140 Broadway, 21st Floor, New York, NY 10005 Tel: 212-380-2280 Fax: 212-380-2290 www.fpcmllc.com Tweets at the Federal Reserve and #FOMC @federalreserve Don’t be afraid to #raiserates at #FOMC meeting. Don’t be afraid to sell some of your QE portfolio! “But I still haven’t found what I’m looking for” -U2 he Minutes from recent Federal Open Market Committee (FOMC) meetings are filled with economic excuses. Whether it’s global equity volatility, the falling T commodity complex, one month’s unexpected weak nonfarm payroll report (i.e., May 2016 report) or Brexit, the FOMC has done a masterful job of finding any and all excuses to not raise interest rates. According to the often-followed Taylor Rule, at this level of economic activity, the Federal Funds rate should be at 3.45% by now. Yet, we are stuck at 0.5%. As in the U2 song, the FOMC still hasn’t found the data they are looking for. While nominally Fed members have been stating that they are economic “data-dependent” in their approach to interest rate policy, empirically, they have been primarily financial markets- and geopolitical-dependent. Economic data has taken a back seat of late in terms of FOMC concerns, overshadowed by well-covered global events. As global equity markets sell off, the succeeding FOMC minutes lean towards dovishness; and as equity markets rebound, the hawkish verbiage reappears. From a behavioral perspective, it is understandable for Committee members to be reactive to financial markets for several reasons. First, global markets act as an economic scorecard. Financial markets often reflect the efficacy of monetary policy, providing constant feedback to policymakers. Second, the scorecard is easy to follow. Via Bloomberg, CNBC, Yahoo Finance,WSJ.com and others, anyone can find minute-by-minute values of significantly traded markets in a flash. Third, the media’s impact on our daily behavior is skewed because bearish events are often more newsworthy than bullish, and typically more impactful on our psyche. Plus, central bankers are often pushed to respond to headline events in press conferences, which offer free and rich content for news-hungry business media outlets. It’s easy to see why FOMC members react to changing global assets and events as they consider policy. We all do it. I would wager, however, that the FOMC’s interest rate policy approach would change if members considered the change in value of global liabilities in the same manner they consider the volatility of global assets. Perhaps the language in the Minutes would not change as much if both sides of the economic ledger were considered. Unfortunately, none of us see the daily or minute-by-minute change in value of major global liabilities. Whether municipal or corporate, pension fund liabilities are not marked-to-market on exchanges. Similarly, we can’t get the daily mark-to-market of a life insurance company’s long-dated insurance policies. We know intuitively that these long-dated contracts are being 1 negatively impacted by monetary policy decisions, but we’re not quite sure by how much; and out of sight . out of mind. Just imagine if the economic value of major liabilities of enormous financial entities like How big are the major pension-driven CalPERS (California Public Employees entities? Retirement System) and CalSTRS (California Just how big is CalPERS? Based on assets State Teachers’ Retirement System) were quoted of more than $300 billion, CalPERS would on CNBC data-feeds or Bloomberg terminals for be the 5th largest insurance company in all to see. If we could see the recent skyrocketing the US, and the 10th largest bank, and this changes in value of IBM’s, Boeing’s and UPS’ is an employee pension system for just pension obligations, we would see not only the for one state. There are going-concern pension systems for the 50 states, their enormous capital erosion of these pension plans major cities, and various corporate caused by global central bank policies, but also pension plans as well. In addition, the top the massive interest-rate volatility that these 100 corporate pension plans have total entities contain. If the media covered the liabilities well in excess of $1.8 trillion. negative impact on these pension-related deficits with the same fervor as falling commodity prices or a Tesla blurb, then we might have an FOMC unafraid to raise interest rates. Members would see the significantly deleterious impact of global ZIRP (zero interest rate policy) in real time. More importantly, they would likely see that for many pension plans and financial institutions, their funded status (and capital) would likely outperform and improve if rates were to rise – even with a meaningful sell-off of global assets. This is a point worth emphasizing: a number of major economic institutions in the US have the opportunity to materially outperform if the Fed were to