The anticipation of the “big game” impacts us all in a variety of ways. It appears to have distracted the PBGC, too, as little was accomplished last week as it relates to the implementation of the ARPA legislation to rescue struggling multiemployer pension plans.
There were no new applications filed with the PBGC seeking Special Financial Assistance (SFA) and no applications that were either approved or denied. However, there was one plan that withdrew its application. The Defined Benefit Plan for the Operative Plasterers’ and Cement Masons’ International Association Local Union 394 Pension Trust Fund (say that 10 times fast!), a Priority Group 5 plan seeking $6.9 million in SFA for its 464 plan participants, withdrew its initial application on February 7th.
In other news, the PBGC did announce last week that the window for Priority Group 6 plans, the last official “priority” window, has opened effective February 11th. As the chart below indicates, there are 14 Priority Group 6 plans that could potentially file an SFA application.
Finally, it is left to be seen just what the process will look like for the more than 200 unclassified plans that could potentially file an application with the PBGC to receive SFA for their struggling plans. Will the process be orderly or will it devolve into a free-for-all?
Could it be that the investing community is finally waking up to the fact that the US Federal Reserve is serious about combating inflation by raising the Fed Funds Rate well above the recent consensus? (see graph below) How many times do we need to hear Fed Governors mention that a great pivot is NOT about to happen in 2023? I’ve heard members of the FOMC indicate that the target FFR is 5.4% or higher. Why hasn’t that resonated with investors? I read just today that some members are even talking about 6% on the FFR. What a shock that must be to those investors that have just been hitting snooze on their alarm clock in anticipation that a little more sleep will help them get through their nightmare. Well, it is time to stop hitting snooze and wake up to the fact that inflation will not be eradicated anytime soon. The Fed mantra remains higher for longer.
Don’t panic plan sponsors of pension plans. Rising US interest rates are a positive development for your plans in terms of both liabilities and assets! With regard to your liabilities (promised benefits), rising rates reduce the present value (PV) of those future value (FV) benefit payments (and expenses). Those operating in the private sector certainly appreciate that fact as they are obligated to use market rates (ASC 715 discount rates) to value a plan’s liabilities. Unfortunately, the public pension ignores market rates and uses the ROA as its discount rate which is always a fairly steady positive growth rate.
With regard to the impact on the asset side, 2022 was a challenging year for most pension plans. But with rates rising, corporate bond portfolios are producing yields in excess of 5%-5.5%, which gets a plan fairly close to the target ROA with much less volatility than a traditional asset allocation. Furthermore, bonds are not a performance instrument in a rising rate environment, but they are a great source of cash flow (liquidity) to fund required benefits and expenses (liabilities). Use bonds to create a cash flow matching portfolio that defeases benefits and expenses chronologically from next month as far out as your bond allocation can go. The benefits are enormous. We explain all of them in various blog posts and research (White Papers) that can be found at Ryanalm.com. We are here to answer any of your questions. Please don’t hesitate to reach out to us.
It is understandable why the investment community still believes that the Fed will cut rates at some point during 2023. As I’ve mentioned many times that unless you are my age and in the business for 40+ years, you have always experienced the Fed stepping into the fray and providing support whenever markets became wobbly. That support was in the form of a reduction in the Fed Funds Rate (FFR). I would suggest that the Fed’s game plan is very different this time. Why? They have said so! Many times!
Yet, their proclamations seemed to have fallen on deaf ears. According to Neel Kashkari president and CEO of the Federal Reserve Bank of Minneapolis, the target rate for the FFR is 5.4%, and he said just this morning that they could go beyond that level depending on what continues to happen in the US labor market and with wage growth. 5.4% or more! Janet Yellen, US Treasury Secretary, stated yesterday that recessions don’t happen in environments with 500+K job growth, 3.4% unemployment, and 4.4% annual wage growth.
