Follow The Fed Pension Fund’s Actions

Fed Pension Fund Bearish?

I disagree with almost all the Fed’s monetary policy decisions, but I have found one Fed related vehicle which I agree with. The vehicle I agree with is the Fed’s pension plan because it has been lessening exposure to equities. The Fed’s plan is not run by Fed members. However, it does reflect an understanding of monetary policy cycles and valuations. After the Fed has raised rates three times and when median valuations are this high, it’s clearly a time to lessen exposure to stocks. It’s disturbing that the Fed can create asset bubbles and then not have much personal negative impact on themselves when they burst. I’m saying the Fed needs to have its pension fund do poorly; I’m saying it should stop encouraging risk taking through its QE program which lowered rates and put people in stocks. The chart below shows how the Fed’s pension fund has allocated capital. Fixed income was 48.9% in 2016 and equities were 40.9%. If the ‘dumb money’ which has been driving this rally lately were this cautious, returns year to date would be much lower.

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Retail Bankruptcies Explode

One bearish story which has gained media attention lately is the increase in bankruptcy filings in retail. In less than three months, the number of retail bankruptcies reached the amount seen in 2016. Rising interest rates played a role in this increase, but the weak consumer and the move to buying goods online are bigger factors. The Bank of America high yield index interest rate has actually fallen from 6.19% at the start of the year to 5.91%. Defaults are a matter of profits not making up for the debt increases for years. Companies don’t go into bankruptcy overnight; it takes years of declining sales to get that point. Rising interest rates were only the straw that broke the camel’s back.

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In Q3 2009, ecommerce was 4.1% of retail sales. Now ecommerce is 8.3% of sales. The retailers which didn’t see this trend coming or didn’t adjust to the changing environment are now paying the price. Payless is closing 500 stores and filed for Chapter 11 bankruptcy Monday. That’s the type of company which was put in a bind by online competition. The managers probably thought because shoes need to be tried on, that the firm would be resistant to the trend in online sales growth. Since it was a discount store, it probably didn’t have the money to invest in building a web infrastructure. I’m basing this opinion of what may have happed at Payless on what I’ve read about Signet Jewelers and Party City. Party City says Halloween costumes need to be tried on and that party goods are often purchased at the last minute which makes it resistant to online stores from taking share. Signet says diamonds are an item which need to be seen in person before purchased. Most physical retailers which try to explain why they won’t be hurt by online gaining market share have been wrong. Home improvement is one the few areas which hasn’t been hurt because of the sheer size of the items sold.

The other trend which has hurt retailers in the past few years is the shrinking amount of disposable income the average worker has. As you can see from the chart below, the urban rent CPI has been rising faster than the increase in hourly wages since mid-2012. Whenever wage growth beats expectations or shows improvement, it always needs to be put in the context of the speed at which costs are increasing. If your rent is up 3.5% and you just got a raise of 2.5%, you didn’t get a raise. You got a pay cut masquerading as a raise.

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Consumer Saddled With Debt

Saying the consumer is in an unhealthy position is an opinion which is outside the mainstream because those who own houses or have their money in stocks have seen their wealth rise this cycle. Even with this rise in wealth, student loan and auto loan delinquencies are rising. Because of the accelerated clip at which college costs are rising, the debt is mainly held by recent graduates which probably haven’t been able to take advantage of the gains in stocks and housing prices.

Because the debt bubble is in auto and college loans, they will be the leading indicator in this default cycle. As you can see in the chart below, revolving home equity loan and mortgage defaults started to increase in late-2006 which was well before the recession. The term subprime became part of the lexicon of everyday people in 2007. As you can see, the auto loan delinquencies are now starting to perk up like mortgage delinquencies did in 2006. The auto loan bubble is a cyclical one. The student loan bubble has been building for much longer. It finally is at the size where it’s burst would hurt the economy as it represents 10% of consumer debt.

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The reason the student loan debt burst is inevitable is because of the same math which the housing market was susceptible to. The price of a good can’t rise above what people can pay for it. Higher prices eventually beget lower demand; the price increases take a longer time to hurt demand when credit is easily accessible.

In 2005, people who had salaries of about $80,000 were buying second and third homes like they were millionaires. Now students are using student loans to finance majors which won’t help them get a job. The crazy decisions always happen at the fringes of the market, but the fact that they exist show the extremes the bubble has gotten to.

Conclusion

The consumer is about to be in a major bind. The wealth increase they have seen from rising financial assets are temporary, but the debt they have taken out to go to college and buy a car is permanent. It will need to be paid off even if stock prices decline and the labor market weakens. The labor market is about as strong as it will get this cycle. The fact that student loan delinquencies have risen in a relatively strong labor market gives you a signal as to how bad delinquencies will bet when the labor market softens. On Wednesday, the ADP private sector payrolls report will give us an update on how the labor market is doing.