Tuesday, June 21, 2011

It's all Greek to me

Well, the markets will be obsessed with news out of Greece today and their (no) confidence vote. This could pave the way for an eventual bailout - saddling each European household with something like 1,400 Euro of additional debt to save the Greeks (and the French, German and American banks).

The impact of the turmoil in Greece (and other European countries) is starting to have an impact on economic sentiment.

The German ZEW Indicator of Sentiment dropped to -5.9 in June from 13.6 in May. The Euro zone economic sentiment index fell to -9 from 3.1.

Both of these levels are at their lowest levels in 2 years.

Two great, but controversial ideas were proposed today in papers released by fairly smart financial minds.

1) I've mentioned Bill Gross before who, as the manager of the world's largest bond fund, is more in touch with pulse of the global economy than just about anyone I know. Mr. Gross penned an interesting letter today that strikes a chord with me as we are about to send another class of high school graduates out into the world - "Is College Worthless?"

Obviously, it's a provocative title and it's hard to argue that college was worthless for the millions of people that achieved more than they could have imagined in the 70's, 80's, 90's and beyond with a college degree. However, there is some validity to the points he makes.

"The past several decades have witnessed an erosion of our manufacturing base in exchange for a reliance on wealth creation via financial assets.

Now, as that road approaches a dead-end cul-de-sac via interest rates that can go no lower, we are left untrained, underinvested and overindebted relative to our global competitors. The precipitating cause of our structural employment break is both internal neglect and external competition. Blame us. Blame them. There’s plenty of blame to go around."

"Students, however, can no longer assume that a four year degree will be the golden ticket to a good job in a global economy that cares little for their social networking skills and more about what their labor is worth on the global marketplace."

"The “golden” days are over, and it’s time our school and jobs “daze” comes to an end to be replaced by programs that do more than mimic failed establishment policies favoring Wall as opposed to Main Street."

I'm not sure how to implement a new model but it is food for thought.

2) The far more disturbing paper covers the risk to our nation's pension plans if we are truly in the midst of another lost decade.

Most pension funds shoot for an annualized return of 8% because that was the rough blended average return on financial assets as our country emerged from a fractured nation after the civil war to become the greatest economic force on the planet. There are concerns as to whether that rate of growth can continue as our status in the global economy is challenged from the East.

Since most pensions are only earning 3-4% on their bond portfolios they have to chase aggressive returns in their equity portfolios that hopefully will yield 10% + returns. This explains why every major fund is heavily invested in Apple, Google, etc (and they are probably sweating now that both stocks are down this year).

But as I've pointed out before, for all of the wild swings in the market we basically went nowhere in the 2000-2010 decade. What happens if we tread water for another decade while pension plan participants live longer than expected? Well, the ugly truth is that all pension plan employers (states, schools, etc) will have to contribute a much, much higher proportion of their budgets to make up the difference. This drains the operating budgets to fund non-operating activities and basically, the country becomes GM circa 2007.

"The second major problem outlined in this paper is that pension managers, in an attempt to deal with the realities of underfunding, may be tempted to chase higher performing and riskier asset classes, and may end up compounding the underfunding problem even more through exposure to these risky asset mixes. Interestingly, according to Biggs, the targeted equity allocation does not correlate with projected return. Even worse, as shown in Exhibit 1 (above), funds using the highest return assumptions have the most underfunded pensions, a scenario that could be called, “fingers crossed and eyes closed”.

Happy days are here again.


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