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The Emperor's New Clothes

June 23, 2017

 

We all know the story of the Emperor who spent his fortune in order to ensure that he was the best dressed in the land. Ultimately he was fooled by a swindler claiming the ability to weave the most magnificent fabric imaginable, one that could be visible only to those that were worthy. Out of fear of appearing foolish, all the townspeople remained silent while the Emperor paraded around naked. Not until a little girl shouted “he hasn’t got anything on” did the townspeople speak up. Despite the Emperor suspecting they were right, he continued to think “this procession has got to go on” and continued to walk proudly, as his noblemen held high the train that wasn’t there at all.

 

 

As bizarre as it may sound, there are many parallels between this tale and the story we are living and writing today. Unfortunately, the ending chapters of this story do not look to be as humourous as the one in The Emperor’s New Clothes. In this blog post, we highlight two big problems that will have a profound impact on shaping the final chapters of this story. These two problems are: unfunded promises and debt.

 

Problem One: Unfunded Promises

 

To be candid, governments have made endless false promises over the course of our lifetimes, which they frankly cannot afford to keep, such as healthcare coverage, social security and pensions. Citibank reports that the OECD countries face $78 trillion in unfunded pension obligations or 50% more the size of their whole economies. In the U.S., Medicare represents a $32 trillion obligation over the next 75 years, while social security represents an $11 trillion obligation. Entitlement programs alone will equal 84% of Federal revenues by 2027. These are scary and unsustainable figures.

 

Despite the financial markets reaching all time highs, unfunded liabilities continue to balloon. Many pensions still have not adjusted their expectations for future investment returns to a more realistic objective given interest rates have been very low, meaning they are wildly overstating their future return assumptions. The fact is that we are in a slower growth, highly levered and lower inflation environment. This means interest rates and returns will be lower. Companies and governments burdened with such liabilities will have no choice but to divert funding from real tangible investments to the covering of this spending shortfall or alternately, simply renege on their promises. The burden is just too large and unmanageable.

 

Making matters worse, those citizens that will be most impacted from pension shortfalls are the individuals that need it the most. A Federal Reserve report highlighted that one-third of the population in the U.S. would need to borrow in order to meet a $400 unexpected expenditure. You think inequality is bad now? If the government can’t afford to take care of its citizens, the burden will fall to the younger generation to fill the void. The problem is that this generation is laden with student debt and there are fewer of them. In 1970, for every senior citizen there were 5.4 individuals between age 20 and 64, this will soon decline to just 2.6.

 

The retiring baby boomers, the largest retirement wave in history, will also have a profound impact on the financial markets. With retirement comes no steady job related income. By the time the next recession comes around, baby boomers will have no choice but to be net sellers of their assets to raise funds for daily financial needs. With no steady income stream, baby boomers cannot be relied upon to re-invest back into the stock market during a recession like they had in the past, which helped provide stability. We must acknowledge that Baby Boomers, the largest holders of equity in the past, may now be at their peak equity allocation within their investment portfolios.

 

Problem Two: Debt

 

A government’s main source of revenue is the tax dollars it collects. From these tax dollars it pays expenses. If the government is unable to cover all of its expenses it runs a budget deficit and must borrow. The government today has accumulated a large deficit. There are two explanations: 1) the government falsely believed that tax revenue would be adequate to cover such promises or 2) they figured the issue was the problem of future politicians. We are leaning towards the latter and note that the issue now is that those future politicians are today’s politicians, but they continue to add to promises they cannot keep as if they were not.

 

Consider the following on tax collection in the U.S.:

 

  • 4.2% of all U.S. income tax returns exceed $200,000 in income and they comprise 63% of total federal income tax receipts.

  • One third of U.S. tax returns filed paid no taxes and received tax refunds; 45% had income of $30,000 or less.

 

And consider the following on government spending:

 

  • U.S. defense spending is already larger than the combined spending of the next eight largest national defense budgets yet under the Trump the promise is for this to keep rising.

  • U.S. government spending on healthcare is higher than the average industrialized nation as a percent of GDP and as the boomers age, this is likely to get worse.

 

See the disconnect?

 

These large continued deficits have amounted to a total gross national debt of $18.96 trillion, a threefold increase from 2000 levels. The government paid $432 billion in interest payments last year, at a blended rate of 2.2%. Interest payments are the third largest component of the Federal budget, just after social programs and the military. In 2000, the government paid $361 billion in interest at a blended rate of 6%. Despite the debt load tripling to today’s levels the interest payments are only $70 billion more thanks to the Federal Reserve which has kept interest rates at all time lows.  Now that the Federal Reserve has embarked on the path of increasing rates, this interest burden will not be as manageable going forward. According to the Congressional Budget Office, every percentage point increase in rates will cost $1.6 trillion over the next 10 years. Put another way, a 1% rate hike will take an additional 3% of the U.S. current tax revenues every year.

 

This debt level is a significant burden on the budget (and is only getting worse) and will strain the government’s ability to care for its citizens. Investors and politicians have become complacent about these debt levels. The basic principles of Finance 101 are being ignored (greater debt level = greater financial risk = higher interest rates). This complacency is rooted in the government’s current ability to refinance its debt so easily. Financing the debt is not a problem as long as foreigners, such as  Europe, Japan and China, are willing to buy their bonds. It also helps when the Federal Reserve keeps the cost of servicing the debt extremely low by maintaining interest rates at artificially low levels. But now rates are starting to edge higher and in the first six months of the year alone, Europe has sold 500 million Euros worth of its US dollar reserves and bought Chinese Renminbi instead. This could be the beginning of a big change in the supremacy of the dollar.

 

So it is naïve to assume this accommodating intoxicating party will go on forever. There is always a last call. This isn’t an issue that should blindside us, as the problem is right in front of us. The government can’t afford to maintain this debt level and take care of its citizens, so we are left with unfunded promises. In essence, the citizens have been swindled into believing they are fully clothed and that their well-being is safely ensured by the all mighty government when in fact they are completely naked.

 

If you consider other major structural changes we are witnessing, such as the potential destruction of just about any job through Artificial Intelligence and robotics, at this point, you might have thought the movie Armageddon played for a better analogy for this blog than a naked Emperor. Regardless, understanding these problems is crucial for investing for the future and sometimes it takes the brave soul to call out the obvious among a herd of ostriches with their heads in the sand.

 

Those investing in general market funds may be in for a surprise as the world is indeed entering a much different phase. The next decade is unlikely to see the rising tide lifting all boats given the structural headwinds that will be faced. Being in the right investments and proceeding with great prudence will be more important than ever. Taking care of your own future and not relying on the government will also be absolutely imperative.

 

The Summerhill Team

 

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