‘Investors are buying bonds for capital appreciation and stocks for income. The world has turned upside down… It is a poison brew that central banks keep serving us.’
— James Abate, Chief Investment Officer at Centre Asset Management LLC
‘Fears mount for pensions as gilt yields touch negative territory’
— Financial Times, 11 August 2016
‘Royal Mail set to close door on ‘gold-plated’ pension plan — Record-low interest rates add to fears’
— Financial Times, 11 August 2016
In the blind pursuit of making debt cheaper to keep the debt-dependent economic growth model in motion, central banks appear to have forgotten Merton’s Law of unintended consequences.
Actions always have reactions.
With negative interest rates, governments, and some high quality corporates, are now being paid to borrow money. This is plain dumb. But that’s the upside-down world we currently inhabit.
I say ‘currently’, as it defies logic to think negative rates are a lasting phenomenon.
Best guess is that it’s going to be one of those periods economic historians will file away under ‘insanity’, ‘desperation’ or ‘what the hell were they thinking back then?’
While some say economic pundits believe negative rates can become a permanent fixture, the logic fails the ‘smell test’.
According to a September 2015 IMF paper titled ‘A Strategy for Resolving Europe’s Problem Loans’:
‘European banks face significant challenges from their high levels of impaired assets. The global financial crisis and subsequent recession have left many countries with elevated levels of nonperforming loans (NPLs). NPLs in the European Union (EU) stood at about €1 trillion (or over 9 percent of the region’s GDP) at end-2014, more than double the level in 2009.’
Given the plight of Italian banks, it’s not a stretch to think the amount of non-performing loans in Europe could be even higher these days.
This is the definition from Investopedia of a non-performing loan:
‘A non-performing loan (NPL) is the sum of borrowed money upon which the debtor has not made their scheduled payments for at least 90 days. A non-performing loan is either in default or close to being in default.’
In the old days, we called these ‘bad debts’.
But in this upside-down world, calling things as they are is a definite no-no.
Why have non-performing loans doubled since 2009 (especially when interest rates — the cost of money — have been falling)?
Sorry, I can’t call it as it is. The official spin goes something along the lines of ‘sluggish growth’.
To put €1 trillion into perspective, it is roughly $1.5 trillion…which is pretty much the size of the Australian economy.
How did all these loans become non-performing?
Underlying economic activity did not produce sufficient revenues to fulfil loan obligations. You lose your job, or have your income reduced, or your business turnover slumps (deflates)…then you go to your bank and tell the [him/her/transgender/cross-dresser] bank manager ‘you’re up s**t creek without a paddle.’
90 days later, you are a non-performing loan statistics. Welcome to the club.
The bank is in a bind. Recovering its money is not that easy. The security offered is worth far less than the loan. Not only that, but if all banks started selling the assets behind the distressed loans, asset prices would be driven even lower. So the non-performing loans sit on the books…waiting.
Waiting for what? Economic growth. When the elusive growth does eventually appear, it’ll pick up revenues — incomes rise, profits increase, outstanding loan commitments can be repaid. The ‘non’ can be dropped, and performing loans become the order of the day.
Call me silly, but for growth to make a sudden and lasting appearance on the economic stage, I’d have thought providing people with an income to spend would’ve been somewhat crucial to that outcome. As I said, ‘call me silly’.
And that’s where the quotes and headlines at the start feed into this perplexing story.
The traditional bastion of secure income used to be the fixed interest bond…backed by ratings agency credit scores like AAA, AA+ and so on.
Pension funds — with obligations to pay employee pensions for decades to come — have traditionally invested in high quality bonds to provide a portion of the return required to meet those ‘written in stone’ obligations. Tens of millions of people are relying on their pension fund to come good with the promised payment each and every month during their retirement.
To meet these obligations, the pension funds have two options available — firstly, to generate a rate of return on current assets and/or secondly, where those returns fall short of the projected level, the employer is required to make up the shortfall.
This sounds simple enough, but with millions of fund members having varying life expectancies and differing pension entitlements, this creates a mathematical nightmare…especially with medical science increasing our life spans with every passing decade AND central banks decreasing the rates of return on offer from the traditional safe haven investment used by pension funds.
Which is why headlines like this…
‘US faces ‘disastrous’ US$3.4tn pension funding hole – Collective deficit of retirement plans is three times larger than official figures’ —Financial Times, 10 April, 2016
…and commentary like this…
‘Many well-known companies, including BT Group [British Telecom], the telecoms company, and energy businesses Royal Dutch Shell and BP, have pension deficits that run into the billions, according to LCP, the pensions consultancy.’ — Financial Times, 3 January, 2016
…are finding their way into mainstream reporting.
Pension funds (the primary source of retirement income for tens of millions of baby boomers) are woefully underfunded. The prospect of having the money available to meet these obligations grows dimmer each year.
Depending upon which report you read, the average pension fund, to fulfil its obligations, needs a return of between 5% and 8% PER ANNUM — that’s each and every year.
Government bonds paying MINUS rates of return obviously make achieving that projected return that much harder. Hence the headline — ‘Fears mount for pensions as gilt [UK government bond] yields touch negative territory’.
So where do pension funds go to achieve the desired rate of return? Shares, hedge funds, junk bonds, and private equity funds.
Given that each of these investment categories has a history of shredding investor capital, there’s the very real prospect that pension funds could find themselves sliding further down the greasy ‘rate of return’ pole…making their task of paying the promised pensions even harder.
The central banks have indeed served up a poisoned brew.
With millions and millions of boomer retirees faced with the prospect of lower retirement incomes, there’s no way the much sought-after economic growth is ever going to be realised.
Non-performing loans are going to fester on the banks’ books until the open sore can no longer be covered up with Band-Aid measures.
Failing banks will then need to be bailed out by shareholder capital, bond holders and depositors…all this shreds more investor capital.
The negative loop means pension funds then lose even more money on their bank shares, bond holdings and cash deposits. Pension payments are cut…and we repeat the exercise.
This upside-down world has sent a lot of blood rushing to the head of central bankers, denying them the ability to think and act with any clarity.
Which is why I think, after the next credit crisis, we’ll see some sort of permanent ‘helicopter money’ program introduced.
More unintended consequences are definitely in our future.
For Markets and Money