raise rates – or heaven forbid – were to sell some of its longer-maturing QE (Quantitative Easing) portfolio. “It’s not time to worry yet” -Harper Lee e continue to live in an abnormally low interest rate environment, which has exacerbated public and corporate pension underfunded status, and impacted the W capital profile of insurance companies and reinsurers (e.g., many publicly-traded insurers trade below tangible book value). Many of these entities have two things in common. First, they have extremely long-term liabilities – some with cash flows exceeding 40 - 50 years, and many with interest-rate durations between 10 and 15 years. Second, they often have assets that are less sensitive to changes in interest rates than their liabilities. Why have these entities been so severely impacted? Hasn’t monetary policy helped them? In short, yes and no. Using the Global Dow Index as a proxy, global risk asset prices have increased, on average, 25% since the Federal Reserve initiated its QE portfolio in 2012, clearly helping the asset side of the pension equation. However, on the liability side, values have increased even more. Monetary policy initiatives like ZIRP, QE, Operation Twist (i.e., purchase of long- term Treasuries and selling short-term Treasuries), and the recent global bull-flattener rally of most major global interest rate markets (i.e., negative rates) have materially impacted discount rates for long-term pension obligors. This, in turn, impacts their funded status profile. Consequently, global monetary policy has done more harm than good for insurance and pension-related entities (i.e., institutional savers). Just how bad is it? It’s bad. 2 U.S. corporate pensions funded at 76% on average in June 2016 In June 2016, according to Milliman, the 100 largest corporate pension plans had an overall funded status of 76%, as highlighted in the chart below. The funded-status trend has not been good even with recent all-time highs in the US stock market. The deficit amount for the top 100 plans is near all-time highs, with the aggregate underfunded amount now reaching -$447 billion in Milliman's 100 Largest U.S. Corporate Defined Benefit Pensions June 2016, worse by $140 110% 7.0% billion since December 105% 6.5% 2015. This means that the economic present value of 100% 6.0% pension-related liabilities 95% 5.5% has grown faster than global 90% 5.0% risk assets pumped up on central bank steroids. 85% 4.5% 80% 4.0% To appreciate the magnitude 75% 3.5% of a $447 billion deficit, the unfunded amount is more 70% 3.0% than the individual market capitalization of every stock Pension Funded Ratio (Left) Discount Rate (Right) in the S&P 500 index, except for Apple and Microsoft, and is nearly 45% of the annual earnings of all 500 companies in the index. (Perhaps purely coincidental, neither Apple nor Microsoft have a qualified pension plan.) In short, plugging this pension hole will be a major future corporate earnings burden borne by shareholders. What’s more, this predicament is even worse at the municipal level, where the burden is borne by future taxpayers. State and local public pensions funded at 74% in 2015 Last year, the largest 160 state and local public pensions were funded at 74% on a Governmental Accounting Standards Board (GASB) basis, according to the Center for Retirement Research at Boston College. Moreover, the aggregate unfunded liability among the group was $1.2 trillion in 2015. Although the aggregate was 74% funded, there was much variability among plans, with approximately 38% of plans funded over 80% and 20% of plans less than 60%. Some large state pension plans were funded at less than 50%. For example, the Illinois State Employees Retirement System was funded at 36%, and the Connecticut State Employee Retirement System was 43%. Extrapolating from Milliman’s corporate index, the municipal funded status is likely even worse in 2016. Plus, the deficit amount could be much worse depending on which discounting methodology is used. There is much debate among practitioners, academics and regulators on suitable discount rates for municipal and corporate plans. Even the Federal Reserve uses a smoothing (i.e., mean-reverting) technique in evaluating pension liabilities, materially understating the economic exposure. However, in all cases, we know with reasonable certainty that the change in any pension discount rate will be highly correlated to changes in yields of long-term Treasuries. With 10- and 30-year Treasury yields near record lows, it certainly bodes poorly for any plan’s funded status – whether corporate or municipal. 3 State and Local Pensions Funded Status How big is a $1.2 trillion municipal pension shortfall? It’s nearly three times larger than the comparable corporate burden and nearly four times larger than the combined 2016 state annual budgets of California, New York and Texas.