I hope the managers of public pension funds and, even more importantly, the politicians who construct the plans they administer, take Bill Gross of bond giant PIMCO’s advice:
The U.S. for sure is near the top of the “more certain” list, but 2% real growth since the Great Recession is nothing to brag about. It would have been a bare minimum expectation back in 2010. Elsewhere, an investor not only has to wonder, but perhaps retreat from the lack of growth sunshine. South America is in virtual recession with its big three – Brazil, Argentina, and Venezuela – approaching lockjaw conditions of one sort or another. Euroland is above water, but floating on water wings with peripheral country unemployment (Spain, Portugal, Italy) averaging close to 20% – unprecedented except for the 1930s. Russia is retreating for geopolitical reasons. And Japan/China are supported only by credit creation of a magnitude that reminds one of Minsky, or Ponzi, or Potemkin with his mythical villages of growth due to paper, not productivity. Where is the growth? The world as McCulley correctly analyzes it, is demand deficient and supply rich.
Asset price growth therefore – capital gains in market speak – will be harder to come by. Without the tailwind of declining interest rates which have increased profit margins as well as decreased cap rates, they will instead face structural headwinds. Let me be clearer though – clearer than I was to my Vietnamese friend. PIMCO is not saying that asset prices will go down – they just won’t go up as much as many expect. And income – not capital gains – will be the dominant driver of future returns. “Good evening,” capital gains. “Good morning,” more dependable income – even in this age of artificially low interest rates.
These funds frequently assume returns of 7% or even 8% annually. That’s significantly above inflation and significantly above the real rate of growth. Where is such growth to come from?
The only possibility open to them is investing in increasingly risky assets which inevitably means that some of them will lose which in turn means either that legislators will need to make up the difference or promises to public employees cannot be honored. State and local budgets are already seriously pressed by healthcare costs and increases in tax rates are not yielding proportional increases in revenues.
We need to start questioning the assumptions.