Red Cross Pension Chasing Yield into Minefields

I happened to be going through the Red Cross audited financials this morning (this is not typical morning reading for me but I’m doing some due diligence on another matter).  Under the Notes to Financials I came across the organization’s pension assets breakdown and what I found was a bit shocking. Screen Shot 2016-05-25 at 7.20.52 AM More than half of the organization’s pension assets are level 3 assets.  For those not up to speed on the level 3 assets here is the definition from Wikinvest.

“Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign stock exchanges, foreign options and long dated options on gas and power). Level 3 assets trade infrequently, as a result there are not many reliable market prices for them. Valuations of these assets are typically based on management assumptions or expectations.”

Now I’m not an expert in ERISA regulations but I was surprised to see this allocation mix for the Red Cross pension assets.  My (limited) understanding is there are fairly strict guidelines and limitations on what portion of overall assets can be allocated to high risk investments; level 3 assets representing the highest risk on the risk continuum. However, as a portfolio manager one is under pressure to generate sufficient yield to sustain cash outflows (obligations) of the pension.   While historically PM’s could achieve 7% returns with quality corporate paper and Treasuries, today that is simply a pipe dream.  Currently the US 10 yr is at all time lows and has continued to decline since 2007, now yielding around 1.8%.  As interest rates declined from 2007 we can see the allocation shift from safe to risky assets by the Red Cross pension. Screen Shot 2016-05-25 at 8.21.24 AM Between 2007 and 2008 the Red Cross pension went from 14% of assets allocated to level 3 assets (nonmarketable & MBS) up to 28%.  By June 2009 they had lost 25% of total assets, which meant they had 75% of the assets to generate the same obligations but with interest moving to 0%.  The end result is the chase for yield with 53% of assets today being allocated to level 3 assets.  Why?  Because the obligations of the pension are essentially fixed but the returns are floating with Fed policy deteriorating risk adjusted returns.  And so it’s not really a matter of choice but a mathematical necessity for the PM’s managing the pension to look toward riskier assets for that same 7% return. And so we see how the Fed policies are directly responsible for ballooning the systemic risk in the financial and socioeconomic landscape.  Not just pensions but actual individual retirees are facing the very same dilemma.  That is, the cost to live is not something most have much control over.  And so because retirees had baked in a 5% to 7% return on their nest egg they must achieve that annual return.  This means for those lucky enough to still have a nest egg after the last two bubble crashes they are forced to venture further out onto the risk continuum.  Risk adjusted returns have deteriorated into negative territory in Europe (it’s the only way an investor would accept a loss going into an investment i.e. negative rates) and we are very close to that here in the US. But there must be some upside to the ZIRP policies to offset the almost unmanageable amount of resultant risk, right?  I mean these policies are meant to help the average American not hurt them, correct?? Screen Shot 2016-05-25 at 8.55.57 AM The above chart actually shows a decline in weekly earnings of the American worker. The next chart, however, shows just where the policies’ upside landed. Screen Shot 2015-11-06 at 8.46.47 AM Banks benefited most with 400% growth in income, followed by nonfinancial corporations with 280% growth in income but again with no benefit to the American working class incomes. So while risk to the entire system has ballooned by way of forcing pensioners (and all savers) to chase yield into the darkness as a result of the Fed’s policies over the past 8 years there has been absolutely no benefit to the American worker.  However, banks and corporations have reaped significant rewards.  And so I ask the PhD economists who have so gregariously supported the performance of the Fed for the past 8 years to explain just how these policies have helped the American people?  And Zandi, stating you don’t believe the data is not an argument suitable to a PhD.

Can You Solve This Riddle?

I recently wrote a piece about Bill Gross’s May Investment Letter.  In the letter Bill predicts a jobless society in the not too distant future suggesting technology will replace human labour at a lower cost.  Now to solve this problem Bill proposes the government implement a program of Universal Basic Income (UBI – an allowance for the citizenry to enable them to consume which will be paid for by government).  The point of my article was that capitalism (i.e. free markets) would never seek a jobless society.  It is only through socialism that investors can generate profits in a jobless society.  Without government subsidies investors are incentivized to optimize not minimize labour costs.  And that if Bill was proposing what he was proposing he doesn’t understand or believe in free market capitalism.

In short, the problem of a jobless society is not a problem unless we implement Bill’s solution to the problem.  Meaning it is only by way of the very solution proposed (UBI) that investors would seek a jobless society.  A truly government concept.

