As a child playing football, I was told to look at my opponent’s belt buckle when going to make a tackle, so as to avoid head fakes. Well, market participants cheering yesterday’s inflation news might do well to heed this advice, as head fakes occur in the capital markets all the time. What would be the equivalent of focusing on the opponent’s belt buckle? In the inflation case, perhaps we should avoid the headline # of 8.5% and focus more attention on those components that continue to highlight significant inflationary pressures such as food and housing. Also, the 8.5% CPI number is still significant, as wages continue to fall substantially below that level at 5.2% YOY growth.
The graph below highlights the path that inflation took during the 1970s into the early ’80s. In August 1972, before Tug McGraw would famously chant “You Gotta Believe” in reference to the NY Mets going from bottom dwellers to the World Series, annual inflation would bottom at 2.95%. It would continue an unabated rise “peaking” 23 months later at 11.54%. Following that month (July 1974), the annual CPI would fall to 10.89% or -0.65% in one month – sound familiar? Did that occurrence represent the beginning of the end for inflation – NO! As August’s CPI quickly rebounded producing a 1.06% increase to an annual rate of 11.95%. Inflation wouldn’t peak until November of 1974 at an annual rate of 12.2%.
In an attempt to thwart these inflationary pressures, the US Federal Reserve would raise the Fed Funds Rate (FFR) to 16% by March of 1975. However, they would dramatically reduce the Fed Funds Rate in April down to 5.25%, as inflationary pressures were subsiding – was that action premature? Inflation would fall precipitously from that November peak in 1974 to a bottom in that cycle in December 1976. However, the low annual inflation # was still at 5.04%, or 2.5 times where the Fed would like to see inflation today. Regrettably, inflation once again took off eventually peaking at 14.6% in April 1980. However, despite increasing the FFR to a whopping 20% in the month prior to the peak, it would have to revisit that extraordinary level on several occasions during the next couple of years.
Where did inflation go following these unprecedented moves? Well, it didn’t plunge. In fact, it took 3 years and two months to finally have inflation post a number that began with a 2! Inflation would eventually bottom out at an annual rate of 2.36% in July 1983 before once again ascending. Market participants that believe a Fed Funds Rate of 2.25% will quickly extinguish our current inflation have not studied past cycles. One should realize that unemployment touched 10.8% in 1982! With current unemployment at 3.5% and annual wage growth of 5.2%, just how much economic activity will be tamped down by our current levels of interest rates? I suspect very little. Don’t let one month of “falling” annual CPI rates cloud your judgment. History suggests that we are in for quite the rollercoaster ride.
I look forward to these Monday updates but would prefer a bit more activity to get everyone excited by the progress being realized in the quest to secure the pension promises that are so important for our American workers. However, I can only report on what is actually happening at this time. That said, we had Local 966 Pension Plan file a revised application seeking Special Financial Assistance of $51.3 million for its 2,356 plan participants. The initial application was filed on March 31, 2022 and withdrawn for unknown reasons on July 15th. The PBGC now has 120 days to act on this revised application.
In other news, the PBGC announced last Monday, August 1st, that the Pension Plan of the Printers League – Graphic Communications International Union Local 119B, New York Pension Fund had its application approved for $90.6 million in SFA proceeds that will go a long way in securing the promised benefits for 1,213 plan participants.
We, at Ryan ALM, are working with a few pension plans that have or will receive SFA proceeds. We are still waiting to see how these plans and their consultants will react to the PBGC’s Final, Final Rules that permit the expansion of permissible investments. We still favor only using SFA proceeds to invest in bonds that would be used to defease the promised benefits (and expenses) chronologically from the next month’s benefits as far out as possible. I’ve modeled many scenarios using historic data and possible future returns with the newly expanded investments. I will be reporting in a separate post on those results, but I haven’t been motivated to change my opinion on how the SFA should be invested. More to come!
Yesterday, I produced the chart below with the intent to write a piece regarding premature recessionary fears. My premise was based on the fact that since 1970, recessions only occurred as unemployment rose/peaked. With today’s jobs report, I am more convinced that we will be saddled with inflationary pressures for longer without a corresponding recessionary environment. The calendar year 2000 is interesting as unemployment began to rise but given the low level of unemployment at that time, the economy never went into recession. Could our current landscape be foretelling a similar outcome?
