Sunday, June 3, 2012

No Guarantees in Fiat Currencies or Retirement

One of our younger relatives told my wife and me years ago that he couldn’t settle down because he had “too many questions in his head.”  Unknowingly he repeated what market sages for years have stated, that the market needs “certainty.”  Thus both the young and the wise are grappling with an unknown and perhaps more correctly, an unknowable future.

To answer our basic concerns, the strongest human marketing powers in business, government, science, and religion have repeatedly provided generally accepted guarantees that answer our concerns. During the current period of global neurotic economic stress, one wonders whether the title of Andy Grove’s book, “Only the Paranoid Survive”  is relevant. I am suggesting that as with all well-marketed messages, guarantees provide necessary comfort, but they may not be complete in each individual case. Given the uncertainties facing the modern world, the backing behind each guaranty needs to be understood.

Briefly this blog will touch on some of the accepted guarantees involved with retirement income and the value of money. As usual at the end of this blog I will suggest investment implications to these views. (Many of the views expressed will be provocative and will hopefully generate feedback.) 

The Promise

The heart or essence of any guaranty is the promise that under specifically-stated events or occurrences a predetermined reaction will automatically be triggered. In effect, the promise is a contract, often ill-defined or in some cases not even written down. As time passes, what is remembered is what someone believes to be the promise, without any review of the contract. In typical wedding vows, the only exit is by death. There is no mention of actions and attitudes that lead to today’s large number of divorces. In Europe and elsewhere, the fear of either the marriage contract or divorce has led to a large portion of the population living together for extended periods of time rather than marrying.

Retirement Income

Rational people for ages have been saving money, in part to meet a future period where they will no longer be sufficiently economically active to provide for their own needs. For centuries hoarders have converted much of their stash of wealth into savings. In turn some or all of their savings have been entrusted to various financial instruments and institutions. Since the 19th century and that great “humanitarian” Otto van Bismarck, people have increasingly relied on taxing authorities to supply retirement income.  (Bismarck created the first social security system which would pay retirement income starting at age 65. He picked that age because he believed that very few would reach that age.) In a more modern era, recognizing that most employees would not have enough discipline to save for themselves, companies would defer some current compensation to be paid out later in retirement. Unfortunately, these two sources, the government and various employers, represent the bulk of the expected retirement income for those that had a career of working. For the most part these people are not worried now and don’t expect to be worried in the future because they believe that they have been guaranteed these payments.

These guarantees are increasingly being issued by some  entities  that are having their own financial difficulties. Most federal and some state and municipal governments around the world are operating at a deficit. We, the citizens, consciously or involuntarily are consuming more from the government than is being taxed. Almost all now recognize that this deficit production cannot continue forever. The two standard solutions are to cut expenses or raise taxes. Somewhere in between these two difficult choices there is a stop-gap measure of changing the payment schedule assumed by the government.  Delaying debt repayment to foreign borrowers can lead to materially higher borrowing costs in the future. One can see the possibility that the government could materially change the net effective payment of social security payments. After all, it is difficult or almost impossible to sue the US government without its permission. Most beneficiaries may not realize it, but social security payments are already effectively means tested. The amount of the payment which becomes reportable as taxable income is based on the level of other income received. Remember that half of the benefit received came from your employer or you as self-employed. Changing the date of full retirement is another way of changing the shape of the government debt. For some time I have warned all of my young employees that they should view that FICA (social security) taxes withheld from their pay and matched by their employer are tax payments and they will be unlikely to receive any real retirement income from their tax payments.

What is probably a larger problem for some is the so-called Pension Guaranty Corp, a government body that is meant to guaranty some pension payments for corporate pension plans of bankrupt US corporations. With the government proclivity to bailout pre-packaged bankruptcies of companies with large union member work forces, the guarantor will run out of money and will have to raise fees on those declining number of defined benefit plans or get an infusion from the US Treasury through an act of Congress. Both are uncertain.

Other ways to save are through various financial instruments directly or thru financial institutions. These are only as good as their continuing credit conditions.

Bottom line:  the various sources of retirement income are not perfectly secure under all conditions. The prudent saver needs to be aware that the expressed guarantees have some limits.  

The Value of Money

In the US, much of life’s activities are ultimately measured by colored pieces of paper approximately 6 by 2 ½ inches called the dollar. The pretty paper which circulates around the world in various denominations has little face value, but has substantial spending and trading value based on the belief that there is some almost universally accepted value because of a series of ill-defined guarantees.  Thanks to President Nixon,  the US dollar no longer has direct backing of gold or even now a fixed basket of currencies. As long as others will exchange goods and services for these painted pieces of paper, the dollar and other fiat currencies have value. Around the world the dollar trades against other currencies 24/7. In theory the Federal Reserve currency  has the vastly expanded Fed balance sheet as backing. These are supported by various issues of  US Treasuries that are the debt of the US government. What makes this curious to a financial analyst is that we have never seen a published balance sheet for the US government. We can speculate as to the enormous value of the government’s real and intellectual property. Most of us don’t know the size of the debt against these assets, particularly the future contingent debt. Value-oriented investors regularly arbitrage the difference between a quoted price and its intrinsic value. I cannot perform this equation as I lack any sort of precise knowledge as to the value of the dollar other than what is trading for now versus other currencies, including gold. Thus, I do not recognize fiat currencies such as the dollar have a guaranteed conversion price.

The Terrible Link

Both the value of future retirement income and the value of the dollar are linked to the rate of future inflation, which itself has no guaranty. The value of the current dollar, euro, pound, yen, and Renminbi is exclusively based on what they can buy today in the way of goods and services. If one isn’t going to spend currency today, one must be concerned as to its future value. Often its future value will be dependent on the path of relative prices. This is particularly true for the retired when an expenditure is likely to draw down retirement income or capital. As these are unknown or probably unknowable, I seriously question the certainty of both currencies and retirement capital that people are using.

 Investment Strategies in a World of Questionable Guarantees

First is my guaranty. My guaranty is that I won’t guaranty any specific future scenario or strategy that will produce only winners.

Second, in a period of increasing uncertainty, excessive concentration is dangerous. 
Third, as I believe significant inflation is eventually probable, I believe up to a quarter of one’s portfolio should be in an inflation defensive mode to include TIPS and selected foreign treasuries of up to five year maturities issued by  small population/commodity rich governments with small to no deficits.

Fourth, all equities should have a global orientation. These companies should have some of these characteristics: exporters, foreign operations, net royalty recipients and managements that think beyond their local borders.

Fifth, technology developers and users should play dominant roles.

Sixth, put at least 25% of your or your clients’ portfolio into stocks of companies that are more flexible than their large competitors. This puts one into smaller capitalization securities.

Seventh, as only a few mutual funds are constructed exactly along these lines, a portfolio of funds that appropriately counterbalance their portfolios will be needed and selected carefully.

Feedback Sought

Please share with me your thoughts on the guarantees discussed and or how one should construct a portfolio for such uncertain times.
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