Friday, January 29, 2016

The New Negative Normal?

Justin McCurry of the Guardian reports, Bank of Japan shocks markets by adopting negative interest rates:
Japan’s central bank has made a shock decision to adopt negative interest rates, in an attempt to protect the flagging economy from market volatility and fears over the global economy.

In a 5-4 vote, the bank’s board imposed a 0.1% fee on deposits left with the Bank of Japan (BoJ) – in effect a negative interest rate.

The move, which follows the similarly aggressive precedent set by the European Central Bank in June 2014, is designed to encourage commercial banks to use excess reserves they keep with the central bank to lend to businesses.

The surprise decision came just days after the bank’s governor, Haruhiko Kuroda, suggested he had dismissed any drastic easing measures to boost business confidence.

On Friday, the bank said it had not ruled out a further cut. “The BoJ will cut the interest rate further into negative territory if judged as necessary,” it said in a statement.

It said the move was intended to lessen the risk to Japanese business confidence from turbulence in the global economy, a week after data showed the Chinese economy had grown at its slowest pace for a quarter of a century in 2015.


Some BoJ board members are reported to have voiced concern that slumping Tokyo stocks could threaten attempts to get firms to boost capital expenditure.

The shift to negative interest rates – which in effect “taxes” financial institutions for parking excess reserves with the BoJ – is seen as an attempt to drag Japan out of its deflationary mindset.

Policymakers have been trying to achieve that through qualitative and quantitative easing, under which the BoJ expands its monetary base through the aggressive purchase of Japanese government bonds and risky assets.

But with so few assets left to buy, that policy appears to have run its course, according to some analysts. “I think this is a regime change and the BoJ’s main policy tool is now negative interest rates,” said Daiju Aoki, an economist at UBS Securities in Tokyo. “This shows that the ability to buy more Japanese government bonds is limited.”

The decision took some analysts by surprise. “Kuroda had been saying that he didn’t think something like this would help so it is a bit surprising and it’s clear the market has been surprised by it,” said Nicholas Smith, a strategist at CLSA based in Tokyo.

“The banking sector is getting smoked right now, though everything else seems to be doing just fine. This has obviously had a big effect on inflation and on inflation expectations.”

Markets had been divided on whether the central bank would opt for more stimulus as slumping oil costs and soft consumer spending have ground inflation to a halt in the world’s third biggest economy.

Earlier on Friday, official data showed Japan’s inflation rate came in at 0.5% in 2015, way below the BoJ’s 2.0% target, as the government struggles to convince cautious firms to usher in big wage hikes to stir spending and drive up prices.

“The 2% target is now totally out of reach,” said Taro Saito, economist at NLI Research Institute.

The bank extended the deadline for achieving its 2% inflation target to the first half of fiscal 2017 from its previous estimate of the second half of fiscal 2016.

Other data published on Friday pointed to a weak economy with spending by households in December falling 4.4% from a year ago and monthly industrial production contracting 1.4%.

The BoJ cut its core consumer inflation forecast for the coming fiscal year beginning in April to 0.8% from 1.4% projected three months ago.

The authorities will be hoping negative interest rates encourage commercial banks to lend more to promote investment and growth.

The rate cut had an immediate knock-on effect, sending shares on the Nikkei average up by more than 500 points early on Friday afternoon. However, shares soon plunged back down again as traders digested the broader implications of the move, which forced down the value of the yen and which could spark a currency war.

“The fact markets pared back this bounce soon after the announcement may in some respects reflect growing market concern that central banks are delving into a tit-for-tat currency devaluation war,” said Angus Nicholson at the online trading firm IG in Melbourne.

“And the grand macro-economic elephant in the room is what happens if China is forced into a major one-off devaluation in retaliation. Markets are unlikely to react well to a big yuan devaluation, and the further the ECB and the BoJ force their currencies down the more they push China to act.”


The decision came a day after the prime minister, Shinzo Abe, lost one of the key architects of his inflation-oriented economic policy, known as “Abenomics”. Akira Amari was forced to resign as economy minister on Thursday following allegations that he and his aides received bribes from a construction company. Amari has denied any wrongdoing.

