STEPHANIE POMBOY: If this is the underfunding situation now, when we're arguably at the peak of economic and financial activity, what is it going to look like when, heaven forbid, the market actually sustains a downturn? It's remarkable, the complacency around the corporate sector's ability to service all of this debt. It's going to take people a while to wrap their heads around the size, the sheer magnitude, of money printing that's going to be required.
GRANT WILLIAMS: Yeah.
I'm about to have a long overdue conversation with my dear friend, Stephanie Pomboy. I've been trying to get her to come back on Real Vision for a long, long time, and she has resisted for reasons best known to herself. But there's a whole bunch of stuff we want to talk about. I'm going to ask her why she resisted, and she's going to blame me. But don't believe her.
The Fed, corporate bond markets, junk bonds, equities, there's so much going on. And Steph does some of the best work out there on all of it, much to her chagrin. She's going to hate me saying that. So let's go and sit and talk to Steph.
Well, well, well. Fancy seeing you here.
STEPHANIE POMBOY: Here we are.
GRANT WILLIAMS: Here we are again. Now this has taken a long, long time. Personally, I blame your almost pathologically misplaced modesty. You're probably going to blame me.
STEPHANIE POMBOY: No.
GRANT WILLIAMS: But--
STEPHANIE POMBOY: There's no blame whatsoever.
GRANT WILLIAMS: But we're here. We're here, finally.
STEPHANIE POMBOY: We made it.
GRANT WILLIAMS: Steph Pomboy, welcome back to Real Vision.
STEPHANIE POMBOY: Pleasure to be here.
GRANT WILLIAMS: It's been far too long. So, so much to talk about. And as you and I tend to do we get together, we have to start with the Fed, right? It seems the logical place to start because from the mails or the Fed, all sorts of things tumble out. So I've got to ask you, what do you make of Powell's flip-flop? How important is it? Or are we wasting our time worrying about it?
STEPHANIE POMBOY: It's amazing to me the speed and magnitude of the turnaround. You know, at the end of October, they were debating whether they were going to raise rates two times or three times and everything was fantastic. And in the span of six weeks, now they're talking about not just-- not raising rates but pausing the balance sheet, unwind, et cetera. And what's been stunning to me isn't even that the Fed reversed course but the way the markets interpreted that.
It's going into it when they were talking about raising rates two or three times in 2019, everyone was saying, hey, this economy is so strong we can handle the higher rates. You know, bring it on Fed. And then when they flipped in, you know, whiplash-inducing fashion, the narrative was, oh, this is great because now we're going to continue to get liquidity.
GRANT WILLIAMS: Liquidity.
STEPHANIE POMBOY: So there was no reflection on why they had to abruptly reverse course and what that says about the fundamental state of the US economy, and more broadly-- from our long discussions about the Fed-- how they can ever extricate themselves from this box that they've neatly drawn around themselves, where they can't ever raise rates. We got 10 year Treasury yields just above 3%. And you can feel the economy is starting to shake like an old car on the highway.
GRANT WILLIAMS: But, I mean, I think that's exactly it. They've built this trap around themselves. I remember putting a picture a couple of years ago of the central bank governors-- Bernanke was in the chair at the time-- in a corner with a painted floor where the last bit of floor of the painting was right in front of them, and that seems to be what they've done. And yet, for now, they've gotten away with it, which I'm just-- I'm just baffled by it.
STEPHANIE POMBOY: It is baffling. You know, they've demonstrated a perfect record and getting it wrong every time. And yet the markets continue to adapt to them with some great gift of insight and ability to navigate us through any kind of economic or financial shoal, all evidence to the contrary.
GRANT WILLIAMS: Right. But is it that? Is the market thinking that? Or is the market-- I think liquidity cheering thing is just that. It's, OK, almost as if they kind of expected this to happen. We're going to keep going. There's no way they're going to get these four rate hikes away in 2019. So we'll kind of keep buying. We had that wobble in December. And as soon as they about turned, it was like, we knew this would happen.
STEPHANIE POMBOY: Right. The status quo is great as far as Wall Street is concerned. What happens in the underlying economy is almost irrelevant at this point, as long as you keep the liquidity pumping and there's cheap credit to buy back shares, what's to stop this game from going?
STEPHANIE POMBOY: Well, let's talk about those buybacks because that's such a massive component of what's going on. I don't have the numbers to hand, but the percentage of the advances that are down to share buybacks is, I mean, so staggeringly beyond anything you could have imagined. But, again, it's hard to see how people aren't looking at this and going, this is a terrible thing.
STEPHANIE POMBOY: Well, the numbers are staggering. And it really-- the corporate sector, I guess, is the largest purchaser of stocks in the post-crisis period. I was looking at-- we have seen this ballooning in corporate debt in this whole recovery phase. And I was looking at that relative to buybacks because we all know intuitively that buybacks have been debt financed primarily. And the numbers are actually even more remarkable.