While most understood my point it seems the syllogism, to many, was lost in translation.  I’ve had an abundance of comments by Bill’s likewise faux ‘free market supporters’ explaining that preventing profit maximization by not allowing investors to replace humans with robots is akin to socialism and that we must allow the free markets to be efficient.  But I wasn’t suggesting preventing anything, only that a jobless society is an impossibility in a free market.  And so it was obvious to me I had done a poor job of clarifying my point sufficiently so that even the low hanging fruit could eat.   Therefore, given the immense significance of this subject currently, I’d like to take another stab at it by getting rid of the literary clutter from my article and really simplify the point.  It is an extremely important matter as it transcends into the concept of ‘free’ trade agreements (think NAFTA, GATT, TTIP &TPP) for obvious reasons.

Here is the same point from my earlier piece but without the clutter.

Solve this riddle.

A true free market exists with no government intervention.  So let’s assume no government exists and thus no government income subsidies of any form can exist.  The following then is a representation of a free market at work:

Investment requires profit, profit requires consumption, consumption requires income, income requires investment, investment requires profit….

Now explain, in a free market i.e. in a world with no government, how do investors profit if income (i.e. labour cost) is taken to zero?  (And remember with no government no additional public debt i.e. money stock or welfare can be created.)

Send a note to the Nobel committee if you come up with a viable answer.  You are a sure bet to win.

A second riddle…

If we are going to simply print money and hand it out with no expectation or means to pay it back, why would we not print enough to make everyone wealthy?

Socialism is not about equality, quite the opposite.  If it were Bill (and the ECB) would be discussing limitless debit cards paid for by the Central Banks.  Socialism is a mechanism to subsidize profits and cement control of the masses.

So to those that couldn’t get it on the first pass…. how do you like them apples?  Great.

Bill Gross’ May Investment Letter: The Scariest Thing I’ve Read In Years

A friend recently sent me Bill Gross’ May investment letter and I haven’t been able to stop thinking about for days.  Now one cannot deny that Bill is a highly intelligent man which is clear when reading his letters.  He thinks differently than most and that comes out between the lines.  But this latest letter has me more on edge than I normally find myself and for two reasons.  First is that I cannot decipher if Bill is actually championing what he is discussing or simply suggesting it is a stark reality that we must accept.  Second is that it reveals that even the likes of Bill Gross does not understand free market capitalism.

The gist of the letter was discussing the fact that technology is accelerating the replacement of human capital with software and machines.  It is a fact.  Bill rightly suggests that if this continues on course (which he believes it will) we will find ourselves in a jobless society.  He describes a future where jobs are no longer part of societal life.  Bill includes an excerpt from Andy Stern’s Raising the Floor,

“a policymaker – a future President or Prime Minister – must recognize that existing government policies have “built a whole social infrastructure based on the concept of a job, and that concept does not work anymore.” In other words, if income goes to technological robots whatever the form, instead of human beings, our culture will change and if so policies must adapt to those changes.”

To this proposition Bill then proposes a solution,

“What should the policy response be?  Retraining and education sound practical and are at the head of every politician’s promised ticket for the yellow brick road, but to be honest folks, I doubt that much of it will be worth the expense. Four years of college for everyone might better prepare them to be a contestant on Jeopardy, but I doubt it’ll create more growth; for the Universities perhaps, but not many good jobs for the students. Instead we should spend money where it’s needed most – our collapsing infrastructure for instance, health care for an aging generation and perhaps on a revolutionary new idea called UBI – Universal Basic Income. If more and more workers are going to be displaced by robots, then they will need money to live on, will they not? And if that strikes you as a form of socialism, I would suggest we get used to it”….

“The question is how high this UBI should be and how to pay for it, not whether it’s coming in the next decade. It is. Strangely, the concept is endorsed more by conservatives than liberals and in Silicon Valley as well. Even with a theoretical $10,000 UBI per eligible citizen, the cost of $1-2 trillion dollars is seen as an income pool to consume many of the high tech products they produce.”

When I first read this it quite literally sent shivers down my spine.  An anthology of futuristic Sci-Fi movies flashed through my mind.  Not only are we being bombarded with calls for criminalizing physical money – negating our natural rights to private trade and also to private wealth in the sense I can no longer bury my money in a jar in my backyard in preparation for a cataclysmic event – but now we are being told by highly respected financial minds that we need to accept a mandate of being placed on a government allowance program (Universal Basic Income).  The amount of which will be decided by a committee of government bureaucrats and corporate lobbyists ensuring it meets the needs for basic survival plus some sufficient amount of discretionary consumption (tied to QoQ earnings growth estimates, no doubt).  I can only imagine how proud Jefferson and Madison would be should they see what we’ve done to their American ideology.

