Brian Reynolds, Chief Market Strategist at New Albion Partners, argues that the current credit-led bull market in the US will likely last for several more years, even outpacing the 1990s bull market culminating in the tech bubble, as severely underfunded pension funds are forced into corporate debt and equity to meet their return requirements. Even though Brian thinks this will ultimately drive the US stock market much higher, he does not think it will end well and refers to this process as a “daisy chain of financial engineering.”
Here’s a portion of his recent podcast interview with Financial Sense where he also provides his outlook on where the next bubble is likely to concentrate, how it will end, and what investors should pay attention to for monitoring how this will unfold in coming years.
Brian, you discuss three very important themes when it comes to understanding the credit boom and bust cycle, particularly as we see it playing out currently here in the US. Let’s talk about the first theme that you highlight driving US markets today and which you say could even possibly rival what we saw in the 1990s leading up to the tech bubble.
“Well, I think it’s not only going to rival the 1990s, I think it’s going to exceed it because our nation’s public pension funds have grown to the point where they dwarf the Federal Reserve. Since Detroit went bankrupt in 2012 those pensions have realized that they are underfunded and their current and future retirees are on the hook for any shortfall so across this country in the last four to five years, every major state has either thought about raising taxes or has raised taxes to bring more money into our pension system; and that money is being allocated to our credit market so instead of worrying about if it’s going to end, it’s actually more likely to intensify in the next two to three years.”
So pension funds are massively underfunded and they are becoming more and more risky by shifting out of low-yielding fixed government debt and into corporate bonds and stocks and, you believe, that’s really what’s driving this credit-led bull market as you refer to it. Is that correct?
“That’s correct. That’s been the driver of this bull market for the last 7.5 years. But pension fund returns have been below their expectations. Most governors and legislatures have underfunded the pensions to the point where they need to make 7.5% per year and they haven’t done that, which means they need to be more aggressive in the next 3-6 years to try and make their target.”
And this isn’t just pension funds right, but institutional investors across the board. We recently spoke with David Marsh at the Official Monetary and Financial Institutions Forum (see here) and they track the investment behavior of central banks, sovereign wealth funds, public pension funds—what they collectively refer to as “global public investors”—and they are increasingly moving into alternative assets, including equities, corporate bonds, and real estate as the desperate search for yield continues around the globe.
“Exactly. Our public pension funds are far and away the biggest investors. Number two would be the insurance companies and then the endowments and the foundations. And they all need to make between 6 and 7.5% in an interest rate environment that’s extremely low, which means they have to invest extremely aggressively in order to have a chance of meeting their targets.”
Brian, let’s go to a point you make in a recent note where you say that 2012 marked the beginning of what should be at least a 7-year surge of money into pensions from cities and towns. Why is that?
“Until Detroit went bankrupt in 2012 this was not an urgent issue. But when Detroit went bankrupt they filed in US bankruptcy court. Most state pensions are protected by their state constitutions but the bankruptcy judge said you know what you are going under US bankruptcy law so US law trumps state law. So even though the pension was protected by the Michigan state constitution, the pensioners needed to take a hit under that bankruptcy. That raised this issue to the top of every public labor unions agenda and so from California to Massachusetts to Connecticut to Illinois, taxes have had to go up to bring in more money for the pensions to stop the underfunding and protect the employees from a bankruptcy. That means we’ve had a wave of money coming into the credit market, which has produced this credit boom, which is then turned into stock buybacks from companies taking this money and pushing their stock price up.”
And when we spoke to you previously, I believe you referred to this as a daisy chain of financial engineering.
“Yes. And it’s a string where our pensions bring in money, they have to invest aggressively in credit to make their numbers, managers they hire buy incredible amounts of corporate bonds to try and meet that target, those inflows into companies selling those corporate bonds allow CEOs to buy their stock back and push their stock prices up…
We think the pace of buybacks is actually going to accelerate over the next few years and most investors have not participated in this. Performance in the industry has been atrocious. Most active investors have underperformed the stock market and so what we’re seeing is that pension clients are firing their most bearish underperformers and replacing them with fully invested ETFs, so that’s like a double-barreled push for stocks in that you have more money for credit funding buybacks and you’ve got a shift from investors who are overweight cash, overweight short-selling positions going into fully invested ETFs. So I think that’s a double-barrelled positive for stock prices for the next 2-3 years.”
Okay, so looking out a few years you’re bullish. What about in the short-term? Do you see any near-term risks or is it just off to the races from here?
“One of my themes is that most people feel that if the Fed raises rates, that’s going to be a disaster. So I felt that we would have corrections and we’ve had a number of corrections during this bull market—scary, panicky drops that feel like the world is ending; but I’ve also forecasted that since our nation’s pensions need to put more money to work in investments that any drop in the stock market would likely be brief, although scary, and then stocks would rebound to a new high. And that’s been the case with every panic for the last five years, including when the Fed hiked rates last year. So I think the Fed is going to raise rates…sometime in the latter part of 2016 and that may cause a brief drop in stock prices but I think that drop will be met with an increase in stock prices as pensions put more money to work. In other words, these drops are opportunities to add exposure to the equity market because when you look at the long-term history of the Federal Reserve, when they raise interest rates that’s usually bullish for stock prices, not bearish.”
Listen to this full interview with Brian Reynolds at New Albion Partners where he also provides his outlook on where the next bubble is likely