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Positive Economic Commentary
A Bear Market Can Strangle An Economy In Various Ways
October 21, 2002
Most of the discussion with regard to how the bear market in stocks could hurt the economy is centered on households. The unprecedented drop in household net worth in the postwar period is expected to raise the personal saving rate, which could lead to slower growth in consumer spending, depending on the growth in disposable personal income growth. And, in fact, as shown in Chart 1, the personal saving rate is starting to move up, albeit more slowly than might have been expected thanks to home mortgage refi cash-outs and home equity borrowing. Is this increase in the personal saving rate due to the "negative" wealth effect? Well, the low level of real interest rates certainly isn't enticing folks to save more.
In the late 1990s, state and local governments enjoyed a revenue bonanza due to capital gains taxes. Of course, money burns a hole in the pockets of governments, so spending soared. But now that capital gains have evaporated, state and local governments are up against tight budget constraints, which is resulting in a dramatic slowdown in the growth of their spending, as shown in Chart 2.
But there is yet another tentacle of the bear market that could be starting to strangle the economy - underfunded defined benefit pension funds. This tentacle reaches out to both corporations and state and local governments. During the bull market, defined benefit pension funds became overfunded due to the runup in stock prices. This meant that plan sponsors did not have to make any cash contributions to the funds. All of that is changing. It is estimated that pension funds are underfunded by roughly $300 billion for companies in the S&P 500. Thus, plan sponsors now are having to make cash contributions to refund underfunded plans. This means that there will be less cash left over to purchase plant and equipment, pay salaries, and buyback shares (in order to boost earnings-per-share when profits are waning). Recently, the US auto producers have gotten the most attention with respect to this issue. Fitch Ratings just reported that the underfunding of auto workers' pension plans at US producers will rise at year-end to an estimated $30 billion from $13.9 billion last year. GM is the most hard hit of the Big Three, with its pension underfunding expected to rise to around $21 billion to $23 billion at the end of this year from last year's underfunding of $9 billion. This pension issue was a major reason for Standard & Poor's downgrade this past week of GM's debt to BBB, just two notches above junk status. But the pension-underfunding problem is not restricted to the auto producers. Indeed, the venerable IBM announced in its third quarter earnings report that it would be adding as much as $1.5 billion to its underfunded plan at year-end. If the value of its pension assets stay approximately the same, it is estimated that IBM might have to continue adding $1.5 billion annually over the next three years to hit its goal of a fully-funded plan by 2005. This annual contribution represents about 20% of IBM's free cash flow over the past four quarters. Ouch! Less left over for Big Blue to use for stock buybacks. And that means that Big Blue will actually have to increase its earnings if it wants to show increases in its earnings per share.
This issue of underfunded pension plans does not affect corporate profits, but rather to what uses profits will be applied. However, corporate operating earnings are affected by pension fund profits. Pension fund profits are the difference between the "expected" return on pension fund assets in an accounting period and the pension expenses in that period. If pension fund assets are rising because of a bull market in stocks, then, all else the same, pension profits will be rising, too. I say "expected" return because corporations are allowed to specify an assumed long-term rate of return on pension assets, which may be higher or lower than the actual return in any given accounting period. Although pension fund profits are allowed to be counted in operating earnings - and, thus, are an addition to earnings per share - they cannot be used to pay out to stockholders. These profits belong to the pension plan. But the bigger these pension profits are, the less the corporation will have to contribute to the pension plan in the future to keep it fully funded.
Pension fund profits were bolstered in the late 1990s by the bull market in stocks. For example, in 1998, Lucent's operating earnings were boosted by $558 million, or 10%, from pension fund profits. But the times, they are a-changin'. Now that we are in a bear market, the value of pension plan assets is falling. And corporations are beginning to lower the expected rate of return on the assets in their plans. At the beginning of this year, IBM lowered its expected return on pension fund assets from 10.0% to 9.5%. Last week, it indicated that it would be lowering this expected return further, to 8% or 8.5%. It is estimated that this will reduce IBM's operating earnings by about $700 million. IBM expects to more than offset this hit to operating earnings from lower pension fund profits by reducing other costs by $900 million. So, a decline in "untouchable" pension fund profits are inducing firms to make genuine cuts in their spending.
In sum, the bear market in stocks is not only going to cause households and state and local governments to rein in their spending, but Corporate America, too. As I've been saying since early July, the risks are to the downside for economic growth in 2003.
Paul Kasriel
Senior Vice President & Director of Economic Research
Co-author of Seven Indicators That Move Markets, now in its second printing by McGraw-Hill
The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
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