Inside the Box: The Consensus Economic Outlook
Most economists expect the U.S. to continue a tepid recovery. For every positive growth catalyst, there is an offsetting drag. GDP growth from business inventory re-stocking will be offset by further home foreclosures and a weakening commercial real estate sector. Federal stimulus spending will be offset by state and local government budget cuts as sales and property tax revenues remain stagnant and reserves are depleted. Reviving export demand from overseas trading partners will be offset by persistently high American unemployment that is likely to remain above 8 percent through the midterm elections. Tepid job growth will be offset by consumer debt repayments and desperate Baby-Boomer retirement savings, which will curb consumption and thus GDP growth. Americans will experience "Eurosclerosis" in 2010.
In this context, a runaway year in the financial markets seems unlikely. With stocks already recovering more than 60 percent from their March lows, the market has already anticipated a stronger economy. Bond yields are already rising as global economic growth triggers inflation concerns at the same time that governments worldwide are still borrowing heavily to stabilize their economies. Even though the Federal Reserve is expected to stand pat on short-term rates, the yield curve is likely to continue steepening. Some economists expect yields on long-term bonds to be a full percent higher this time next year. Bond managers will struggle to "earn their coupon" in 2010 as they suffer market price erosion with rising rates.
Real estate, especially commercial real estate, is expected to languish as $1.5 trillion of mortgage debt comes due in the coming 3-4 years -- and much of that is probably worth far less than par. It's too early to see this market bottoming. Only the "grave-dancers" who find bargains in the trash bin will make money in this sector, and their returns will not become evident before 2012.
Many economists and investors would be happy if the markets can simply maintain equilibrium for another year. That would give the major economies worldwide a chance to stabilize and recover. Slow growth in 2010 would set the foundation for 2011 as a stronger year for global expansion. By the second half of 2010, equity investors might be able to look into the next year for better investment prospects. But there are plenty of risks to that outlook.
Outside the Box: Risks to the Consensus Forecast
o Federal tax impacts on investment growth. 2010 may be the year in which private investors in the capital markets finally begin to place a cost on the likelihood of increased federal taxes. The new health care reform taxes are just the opening salvo. Marginal income tax rates are scheduled to increase for upper-income investors and executives, and the preferential tax rates on capital gains and dividends will inevitably rise by a third, from 15 percent to 20 percent. Hedge fund managers are likely to face a movement to tax their "carried interest" at higher rates, possibly even ordinary income tax rates. Medicare and Social Security taxes are likely to increase by 3 percent of payroll for employers and 3 percent for employees in a few years, probably in 2013. All of these taxes will place a drag on GDP growth and investment returns on capital, even if they are delayed until the economy starts expanding.
I'm not instinctively anti-tax, and I would prefer to see higher taxes and fewer government subsidies in order to replace gaping government deficits once the economy begins to expand sustainably. But as an investment economist, it's my job to point out the impact those taxes will ultimately have on the long-term earnings on retirement assets.
Here's another tax that could impact pension funds: a federal transactions tax on securities trades. Even if small investors are exempted (perhaps a 50-trade-per-year limit), there is a lot of potential revenue for Uncle Sam to capture if a tiny tax is placed on securities transactions. A dollar of tax per $10,000 of trade value (0.01 percent or one basis point) is the magnitude that would make most sense -- far below the 0.25 percent tax proposed by several prominent Democrats. The idea has champions in both houses, and would likely be targeted at the high-volume computer trading systems that dominate the exchanges now. Although the trading houses will complain that such taxes would impair market liquidity, a good argument can be made that the kind of arbitrage they capture adds no real value to the overall economy, and a targeted transactions tax hits the rich guys who are making parasitic profits. Only when the taxes begin to impair returns of the average mutual fund and 401(k) investor by more than 5-10 basis points annually will there be broad public opposition. Public pension funds could see a modest impact on their total returns if they engage money managers who trade at high frequency or high turnover.
Most importantly, the long-term return assumptions of many public pension funds may require a re-evaluation that takes into account the prospects of lower returns on capital as a result of rising tax rates. It's no coincidence that the higher returns on capital in the 1980s and 1990s were correlated with lower marginal tax rates on capital investment, and the disinflation of that era. The next decade could see a reversal of those trends, and hence a lower rate of return than many pension funds now assume.
o China: The Wild Card. China continues to grow at breakneck speed, with government stimulus and easy credit fueling an infrastructure boom. With millions of rural Chinese migrating annually to their 100 cities with populations over 1 million, the central party must stimulate GDP growth of 8 percent just to avoid a boomerang of urban poverty and civil discontent.
Two investment risks should be considered: As Forbes magazine explained in its December 28 article ("Ponzi in Peking?") there is a mounting risk that Chinese lending standards are too loose and could sow the seeds of the next bubble. An Asian panic in 2010 would likely ripple across the globe and clobber stock markets worldwide. If bank credit ever collapses there, however, the Chinese central bank could readily sell excess reserves, but that would put billions of U.S. Treasury and agency bonds on the market, pushing American interest rates higher unless sterilized by our Federal Reserve.
