Friday, November 27, 2015

Elite Funds Prepare For Reflation?

Ambrose Evans-Pritchard of the Telegraph reports, Elite funds prepare for reflation and a bloodbath for bonds:
One by one, the giant investment funds are quietly switching out of government bonds, the most overpriced assets on the planet.

Nobody wants to be caught flat-footed if the latest surge in the global money supply finally catches fire and ignites reflation, closing the chapter on our strange Lost Decade of secular stagnation.

The Norwegian Pension Fund, the world's top sovereign wealth fund, is rotating a chunk of its $860bn of assets into property in London, Paris, Berlin, Milan, New York, San Francisco and now Tokyo and East Asia. "Every real estate investment deal we do is funded by sales of government bonds," says Yngve Slyngstad, the chief executive.

It already owns part of the Quadrant 3 building on Regent Street, and bought the Pollen Estate - along with Saville Row - from the Church Commissioners last year. But this is just a nibble. The fund is eyeing a 15pc weighting in property, an inflation-hedge if ever there was one.

The Swiss bank UBS - an even bigger player with $2 trillion under management - has issued its own gentle warning on bonds as the US Federal Reserve prepares to kick off the first global tightening cycle since 2004. UBS expects five rate rises by the end of next year, 60 points more than futures contracts, and enough to rattle debt markets still priced for an Ice Age.

Mark Haefele, the bank's investment guru, said his clients are growing wary of bonds but do not know where to park their money instead.

The UBS bubble index of global property is already flashing multiple alerts, with Hong Kong off the charts and London now so expensive that it takes a skilled worker 14 years to buy a broom cupboard of 60 square metres (click on image).

Mr Haefele says equities are the lesser risk, especially in Japan, where the central bank has bought 54pc of the entire market for exchange-traded funds (ETFs) and is itching to go further.

As of late November, roughly $6 trillion of government debt was trading at negative interest rates, led by the Swiss two-year bond at -1.046pc. The German two-year Bund is at -0.4pc.

The Germans and Czechs are negative all the way out to six years, the Dutch to five, the French to four and the Irish to three. Bank of America says $17 trillion of bonds are trading at yields below 1pc, including most of the Japanese sovereign debt market.

This is a remarkable phenomenon given that global core inflation - as measured by Henderson Global Investor's G7 and E7 composite - has been rising since late 2014 and is now at a seven-year high of 2.7pc (click on image).

In the eurozone, the M1 money supply is rising at a blistering pace of 11.9pc. A case can be made that the European Central Bank should go for broke, deliberately stoking a short-term monetary boom to achieve "escape velocity" once and for all. The risk of a Japanese trap is not to be taken lightly.

Yet even those who feared looming deflation in Europe two years ago are beginning to wonder whether the bank is losing the plot. If the ECB doubles down next week with more quantitative easing and a cut in the deposit rate to -0.3pc, as expected, it will validate the iron law that central banks are pro-cyclical recidivists, always and everywhere behind the curve.

Caution is in order. The investment graveyard is littered with the fund managers who bet against Japanese bonds, only to see the 10-year yield keep falling for two decades, plumbing new depths of 0.24pc this January (click on image).

Inflacionistas in the West have been arguing for six years that the QE-fuelled monetary base is about to break out and take us straight to Weimar or Zimbabwe. They failed to do their homework on liquidity traps.

Yet their moment may soon be nigh. Catalysts are coming into place. Globalisation is mutating in crucial ways.

China, the petro-powers and Asian central banks led a sixfold increase in foreign reserves to $12 trillion between 2000 and mid-2014 (and trillions more in sovereign wealth funds). This flooded the global bond markets with capital and stoked asset bubbles everywhere.

The process has gone into reverse. Data from the International Monetary Fund show that these reserves dropped by $550bn in the year to June as capital flight and the commodity bust forced a string of countries to defend their currencies. Saudi Arabia is still burning through $12bn a month to cover its budget deficit.

This shift in reserve flows amounts to fiscal stimulus for the world. Less money is being hoarded as capital: more is going back into the real economy as spending - or it soon will do - exactly what the doctor ordered for a 1930s world, starved of demand (click on image).

It comes as China goes through a social revolution, moving through the gears towards affluence. Consumption was barely above 30pc of GDP in 2010, the lowest ever recorded in a major country in history. The Communist Party is trying to push it to 46pc by 2020.

Or, put another way, Ben Bernanke's "savings glut" is starting to dissipate. The global savings rate peaked at a record 25pc and is finally rolling over.

There is a further twist. Professor Charles Goodhart from the London School of Economics says the entry of China and eastern Europe into the world economy after 1990 doubled the work pool of the globalised market at a stroke. It lead to a surfeit of labour and a quarter century of wage compression. The rich got richer. Deflation became entrenched.

This episode is over. The old age dependency ratio is about to rocket. Labour will soon be scarce again. Wages will rebound. Prof Goodhart thinks it will push real interest rates back to their historic norm of 2.75pc to 3pc. "We are on the cusp of a complete reversal," he says.

All the stars are aligned for an end to the deflationary supercycle, and therefore for an end to the 35-year bull market in government bonds.

With equities already at nose-bleed levels it is hard to know exactly where to seek refuge. Wall Street's S&P 500 has been on a blinder for nearly seven years, and is now hovering near an ominous double-top.

The MSCI index of world equities is trading at 18 on the CAPE price-to-earnings ratio. This is below its 40-year average of 22, but only if you believe the earnings (click on image). 

Mr Haefele from UBS recommends niche plays in clean air, emerging market healthcare and, above all, oncology and immunotherapy, a sector currently running 300 clinical trials, with treatments costing $100,000 per patient.

Spending per cancer patient jumped 60pc in the US, Canada and Germany from 2010 to 2014, a pattern likely to be repeated over time in China, east Asia and Latin America.