However, I read this morning in a Bloomberg email that the current inverted yield curve, which has been inverted for the last seven months beginning in July, would have to see 2-year yields snap down rapidly since the 10-year has never “uninverted” before by having its yield rise through the 2-year Treasury yield (6 previous observations). That might have been the case, but again, we’ve enjoyed four decades of an incredible tailwind provided by falling inflation and lower US interest rates. That scenario no longer exists. With the prospect of a 5.4% FFR, why would the US 2-year Treasury yields fall rapidly? Core inflation remains stubbornly high. Employment remains solid. Wage growth is providing workers with opportunities to demand goods and services. Where is the recession? It certainly doesn’t seem immediate. Given those conditions, where is the 2-year Treasury yield going other than possibly up?
Please stop looking at the last four decades of Fed policy as a clear indication of what they intend to do today. I was always taught to NOT ignore the Fed. The Fed has certainly been very transparent about the fact that they don’t see the FFR being cut in 2023. The FFR is 4.5%-4.75% today. The 2-year Treasury Note has a yield of 4.45%. The 10-year yield is at 3.65% (10:30 am). If the Fed achieves its current target for the FFR of 5.4%, is it truly realistic to presume that the 2-year Treasury yield is going to fall dramatically from its current level and get below the 3.65% 10-year Treasury yield? I believe that it is much more likely that the entire yield curve ratchets higher. Despite the Fed’s actions to date, little has been accomplished to get inflation (price stability) back to its 2% target. The US employment picture is just too strong for that to happen at this time.
At yesterday’s press conference following the release of the latest Fed Fund Rate (FFR) increase, Federal Reserve Chairman Powell was asked if he believed that financial conditions have eased, which would make the Fed’s job of combating inflation that much more challenging. His reply was somewhat shocking to me, as he said “no”. Really? The investment community has been aggressively buying US Treasury securities in the face of Fed tightening. How much? The US 10-year Treasury yield is currently 3.36% (9:15 am) having peaked at 4.25% just 3 months ago (10/24/22). That certainly seems like significant easing to me, and it isn’t relegated to the 10-year either, as the yield curve’s inversion has grown steeper.
As further proof of financial conditions easing, I share with you two charts. The graph on the left is from Bloomberg and the one on the right is produced by Goldman Sachs.
Bloomberg’s financial conditions reading shows easing when the line is rising, while Goldman’s highlights easing when the line is falling. Clearly, these two readings are in sync. Both measures are revealing considerable easing. Powell may not believe that conditions have eased, but clearly, economic growth is not being thwarted to any great measure. We still have an incredibly strong labor market environment with wage growth that may be moderating still showing 5%+ annual growth. Mortgage and auto loan rates have fallen by 1% or more from peaks achieved in the fourth quarter.
Again, Powell may not currently recognize the easing, but eventually, he’ll have to come to that conclusion. Powell and the Fed Board have reiterated their posture of further increases, yet those pronouncements are being ignored by the “STREET”. If in fact, economic conditions have eased (dramatically) the Fed may be forced to continue to raise the Fed Funds Rate aggressively until they actually achieve the desired 2% inflation rate. The investment community cheered Powell’s comments regarding the future path of smaller increases, and I believe that they still anticipate rate cuts before year-end. I just don’t see it and neither does the Fed. One of these entities (the Fed or investment community) will have significant egg on its face come December. How that translates into market performance is anyone’s guess at this point.
Yesterday was a strong day for the Nasdaq 100 index capping off an incredible January 2023. In fact, the WSJ is heralding this performance (+11.5% for the initial month of 2023) as the strongest beginning to a calendar year for the Nasdaq since 2001, when the index rose an amazing 14.2%. But wait! Didn’t that performance occur within a bear market environment (3/2000 – 10/2002) in which the Nasdaq 100 would eventually decline 83% from start to finish? Is this month’s performance the start of a bull market rally or a great month in the continuing saga of last year’s bear market in which the Nasdaq declined -32.5%?
Market participants have certainly cheered every anecdotal piece of evidence potentially indicating that inflation’s peak is long behind us. They fully anticipate that the Fed will soon come to their collective senses by stopping the Fed Fund Rate increases to be soon followed by an easing trend. If they are right, perhaps January’s strong performance will be only the beginning of a sustained rally, but what happens to equities, including the Nasdaq, if the Fed isn’t convinced and they continue to elevate rates? What happens if our current historically strong labor market doesn’t weaken? What if the current level of interest rates isn’t capable of thwarting economic activity? What if? What if? What if?