So according to the Federal Reserve's flow of funds numbers, there was $3.3 trillion increase in corporate debt.
GRANT WILLIAMS: Right.
STEPHANIE POMBOY: Buybacks over that same stretch were $3.4 trillion. So [LAUGHS] I mean, the numbers are just truly staggering. And one window that I think is really important into the role that buybacks have played is the difference between S&P earnings numbers, which are heavily flattered by these buybacks because they're per share earnings numbers, and the profit numbers reported by the government as part of their GDP report. And this is super wonky. Only nerdy economists like me would look at this.
But it's been amazing to watch the gap between those two measures expand. We had this huge obviously 24% increase in S&P earnings last year, and the rule to which that was influenced-- even notwithstanding the tax cut by the record amount of buybacks-- is so under appreciated. And it's had me worried that as we come into 2019 in that tax cut lift phase, people might start to realize, hey, the underlying fundamentals here aren't really that strong because while the S&P was reporting earnings of 24%, the broader government profit numbers were only up 7%.
That's a massive gap. And you've only seen gaps like that a handful of times in the last 50 years. And every time you've seen a gap where the S&P ran ahead of the government numbers, it's been ultimately reversed.
GRANT WILLIAMS: It's catch down or catch up. Yeah.
STEPHANIE POMBOY: The BEA, the government, has had the numbers, right? And S&P ends up moving back into alignment with it which will be really painful if it happens this time.
GRANT WILLIAMS: Well, and also the estimates for earnings growth, I mean, are plummeting, right? I mean, it was a great chart you put in macromavens which I shamelessly stole. And if I--
STEPHANIE POMBOY: Steal away.
GRANT WILLIAMS: I would have tried to pass it off as mine, but everyone would have known that it was not me. But, I mean, it's-- I mean, these things are falling off a cliff. And yet, and yet, and yet--
STEPHANIE POMBOY: Right. The chart is, you've got the earnings revisions going down and the stock market just keep going up. And I guess part of it is that we're really kitchen sinking, if that's a phrase, the weakness into the first quarter. And if you look at that trend in estimates going out, they see earnings picking up. And then ultimately going back to double digits in 2020. So this is just temporary. You know, it's--
GRANT WILLIAMS: Transitory. Yeah.
STEPHANIE POMBOY: Right. It's seasonal. It's the one time effect of the tax cut. So nothing to see here.
GRANT WILLIAMS: But, I mean, everywhere we look-- and the work you do and the work that your brother Eric does, these charts with these alligator jaws, I mean, it's almost hard to find one that doesn't look that way at the moment. And, look, we've this before. And you and I worry. I mean, you and I when we get together, we worry. That's what we do. And for many reasons, that's been the wrong thing to do. You should just lay back and let it all go over you, right?
But at some point, you have to do the worrying because at some point, it will matter to. When you talk to your clients--
STEPHANIE POMBOY: When is that day going to be though? [LAUGHS]
GRANT WILLIAMS: Yeah. Right? I mean, I don't know. I really don't know. And how bad is it going to be by the time we get to it? But when you talk to your clients, what's the sense you get of the way people approach this? Are they genuinely thinking everything's great and forget all this stuff? Or are they thinking we're going to ride this Fed wave, and then we're going to jump off right before it crashes onto the shore?
STEPHANIE POMBOY: Yeah, no. I think there's much more complacency. I mean, I think there's an acknowledgment that there are some fundamental and structural issues, the debt, you know, the funding issues around pensions. People acknowledge that these are big headwinds for the economy long-term. But they don't see any kind of cataclysmic event.
They don't-- I think the path of least resistance for the average investor is this kind of muddle through scenario where maybe the economy slows a little bit. But that's fine because then the Fed doesn't have to raise rates. So it's kind of Goldilocks. And then not everything moves in a straight line. We'll have little slowdowns here and there. And it's really we'll be able to navigate our way through this. You know, how we'll be able to do that is unclear.
But the burden of proof is on folks like you and me because so far it has muddled through and we have been able to move forward despite what we worry about as major, insurmountable obstacles that will have to be addressed at some point.
GRANT WILLIAMS: Well, you mentioned pensions there. And that's something you've done a lot of work on over the last few years. And you put a chart up-- I forget who it was, but the underfunding of the pension system. And this was two or three years ago maybe you put this thing up there. And when I looked at it the time, I was like, holy cow, this is really dangerous.
STEPHANIE POMBOY: Right.
GRANT WILLIAMS: And I keep going back to the chart and it doesn't get any better.
STEPHANIE POMBOY: It's probably doubled since then.
GRANT WILLIAMS: Right? So just talk a little bit about that and what you see there. Because it's-- I mean, it's really, really dangerous.
