This letter we are going to touch on a bit more than usual as there are three topics that need to be visited: Operation Twist and its negative impact on Pension Funds; Sector Returns for Q3; and Final Q2 GDP.
Twisting Your Retirement Away
The Federal Reserve did what most expected and announced Operation Twist on September 22. However, what many do not realize is the Fed also released a stealth anchor on the nation’s largest pension funds.
Underfunding is already a big issue for pensions around the country as they seek a low risk investment that supplies an ample return to service future outlays.
The 100 largest pension funds of U.S. companies had assets covering 79 percent of their liabilities at the end of August, down from 86 percent at the end of 2010. The all time low for the funds was 70 percent in August 2010.
A large chunk of pensions invest in U.S. Treasuries as not all capital can be risked in equities given the guaranteed payouts that must be made by pension funds. Remember, most of these pensions are defined benefit plans that work on a future payout target. Generally, it is believed that each 1 percent drop in yields increases a pension’s liabilities by 10 to 15 percent.
Plain and simple, the Fed is now pushing down yields on longer-term bonds as it goes further out on the curve with its purchases. Fund managers get a whopping 1.92 percent on 10 year treasuries right now. So, the question becomes: Do funds raise their risk appetite to try and make up some ground or do they watch as the underfunding gap expands further.
Please don’t think this is just an issue for corporate pensions either. See the below chart referencing state government underfunding on pension and healthcare liabilities.
Relative Returns in Q3; A Quick Sector Analysis
In a prior letter we discussed if U.S. equities were now a “value” based on P/E ratio as many talking heads would have you believe. In that letter we talked about the strongest sectors in market downturns and economic recessions (Utilities & Consumer Staples) and especially how those stocks were offering solid dividend yields (better than U.S. treasuries!) as their stock prices became depressed.
The below chart of Q3 results tells us what we need to know; it was an ugly quarter but the utility and staple names held up best, while again, paying a decent dividend (more than 3 percent).
Q2 GDP and The Y-O-Y Recession Indicator
Below is a chart that has become a staple in a our recent letters.
Remember, as the chart shows, every time the year-over-year GDP growth rate has fallen under 2 percent a recession has followed (shaded area).
After the final Q2 GDP estimate, year-over year GDP growth sits at 1.6 percent. As I’ve stated before, the writing is on the wall.
Your preparing his portfolio for the slowdown analyst,
Mitch Jaworski