On the eve of the REAL2015 Reshaping Real Estate Conference in Brisbane, I was asked to engage in some of the economic foresight that created a bit of a stir in 2006 and 2007 when I precisely discussed the certainty of what is now known as the Global Financial Crisis or GFC. Subsequent to that, a dear friend called me to inquire as to the timing of the next major market paroxysm and how one might be prepared for that eventuality. I have hesitated weighing in on this topic in InvertedAlchemy but given the U.S. Federal Open Market Committee (FOMC) actions of this past week, the iceberg is now in full view and the helmsman is drunk.
The Federal Reserve erroneously states that its mandate is to “foster maximum employment and price stability”. It continues to run its Ponzi auction of “reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-back securities and… rolling over maturing Treasury securities at auction.” In what they continue to describe as “accommodative policy” the FOMC has satiated the wealth transfer mandate of their benefactors while placing the whole of the U.S. (and by extension, the global) economy in irreparable harm. And my choice of words is precise in that the architecture of the next GFC is much more precarious than the conditions leading to the 2008 hiccup.
According to the data reviewed by the Committee prior to its September 17, 2015 meeting, the consensus view of the Federal Reserve Bank Presidents is that GDP is likely to hover around 2% for the foreseeable future despite evidence that it’s probably between 1.8% and 2.0% in reality. Personal consumption expenditures or PCEs are expected to lag GDP by 0.2%. And over the next 4 years, the Presidents expect that their “firming” policy (in contrast to accommodative) will land the federal funds rate at about 3.5% with the largest spike expected in 2016.
But the seeds of the looming challenge were respectively planted by Franklin D. Roosevelt in August 1937 and by Gerald Ford in September 1974. Roosevelt’s Old-Age, Survivors, and Disability Insurance (OASDI or Social Security) and Ford’s Employee Retirement Income Security Act (ERISA) have placed the U.S. economy on a collision course with a reality that Senator John L. McClellan (D-Arkansas) would have found unimaginable in 1963 when, as a result of the Studebaker Corporation’s default on pensions, he led the Senate’s investigation into pension fund misuse. In 2009, the Office of the Chief Actuary of the Social Security Administration reported that the program had $15.1 trillion greater obligations than assets. Since 2010, Social Security’s costs have exceeded its tax income and its non-interest income combined and are expected to do so through 2024 “and beyond”. In their Communication, the Board of Trustees have stated that the Disability Insurance component of the OASDI will experience “fund depletion” in 2016 and that the OASI funds will be depleted by 2035. What this means is that in 2016, the program will be able to meet only 80% of its statutory obligations. In other words, 60 million Americans will have 20% less to spend beginning in 2016 while the FOMC expects spending to grow during the same period. Take 20% of a population and cut their purchasing power by 20% (to say nothing of the increased tax that will be placed on current wage-earners rising a gross 2.62% thereby wiping out the FOMC PCE projection) and you’ve got a massive problem. The FOMC and the Social Security teams don’t have the same crystal balls. Not surprisingly, Social Security wants full employment so that they can collect tax and fund themselves. The Fed wants unemployment below 6%. The trouble is that Social Security bases its solvency estimates on employment numbers that don’t currently exist and are not projected to exist thereby accelerating their insolvency. And it gets much worse.
Both the Social Security investment program and the ERISA program are required to invest heavily in interest bearing securities backed “by the full faith and credit of the United States Government”. With the FOMC’s decision to keep “accommodating” low interest rates, this means that all the actuarial assumptions about investment income necessary to meet fiduciary obligations in the future are entirely wrong. And they’re not wrong by a bit. They’re wrong by over 200%! The “real interest rate” from 1966 to 2007 averaged 2.8%. The real rate in 2014 was 0.4%. To make Social Security work in the low cost (read fewer benefits) and high participation (read more workers paying more for less benefits), they need a rate of 4.4% - only 1000x greater than reality! And this same assumption error plagues other investors as well. With nearly 6 full years of interest rate manipulation, fiduciary investors across the board are beyond the point of no return. There is no economic scenario in which you can make up the lost ground of persistent interest rate manipulation at the scale we’ve seen since the GFC. Making the situation worse, the assets that are currently profligate on the balance sheets of many pension funds are agency-real estate linked meaning that the investment picture for pensioners is going to be far worse than imagined.
So long about the U.S. Presidential election next year, the first pillar will actually fall. And, for better or worse, there’s no getting out of this one. The market is going to lose a cylinder called the Baby Boomer consumer. And given that the U.S. economy is not growing at a rate to absorb wage increases or any other off-setting economic driver, the age of entitlements is in for serious accountability.
What does this mean to the global investor? Well, the answers are already being written on a number of walls like King Belshazzar’s illustrious inscription in the Book of Daniel. “Your days are numbered; you’ve been weighed on the scales and are found wanting; and your kingdom is about to be divided.” This time around, Medes and Persians are not at the literal gate but the American consumer’s fate is not enviable. Therefore, it’s reasonable to carefully examine where discretionary spending is most vulnerable to senior purchasing power reduction and begin by unwrapping these positions. More broadly, on the U.S. domestic front, general interest-rate dependent sectors are likely going to suffer disproportionately to other sectors.
But the real shift is something that I discussed at the University of Notre Dame’s 10-Years Hence speech in the Spring of 2007. Then, I discussed the importance of drawing a line from the Mediterranean eastward with one arc bending across the Indian Ocean to India onwards to Indonesia, Australia and across to the South America and another bending up through Persia and across China to Canada. The former line is the line of cooperation and growth where real economic opportunity will transition in the diverse fields of health, agriculture, materials, finance, logistics and technology while the latter will be economies that have a much higher likelihood of achieving self-sufficiency with minimal foreign dependency. And, with my 10 year projection a mere 1.5 years off, nearly each point in my 2007 speech has landed precisely where the arc of my speech had projected. China is not in crisis. China’s role on the global stage is changing as it turns its economy inwards for its own benefit. Economic ties between India, Australia, Brazil, Chile and other Oceania states are growing and the interdependency in these areas will be more noticeable in the coming months.
Ironically, it was economic distress and global conflict that stimulated President Roosevelt to create the octogenarian that is now on life-support. It was global manufacturing shifts that led to economic conditions stimulating President Ford to enact legislation which is now coming off of its drunken mid-life crisis. And while we’ve got some tough sailing ahead with gross incompetence at the helm, then as now, we’ll develop a new model that, with any luck, will not be based on actuarial models and willful ignorance. Until then, there’s turbulence ahead so buckle in!