There is an uncivil war raging in the United States. It’s between government employees and taxpayers who fear that those employees’ generous pensions will lead to inexorably higher taxes and more slashes in services. This war is particularly hot in jurisdictions such as the City of San Diego, in which it is clear that the government cannot pay what it owes the pension fund in future years.
Intensifying this war is the fear of deflation, or an extended period of falling prices and wages, last seen in the Great Depression of the 1930s. Some prominent economists who predicted the current mess, such as New Jersey’s A. Gary Shilling, think deflation is coming. The economy of the past three decades was pumped up by debt. Now individuals and institutions are trying to shave those debts. There is at least a 25 percent chance that a deflationary skein could result, says North County financial advisor E. James Welsh.
In a deflation, people on fixed incomes, such as those receiving pensions, are the winners: their money rises in value when prices recede. But the governments paying those pensions suffer: as prices and incomes drop, so do tax receipts. That makes it even harder to make those pension payments.
All this has created a second war. It’s between those who foresee deflation and those who are more fearful of inflation, or rising prices. Actually, we could get hit with inflation because of the government’s frantic efforts to prevent deflation.
If a pension fund believes deflation is coming, it should load its portfolio with high quality bonds, such as U.S. Treasury paper, and cashlike instruments, which gain value in deflation. Quality bonds and cash did very well during the Great Depression, while stocks did poorly.
But to fight deflation, the federal government has rolled up massive deficits while the central bank, the Federal Reserve, has created money at a breathtaking pace. If the economy actually does turn upward significantly, inflation and interest rates will go up, the bonds (which move inversely with interest rates) will crash, the portfolios wither, and seething taxpayers will have to pick up the tab. Those foreseeing deflation will lose their war — and their shirts.
In an inflation, those receiving pensions will lose: the value of the money they receive will go down, not up as it would in deflation, even though they may get a cost-of-living adjustment.
The Federal Reserve wants to see mild inflation — the best of all possible worlds. But pulling that off requires heroic dexterity. Stocks would do well and bonds would do moderately poorly in mild inflation. If inflation zooms as it did in the 1970s — and that’s likely considering how much money has been created — bonds would certainly go in the tank, and stocks would probably join them.
Most pension funds today are still loaded with stocks, not bonds, as if mild inflation will win out.
The City and County are going in different directions. San Diego City Employees’ Retirement System has almost 60 percent of its portfolio in stocks and only about 25 percent in bonds. “Our board is thinking about deflation…we have a new investment consulting firm looking at where the economy is,” says chief of staff Rebecca Wilson, but the system sticks with its stock-heavy portfolio.
By contrast, U.S. Treasury bonds of various maturities are the single biggest holding in the portfolio of the San Diego County Employees Retirement Association. Conservative, stable value assets are a much larger piece of the pie than gamier investments. Says chief executive Brian White, “We’re definitely concerned about [deflation] and looking for downside protection. We have added Treasury bills to the mix. They are closer to cash.”
Both funds carry an assumed rate of return that Mike Stolper, San Diego investment advisor, calls “delusional, an exercise in fantasy.” The City’s is 7.75 percent a year, and the County’s is going from 8.25 percent to 8 percent next year. Both funds have lost money over the past three years and made far less than their assumed rate of return the past five.
I asked San Diego financial advisors what they are telling pension plans to do. “There is a significant possibility of global deflation,” says Stolper, noting that there is “excess capacity and massive debt liquidation” — two of the classic signs. Pension funds “have two entirely different strategies [stocks versus bonds] that are arguably polar opposites,” says Stolper. “Funds could get genuinely whipsawed.” While bonds have done better in the past ten years, stocks have outperformed over many decades, says Stolper. So he would still have more stocks in a portfolio. “There will be a reversion to the mean, but I may be wrong for another ten years.”
Solana Beach advisor Neil Hokanson says, “Countries tend to inflate their way out of debt problems.” That’s what the United States will likely do. “Equities [stocks] look more attractive to us than bonds, particularly since dividend yields of stocks are higher than the yields on bonds.” But if deflation can’t be thwarted, he would buy 30-year Treasury bonds.
Also preferring stocks is Mike Munson, portfolio manager of San Diego’s Denali Advisors. “I would still have 55 to 60 percent of the portfolio in high-quality stocks just because I think the Fed will keep rates low enough to prevent deflation. We might have deflation in the short run, but it’s highly unlikely we would have it in the long run.”
Stocks used to make up 60 to 70 percent of the balanced, conservative accounts at San Diego’s Messner & Smith money management firm. “Now we would have between 45 and 50 percent in equities and the rest in fixed income [bonds] and cash [short-term instruments paying interest]. Things are so negative now that we don’t want to kill everybody,” says John Messner, whose primary concern is the risk of another economic downturn.
Pension funds have a particular problem, says Messner, quoting a New York Times story. In 1950, life expectancy was just short of 69 and the average retirement age was 67. Now the average life span is 78 and the average retirement age has dropped to 62. Funds make payments for many more years.
“In deflation, cash is king,” says Welsh. “In the short run, Treasury paper [is] the safest game in town, no matter how low the yields are. But will that continue indefinitely? I doubt it. The government has issued so much debt that eventually it will have trouble selling bonds, and interest rates will rise and bonds fall in price.”
Here is a sobering thought. In the 1970s, the nation suffered high inflation and interest rates. Then in the 1980s and 1990s, as interest rates declined, both stocks and quality bonds enjoyed a rowdy bull market. That ended for stocks in 2000, but the bond bull market is still going. Today, however, short-term interest rates are near zero and long rates are as low as they have been in half a century. So it’s doubtful that there will be a joyous orgy in either stocks or bonds unless there is first high inflation and interest rates — that is, lots of pain.