Now once the initial shock of what was being proposed by Mr. Gross had worn off, the left side of my brain kicked in.  It struck me like a woman scorned that we have deviated so far from free markets at this point that even the top financial minds no longer have any understanding of what is meant by capitalism.  It must be true, for anyone who understands capitalism could never have published such a letter.  The logic in Mr. Gross’s argument is beyond invalid, in fact, it is so ludicrous it borders on insane.  I mean this quite literally.  Let me explain.

I have not only written about the fundamental law of capitalism that is the natural bond between profit and labour, I have provided both theoretical and observable quantitative proofs to the law.  In a nutshell it goes like this – Investors seek profit, profit requires consumption, consumption requires income, income requires labour, labour requires investment, investment requires profit.  If we allow each aspect of this circuit of capitalism to exist without manipulation then the perceived issue of technology replacing rather than complimenting human capital cannot occur.  It is impossible because each is a dependent and precedent aspect in the circuit.  If you weaken one you weaken all.  That (dependent/precedent) circuit is the mechanism by which capitalism (unmolested) naturally creates a balance across these paramtres such that each is optimized (not maximized).

The so called ‘Free’ Trade Agreements are an attempt to circumvent capitalism’s inherent optimizing mechanism for the objective of maximizing profit by weakening labour (and negating the higher risks associated with lower labour cost regions).  The technology problem being discussed by Gross and Stern (and others including Kevin Murphy, a MacArthur “Genius” Award recipient and my former Economics Prof from Booth Business School, in the latest issue of the school’s Alum magazine) arises from the very same objective of maximizing rather than optimizing profit.

Specifically, the problem is that of replacing existing labour with lower cost labour while at the same time expecting the consumer to remain strong, which is a necessary condition to achieve the desired goal of profit maximization.  Whether it’s poor farmers in China or robots replacing the American workforce it is the same issue.  And I recently discussed this problem in an article where I defend Trump’s trade policies. Tariffs on corporations that attempt to take advantage of labour arbitrage created by trade agreements (i.e. agreements that negate the inherent higher risks of the chasing the lower cost labour) simply build back in the inherent risk cost i.e. the tariffs re-establish the true free market costs.  However, the trade agreements, while offsetting the risk problem, do not offset the income problem.  That requires subsidies.

In the end whether by way of trade agreements or technology, maximizing profits by weakening labour and thus distorting the natural balance of capitalism requires a subsidy to the consumer.  This is not up for debate, it is not an argument, it is an absolute logical syllogism.  Period.  If you weaken labour but do not subsidize the consumer profits actually deteriorate and the maximization strategy will naturally revert back to capitalism’s natural process of optimization.  What this suggests is that optimal profit is also maximum sustainable profit.

So let’s take a look at the subsidization process required by the profit maximization strategy as corporations chase cheaper labour resulting in weaker consumers (by way of lower income).  The subsidy will look to replenish the lost consumption resulting from the consumer’s lost income.  The subsidized consumption becomes a conduit for subsidized profit which is the real and ultimate objective.  Yes, we are in fact, subsidizing corporate profits.

Now in theory we know the subsidies can come via welfare (synonymous to Gross’ proposed Universal Basic Income), credit and population growth.  Looking at the observable data we see the subsidies did come through consumer credit, welfare and population growth (i.e. 15 million (undocumented) immigrant consumers).  The following chart tracks the increasing reliance on welfare and credit for consumption.

Screen Shot 2016-05-12 at 9.17.18 PM

NAFTA was signed in 1993.  This chart depicts the proportion of personal consumption (PCE) that comes from consumer credit and welfare.  You can see that the amount of consumption being subsidized has increased by 40% since the inception of NAFTA.  In nominal terms this year PCE is $12.5T.  That means the growth in welfare and credit above the 1993 levels allowed for an additional $1.25T in revenues for corporate America this past year.

And so to summarize, if we remove the condition that subsidies are, as Bill Gross appears to be suggesting, a given within our system of ‘free markets’ then the problem he discusses in his latest letter is not in fact a problem.  This is why I suggest the logic that Bill is using borders on the insane.  The problem he describes is only a problem if you allow the solution he proposes to solve the problem he proposes.  The profit maximizing objective attempted via lower cost labour strategies (poor farmers or robots), is impossible if we simply reject the concept of subsidization.  Capitalism will naturally optimize each aspect of the capitalism circuit.

*And just to respond in advance to the die hard socialists, rejecting profit subsidies does not preclude social assistance for the purpose of real social assistance.