This week, we recap discussion from a recent industry panel addressing possible impacts of the global economy on U.S. States and describe additional metrics to watch to monitor health of municipal pensions.
Last week, Lumesis attended the Bond Buyer 2015 National Outlook Conference. CEO Gregg Bienstock participated on the panel: Finding Opportunities, Avoiding Pitfalls-Investing in the Municipal Bond Market. Gregg's comments touched on several themes:
- Any increase in interest rates this year is likely to be modest
- European Quantitative Easing will mirror ours: multiple rounds
- A strong dollar will impact U.S. exports and trade deficit
Several factors have led to a high and rising value of the dollar vs. most other currencies. The relatively strong U.S. economy and the potential of its third recession in 6 years led to Europe's introduction of QE. Other countries around the world are also wrestling with slow growth. China, Japan, and the Emerging Market countries are all experiencing slow economic growth and/or low (sometimes negative) inflation.
Slow growth and low inflation will continue to drive low rates. Anecdotes abound: Germany (one of the better Euro economies) just borrowed at 0%; Sweden cut rates to below zero 2 weeks ago; Denmark has cut its rates four times in three weeks.
Low global interest rates and periodic flights to quality have supported demand for Treasuries and by extension municipal bonds. These factors have also led to a strong value of the dollar vs. other currencies.
The strong dollar complicates the Fed's task of beginning to "normalize" U.S. rates (whatever that might mean; it is certainly not the rates we have been accustomed to over the past 10, 20 or 30 years). While the Fed appears eager to begin to tighten monetary policy, the strong dollar threatens U.S. exports and, together with low oil prices, puts downward pressure on U.S. inflation.
The strong dollar could have negative repercussions for U.S. companies. U.S. multinationals count exports as a significant part of their business. Raising prices to offset the dollar's rise is not an option. Many multinationals have indicated that revenues are more exposed to dollar strength than expenses. For example, Johnson and Johnson and PepsiCo both recently cited currency exchange rates as a drag on earnings.
The strong dollar impact on the municipal market can come from several channels. The decline in corporate profitability directly impacts municipalities via lower than expected tax revenues. This impact is especially pronounced where employment is concentrated in a particular area or region. (Johnson and Johnson is the 7th largest employer in New Jersey.)
Another channel of strong dollar impact for municipalities is declining export volumes and the resulting weakness in local economies. Fourteen U.S. States derive more than 10% of their GDP from exports (at 9.8% Illinois is 15th). Exports account for more than 20% of GDP in three states: Louisiana, Washington, and Texas. Export volumes from Louisiana and Texas will also see declines due to low oil prices.
According to the Census, half of Washington's exports are Civilian Aircraft, Engines and Parts. At a recent conference, Boeing's CEO commented that his company will be somewhat insulated from currency impacts because of the long purchase cycle, and because of prior currency hedging activity by Airbus. Leaders in Washington State are likely hoping he is correct.
Important Pension Metrics to Watch
We continue to feel that pensions will be one the key issues faced by the municipal market in 2015. The audience at the Bond Buyer conference seemed to agree. In a poll taken at the conference, 32% indicated that Pension Reform would be the "Biggest Headline of the Year." The top vote getter (33%) was SEC Enforcement.
During his panel, Gregg highlighted data from the Lumesis pension database indicating that the pension problem is severe. The average funded ratio for State plans was 65.4% in 2013 (down from 67.7% in 2012). Gregg pointed out that the nine worst States for funding ratio all have levels below 58%.
While this rough cut is helpful at identifying the most extreme issues, Funded Ratio and ARC % paid do not give a full picture of a State's or city's pensions. For each plan, it is important to study the underlying assumptions (discount rate for one) and how they are changing.
A particular area of concern is life expectancy assumptions, which have been increasing. In fact, the same were just increased by two years. It is important to verify that the aggregate pension calculation is based on timely analysis, which can be verified by checking the Actuarial Valuation Date. Stale actuarial data or assumptions can lead to a false sense of security.
Other metrics that we monitor and which we encourage our clients to watch are:
- ARC Paid as % of General Fund Expenses
- Unfunded Liability as % of GDP
- Discount Rates
- Smoothing method
Together with Funded Ratio and ARC % Paid, these additional metrics help to give a more complete picture of the potential pension challenges for a State or city.
Michael C. Craft, CFA, is Managing Director, Credit at Lumesis, Inc.