His colleague Bill O'Neill says equities are "not cheap" on the UBS proprietary gauge, but none of the bank's crash signals is flashing red, and you have to put money to work. "We think there is a good chance that the cycle will last another three years," he said.

Mr O'Neill said the "trillion dollar question" is whether the Fed and fellow central banks will wake up one day to find that the inflationary horse has already bolted.

My fear is that this is exactly what will happen. There will then be an almighty reckoning as global finance braces for a rush of staccato rate rises by the Fed, and a belated pirouette by the ECB (click on image). 

We will then find out whether the world can cope with public and private debt ratios hovering at all-time highs of 265pc of GDP in the OECD club and 185pc in emerging markets, up 35 percentage points since the top of the pre-Lehman credit bubble. Equities will not fare very well either when that moment comes.

It is a story for late-2016, perhaps, but not today. Until then, laissez les bon temps rouler.
This is another excellent article by Evans-Pritchard but the problem is I simply don't buy that we're on the cusp of major inflation or that it's the end of the deflation supercycle, especially in the eurozone where I see Mario Draghi's worst nightmare eventually ravaging that region for a very long time.

Moreover, elite funds I'm tracking are buying battered closed-end bond funds or leveraging up their buying of U.S. Treasuries. This includes some of Canada's highly leveraged pensions which makes you wonder who is on the right side of this global bond trade.

I've long criticized people warning us of the scary bond market, including hedge fund guru Paul Singer who calls the bond market the "bigger short" and former Fed Chairman Alan Greenspan whose dire warning on bonds has largely fallen of deaf ears.

Importantly, the bigger issue right now is whether China's Big Bang is the beginning of something more ominous and whether central banks will be able to save the world and stop deflation from spreading to America (if you look at the drop in oil and gold prices, you'd conclude there's a lot more work ahead to raise inflation expectations).

As far as I'm concerned, the bond market has it right and a lot of the funds betting big on a global recovery are either way too early or they're going to get killed betting on energy and commodity shares and futures. This is especially true if the secular stagnation Larry Summers is warning of is here to stay as economists have yet to figure out a new macroeconomic paradigm to get us out of this global rut.

One thing that scares me is the ongoing property boom, especially in global prime markets. Whether or not you're in the inflation or deflation camp, this is the bubble that should scare you the most especially when you see the Norwegian Pension Fund starting to fund property purchases through sales of government bonds (something tells me this is the top in global real estate).

Pay attention here folks as the mighty greenback keeps surging higher as everyone expects the Fed to start hiking rates in December. We might be in for some very nasty surprises in 2016 and if you ask me, it has nothing to do with the end of the deflation supercycle or the unleashing of a tsunami of inflationary pressures. This is all hogwash that investment banks are feeding you, I'm not buying it.

Below, Bloomberg's Tom Keene displays the long-term deflation of the commodities market. He speaks with Harry Tchilinguirian, head of commodities strategy at BNP Paribas, and Michael Holland, chairman at Holland & Company on "Bloomberg Surveillance."

I also embedded a CNBC interview with David Stockman of Contra Corner from this summer (August, 2015) where he discussed why the global economy is heading into epochal deflation. I don't agree with his gloomy forecast and think he is underestimating central banks' resolve to fight deflation with everything they've got, including more QE, negative rates and outright purchasing of stocks and bonds, all in an effort to reflate assets and increase inflation expectations.

But Stockman is right that we're in uncharted territory and the danger is that all these unconventional monetary policies will exacerbate global deflation and investors who are in the wrong sectors or  countries are going to get killed in these markets (read my October surprise to see my thoughts).

Hope you enjoyed reading this comment and please remember to donate or subscribe to this blog on the top right-hand side. Thank you and have a great weekend!

Thursday, November 26, 2015

Battered Bonds For Thanksgiving?

Rob Copeland and Sarah Krouse of the Wall Street Journal report, Hedge Funds Stalk Battered Corner of Bond World:
Wall Street traders are circling a corner of the bond world they say is taking an unwarranted beating in anticipation of rising interest rates.

They are betting on closed-end funds, often-volatile structures that mostly cobble together risky collections of bonds and often employ leverage, or borrowed money, to try to boost returns.

These funds as a group are wallowing in their lowest levels since the financial crisis, partly on the expectation that the Federal Reserve’s expected interest-rate increase will make their holdings less attractive.

The average closed-end fund recently traded around a 9% discount to the value of its holdings, according to Morningstar Inc., and some funds focused on bank loans and junk bonds run by Blackstone Group LP and KKR & Co. are down even more (click on image).

Some investors, including hedge-fund manager Boaz Weinstein and mutual-fund heavyweight Jeffrey Gundlach, say the selloff is unlikely to get worse. Among investors’ reasons: Closed-end bond funds don’t have to unload their assets when investors sell, meaning they may be able to wait out a storm and collect bond income while more-traditional mutual funds could be forced into fire sales if withdrawal requests pile up.

Meanwhile, activist investors see opportunity, too, with some acquiring stakes in particularly beaten-down funds and pushing for changes in management or how the funds are structured.

“You could be in for a wild ride,” said Patrick Galley, chief investment officer of $3 billion RiverNorth Capital Management LLC. Last week, RiverNorth’s hedge funds attempted to force changes at a closed-end fund run by Fifth Street Finance Corp. in which the firm holds a stake. Fifth Street rebuffed the attempt as “inflammatory and misleading.”

Closed-end funds are usually the province of relatively small individual investors who tend to buy and hold while collecting regular interest off the corporate bonds, municipal debt, bundled loans and other assets the funds hold.

They share more similarities with stocks than their more common open-ended mutual-fund cousins. Closed-end funds raise money in an initial public offering, and the managers immediately invest the sum raised. When subsequent investors buy into or sell these funds, the fund price changes much like a stock after an initial public offering. The amount of investor money the fund has available to use remains unchanged from what it raised in the original offering.

