The “Reach For Yield Is Spreading” by Worth Wray – STA Wealth Management

INSIDE THIS EDITION:

The “Reach for Yield is Spreading”

For What It’s Worth

Weekly Technical Comment

401k Plan Manager

Features Articles & Interviews

“Open House”

We will be hosting an Open House event entitled “Portfolio Construction for a Stormy Market” on Wednesday, September 7, 2016 from 6:00-8:00 o’clock in the evening and we will be honored to have you attend. Here we will discuss not only current market conditions and how they will affect you but more importantly how to prepare and plan financially in spite of them. 

Please take advantage of this opportunity and confirm your attendance to the Open House and REGISTER HERE. Seating WILL be limited.

We look forward to seeing you!

Economic Growth Slows and the Fed Talks of Raising

Written by: Luke Patterson

CEO & Chief Investment Officer

Overall economic growth has been tepid since late last year, with GDP advancing at a modest pace of 0.9% in the fourth quarter of 2015, 0.8% in the first quarter of 2016, and 1.1% in the second quarter.

Friday’s revised report showed slightly weaker second-quarter GDP growth compared with the government’s initial estimate last month of 1.2%.

Yield Spreads

Also, last week the Fed governors met in Jackson Hole, Wyoming, and the market took notice of the Fed Chair’s commentary.

Janet Yellen’s main sermon was about the tools the Fed could utilize in the future when easing will be required, and what made headlines and caught the market’s attention was this:

“Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months”

Investor’s clearly took notice with bond yields rising to two-month highs and the equity market suffering from its worst week since the Brexit referendum (Dow -0.8%, the S&P 500 -0.7%, and the NASDAQ -0.4%).

Tightening into a one percent growth economy and a six-quarter long profits recession is a risky game to play.  But this is the same Fed that pulled the trigger last December under similar macro conditions.

No doubt the Fed has made the threats before.  Whether you look at the “taper tantrum” of three years ago or the pledged four hikes at the start of 2016, we have been here before.

The general investing public buys the least at the bottom and the most at the peak.  Global bond funds posted a $6.6 billion net inflow last week and the intake during this QE era is approaching the $1 trillion mark.  Investors continue to chase returns here, returns that can only occur if yields become even more microscopic or, in some cases, more negative.

Take note – all “crowded” trades that worked well on the Fed-on-the-sidelines view could be on the receiving end of a serious test in coming weeks and months. Friday’s response to the Jackson Hole commentary by the Fed should be used as a template of what to expect if the Fed isn’t bluffing again.

The “Reach for Yield is Spreading”

In last week’s report we featured a piece entitled “Quest for Yield”. Well… the quest continues as investors seek income and the increase in portfolio risk is the result of desperate maneuvers to fill the shortfall in state pensions.

According to The Pew Charitable Trusts state pension funds are looking at a $1 trillion shortfall in what they owe workers in benefits. While many states have cut benefits to new workers and frozen plans for current staff, they cannot cut benefits that have already been earned by public employees. That means they have to find money to make up the shortfall by cutting other programs, raising taxes, generating higher returns or some combination.

Pew reported that states were to make up $35 billion of their unfunded liabilities in fiscal 2014, leaving a shortfall of $934 billion. That’s because of stronger returns in 2014, but returns fell again sharply in 2015, to just 3 percent. Those lower returns mean states with badly underfunded liabilities will have to come up with more money to fill the shortfall.

States with the biggest funding gaps include Illinois and Kentucky, the two worst-funded systems, with just 41 percent of what’s needed to pay the benefits promised to public employees. New Jersey has set aside just 42 percent. Only three states have set aside enough money to fully pay retirement benefits owed to current and future retirees: South Dakota, Oregon and Wisconsin. For those of us in Texas, the Lone Star State has just over 80 percent of what is needed.

With few options and time running out to fill these pension shortfalls. The “reach for yield” is spreading to U.S. pension funds. They are now employing option strategies in an attempt to increase the yields on their portfolios. What could possibly go wrong?

In this case, they are selling put options on the S&P 500 which produces income but they in turn bear the risk if stock prices fall.  This process is sometimes called selling portfolio insurance because others will buy these options to protect their account from declines. The Wall Street Journal reports pension funds in Hawaii and South Carolina are now doing this with the thought this income will protect against declines in the U.S. stock market. In reality, they are essentially increasing their exposure to losses if the market falls quickly.

Typically, as long as the stock market remains unchanged or higher, the pension funds will keep the premium they receive for selling this insurance. If the stock market declines, they will have to pay those who purchased protection from them in an amount equal to the losses incurred. Generally, the bigger the stock market decline the more they would pay out.

Even more troubling, the pension funds are misunderstanding the likely effect on their portfolios. The pension funds believe this strategy will reduce risk. However, past returns show this will likely increase portfolio risk and the correlation to the stock market. Not likely the desired outcome that is needed.


For What It’s Worth…

R* You Ready for a Global Shock?

Written by: Worth Wray

Chief Economist & Global Macro Strategist

Summary

  • 2016 has been a year of desperate central bank intervention to contain the US dollar, support a global reflation, and buy time for major governments to build on this fragile peace in the currency war.
  • This “Shanghai Accord” has held the world together for six exceptionally strange months, but time is running out as political pressures in fragile economies change the incentives for central banks to put global stability ahead of their domestic mandates.
  • Japan is getting desperate. The Euro area is slowly tearing apart. Oversupplied commodity markets aren’t seeing the demand growth most analysts expected going into this year. And China’s incentives to cooperate with the Western world are quickly fading away as a number of key dates (the G-20 meeting on September 4-5, the RMB’s inclusion in the SDR on October 1, and the US Presidential election on November 8) come and go.