We are pleased to provide you with the weekly update on the PBGC’s progress in implementing the ARPA legislation. Last week witnessed seven multiemployer plans receiving approval for their SFA applications. In two cases, the Plasterers Local 82 Pension Fund and the Alaska Ironworkers Pension Plan, received approval for their initial applications. These Priority Group 2 funds, both MPRA Suspension eligible, were seeking $20.1 million and $50.4 million, respectively for their combined 1,061 plan participants. The other five plans received approval for supplemental SFA filings.
In addition to the seven approvals cited above, there was one application withdrawn, as the Composition Roofers No. 42 Pension Plan withdrew their initial application (9/30/22 submission) seeking $33.7 million for 495 participants. As we’ve seen in the past, these withdrawn applications tend to get resubmitted quite quickly.
There were no new applications submitted last week and none were denied. There remain 6 potential applications yet to be submitted among the 5 Priority Groups that are eligible to file. February 11, 2023, is earmarked as the starting point for Priority Group 6 applications. Once those applications have been filed, I’m anticipating that the potential 218 additional multiemployer applications will create an avalanche of activity for the PBGC.
It seems to us that the investment community is all in on the idea that inflation has been tamed and that a 2% CPI or PCE is right around the corner. But could this belief be setting investors up for another inflation shock? 2023 has witnessed strong rallies in both bonds and stocks driven by the belief that the Fed has pretty much accomplished its objective. Investors have been driving down yields across the yield curve since mid-October’s peak, and as a result, financial conditions have actually eased quite substantially, which we recently pointed out in our post titled, “Fighting the Fed – What’s the Implication. Falling US rates have led to a sell-off in the US $ relative to the Euro, Yen, and other major currencies.
In addition, gasoline is up nearly 6% so far in January, while copper (up 12%) and other commodities have seen strong rallies as the weaker $ and lower import prices combine to spur on demand. Furthermore, the historically strong labor market is encouraging folks to dine out more according to the OpenTable seated diners index which has been rising recently. Both rents and used cars have seen price increases since November. All of this taken together will likely make the Federal Reserve’s job much more challenging. So as my picture above depicts, will the market get its soft landing or will the investment community land squarely on its collective head? Are you prepared for a possible market reversal?
I believe that Pension America would be well served by adopting the SWAN strategy. These majestic birds embody a serenity that anyone would appreciate that has to deal with the uncertainty of the capital markets and the damage that they can create for plan sponsors of defined benefit pension plans. I have to believe that the asset consultants who serve these plan sponsors would also appreciate the SWAN strategy that enhances the probability of success while dramatically minimizing the volatility around potential outcomes.
What is the SWAN strategy? Simply put, it is a “Sleep Well At Night” strategy that Ron Ryan and Ryan ALM, Inc. (Cash Flow Marching) have been espousing for decades. How comforting would it be for the plan sponsor and their advisor(s) to know that no matter what happens in the markets- good, bad, and/or ugly -, the necessary liquidity has been secured to meet the promises to their plan participants for some prescribed period of time whether that be the next 5-, 7-, 10- years or more. Furthermore, in this period of great uncertainty due to rising US interest rates fueled by inflationary pressures, wouldn’t it be incredibly reassuring that the SWAN strategy isn’t impacted by changes in US interest rates, as a Cash Flow Matching strategy carefully funds (secures) the future value of benefits and expenses, which are not interest rate sensitive.
With so many benefits to help one sleep like a baby, why is CFM not being used more often? With bond yields up significantly, why aren’t pension plans adjusting their risk profiles to create an environment with a higher probability of success and less uncertainty? As plan sponsors have moved significantly more assets into alternatives, why haven’t they adopted a bifurcated approach to asset allocation that creates a liquidity bucket and a growth bucket instead of placing all their eggs in one bucket with a singular focus on the ROA? During periods of great uncertainty, such as the one we are currently living through, liquidity can become difficult to find, as all assets seem to correlate to 1. Having a bifurcated approach (liquidity assets and growth assets) to asset allocation ensures that benefits and expenses have been secured chronologically for a certain period of time (i.e. 5 to 10 years) until the allocation is exhausted.