Closed-end funds typically trade at either a discount or a premium to the value of their underlying holdings. By contrast, traditional open-ended mutual funds must buy and sell assets to match the amount of money coming in or going out.

Closed-end funds, including offerings from managers like BlackRock Inc. and Nuveen Investments Inc., manage a cumulative $264 billion, according to the Investment Company Institute.

Jonathan Isaac, director of product management at Eaton Vance Corp. , a fund company that manages closed-end funds, said there was a “cloud hanging over the market,” in the form of the Fed’s interest-rate plans. If rates rise, the cost of leverage will go up, and the fixed-income holdings favored by many closed-end funds also could lose value.

Other problems abound. Closed-end funds sold off far past their current levels in the crisis. With retail investors comprising the biggest investor group by far, according to analysts and fund managers, these funds are particularly prone to dropping quickly if the economy stumbles and ordinary savers grow fearful.

“It’s definitely more in the high-risk area” of investor portfolios, said Morningstar analyst Cara Esser.

Still, the lopsided prices lately have attracted the attention of Wall Street traders known for their ability to move quickly on investments that appear out of whack.

Mr. Weinstein, who earned attention for his early bets against J.P. Morgan Chase & Co.’s “London whale” trader who cost the bank more than $6 billion in ill-fated trades, is pitching deep-pocketed investors on a new fund that will invest only in closed-end funds—and in some cases place the trades without any offsetting hedges, people familiar with the matter said.

The main hedge fund at Mr. Weinstein’s Saba Capital Management LP has been hit by persistent investor redemptions and three consecutive years of performance losses headed into 2015, when it is up through mid-October, according to investor documents.

With his latest offering, Mr. Weinstein is cutting his fees to win back investors. He is halving Saba’s customary 20% performance charge for the new closed-end-focused fund, his first to bet on a specific area, and forgoing collection on even the reduced fee until the venture achieves an 8% annual return.

That target is made easier because even if closed-end funds drop further in price, investors may still make money. The funds pay investors a yield, often in the high single digits percentagewise a year, offering a potential cushion if discounts deepen.

Mr. Gundlach, founder of $76 billion asset manager DoubleLine Capital LP, this month told investors that credit-focused closed-end funds were a better bet than equities, because the former were unlikely to fall much further from their current prices.

Others are looking to profit by buying minority stakes in struggling closed-end funds and jostling for management changes, merging underperforming funds or converting them to open-ended varieties with an eye toward quickly liquidating their holdings.

The campaigns have had mixed success. AllianceBernstein LP agreed in August to convert one of its closed-end funds after an activist fight, but Pacific Investment Management Co. beat back a campaign from a hedge fund demanding new board members and a share-repurchase program.
You'll recall Boaz Weinstein's Saba Capital was embroiled in a lawsuit with PSP Investments last month for supposedly fudging his performance figures at a time when PSP was redeeming. I don't know if that lawsuit has been settled but Mr. Weinstein is making bold bets in closed-end funds and I like the terms he's offering investors, including an 8% hurdle rate before his fund starts collecting fees.

And the fact that Jeffrey Gundlach also likes closed-end funds is a positive for these structures. I think too many investors are making too big a deal on whether or not the Fed is preparing to hike rates in December and it's obviously impacting riskier credit investments.

So, this Thanksgiving, some smart fund managers are going bargain hunting, stuffing their portfolios with closed-end bond funds. Are they going to regret it? I don't think so and will discuss some of my thoughts on interest rate risk in subsequent comments.

Below, UBS Securities' Sangeeta Marfatia discusses closed-end funds investing. She speaks with Pimm Fox on Bloomberg Television's "Taking Stock." Have a Happy U.S. Thanksgiving!

Wednesday, November 25, 2015

A Bad Omen For Private Equity Returns?

Sebastien Canderle, a consultant, university lecturer in private equity and author of Private Equity’s Public Distress, sent me a guest comment, A Bad Omen for Future Returns in Private Equity:
A recent report by research firm Preqin (the 2016 Private Equity Compensation and Employment Review) received some well deserved attention. Apparently, the year 2015 has already seen more private equity General Partners raise their first fund or at least reach their first close than the previous record year of 2007 had witnessed. For Limited Partners currently participating or planning to participate in this segment of the alternative investment sector, this growing number of GPs is bad news. The healthy clearing-up of underperformers that had taken place in the years since the financial crisis is poised to be undone. The weaklings that rightly failed to raise follow-on vintages after 2008 are being replaced by new managers with questionable or unproven track records.

We can understand why GPs are finding it hard to resist the call of 1.5% to 2.5% in annual management fees they can suck out of their closed-end funds. For LPs, however, caution is de rigueur as the upside is far from obvious.

If market data stating that, historically, half to two-thirds of GPs failed to meet the hurdle rate are to be believed, there is no apparent reason why the new breed of PE fund managers will do better than their predecessors. For this to happen, several conditions would have to be met.

First, deal opportunities would need to be more compelling than in previous decades. There is serious doubt that it will be the case in North America and Europe, two continents where there is saturation of fund managers and structural over-intermediation of M&A transactions. There remains an oversupply of funds chasing too few deals. The newcomers certainly won’t remediate this situation. The permanently high number of secondary buyouts is just one indicator that GPs have run out of fresh targets. A second clue is the persistent high multiples assigned to LBO targets.

Second, the first-time GPs would have to possess unique and superior investment skills compared to those of the previous generation. Given that the vast majority of newly established funds are being run by executives who used to work at existing GPs – in some cases they even come directly from old GPs who failed to raise a new fund on the back of poor performance – LPs need to query why these new managers should be expected to do a better job than when they worked at their former employers.

Third, to outperform their peers, the new generation would have to have received better training. Given that most have the same educational and professional background (ex-investment bankers, accountants and consultants, and MBA degrees) as the existing managers, doubt also exists about their ability to bring a new approach to deal making, portfolio management and value creation.