STEPHANIE POMBOY: Yeah. Well, I think this is obviously there are a lot of unintended consequences of monetary policy. And right now I think this is the most blaring and dangerous side effect of these repressive rate regimes that we've had here and around the world for the last almost decade. And to be fair, I think when central bankers got into this thing where they pushed rates down and decided we're going to hold rates down at absurdly low levels, they never imagined they'd have to hold there as long as they ended up doing.
So they probably thought, we'll hold rates down to the point where we spur animal spirits again, and then we'll be able to lift things up, and we'll have that handoff between reliance on debt to drive the economy to finally getting to income growth. Households will be able to rather than borrowing to sustain consumption will get wage growth and everything will be able to move on its own.
Of course, we went through a long, long, long period where that was not-- they couldn't make that handoff. So they had to hold rates incredibly low. And what happened is there is essentially they silently bankrupted the entire pension system throughout the US.
GRANT WILLIAMS: Right. It sounds dramatic, but that's exactly right.
STEPHANIE POMBOY: Yeah. No, it absolutely is true. I mean, when we started this, I think we were at $3 trillion in total underfunding public and private. And today, we're just a hair under $7 trillion. That's 33% of GDP today. And the scariest thing to me about that is that, again, this is after a decade long, almost-- decade long economic expansion and the longest bull run in stock in history. So if this is the underfunding situation now, when we're arguably at the peak of economic and financial activity, what is it going to look like when, heaven forbid, the market actually sustains a downturn or we go into a recession?
You know, the answer, if you want to look back to 2000 when we had the dot.com bust and then the 2008 episode is on average of those two cycles the funding deficit doubled. So we would go from seven to $14 trillion which, if GDP is where it is today, so you to 2/3 of the GDP.
GRANT WILLIAMS: Yeah. Exactly right. Yeah.
STEPHANIE POMBOY: I mean, at what point do those numbers actually start to matter? I would have thought at 33% just--
GRANT WILLIAMS: So you have three years ago. Right.
STEPHANIE POMBOY: Right. That would have been enough of a wake up call. And it's again when you start talking about pensions, it's something people see as a long-term problem that we have the luxury of time to solve. But that's really not true because we have an aging population and we have more and more people every day who are coming to collect on these pensions that aren't funded. So the problem is really coming into focus now.
I mean, we had a brief example with the Dallas police pension--
GRANT WILLIAMS: Yeah. But that was, what? Three years ago? Four years ago? Yeah.
STEPHANIE POMBOY: At least.
GRANT WILLIAMS: Yeah.
STEPHANIE POMBOY: And it was really, I think, an interesting window into what we could see more broadly. But a terrifying window, because basically what happened there was that word got out that the Dallas police pension was woefully underfunded, and it started a run on the pension where people who were nearing retirement said, well, let's get back mover advantage. Whatever money is there, I want to collect mine. And it didn't take long before they actually had to close the doors and say, look, we're not allowing this anymore.
So you could see a situation where those kind of examples could happen in Chicago, New Jersey--
GRANT WILLIAMS: New Jersey. Yeah.
STEPHANIE POMBOY: There are so many places where you have really problematic pension issues, and they're not going to be resolved this long as the Fed keeps these rates artificially low. But, on the other hand, raising rates is also a problem.
GRANT WILLIAMS: Exactly. Exactly right. I mean, we didn't have-- this fascinates me because I remember when I moved to Japan in 1989, they were talking when I got there that in 2015 the Japanese population will begin to shrink. And 2015 was a lifetime away, right? And so it was such a big concept and such a big thing to be worried about. It's like they're figure it out. They'll figure it out. And, of course, 2015 comes. The population starts declining. And people are going, how the hell do we solve this problem?
And this is-- when I look at this pension situation, I see that exact same thing happening. It's such a big problem. We're talking possibly $14 trillion in unfunded liabilities. How do you even think about a solution to that until it stands up, slaps you around the face, and you have to deal with it? So does this almost have to fall over if it's not going to be done? And can people just go, it's not a problem because they'll fix it when they have to?
STEPHANIE POMBOY: Well, the pushback I get on this one is interesting to me because most people will say, they'll just renegotiate the pensions. It's obvious. We can't possibly fulfill the obligations as outlined right now, as promised now. So they'll just renegotiate, as some companies have done. The problem is, while that very well may end up being the solution, it simply passes the saving burden from the company or the state or the city to the person who was trying to retire.
GRANT WILLIAMS: Right.
STEPHANIE POMBOY: So if you haven't set aside the money because you think your city, or your state, or whatever pension is going to be there, and all of a sudden they say, look, Joe Blow, we're going to pay you half what you thought, now either you have to continue to work. No mystery why the labor force participation rate of people 65 and over is the highest since the 1960s right now, or you're going to have to cut your spending and downsize your lifestyle, et cetera, which has-- all of those things have a real economic impact.
So we're either going to have to address the pension thing in some kind of cataclysmic crisis way, or we're going to have this steady economic drag exerted by