Managing a pension plan should be like operating an insurance company or lottery system. You have an obligation (liability) that has been promised. Fund that liability with certainty and don’t rely on the markets and all of the uncertainty that comes with that to accomplish your objective. You will Sleep Well At Night (SWAN)!
2022 proved to be a very good year for active large-cap (LC) US equity managers relative to the S&P 500 even if few managers made money on an absolute basis. For the first time since 2009, a majority of LC equity managers outperformed. It has been a long-time coming, but it shouldn’t be surprising.
Chart from Strategas Securities
The outperformance is a direct reflection of portfolio construction biases inherent in most equity strategies. First, the S&P 500 is a capitalization-weighted large-cap index that is driven by momentum. For the past 10+ years, Technology stocks lead the market and thus the S&P 500. This sector concentration and mega-cap biases made it very difficult for the average equity manager to outperform given their more equal-weighted exposure. Few managers construct portfolios with a cap weighting preferring to invest more equally in their portfolios. This creates an average cap weighting that tends to be much smaller than the index. Furthermore, most US equity managers overweight Value as a screening tool choosing portfolio holdings based on some relative price comparison – P/B, P/E, P/CF, P/S, and/or P/FCF. Again, the S&P 500 is a fully invested, momentum-driven, capitalization-weighted index that will beat a significant majority of managers in rising equity markets that have been enjoyed nearly annually since 2009.
So what happened in 2022? Well, we finally had a market that favored both Value and small-cap. With regard to Value, the S&P 500 Value index declined -5.1% in 2022, while the S&P 500 Growth Index was down a whopping -29.4%. With regard to small cap, the magnitude of the outperformance was more muted, but it still contributed to the outperformance of active managers relative to the S&P 500, as the S&P 600 was down -16.1% versus the S&P 500’s -18.1%. More important, the equal-weighted S&P 500 was down only -11.5%. Furthermore, we have a declining equity market that favored any firm that had a cash reserve, even a small one.
When all three market influences present themselves, it isn’t surprising that a majority of equity managers will outperform. What is surprising is the fact that only 61.6% of managers did. This gets back to the problem of fees. Not only do managers need to beat the S&P 500, but they need to do that after fees, which can be a difficult hurdle given how modest an index fee can be (< 5 bps).
What is the probability that these trends persist? As the graph below suggests, the Growth vs Value “cycle” tends to be lengthy. In this case, Growth’s underperformance has just begun. If previous cycles are any window into the future, it appears that Value has much more room to outperform. If that’s the case, it may be time to shift to more active equity strategies.
Graph by Ryan ALM, Inc.
Did you take some profits from your Growth manager(s) when it reached its most recent peak relative performance?
Things are getting more interesting. For the first time, the PBGC has denied an application on the basis that the fund did not qualify as a Priority Group 2 plan. The Bakery Drivers Local 550 and Industry Pension Fund was seeking slightly more than $132 million for its 1,122 participants. The fund had described itself as a Critical and Declining Plan. The PBGC rejected their initial application. I don’t know if they qualify for SFA under a different priority grouping, but we will monitor this situation given this unique outcome.
In other news, two more plans had supplemental applications approved. The Pension Plan of the Printers League – Graphic Communications International Union Local 119B, New York Pension Fund and the Teamsters Local 641 Pension Plan will receive $15,928,030 and $96,092,818, respectively, for their combined 4,823 participants. The Teamsters application was a revised supplemental filing.
There were two Priority Group 2 applications filed last week. The Local 966 Pension Plan filed a supplemental application seeking an additional $8.3 million in SFA for its 2,356, while the U.T.W.A. – N.J. Union – Employer Pension Plan submitted a revised application that had only been withdrawn last week in which they sought $7.5 million for 449 plan participants. As a reminder, the PBGC has identified 14 plans that they believe qualify under Priority Group 6 (present value of financial assistance in excess of $1 billion) that may begin to file their applications beginning February 11, 2023.
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