Fourth, the lack of market branding means that most new GPs will struggle to attract the best deal flow. Thus, many of them will be left with complex transactions or those that their better established rivals are not interested in because of low-return prospects. Beggars can’t be choosers. Desperate to do deals just to show that they are active, first-time managers will not be able to be as selective as more prestigious PE houses. That cannot be good for expected returns.

Last, in view of the mess created during the bubble years, the upstarts would require better risk management than GPs that have already run several vintages. It is very unlikely to happen for two key reasons: small funds (most of the first-time GPs will only be managing a few hundreds of millions at best) will not have the capabilities to establish best-practice corporate governance and investment discipline; and deal doing rather than risk management will be top of the agenda as they try to prove themselves. In short, their risk profile is likely to be worse than old-time players.

What should LPs still keen to invest in the space do to limit the risk of seeing this new breed of private equity managers underperform as so many members of the previous generation did?

They should impose strict discipline, for a start. The best way to do so is by sitting on the GP’s advisory board in order to regularly monitor the GP’s investment and portfolio management practices. Similarly, co-investing alongside General Partners gives LPs the opportunity to assess whether the GP’s due diligence process is thorough enough. But the best way to improve performance is to make sure that fund managers receive proper training. Traditionally, transaction experience had mattered a great deal more than classroom lectures. For that reason, on-the-job learning and one-day seminars had been the preferred methods to acquire new techniques and stay up-to-date with the latest developments. Given how competitive and mature the space has become, that approach won’t do anymore. Since few GPs will ever be willing to spend a meaningful proportion of management fees in training staff, they will have to be compelled by their Limited Partners. The latter can make the payment of fees conditional on a minimum allocation towards an annual training budget. Naturally, the quality of these training sessions will need to be monitored. If there is one thing that the recent fee scandal has shown, it is that GPs cannot be trusted to be acting in the interest of their investors. There is little evidence to suggest that this year’s swarm of first-time managers will behave differently, even though it would be a sure way for them to differentiate themselves from the old guard.
I thank Sebastien Canderle for sending me this very informative comment. Sebastien worked for four different GPs during a 12-year stretch, including Candover and Carlyle in London. At the moment, he continues to advise on due diligence and also lectures on the topic at various business schools (you can contact me if you want to reach him).

What do I think of his comment? In 2012, I wrote a comment on the changing of the old private equity guard welcoming new and smaller GPs whose alignment of interests are typically better than the large behemoths looking to gather assets. In fact, at a recent conference in Montreal set up by the U.S. Department of Commerce ("Montreal Trade Mission"), I met a few of these smaller American GPs which actually do what private equity people are supposed to be doing, namely, less financial engineering like dividend recaps and simply rolling up their sleeves to help bolster the operations at private companies.

But I agree with Sebastien's comments, there are many new GPs popping up in recent years and while some are excellent, the majority are questionable. Above and beyond that, this is a brutal environment for even the best private equity funds. Some even think it's time to stick a fork in private equity and that it's the end of PE superheroes. Moreover, I expect more regulations to hit the industry as news breaks of private equity funds stealing from clients.

As far as limited partners (LPs) are concerned, it's high time they wise up too. When I see a CalSTRS pulling a CalPERS on private equity fees, I cringe in disgust. I can write a book on the nonsense that goes on at public pension funds investing in private equity (everything from fees to benchmarks). To be sure, private equity is a very important asset class but the large "brand name" funds have been getting away with murder and it's high time limited partners take their fiduciary responsibilities a lot more seriously and squeeze these funds hard on fees and investments, or better yet, just go Dutch on them like Canadian pension funds have been doing for a long time.

[Note: The largest U.S. public pension, the California Public Employees' Retirement System, said on Tuesday that it had paid $3.4 billion to private equity firms in profit-sharing over the past 25 years - a big step to opening the curtain on an industry known for its lack of transparency and high fees. Will others follow CalPERS' disclosure lead?]

Below, Blackstone President and COO Tony James says stock market valuations are ahead of themselves and "a bit of a correction" is coming. I prefer when James talks markets instead of retirement policy but I don't see any correction in stocks as long as Mario Draghi's worst nightmare doesn't come true. However, I have noticed a big correction in Blackstone's shares (BX) which are way off their highs this year (click on image):

And it's not just Blackstone's shares. All the private equity funds I track in the stock market are down this year, not as much as some hedge fund stocks I track, but still down a lot (click on image):

The good news is these shares pay out nice dividends and I expect U.S. public pension funds chasing their rate-of-return fantasy to keep plowing into large, brand name private equity funds no matter how bad the environment gets. But don't rush out to buy these shares just yet as there are strong secular headwinds impacting the private equity industry which is a bad omen for future returns.

Tuesday, November 24, 2015

AIMCo Investing in Renewable Energy?

Geoffrey Morgan of the National Post reports, TransAlta Renewables gets $200M investment from Alberta fund manager AIMCo:
Alberta’s provincially owned investment management company bought a $200-million stake in a local renewable power provider Monday, the day after the province announced it would phase out coal-fired electricity generation.

Alberta Investment Management Corp., which manages more than $75-billion worth of investments from the province’s government pension funds, bought $200 million worth of TransAlta Renewables Inc. shares Monday from the green-electricity provider’s parent company, TransAlta Corp.

TransAlta Corp. will continue to be the largest investor in the renewables company, and plans to use the proceeds from the sale to pay down its debt.

The deal would make AIMCo the second-largest investor in TransAlta Renewables, with eight per cent of its shares, after parent company TransAlta, which also owns coal-fired power plants throughout Alberta.

AIMCo CEO Kevin Uebelein said in a release that “TransAlta has set forth a bold transition plan that will see it become one of North America’s preeminent clean power companies.”

AIMCo operates at arm’s length from the provincial government, which on Sunday announced a series of new climate change policies that included a 2030 deadline for coal-fired power producers to cut their emissions to zero.

