rather than customers?  Hmmm.

Isn’t that the ultimate ready reckoner for these SDG funds? The market is always right. If the performance of the funds deployed isn’t making the grade, don’t attempt to force the best of breed to comply to your self imposed standards. Embrace companies that follow their lead. Not the other way around. It begs the question, what on earth are people who should believe in free markets doing to thwart it functioning efficiently?

Perhaps investors have the clearest indication of socialist activism by the very requirement to join the club. “ACSI drives strong ESG performance in companies in which our members invest because ESG creates long-term value…We use our collective impact to influence companies and financial markets in the interests of our members as long-term investors…Commitment to these beliefs is a pre-requisite for membership of ACSI.

Never has it been a more sound decision to set up an SMSF.

How Gold is made

Take a nerdy 5 minutes to see how gold is made. This was at Sovereign Hill in Ballarat, Victoria. The same 3kg bar has been smelted 90,000 times. No changes to purity whatsoever. Maybe that’s why it has long been regarded as hard currency for over 5,000 years.

Japanese consumer confidence waning as consumption tax hike starts tomorrow

Japan consumer confidence.png

As the 10% consumption tax rate kicks in from October 1 in Japan from the current 8%, it is worth reflecting on the sorry state of consumer confidence. We are back below 2014 levels. While the sales of Japanese rugby jerseys and huge consumption of beer by gaijin at the Rugby World Cup may provide a brief respite, the trend remains distinctly negative.

Note that consumption tax has been the biggest portion of government revenue since 2014 and is on track to be 37% of the total in 2019, followed by individuals and the lazy corporate sector. Japan’s small-medium enterprises (SMEs) are the backbone of employment, comprising 70% of the labour force and 97% of all corporations. Yet 70% of SMEs pay no tax at all.

From an individual level, the top 0.7% of earners in Japan pay 30% of the tax bill, up from 20% in 1974. The bottom 50% have seen their tax contribution fall from 10% to around 2.8%. The top 8% pay around three-quarters of the total.

With Japan running a ¥100 trillion (US$1tn) national budget, the Ministry of Finance needs to sell ¥40 trillion (US$400bn) every year to plug the budget deficit.  The hope is that the consumption tax will lower the dependence on having to debt finance to such extremes.

More public pension roadkill ahead

CM has been writing about the public pensions crisis in the US for years. This chart only serves to highlight that the problem doesn’t seem to be getting any better. It seems in Illinois, 200 of the 650 public pension funds out there have more beneficiaries than active workers contributing to the fund. By 2021 this is expected to be half of all public pension funds in Illinois.

ZeroHedge noted,

The value of all future pension promises to be paid out to public safety workers totalled just $320 million in 2005. By 2017, that number had jumped to nearly $600 million. That’s a jump of over 80% or more than three times the pace of inflation.

It’s the main reason why taxpayer contributions can’t keep up with pension costs. Pols are doing nothing to control the growth of promises to be paid, sticking taxpayers with ever-increasing costs and ratcheting up the likelihood the pension plans will fail…

… In 1987, municipalities owed a total of $2.6 billion in benefits earned to active and retired public safety workers across the state. Today, that number has jumped to more than $23 billion. That’s a jump of nearly nine times.”

Don’t forget what the Illinois Police Dept did several years back. IN June 2017 CM wrote,

“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) wroteAt 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 year…Fund 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.”

What have the police been doing? Retiring early and cashing in their pensions to avoid the inevitable.

The problem for Illinois is that a taxpayer-funded bailout is all but impossible. The State of Illinois ranked worst in the Fed study on unfunded liabilities.  The unfunded pension liability is around 24% of state GDP. In 2000 the unfunded gap to state revenue was 30% and in 2013 was 124% in 2013. Chicago City Wire adds that the police fund isn’t the only one in trouble.

“Chicago’s Teachers Union Pension Fund is $10.1 billion in debt. Its two municipal worker funds owe $11.2 billion and its fire department fund owes $3.5 billion…All will require taxpayer bailouts if they are going to pay retirees going into the next decade…Put in perspective, the City of Chicago’s property tax levy was $1.36 billion in 2017…Paying for retirees “as we go,” which will prove the only option once funds run dry, will require almost quadrupling city property tax bills…Last year, it would have required more than $4 billion in revenue– including $1 billion for City of Chicago workers, $1.5 billion for teachers, and $1.5 billion for retired police officers and firefighters.”