Jesper Koll, chief executive officer at WisdomTree Japan, applauded the BoJ’s decision. “I’m very happy with governor Kuroda’s leadership today – adopting negative rates is exactly what was needed to re-assert the relentless, pro-active and pro-growth determination that underlies Abenomics,” he said.

“The fact that Kuroda has gone out on a limb – with a 5-4 vote – reasserts that this is his BoJ, not the technocratic non-risk taking BoJ of the past. As we keep insisting, this is not a business-as-usual leadership team.
The big surprise out of Japan sent a jolt down global bond markets as bond yields are collapsing all over the world. The U.S. 10- year Treasury yield now stands at 1.93%, making it tougher for U.S. pensions to meet their future liabilities. Meanwhile, negative bond yields in Germany will place even more pressure on European pensions teetering on collapse.

What are my thoughts on "Japan's big bang"? It smacks of desperation and this is where things get tricky and potentially dangerous. Why? Because we saw what happened last year following China's Big Bang, and as I explained in my Outlook 2016 on the deflation tsunami, the risks of a full-blown emerging markets crisis are rising and this will have ripple effects throughout the world:
[...] if China decides to once again devalue its currency, it will have ripple effects throughout Asia, including Japan where the prime minister and central bank governor have applied fresh pressure on companies to do their part in putting a sustained end to deflation by boosting wages and investment, with little success.

All this to say keep monitoring emerging market currencies in 2016. This is where you will see the global battle against deflation take place. Unfortunately, it's a losing battle and one that will export disinflation and deflation throughout the world at the worst possible time.

In my opinion, the problems in emerging markets are only going to get worse in 2016 so I have a hard time buying the global recovery theme which some elite funds are betting on. Even Canada's large and powerful pensions are betting on energy but those investments might not pan out for years or worse still, decades if global deflation sets in.
Now, some commentators, like Yves Lamoureux who is predicting QE4 and Dow 25,000, think deflation in China and Japan is a good thing. Cheaper goods will flood North America and along with that "declining oil price dividend", it will help consumption on this side of the Atlantic.

It has been my contention all along that the sharp decline in oil and commodity prices is not "unambiguously good" as it's a symptom that's clearly warning us the deflation supercycle is not nearing an end.

Worse still, deflationary pressures are picking up steam all over the world, especially Asia, and that means the risks of deflation coming to America are rising too. How is this possible? Through lower import prices. Look at the mighty greenback, it's gaining on all currencies again following the Bank of Japan's surprise move.

The greenback's strength will only reinforce commodity and asset deflation, lower import prices and inflation expectations, and in my opinion, it will force the Fed to reverse course fast.

In fact, the U.S. central bank has now put the world on notice that the slide in oil prices and sharp slowdown in global growth may rank as one of those very shocks, capable of changing the Fed's bias from implying a steady set of future rate hikes to one pointing to an extended pause or even a rate cut driven by stubbornly low inflation. 

Below, I highlight the key passages in this week's FOMC statement:
Information received since the Federal Open Market Committee met in December suggests that labor market conditions improved further even as economic growth slowed late last year. Household spending and business fixed investment have been increasing at moderate rates in recent months, and the housing sector has improved further; however, net exports have been soft and inventory investment slowed. A range of recent labor market indicators, including strong job gains, points to some additional decline in underutilization of labor resources. Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation declined further; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.

Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.
There's a sea change going on at the Fed and even though it decided to stand pat on rates, be prepared for a shift in policy given its renewed focus on global economic and financial developments. Brian Romanchuk is right, the BoJ's NIRP makes a Fed rate hike look even more foolish.

As far as the Fed's 2% inflation target, it's dreaming when it says the decline in energy and import prices are "transitory." I think the Fed needs to wisen up and listen carefully to Larry Summers, low energy prices are here to stay and the risks of deflation are rising fast.

As I write this comment keeping my eye on stocks, I notice there's a little party going on in most high beta stocks that got pummeled early in 2016, especially Metal & Mining shares (XME) which are up almost 7% on Friday mostly because of the 18% surge in the shares of Consol Energy (CNX).