Alberta currently generates 55 per cent of its electricity from coal power, but the province wants to replace two-thirds of that power capacity with renewables by 2030.

Many industry analysts expect utility companies to shut down their coal-fired power plants by that time as a result of the new provincial policies.

Unlike many of its coal-power peers, TransAlta’s shares surged on Monday morning following the government’s announcement. The company’s share price rose nine per cent to close at $5.96.

Trading in the company’s shares was halted leading up to the announcement that AIMCo had acquired a large stake.

RBC Capital Markets analyst Robert Kwan upgraded the company to “sector perform” and said “TransAlta has the potential to benefit from replacement generation.”

TransAlta had been planning to phase out most of its coal generation by 2030 under existing federal regulations, while Edmonton-based competitor Capital Power Corp.’s coal fleet was still expected to operate beyond then.

Kwan said Capital Power is “possibly the biggest ‘loser’ in all of this, but the impact is really far into the future.”
Jeffrey Jones and Jeffrey Lewis of the Globe and Mail also report, TransAlta Renewables acquires wind and hydro assets, sells stake to AIMCo:
TransAlta Renewables Inc. is buying Ontario and Quebec wind and hydro power assets from its parent company, TransAlta Corp., for $540-million and taking on a new big investor: Alberta’s public-sector pension manager.

It’s selling an 8-per-cent stake in the company to Alberta Investment Management Corp., or AIMCo, for $200-million.

TransAlta Renewables, which is currently 76-per-cent owned by TransAlta Corp., is also offering $150-million of shares in a bought deal.

The series of transactions comes a day after TransAlta Corp., Canada’s largest coal-fired power generator, learned that the Alberta government will phase out that form of energy by 2030 under its sweeping plan to fight climate change. The company and a government-appointed negotiator will try to reach an agreement on how to deal with stranded asset value.

It is selling its majority-owned affiliate the Sarnia Cogeneration Plant, Le Nordais wind farm and Ragged Chute hydro facility, adding a total of 611 megawatts of generating capacity. As part of the deal, TransAlta Renewables will issue $175-million in shares to the parent as well as $215-million in unsecured debentures.

The acquisition of long-term contracted generation capacity will support a 5-per-cent increase in dividends, TransAlta Renewables president Brett Gellner said in a statement.

In its budget last month, the Alberta NDP government gave AIMCo, along with other public agencies, a mandate to search out investments in companies that will help the province diversify the economy away from oil and gas.

Kevin Uebelein, AIMCo’s chief executive officer, said the investment is not related to the timing of Alberta’s economic diversification strategy or its climate plan. Still, AimCo is actively scouting for more deals in renewable energy as policies around carbon emissions firm up.

“The short answer is yes,” Mr. Uebelein said in an interview. “As governments move to change the shape of the playing field with regard to carbon taxing and other measures, then these other forms of power generation, the payback calculation will adjust in response to those government actions.”

The AIMCo investment is expected to close on Thursday. As part of the deal, the fund manager gets the right to acquire shares in future financings.

Under the bought-deal financing, TransAlta Renewables will issue 15.4 million subscription receipts at $9.75 each to underwriters led by Canadian Imperial Bank of Commerce and Toronto-Dominion Bank. They will be converted into common shares when the acquisition closes in January, the company said.
Those of you who want to read the details of TransAlta Corporation's (TSX: TA) $540 million investment by TransAlta Renewables (TSX: RNW) in three of its Canadian assets can click here. Also, AIMCo put out a press release which you can read here.

What do I think of this deal? It's definitely advantageous to TransAlta Corp. which is suffering from high debt and welcomes the cash infusion. If you ever want to see why you should avoid investing based solely on high dividends, just have a look at TransAlta's stock over the last five years (click on image):

In fact, 2015 has been a particularly brutal year for TransAlta's shareholders. Even after Monday's pop following the Alberta government's announcement to phase-out of coal generation and accelerate wind and solar power construction, the stock is down more than half this year (but the high dividend yield helped cushion some of that decline). The same goes for TransAlta Renewables Inc. (RNW.TO).

It's no secret among Canadian portfolio managers that TransAlta Corp. has been poorly managed and that's why the stock keeps sliding lower. Having said this, if you're an investor looking for dividend income, I like it better at these levels than where it was a year ago and maybe the company is finally on the right path to a brighter future (that remains to be seen).

As far as AIMCo, the timing of the deal makes it look suspicious but the fund operates at arms-length from the Alberta government and this deal was in the pipeline for months. I think AIMCo is getting in at the right time and investing in renewable energy is a smart long-term play as long as the terms of the deal make sense.

Does this mean we should force green politics on pension funds? Absolutely not! AIMCo didn't buy a stake in TransAlta Renewables based on green politics, it expects to make money on this deal over the long-run, just like the Caisse expects to make money with its big investment in Bombardier.

On Monday, I had a chance to meet up with Kevin Uebelein, AIMCo’s chief executive officer, here in Montreal where he was on a business trip. The deal was announced after we met but during our lunch, he told me he was waiting for an important email with a big announcement and apologized for checking his phone.

I enjoyed meeting Kevin Uebelein, he's a very smart and nice guy and he has an interesting background. For those of you who have never met him, here is a picture of him (click on image):

Kevin worked many years at Prudential before moving on to Fidelity Canada and then AIMCo. His experience with a huge insurer prepared him well for managing a major Canadian pension fund as insurance companies are also in the business of managing assets with liabilities.

We talked about many things, most of which will remain off the record, but I'll share with you a story I liked. He told me about the time Japanese life insurers got whacked hard when the real estate market cratered in Japan in the early nineties. He told me that investment banks and hedge funds came in to buy properties 10 cents on the dollar and they made off like bandits.