Produced by Russ Kamp, Ryan ALM, Inc.
As for today’s news, it’s been reported that US employers added a robust 528,000 workers in the last month which far exceeds prognostications by a factor of 2Xs. Furthermore, these new jobs spanned many industries/sectors. As a result, the unemployment rate now stands at 3.5%, which is the lowest level of unemployment in the last 50 years. As has been reported numerous times, individual balance sheets have been improved since the flood of government stimulus beginning in 2020. Their spending may be shifting from goods to services, but they are spending nonetheless!
Bond investors that were anticipating a dramatic reversal in both inflation and interest rates may want to rethink that strategy given this news. As we’ve been reporting, US real rates are at historic lows providing “investors” with significant real losses after inflation. This news shouldn’t come as a shock. The US Federal Reserve has been showing its hand for quite some time that it would do what is necessary to tame the inflationary beast. We warned you on several occasions to not ignore the Fed. Caveat emptor!
It was announced earlier today that the Bank of England (BofE) has raised its key rate by 50 bps representing the largest increase since 1995. This marks the sixth consecutive meeting in which they’ve raised this rate, which now stands at 1.75%. This decision follows England’s June inflation reading of 9.4% (the US is at 9.1%). The aggressive pace of rate increases mirrors the U.S. Federal Reserve’s, but the magnitude has been slightly less intense, as the Fed Funds Rate currently sits at 2.25% to 2.50%.
In announcing this latest increase they also provided perspective on the future paths for both rates and inflation in stark contrast to the recent pronouncement by the U.S. Federal Reserve which stated that future “guidance” would be limited. BofE is anticipating inflation to eventually peak at 13.2% during Q4’22. They are also forecasting that Great Britain’s economy could suffer a recession for 5 consecutive quarters beginning later this year. However, that is not going to impact BofE’s decision to aggressively fight inflation, which mirrors the US Fed’s position that inflation poses a great threat and must be tamed even if economic growth is impacted in the short term.
It is fascinating to watch the market activity within the U.S. at this time, as investors seem sold on the idea that inflation has already been tamed and that rates will have to fall in the near term. The U.S. has not posted an inflation # yet that would indicate that inflation has peaked. Furthermore, the Fed Funds Rate is at 2.25%-2.50% which is at the low end of the normal range of 2% to 5%. In 1975, the Fed increased the FFR to 13% in July while inflation was still at 11.5%. The US economy would fall into recession later that year and the Fed aggressively reduced rates once again to 5.25% by April, but inflation remained elevated at >10%. This premature action would lead to the Fed eventually raising the FFR to 20% in March 1981. It wasn’t until 1982 that inflation eventually fell below 10%, but rates remained elevated with the FFR still at 20% in March 1982.
Given the history cited above, just how much economic activity will they have hampered with rates remaining this low? Remember, inflation peaked in early 1980, but interest rates didn’t begin to fall until 1982. If a similar pattern forms, bond “investors” will be sitting on huge negative real returns for quite some time. That is not a winning strategy!
Following the publication of yesterday’s post, I received several good questions including the following: “Have real interest rates (nominal rate minus inflation) ever been below -5%, let alone the current -7%?” It is a terrific question and one that should be on the minds of all investors. The simple and not surprising answer is not since at least 1953. We came close during the turbulent ’70s, but nothing to this extreme. With the most recent rally in Treasuries, the real rate for the US 10-year Treasury Note is – 6.22% as of 8:20 am on August 3, 2022.
It makes no sense to me and many others why the investment community continues to accept such a ridiculously low return on US government bonds given the inflationary environment that won’t likely collapse as quickly as it rose. Again, my premise is that 4 decades of falling US interest rates that culminated in historically low rates associated with the Covid-19 crisis have clouded our judgment and anchored us to believe that interest rates will remain low forever and ever. All one needs to do is look at the yield on the US 10-year Treasury Note for the 30 years prior to 1982.
