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Investments and Markets

2008's Top Topics


Girard Miller

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

Public pension funds and retirement plan investors face a challenging year. Here are some key issues for the coming months, including investment return targets, sovereign funds, recession vs. correction, oil, interest rates, the Fed, muni bonds, alternative investments, China, the presidential election cycle and housing:

Market vs. Actuarial Reality

From a purely investment standpoint, the actuarial assumptions made by many public pension funds for their investment returns look too rich for comfort. It's unlikely that an 8 percent annualized long-term return can be sustained through the next recession, whether now or later. Public pension funds should take time in early 2008 to revisit their actuarial assumptions and ask themselves and their expert advisers if they are too bold in their capital market expectations. Two months ago, I interviewed a dozen investment consulting firms on behalf of a public pension fund and off the record many of them would privately scale back their investment return projections for the U.S. capital markets in the intermediate term.

Whether the economy enters or avoids a recession (see below), bond yields below and near 4 percent and weakening corporate profits already tell us that the chances of achieving the 8 percent actuarial returns used by many pension plans are less than 50-50 in the intermediate term. If that's so, funding ratios could deteriorate.

'Sovereign Funds'

Take a hard look at who's been coming to the "rescue" of limping Wall Street firms seeking vital capital injections in recent months -- and on richly favored terms. It wasn't public pension funds. It wasn't even the private capital firms that typically raise big bucks on quick notice for buyouts and special situations. And it wasn't America's Warren Buffet of Berkshire Hathaway. It was mostly recycled petrodollars. In 2008, Big Money is held by Middle Eastern and Asian "sovereign funds," and they are now investing billions in American markets to recapitalize downtrodden companies that are willing to pay a premium to new investors to rebuild capital ratios at the expense of existing shareholders.

This is not good news for public pension funds that already hold the "old" shares of major corporations, particularly if those companies hit a pothole and seek new capital. The emergence of sovereign funds as market leaders in amassing capital suggests that public pension funds could take a back seat in future deals in many other markets.

Which raises this question: Why isn't somebody working more aggressively with public funds to assemble cooperative teams that could compete with these new superfunds from the Middle East and Asia?

Correction or Recession?

Nothing will impact the ability of public pension funds to meet their financial and actuarial objectives in 2008 as much as the direction of the U.S. economy. Although many indicators are now flashing that a multi-sector slump is underway, there is one last chance that swift and decisive Federal Reserve action to cut interest rates could contain the slowdown before it spreads to even more industries. Clearly the housing industry, residential real estate and the subprime mortgage industry are in deep recessions, while consumers, banks, brokers and Detroit automakers look shakier each day. But export-driven businesses, agriculture, high-tech firms and multinationals generally are still in a growth mode.

Looking back over the previous two cycles of long-term business expansion in the U.S., there were two analogous periods when financial markets melted down in the 7th inning. In 1987, the stock market crash shook out the speculators, but once investors booked their losses, the economy plowed ahead. Likewise, the 1998 debacle of Long Term Capital Management amid the "Asian contagion" triggered a six-month corrective period that was followed by more growth. Both times, stock markets gained 40 percent from their correction lows before plunging into recessions. In both cases, the Fed cut rates quickly to stabilize the economy -- an option it may not have this time (see below).

As we next look at specific market sectors, opportunities and risks, keep in mind that 2008 will bring an inflection point. Nobody (including Fed Chairman Ben Bernanke) really knows today which direction the economy will take in 2008. This makes long-term investment and actuarial strategy work all the more difficult -- yet all the more important.


A key factor that could determine whether the American economy gets back on its feet will be oil prices. If global demand or supply shocks push prices too much over $100 per barrel, a U.S. recession cannot be far behind. Consumers have hit their limits; fuel prices for heating and driving will pinch many American pocketbooks in coming months. Oil spiking over $100 per barrel would clearly represent the third "3x" oil price shock in the past four decades. Historically that has tipped the economy into recession. Some economists think the damage is already done, since crude prices have already tripled in the past five years.

If a global recession does take hold, crude oil prices would likely drop by $20 to $30 per barrel. But virtually nobody expects oil to drop 65 percent to 2003 prices.

Public pension funds should watch the oil markets for possible investment opportunities if prices drop in 2008. With our dollar eroding over the long-term from twin trade and fiscal deficits, oil would be one of the investable commodities that provide a long-term inflation hedge for pension funds offering CPI protection to retirees. A price setback would offer a long-term investment opportunity. After the next recession, pension funds and retirement investors will also need to look to oil royalty trusts, pipelines and other income-producing petroleum and minerals investments as alternatives to bonds (see below for more details).

Interest Rates and the Fed

The Federal Reserve board is now behind the curve in cutting short-term interest rates. Whether it's a recession or a growth slowdown, rates are still too high. Many expect the Fed to cut another three times in the first half of this year, and futures markets already anticipate short-term money rates in the 3 percent range, with 10-year bonds already below 4 percent. Many market economists now say that the sooner and deeper the Fed cuts, the better -- even though the longer-term result could be a yet-weaker dollar and higher inflation. The housing industry will not recover until we see mortgage interest rates low enough to attract new homebuyers, and that slump has now infected mainstream consumers who are nervously watching their household net worth shrivel. Ironically, if we do enter a recession, rates will decline even lower than the Fed would cut them in its next three meetings. Thus, the outlook for interest rates is clearly lower. Currency and inflation fears could tie the Fed's hands in the short run, but before the year is over rates must fall one way or the other. It's only a question of how fast and how long.