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 flavour. 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.

In order for states and local municipalities to overcome such gaps, they must reorganise the terms. It could be a simple task of telling retiree John Smith that his $75,000 annuity promised decades ago is now $25,000 as the alternative could be even worse if the terms are not accepted. Think of all the consumption knock-on effects of this. I doubt many Americans will accept that hands down, leading to class actions and even more turmoil.

Did CM mention gold?

Joe Nation’s Pension Tracker is a really good website to look at the actuarial setting of pensions against the marked-to-market unfunded liabilities. Have a stiff drink handy before you open up.

The Grim Repo

What a surprise to see markets show little reaction to the negative repo (repurchase agreements) market in the past week. So much nonchalance and complacency remain in financial markets. It is as if there is this false belief that the authorities can keep the ship afloat with magical modern monetary theory. Not a chance. The tipping points in the financial markets are quantum levels bigger than any that Sir David Attenborough could conjure up in his wildest pessimistic dreams. If we want to cut carbon emissions, the coming economic slump will take care of that.

On average there are $1 trillion of overnight repo transactions every day, collateralised with US Treasuries. Yet many missed that the repo market seized up late last week. Medium-term repos surged from the normal band of around 2.00~2.25% to around 5.25% on Monday. Some repo rates hit 10% on Tuesday.

Essentially what this said was that a bank must have seen that it was worth borrowing at an 8% premium overnight in return for pledging ‘risk-free’ US Treasuries at 2%. In any event, it allowed that particular bank to survive for another day. Banks use the repo market to fund the loans they issue and finance trades that are executed. It is like an institutional pawn shop.

Looking at it another way, why weren’t other banks willing to lend and take an 8% risk-free trade? A look at the global bank’s share price action would suggest that these bedrock financial institutions that grease the wheels of the economy are not in good shape. We just pretend they are. We look at the short term performance but ignore the deterioration in underlying balance sheets. The Aussie banks are future crash test dummies given the huge leverage to mortgages. As CM has been saying for years, the Big 4 risk whole or part nationalisation.

This recent repo action is reminiscent of that before the GFC. The Fed stepped in with $75bn liquidity per day to stabilise markets by bringing rates into the target range. The question is whether the repo action is a short-term aberration or the start of a longer-term quasi QE programme which turns into a full-blown QE programme.

The easiest way to look at the repo market action is to say the private markets are struggling to be self-funding, requiring central bank intervention. Bank of America believes the Fed may have to buy upwards of $400bn of securities to back the repo market this year alone.  This is another canary in the coal mine.

CM wrote a long piece back in July 2016 titled, “Dire Straits for Central Bankers.” In that report, we described how the velocity of money in the system was continuing to drift. As of now, central banks have printed the equivalent of $140 trillion since 2008 but have only managed to eke out $20 trillion in GDP growth. That is $7 of debt only generates $1 of GDP equivalent.

This is the problem. Companies are struggling to grow. US aggregate after-tax profits have gone sideways since 2012. We have been lulled into a false sense of security by virtue of aggressive share buyback programs that flatter EPS, despite the anaemic trend.

Despite the asset bubbles in stocks, bonds and property, pension funds, especially public sector retirement schemes, are at risk of insolvency given the unrealistic return assumptions and nose bleed levels of unfunded liabilities in the trillions.

Also worthy of note is the daily turnover of the gold derivatives market which has hit $280bn in recent months, or 850x daily mine production. This will put a lot more pressure on the gold physical market and also to those ETFs that have promissory notes against gold, as opposed to having it properly allocated.

We live in a world of $300 trillion of debt, $1.5 quadrillion in derivatives – until this is expunged and we start again, the global economy will struggle. That will also require the “asset” values to be similarly wiped out. Equity markets will plunge 90-95% relative to gold. That suggests a 1929 style great depression. The debt bubble is too big. Central banks have lost control.

Buy Gold.