One should also note that US rates kept rising into 1982 despite the fact that inflation peaked in 1980. Again, investors thinking that the US Fed has already accomplished its objective in curbing inflation by increasing the Fed Funds Rate to 2.25% – 2.5% are just kidding themselves. These rates remain near historic lows and likely remain stimulative to economic growth. Couple that fact with full employment and strong wage growth and it remains highly unlikely that the investment community will get their Christmas gift of a Fed providing easing early in 2023. As always, we encourage your questions and look forward to engaging with you in the near future.
We’ve been quite surprised by the magnitude of the moves in both US interest Rates (down) and US equities (up) since mid-June. In fact, July is one of only a handful of observations since WWII in which a -7.5% or worse monthly performance (June) was followed by a +7.5% or greater performance for US equities (as measured by the S&P 500). Those previous monthly gyrations have led to extraordinary returns 12 months out. But be careful not to jump with both feet into the water. False signals can be quite dangerous to one’s financial health, especially in light of the fact that each of those previous occurrences followed aggressive easing by the Fed. That isn’t about to happen anytime soon.
As the chart above highlights, 2022’s equity performance is revealing a pattern not too dissimilar from those of two recent significant market corrections earlier this century. In fact, the patterns are strikingly similar. It certainly seems to us that recent risk-off trades predicated on the belief that the Federal Reserve has actually accomplished its objective of taming inflation seem premature at best, if not just plain silly. The Fed has raised the Fed Funds Rate from effectively 0 to 2.25% at this time. They’ve indicated that another 0.75% increase in September is on the table, while not eliminating the possibility that additional increases might be necessary until they have tackled inflation. Yet, market participants are behaving as if we will see an immediate economic response to these recent increases off a historically low base causing the Fed to swiftly do an about-face. Do investors truly believe that the current interest rate environment is going to choke economic activity? Again, are we ALL collectively anchored with the concept of low rates forever?
In a blog post that we recently produced, the 1970s’ interest rate and inflationary environment took 10 years to unwind. Interest rates began that inflationary cycle in the low 3% range and it wasn’t until 1983 that they once again displayed a 3 before the decimal place. Today we started the day with all Treasury maturities with yields below 3% except for the 1-year T-Bill. That doesn’t seem like a level of rates that would keep most people on the sidelines. For those of us that remember buying our first homes with interest rates in the 11+% range of the early to mid-’80s that thought is almost laughable.
We’ve been encouraging the plan sponsor community to de-risk since last year’s fourth quarter. If you haven’t done so yet, the time is ripe to take profits now as we believe that this correction, due to significant inflationary pressures, is only in the second inning. We look forward to helping you accomplish this objective.
If it’s Monday, it must but ARPA update day! We are pleased to report that there was some activity last week as reported by the PBGC. Teamsters Local Union No. 52 Pension Fund, a Priority Group 2 Critical and Declining plan, refiled an application for SFA. This application is seeking nearly $82 million in Special Financial Assistance (SFA) for the 769 plan participants. They will hear from the PBGC by November 25, 2022.
In other news, Western Pennsylvania Teamsters and Employers Pension Fund and its 21,110 participants have been awarded $715 million in SFA. Congratulations to those members who will now see the reinstatement of benefits that were previously cut under MPRA.
To date, 41 plans have filed an application with the PBGC for SFA. Of those 41, 28 have received approval, and all but one of those have received the award totaling $6.7 billion. This remains a small sample of the estimated 200 plans expecting to receive roughly $80+ billion in ARPA proceeds. As a reminder, Priority Group 4 members were eligible to file beginning on July 1, 2022. None of those have filed an application as of July 29th.
We’ve recently gotten greater clarity from the PBGC in announcing their Final, Final Rules related to the ARPA multiemployer pension relief. Could we be getting closer to a resolution related to Delphi’s full-time employees and their pension benefits that were slashed as much as 70% following Delphi’s bankruptcy in 2009? Not all Delphi employees were treated similarly following the bankruptcy, as GM and the PBGC propped up the pensions of unions, but the full-time employees were subject to drastic cuts. The PBGC believed that they were following standard protocol in this matter, and subsequent court decisions supported those actions. However, the US House of Representatives in one of the recently rare examples of bipartisan support passed the Susan Muffley Act of 2022 by a vote of 254-175.