The other risk is simply a glut of manufacturing production capacity that fuels a global deflation that spreads through other goods-producing countries that can't compete with China's industrial juggernaut. The insidious result of such a long-term development could be similar to the impairment of returns on capital cited in the previous section on taxation. The new Asian free trade zone could intensify deflationary trends as well. Deflation is great for consumers but terrible for investors of competing capital.
o Housing foreclosures. Thirty percent of American homeowners are underwater in their homes. Those with jobs can probably ride it out, but foreclosures are mounting for the unemployed and underemployed, who represent 16 percent of the workforce in the U-6 unemployment statistics. And if buyers can't get cheap mortgages to buy them, the housing market would fester and take the economy down another notch.
o Dollar demise or rising rates. These two risks are probably related, although not necessarily. The worst risk to American pension funds is a continuing slump of the U.S. dollar in currency markets, which would compel long-term interest rates to rise to give foreign investors a fair return on their dollar investments. On the other hand, if U.S. bond yields rise too rapidly for any reason, mortgage rates would spike and kill the housing market. As the U.S. share of global asset values continues to decline, we should expect to see more public pension plans tilt their portfolios more heavily overseas as a hedge against dollar demise.
Outside-the-box Opportunities
Putting risks aside now, let's take a look at a few areas where pension funds may find opportunities in the coming year, as our economy digs its way out of its Great Malaise.
o Venture and Vulture capital. Sow seeds now for harvest in the next boom. One of the major opportunities that pension funds may uncover in 2010 will be venture capital investments. With the economy slowly emerging from a global malaise, the odds of capitalizing on a successful new business in a few years look much better as we cross the valley of death. The trick is finding venture capital managers who are skilled at picking viable firms.
A similar strategy will emerge for vulture investors and grave-dancers who pick off ripe opportunities from various distressed assets including underwater mortgages and real estate as well as bankrupt companies or liquidation assets. Those with fresh capital to invest as vultures, rather than defending a portfolio now underwater, are likely to outperform conventional investors in the coming 4-5 years. These are the deep-value investors who can stomach holding toxic assets long enough for a turnaround. Those with managerial skills to transform junk into performing assets will do even better. Again, this is a talent hunt in which pension funds are likely to partner with skilled, proven vultures.
o Private equity. Private equity should see similar opportunities in 2010, even though the prices of common shares in the public markets have rebounded sharply and most companies have already stripped costs on their own as a survival strategy. There's not a lot of bloat remaining for private equity to capitalize, but the odds of flipping a company over the next 5 years look stronger now than a year ago, and with far less risk. So the case for private equity would be returns above the S&P with lower risks, in selected industries and companies. If stock markets correct by more than 10 percent any time this year, look for opportune private equity investors to pick up bargains.
o Emerging managers. There's a lot of group-think in the investment management industry. The top 25 money management firms control the vast majority of assets under management. Research has shown that smaller investment managers can outperform the goliath firms, although the problem is always how to screen for them. For pension trustees, it's a needle in the haystack problem. A fledgling niche business in the investment industry is the manager-of-emerging-managers approach, which enables a pension fund to make a sector bet while avoiding the parade of dozens of money managers all wanting a crumb to start up their business. There is now enough history to provide track records for these operations, which warrant a closer look. It's a smart way to encourage women and minority managers, as well, for public funds that have legislative mandates in that realm.
o Jumbo mortgages. Sometime later in 2010, after the risk of foreclosures (explained above) has peaked, institutional investors should figure out a way to package jumbo mortgages with 25-30 percent down payments and interest rates at attractive levels well above the conventional market. The market for loans over $1.5 million has virtually collapsed in most areas, and is begging for a solution. The residential housing market cannot recover until this happens, and smart state pension plans will find ways to place strategic investments in their back yards. I would not be surprised to see "participating" jumbo mortgages in which the homeowner shares a fraction of future price appreciation as part of the deal, which would give pension funds an inflation hedge on top of attractive yields from soundly underwritten mortgages. That would sure beat government bond returns. As with venture capital, the key to success here will be in finding shrewd business partners with solid underwriting skills.
o Dynamic risk-managed global asset allocation. If we learned anything from the experience of the past decade, it was that buy-and-hold portfolios failed to match the liabilities of public pension funds -- especially when the benefits formulas were enriched at market peaks in expectation of perennial success in the financial markets. Obviously it's far too early in the business and economic cycles for pension funds to begin trimming their risk exposure to re-align with their liabilities as markets become frothy. However, the discussions of how to approach that issue must begin sooner rather than later, so that a thoughtful plan is installed in advance of the next over-valuation phase. Trust must be developed between pension boards and their consultants or investment advisors selected to guide them through business and market cycles. Laying that foundation now will make it easier to pull the trigger to reduce portfolio risk when the day comes to do so.
Stay tuned for more ideas as the year rolls on.
I expect an inflection point at some time in 2010, from which the direction and velocity of the various economies throughout the world becomes more obvious. Although it's traditional to provide a new year's forecast, there is more value to be found by picking those inflection points when they occur. So stay tuned for mid-year updates.
