Submitted by Taps Coogan on the 14th of May 2019 to The Sounding Line.
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Brian Reynolds, former chief market strategist at Rosenblatt Securities, recently spoke with Real Vision in a wide ranging interview about the role of pension funds in the current credit cycle. In a fascinating interview, Mr. Reynolds details how increasing state and local pension funding combines with an unending reach for yield to fuel massive over-leverage and deteriorating credit quality.
Some excerpts from Brian Reynolds:
“Before we invented the modern credit market, the stock market ran on fundamentals, things like earnings, things like valuations, and then the credit market came along, and starting in the 1990s, disrupted that whole process. So now we are in the third modern credit boom. The first one lasted from 1991 through 2000. Then we had a financial disaster. The second one went from 2004 to 2007. Then we had another financial disaster and then we launched another one in 2009. All this daisy chain is, is our public pensions needing to make out-sized returns. They have become the dominant global investor. Our pensions were only about 60% of GDP in 1984. Now they’re 120% of GDP. That is massive spectacular growth. There is nothing on Earth that’s grown that fast from such a high base. So they’re the dominant global investor but they’re so under-funded (that) they need to make 7.5%… which is crazy because most interest rates are much much lower than that. So, they really have to push the envelope in terms of what they invest in to try and get that… When they buy these record amounts of corporate bonds from these companies, that puts cash on corporate balance sheets. Modern CEOs are incentivized to get their stock price up, so they take this unlimited money that comes from our pensions, via these credit funds, and use it buy back their stock.”
“40 years ago… the average company was highly rated, AA or AAA rated from a credit standpoint. Now we have added so much leverage in the last 40 years that the average credit quality has gone down to just above junk…”
“If you look at a chart of who’s been buying stocks over the last few decades, there’s been money going into ETFs but that’s come at the expense of mutual funds. Pensions, both state and private pensions, have been large sellers. So investors as a whole have really done nothing these last three decades. The buy backs have taken in an increasing share to the point where they are almost 100% of the buyers over the last decade… The result is this daisy-chain of money coming in from taxes to pensions going into credit which is then used to artificially push up stock prices…”
“The stock market has outpaced the economic fundamentals over the last decade. So if you are a fundamentally oriented equity investor, you don’t want to buy stocks. You don’t want to own them. You want to sell them at the drop of a hat every time there’s a worry. We’ve had 35 pullback in the stock market that have been marked by irrational inversions of the VIX curve, where people get so panicked about the downside that they pay up for short term protection when longer term protection is cheaper. The most recent of those was in the fourth quarter of 2018. And when these stock market panics happen and the VIX gets inverted, the credit market shuts down, because these credit funds that are hired by our pensions to put money to work, they’re allowed to take a break during a panic to see if the turbulence creates a better buying opportunity…, but once the stock market panic runs its course…, then the credit market opens right back up. People make up for lost time and stocks go ripping higher on a new round of buy-backs and mergers. We’ve done that 35 times in the last ten years. We’ll probably keep doing that a number of times per year. These drops feel like the world is ended and as soon as the panic is over, we go right back up. That frustrates active managers tremendously.”
“…What we’ve seen over the last ten years, especially the last five, is more and more pension reducing their low yielding cash in favor of more aggressive credit investments. That helps increase the intensity of this credit boom and it exacerbates these up and down panics, because it removes shares from the stock market, which means that the money that remains can move shares with less effort… That makes the downside more rapid and that makes the upside more rapid as well and that further drives people nuts.”
“… Every major state since (the Detroit bankruptcy) has either raised or is thinking about raising taxes to try and narrow this funding gap in our pension system and the result is overwhelming… It’s now growing faster than the average annual value of the federal tax cut that was passed in 2017. In other words, we did a trillion dollar tax cut over ten years, that’s a hundred billion a year. State and local taxes, just for pensions, are now growing at $115 billion a year. So fiscal policy is actually negative now. That’s one more reason why the economy is cooling. But this money goes into levered credit and it comes back in the stock market with five times the buy backs… So if you are a fundamentally based investor, you are looking at a historically slow economy… yet we are putting more money to work then ever in credit and doing it on a leveraged basis, so you get one of the greatest stock market bull markets in history that everyone hates because it’s way outpaced the economic fundamentals… Short selling… is higher now that it was during the 2008 financial crisis… It’s near a record. So active hedge fund managers have been betting against this bull market in near record amounts… They’re betting stocks will go down and we’re in one of the greatest bull markets in history.”
There is much much more to the interview, so enjoy it above.
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