He was able to structure a deal to sell properties of Japanese life insurers Prudential was acquiring at 30 cents on the dollar and he told me it was the first time he realized who was at the other end of the insurance policy and why what he was negotiating mattered a lot. He added: "I want everybody at AIMCo to realize who is at the other end of the pension fund and why what we do matters."

Kevin also told me he wants to attract more people to Edmonton (no easy feat) as well as hire the cream of the crop from Alberta's universities. I gave him an idea to create an intern program where students and even new hires with little experience are exposed to operations across public and private markets so they understand the two cultures and how it all fits into the bigger picture of a pension fund.

What else can I share with you? He told me he doesn't believe that a CEO of a major pension fund can carry the CIO hat as well, "especially when you have different clients like we do at AIMCo." I completely agree and told Gordon Fyfe a long time ago to drop his CIO duties (which he never did because that was the fun part of his otherwise hectic and stressful job) and focus solely on his CEO duties.

At AIMCo, Kevin appointed Dale MacMaster as the chief investment officer. And unlike Roland Lescure at the Caisse who oversees public markets, MacMaster oversees the entirety of AIMCo’s $80 billion portfolio, which is a huge job since he was previously executive vice president for public market investments, a role he held since 2012.

Every CEO of a major pension fund should take note (including Gordon Fyfe who held on to both hats at bcIMC). If you're in charge of billions, make sure you hire a qualified CIO who can oversee and allocate risk across public and private markets. If this pisses off some of your senior people, tough luck, let them deal with it.

Is it easy finding a very qualified CIO who can fulfill these duties? Of course not. People like Neil Petroff and Bob Bertram who held this position at Ontario Teachers aren't exactly a dime a dozen. But in my mind, it's crazy and highly irresponsible to have all the investment people report to the CEO and not to a dedicated CIO whose sole job is to oversee all investments.

What else? On real estate, Kevin told me AIMCo's Alberta properties are going to get marked down but he expects nice deals to open up in that market over the next few years and they still have class A properties with solid tenants providing them steady income.

All in all, I came away with a very positive view of Kevin Uebelein. He's a very nice man who thinks through his decisions and always stresses process over performance. He isn't averse to taking smart risks but he wants to understand the risks AIMCo's staff are taking across public and private markets.

That was that, I enjoyed our lunch, told him I'd love to keep in touch and he went off to meet more important people. Still, I thought it was very nice of him to take some time to meet me. I also told him to say hello to Gordon Fyfe the next time they meet and he told me he saw him at conference last month where he looked "extremely relaxed" (Victoria suits Gordon a lot more than Montreal where running PSP had huge payouts but a lot more stress).

Below, CTV News reports on Canada's new role in the fight against climate change. Listen to Alberta Premier Rachel Notley's comments but remember, this new government policy has nothing to do with AIMCo's decision to invest in renewable energy.

Monday, November 23, 2015

Mario Draghi’s Worst Nightmare?

 David Oakley of the Financial Times reports, Nightmare of Mario Draghi’s crowded trade:
Investors are putting too much faith in Mario Draghi. The European Central Bank president is largely responsible for one of the most overcrowded trades in markets — and there is a risk it could all go horribly wrong.

In the past month, every investor I have spoken to has told me they are overweight European equities, citing the quantitative easing policy of Mr Draghi and the ECB as one of the main reasons. But is Mr Draghi creating a potential nightmare scenario for investors?

The European equity trade makes sense for a variety of reasons. The eurozone economy is recovering, albeit sluggishly, earnings are growing, valuations are relatively attractive and, most important of all, the ECB is buying billions of euros of bonds to underpin the market.

Indeed, European equities have rallied sharply since the start of September when Mr Draghi first hinted he was prepared to launch a second round of QE, expected in December.

Investors reason that it is unwise to fight a central bank. It makes sense to be fully invested in risk assets such as equities when a central bank is actively easing, as looser monetary policy encourages corporations to borrow at cheap rates.

This is certainly true. Euro-denominated investment grade corporate debt issuance has surged to a record high so far this year. This corporate borrowing often translates into higher profits as the money is invested for growth, which in turn boosts the share price.

With the US Federal Reserve expected to diverge from the ECB and tighten policy next month, it makes European stocks even more appealing, particularly given that US valuations are stretched.

With the ECB easing and the Fed tightening, the euro is likely to remain weak. A cheaper euro should lift demand for exports. This is helpful to Germany, the region’s biggest economy, which relies on exports for growth.

However, when a trade becomes this crowded, there are risks.

Upside is limited because the good news is largely priced in. More significantly, if the market reverses, it can be difficult to exit as everyone wants to sell at the same time.

Investors only have to look back to the summer for a reminder of the dangers. Worries about the Chinese economy wiped out all the equity gains from Mr Draghi’s first round of QE, which was launched in March, in a matter of days. European equities plunged about 10 per cent in August.

Yet some investors remain sanguine about China. They think the Chinese can keep the economy ticking over at a relatively healthy rate. The latest Chinese data show the economy is growing at just under 7 per cent.

Although there are some doubts over the accuracy of China’s figures and they are nowhere near the rates of close to 12 per cent before the financial crisis, a number of investors think growth is at least 6 per cent, enough to maintain global growth and underpin market sentiment.

According to the World Bank, the expansion of the Chinese economy in the past decade means it is contributing more to global gross domestic product at its current growth rate than it was in the pre-crisis boom years.

But these same investors made this case before the summer sell-off. If Chinese growth falters and the country depreciates its currency again, then Europe will suffer. Not only will it undermine the big German exporters, it could import deflation to Europe.

Some argue that Mr Draghi could simply keep expanding QE. The US spent three times more than the current ECB programme of €1.1tn in three rounds of QE over more than five years.

But did the ECB join the QE game too late? With Europe’s economy barely growing and inflation below target, Mr Draghi might not be able to save the region. Those investors stuck in an overcrowded trade will then have to pay the price.
I agree with David Oakley, with Mario Draghi hinting at increasing the ECB's quantitative easing in December, there's this euphoria going on in European shares which could end very badly if things don't turn out as expected there.