This Act would direct if passed by the Senate, the PBGC to recalculate and adjust each plan participant’s monthly benefits payment, apply the recalculation to previously made monthly payments, and make a lump-sum payment for any additional benefits based on the recalculation. These plan participants have been waiting a long time for a positive outcome. I suspect that many of these Delphi participants have unfortunately passed away during this lengthy process. Let’s hope that the Senate, which has a bipartisan companion bill, takes up the legislation soon so that these plan participants can once again or for the first time enjoy a dignified retirement.
The Great Resignation, aka the Big Quit or the Great Reshuffle, has been raging on since early 2021. We have witnessed a tremendous migration of workers from one job to another. Commentators have identified many factors as to why workers have voluntarily left their jobs, including stagnant wages, deep dissatisfaction with their current roles, safety concerns related to Covid-19, and a desire to work remotely/hybrid work week. These trends don’t seem to be easing at this time. One of the ways to retain staff and reduce the cost of training new employees is to expand/enhance benefits in addition to wages in an environment of significant inflation.
I’ve written in this blog about how I believe (hope) that the Great Resignation, coupled with rising rates and the creation of pension income (first time in aggregate for the past two decades), might be enough to encourage corporate plan sponsors to re-open frozen defined benefit (DB) pension plans. Define contribution plans which have become the dominant “retirement” savings vehicle are inferior to DB plans as they are dependent on the individual’s ability to fund, manage, and then disburse a benefit for the remainder of their lives – no easy task given the lack of financial resources/training/experience!
Well, it appears that at least one firm may not have gotten the message. Boeing Company is facing a possible August 1st strike involving roughly 2,500 St. Louis area union employees from District Lodge No. 837, International Association of Machinists and Aerospace Workers, AFL-CIO. This union saw its DB pension frozen in 2016 as a result of a 2014 contract negotiation. Boeing is willing to match up to 100% of the first 10% contributed by employees, but as part of the negotiation, they are REDUCING their automatic employer contribution from 4% to 2%. So, in an environment of high inflation where wages for many Americans fall short of covering their monthly expenses, Boeing is further reducing retirement benefits. Do they really believe that the average American worker has the financial wherewithal to take advantage of their “offer” to match greater contributions?
The hiring and training of new workers can be very expensive and time-consuming. Putting in place enhanced benefits, including retirement, that encourage valuable employees to remain at their current place of work seems like quite a reasonable trade-off. The fact that rising US interest rates make the present value of pension liabilities cheaper while also possibly producing pension income is a bonus. DC plans are a terrific supplemental retirement benefit. They were never intended to be anyone’s primary source of retirement income. Perhaps US employees, if not their employers, are finally waking up to this fact.
I was extremely pleased to read Bridgett Hickey’s recent FundFire article, “Pensions Return Expectations Fall Below 7% for First Time” in which she writes that the average public pension plan return on asset (ROA) assumption “has dropped below 7% this year for the first time in U.S. pension fund history.” I can’t speak to what ROAs looked like from the 1950s to 1981 when I first entered the industry, but it is the first time that I can recall seeing ROAs so reasonably low. I’m thrilled that most plans haven’t extrapolated linearly from the most recent performance period and projected those results well into the future. Given 2022’s results to date, it appears that public pension funds were quite prescient.
According to an Equable Institute survey of 167 statewide plans and 61 municipal plans, the average ROA is now 6.93%, which is down significantly when it was 8% as recently as 2001. This trend is further supported by data from the National Association of State Retirement Administrators that showed the average assumed rate of return was 6.99% in March. Despite the progress to reduce annual return expectations there remain 21 plans that have a 7.5% or greater objective according to Equable. It isn’t a seamless task to reduce the ROA as it impacts annual contributions (and budgets), which rise when the discount rate is reduced. But, contributing more, if possible, reduces the uncertainty around achieving a return target that comes with considerable volatility.
It would be wonderful if this lower return target also came with a rethinking related to asset allocation. We’d highly recommend bifurcating the plan’s assets into two buckets – liquidity and growth. The use of a cash flow matching bond program to meet liability cash flows enables the growth portfolio to grow unencumbered as it is no longer a source of liquidity. Having this extended investing horizon reduces the variability of returns longer-term and enhances the probability of success. As we migrate through a very uncertain investing horizon fraught with high inflation and rising rates, gaining a little certainty with regard to enhanced asset cash flows to meet liability cash flows is very comforting.