Don't forget that last year Bill Gross and Dan Fuss, two legendary bond managers, mistakenly called for a long-term, generational uptrend in bond yields -- not long before this latest subprime crisis sent yields in the opposite direction. Although in retrospect their forecasts were premature, they made an enduring point for pension funds to heed. There will likely come a time in 2008 when pension funds will need to trim their bond portfolios -- once interest rates have bottomed. (That often occurs when short-term rates have fallen below intermediate-term rates.)

Likewise, in the longer term, pension funds should use the eventual recession bottom as a time to "dump bonds" and restructure their portfolios for longer-term inflation risks. Already we have seen many public funds shift down from traditional 40 percent asset allocations in bonds. When long-term inflation risks and a vulnerable dollar combine with low interest rates, bonds will be viewed strategically as inferior assets despite their defensive properties.

Muni Bond Crossover

A market aberration has developed that can be exploited by many pension funds. The recent flight to quality in the U.S. Treasury market, weakening state and local fiscal conditions, plus the problems in the subprime industry which blew up the capital base of the bond insurance industry, have caused a rare imbalance in the tax-exempt, longer-term municipal bond market -- which now offers higher interest rates than taxable Treasury bonds. Banks and some insurance companies that typically buy muni bonds for tax advantages don't have surplus capital right now. Thus, pension funds, which ordinarily have no use for tax-exempt debt, may find opportunities for their managers to eventually sell their U.S. government securities and buy unloved municipal bonds with the intent to reverse this trade later when the intermarket spreads return to normal. A more aggressive "alpha" strategy would be to buy munis and short the T-bond future, which is what hedge funds will be doing.

A Surge in Alternative Investments

Look for public pension funds to continue their shift from traditional asset classes into international and alternative investments for greater diversification and higher potential returns. Instead of "traditional" 20 percent equity allocations to foreign securities, some consultants are talking now about 40 percent to 50 percent overseas to reflect faster growth in other countries and a shrinking of the U.S slice of global equity markets. Add to that the risk of dollar deprecation and U.S. inflation, and a chorus of internationalists and some CIOs are suggesting a longer-term shift away from domestic assets.

Global investments will be coupled with yet more moves into hedge funds, private equity and nontraditional investments such as commodities. Many industry watchers expect alternative-asset allocations in public pension funds to double and possibly even triple by 2010. The biggest problem now is how to put pension money to work fast enough, as it's hard to implement sensible alternative-asset allocation programs overnight. So much money is chasing scarcer opportunities that a cautious approach with selective entry points is the wiser course. But if I were a pension CIO facing a potential recession scenario right now, I'd sure want to have a few short-sale-specialist hedge fund sharpshooters on my team.

We may also see a new alternative investment sub-class that I'll call "alternative income." If bonds become inferior investments as suggested above, then income-oriented investments that also offer inflation protection will become more popular. These will include oil and mineral royalty trusts, pipelines, real estate, foreign bonds and floating-rate preferred stock trading under par. Individuals will also find these attractive. Preferred stocks paying qualified dividend income may eventually regain popularity with individual investors.

A Low-Cost Fund-of-Funds?

Municipal pension funds with assets under $500 million need a better vehicle than the private sector has offered them for investing alternative investments. Most hedge funds and private equity managers get management fees of 2 percent plus 20 percent of their portfolio profits, so the fees are high to start with. For smaller players seeking to diversify, a fund-of-funds is the most viable doorway to the market. But those managers typically charge yet another layer of fees, typically an additional 1 percent management fee plus 10 percent of the profits. Thus, the little guys get stuck with 3 percent management fees and 30 percent of their profits going to money managers. This leaves little room for superior returns after all the risks.

What the municipal pension community needs is a lower-cost fund-of-funds assembled by a statewide pension fund or consortium, with fees one-half what the industry now charges. I would urge somebody to figure this out in 2008. A billion bucks await you.

Wild Cards

Three other factors deserve quick mention for those looking for something to worry about. First, the Chinese economic expansion may take a breather in 2009 once the Beijing Olympics have ended. Chinese leaders are window-dressing their country for worldwide attention this summer, and just as the Greeks experienced a slump after their 2004 Olympics, the Chinese could see a slowdown in 2009. A rising yuan could also retard global trade and economic growth.

At the same time, the next new year will bring in a new American president. Despite the typical goodwill of the next inaugural and possibly a 100-day legislative honeymoon, the first year of a presidential term is often the worst for stocks. New presidents typically like to swallow their yuckiest medicine early in their first term to set the stage for re-election later on. With income tax rates already scheduled to head higher in 2009, there are many policy factors that could perplex the financial markets next year regardless of who's elected.

Finally, look for housing to remain weak through 2008 as foreclosures continue to mount and the markets seek a bottom by year-end. That's when most teaser ARMs will finally have re-set. Several national homebuilders are likely to declare bankruptcy or be bought out by competitors. Consolidation is certain. Municipal property tax revenues will decline into 2010 as local government belt-tightening will become a two-year drag on the economy. All of these factors will retard U.S. growth even if a recession is averted.

A Time for Caution

In such a world, it's hard to imagine consistently buoyant portfolio returns in each of the next three years. Hopefully, interest rates will fall fast enough that the economy and markets can chug along with just two cylinders sputtering. And the optimists can also hope for a replay of 1988's and 1999's post-correction growth spurts that carried stocks up 40 percent before recessions ensued. But just remember: Hope is not a strategy.

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