Go back to read my October 2014 comment on why the mighty greenback will surge higher where I wrote the following:
I've been warning my readers of the euro deflation crisis and having just visited the epicenter of this crisis, I came away convinced that the euro will fall further. In fact, I wouldn't be surprised if it goes to parity or even below parity over the next 12 months. There will be countertrend rallies in the euro but investors should short any strength.

What is my thinking? First and foremost, the European Central Bank (ECB) is falling way behind the deflation curve. Forgive the pun, but as long as Draghi keeps dragging the inevitable, meaning massive quantitative easing, the market will continue pounding the euro. The fall in the euro will help boost exports and more importantly, import prices, fighting the scourge of deflation.

Once the ECB starts ramping up its quantitative easing (QE), there will be a relief rally in the euro and you will see gold prices rebound solidly as inflation expectations perk up. This is counterintuitive because typically more QE means more printing which is bearish for a currency -- and longer term it will weigh on the euro -- however over the short-run, expect some relief rally.

But the problem is this. You can make a solid case that the ECB has fallen so far behind the deflation curve that no matter what it does, it will be too little too late to stave off the disastrous deflation headwinds threatening the euro zone and global economy.
And where are we a year later? With the exception of Greece, all of eurozone's economies are doing much better but this is more of a cyclical swing due to the decline in the euro. Nothing has fundamentally changed in the eurozone to address deep structural factors that all but ensure a protracted deflationary episode in that region.

In fact, Alessandro Speciale of Bloomberg reports, Europe's Contented Workers Could Be Worsening Draghi's Deflation Woe:
Low inflation, Mario Draghi once famously said, means people can “buy more stuff.”

The consumption-driven recovery in the euro area is currently proving the ECB president's point. But can the consumer be in too good a mood?

If price gains are so slow that employees stop seeing the need to demand higher wages, then that makes Draghi's task of returning euro-area inflation back to the target of just under two percent all the more difficult. Euro-area annual inflation came in at 0.1 percent in October.

Wage settlements in the region rose an annualized 1.56 percent in the third quarter, just above the record-low of 1.44 percent at the beginning of the year, ECB data released Tuesday show. While the bloc's unemployment rate of just under 11 percent is clearly weighing on salaries, even in areas where joblessness is low, like Germany, there are few signs of wage inflation.

“Workers adjust their demand to the low inflation pattern,” said Alexander Koch, an economist at Raiffeisen Schweiz in Zurich. “The current environment doesn’t push workers to request higher wages.”

To be sure, wage dynamics are notoriously asymmetric; especially in Europe they don’t contract in response to a downturn as much as they rise during a boom. And while they are near a record low, that's still way above inflation.

But soft wage settlements today can crystallize weak inflation for years to come. That's one of the reasons why the ECB will consider fresh stimulus at their Dec. 3 policy meeting.

“Salaries are probably the main driver of services inflation,” said Marco Valli, an economist at UniCredit SpA in Milan. “This low level of wages growth confirms a picture of only slow pick up in core inflation.”
All this to say the last thing the eurozone needs is another Big Bang out of China which will export more deflation to the region. In November 2014, in my comment going over deflation coming to America, I explicitly stated this:
[...] Europe is already spiraling into deflation, and if Chinese deflation gets worse and they are forced to devalue the yuan, it will flood their economies with cheap imports, exacerbating the euro deflation crisis at the worst possible time.
And let me share something else with you, a chart I saw on Friday as I attended a luncheon where Amundi's Global Head of Research, Philippe Ithurbide, went over his top down economic and financial overview. At one point, Philippe showed us the chart of the trade-weighted euro (click on image):

As you can see, the decline of the euro relative to the U.S. dollar has been steep but on a trade-weighted basis, it hasn't really declined because emerging market currencies and the Chinese yuan have declined a lot more. And that's where all the trade is mostly happening.

In fact, if you look at the trade-weighted euro, you can argue that financial conditions in the eurozone remain relatively tight even after one round of quantitative easing and more needs to be done to loosen them up.

But there is some good news too. Philippe notes that while a more severe drop in emerging markets would have significant consequences on commodity prices and currencies, developed markets are less dependent on emerging markets than on other developed markets (click on image):

What else? Philippe notes that while he prefers U.S. government bonds over European ones, in the corporate market, the fundamentals of European credit are better than those in the U.S. (click on image):

[Note: I highly recommend you contact Philippe Ithurbide, who was head of Fixed Income at the Caisse before joining Amundi as their Head of Global Research, to see his entire presentation which is truly excellent. You can reach him at and you can view Amundi's latest research comments here].

This brings me to an important point, just how successful is the ECB in promoting growth in the eurozone? That all depends on who you talk to. In his critical comment in Forbes, economist Steve Keen comments on The Power And The Impotence Of The ECB:
I’ve attended two conferences in two days where both the power and the impotence of the European Central Bank (EBC) have been on vivid display.

Its political power is considerable, both in form and in substance. At both seminars, the ECB speaker—ECB Board member Peter Praet at the first, and ECB President Mario Draghi at the second—spoke first, and then left. In substance, the ECB has no need to defend its policies because it is unimpeachable in its execution of them. In form, it does not even considering engaging with its subjects—I use the word deliberately—in open and robust discussion.

It’s not unusual for a political leader to turn up at an event, speak and then immediately leave. But even political leaders have to tolerate sometimes being savaged by fearless CNBC moderators when they speak in public. And I expected that economic leaders would want to hang around and get some feedback—positive or otherwise—from the economic elite that gathered to hear them. Might they not learn something about why their policies weren’t working as they had expected them to?

Not a bit of that for the ECB. There was plenty that could be criticised, even within the context their speeches set. Speaking at the FAROS Institutional Investors Forum, Praet acknowledged, numerous times, that the ECB had failed to hit many of its policy targets—in particular, he noted how many times the ECB had to put off into the more distant future its objective to return to 2% inflation. But there was no chance to challenge him as to why they had failed, because after a couple of perfunctory exchanges with the moderator, he was out the door.

At the more prestigious Frankfurt European Banking Congress Draghi stated bluntly that the ECB would continue to do all it takes to support asset markets via QE—in the belief that this supported the real economy. This was a declaration of the intention to use unlimited power—since there is no effective limit to the ECB’s capacity to buy assets from the private sector.  A politician would have to respond to sceptics about the use of such unlimited powers. But there was not even a single question, nor even a murmur, from the audience.

There was however a jolt of recognition. Draghi was going to continue supporting asset markets, and that was that. The King spoke, the subjects listened, and The King left. There was nothing his subjects could do about it but cope with its consequences.

German Finance Minister Wolfgang Schäuble, who book-ended the EBC conference, had no such luxury of freedom from interlocution—nor did he need it. He engaged in a lively banter with his interviewer as he defended the far more limited power he has over expenditure in Germany. I doubt that Schäuble will suffer electoral defeat any time soon, but unlike Draghi he faces the prospect that it could happen. That doesn’t make him any less resolute in defending his policies; it just means that he has to defend them.

This is what the originally principled concept of “Central Bank Independence” has transmuted into. The promise was that the economy would be spared the disturbances caused by politicians making economic decisions on political grounds: “pork-barrelling” would be a thing of the past, and we would all be better off for it, for two reasons. Firstly, vital economic decisions would be made without consideration of political advantage. Secondly, the people making those decisions would be economic technocrats, who know how the economy works and would therefore make decisions that made rampant economic instability a thing of the past.

This is where the ECB’s power gives way to impotence. The ECB can cower politicians and the public with its unlimited monetary powers. But it can only make the economy dance to its tune if it knows how the economy works, and can duly pull the requisite levers to keep the economy on an even keel.

Clearly the ECB does not know how the economy works. Not only did it—and all other Central Banks—not anticipate the crisis in which it is now embroiled, its policies to try to restore what it sees as normal (unemployment of about 5-6% and inflation of about 2%) have thus far failed. Even on their most favourable forecasts, the Euro region won’t achieve its pre-crisis level of output until early 2016. Not only does this make the crisis far longer and deeper than any post-WWII European downturn, it also underscores how poorly Europe has performed compared to the USA. There the 2008 crisis also ranks as the longest and deepest downturn, but the USA returned to pre-crisis output in less than half the time that the Europeans hope that they will end up doing.

The ECB is not alone in being granted political independence by politicians who, more likely than not, were happy to pass the poisoned chalice of making interest rate decisions to bureaucrats than to hold itself themselves in the days when inflation was rampant and increasing interest rates to control it aggravated voters. The US Federal Reserve also has independence. But in the USA, all it would take to overturn it, as a failed experiment in economic management, is a vote in Congress. In Europe, an entire new treaty between all 19 member states of the Euro would be required.

The ECB therefore resembles nothing else if not the unaccountable monarchies whose failures to serve the common good led to its revolutions in the 18th and 19th centuries. Laughably, Peter Praet claimed that the ECB was accountable if it failed to meet its objectives—as he admitted it had:
"At the same time, a central bank cannot allow itself too much discretion over the time horizon when inflation should return to its target. A numerical objective which is rarely realised – looking forward and in retrospect – is no hard objective. Our independence rests on the fact that we are accountable, and that means delivering price stability over a horizon that is verifiable by the public."
How are they accountable? They don’t have to answer to any national parliament as the Federal Reserve does—in fact the ECB charter expressly says that it is unaccountable:
"Neither the ECB nor the national central banks (NCBs), nor any member of their decision-making bodies, are allowed to seek or take instructions from EU institutions or bodies, from any government of an EU Member State or from any other body."
Not only are the unaccountable in statute, they have become unaccountable in behaviour as well. What politician could admit to the raft of failures for which the ECB is now responsible, and leave a public conference without answering a single question, nor having to consider an opposing viewpoint—such as the one I gave immediately after Praet at his conference?

Unaccountability with success is one thing. Unaccountability with failure, as the ECB and the entire economic apparatus of the European Union is delivering to Europe, is another altogether. Such impasses have not worked out well in the past—especially in Europe.
I'd like all you eurozone bulls to chew a bit on Steve Keen's thoughts as well as others (including me) who are skeptical on the eurozone's long-term prospects even as the ECB gets ready to ramp up QE2 over there.

Below, ECB boss Mario Draghi discusses why they are getting ready to ramp up quantitative easing to bolster euzone's inflation. I don't think the ECB will successfully engineer higher inflation in the eurozone but more stimulus should bolster risk assets in Europe and around the world.

I also embedded a Le Monde interview with French economist Thomas Piketty that took place in July where he discussed what needs to be done to bolster the Greek economy and avoid a protracted debt deflation crisis in Europe (interview is in French but it's excellent and well worth listening to).

On Friday, Amundi's Philippe Ithurbide told us that Greece is like a boomerang that keeps coming back every two years. I think he's right and the eurozone will be lucky if the Greek boomerang doesn't come back to haunt the region, especially if the deflation crisis gets much worse.

But it's not just Greek banks I'm worried about, it's also Italian ones which are still struggling with a mountain of soured debt, with non-performing loans rising to 200 billion euros in September from 198 billion the month before, prompting the Italian central bank to launch $3.19 billion new fund to rescue banks.

All this to say the ECB doesn't have much of a choice but to continue with more quantitative easing to reflate assets in an attempt to lift eurozone's inflation expectations. This is what all central banks are doing as they push forward to save the world. But something tells me in Europe, it's too little, too late, and Mario Draghi's worst nightmare might become a reality, one investors aren't pricing in yet.