Be very careful here. The big bet is that as central banks pump more liquidity into the system using all sorts of unconventional monetary policy tools, those funds playing the global recovery theme will come out ahead, but for me this is nothing more than another short-covering countertrend rally that will fizzle as global deflation becomes more entrenched. That's what the bond market is telling us.

And if global deflation becomes more entrenched, you can bet the Bank of Canada will regret its recent decision to stay put and that negative interest rates are coming to Canada too (short the loonie on any pop in oil prices).

What else? Right now, central banks are the only game in town and they're desperately trying to save the world from a global deflationary slump that will likely last for decades. Unlike what some market gurus claim, the Martingale casinos aren't about to go bust, but clearly central banks cannot fight the global deflation tsunami and the world desperately needs a new macroeconomic paradigm to fight the secular stagnation Larry Summers has warned of.

But my fear is that the fiscal response to world's economic woes is lacking, either because of politics or high debt levels constraining public finances, and this means central banks will go it alone and negative interest rates will be the new normal.

And if you think negative interest rates can never be used in the United States, think again. In an interview with MarketWatch, former chairman Ben Bernanke said the Federal Reserve should consider using negative rates to counter the next serious downturn.

“I think negative rates are something the Fed will and probably should consider if the situation arises,” Bernanke said in the interview last month. You can read the entire interview here.

Now, I ask all you global asset allocators, especially those of you working at large global pension funds: Are you prepared for the new negative normal?

On that note, please take the time to once again listen to Larry Summers discussing oil prices, global bonds and the risks of deflation below. He is bang on, with the risks of deflation rising and central banks already stretched in terms of what they can do, we're going to have to start thinking of fiscal policy in the years to come. The thing that worries me is do we need another crisis to get the ball rolling on this front?

Second, Bill Gross discusses why the Fed is on the wrong track and why the risks of a U.S. recession are rising in 2016. Take the time to listen to his comments.

And Gordon Long of the Financial Repression Authority interviewed Dr. Lacy Hunt of Hoisington Investment Management who explains why inflation and bond yields are heading lower.  Great interview, listen to his comments and read Hoisington's latest quarterly review and outlook.

Last but not least, I'd like to remind all of you to please take the time to donate or subscribe to this blog and support my efforts in bringing you thought provoking and insightful comments on pensions and investments. You simply won't find a better free lunch on the internet, so please show your support and contribute to my blog via PayPal on the right side. Thank you and have a great weekend!



Thursday, January 28, 2016

Europe's Pension Time Bomb?

Francesco Guerrera of Politico reports, European pension schemes ‘vulnerable to big market downturn’(h/t, Suzanne Bishopric):
Many work pension schemes are vulnerable to a major market and economic shock, the first Europe-wide stress tests of the sector found.

The tests, carried out by the European Insurance and Occupational Pensions Authority (EIOPA), found that dramatic falls in equity prices and other adverse economic occurrences would dramatically reduce the amount of money held by pension funds to pay for the retirement of current and past workers.

Pension funds suffer when markets fall because they invest in equities, bonds and other asset classes. Any reduction in interest rates is also detrimental because it reduces pension funds’ returns.

The results, released Tuesday, showed that “defined benefit” schemes — ones where the pension payout is based on the number of years worked and the level of salary attained — would find themselves with a deficit of more than €750 billion almost overnight under two different adverse scenarios.

That equates to a funding ratio — the amount of money available to pay for pensions — of between 59 percent and 61 percent of future liabilities. Such a low level would put pressure on pension funds to find other ways to fund the gap, such as reducing benefits or forcing the financial groups or companies that run the schemes to inject capital into the funds.

“While pension plan liabilities have a very long-term nature, it is important that supervisory regimes are prepared to deal with these stresses in a transparent way, be it through appropriate recovery periods, the role of pension protection schemes, increased sponsors’ contributions and/or benefit adjustment mechanisms,” said Gabriel Bernardino, chairman of EIOPA.
You can read the entire IORPs Stress Test  Report 2015 to get a better understanding of the serious challenges many European pensions face.

I strongly recommend you read the report as it discusses various investment, interest rate and longevity risk stress tests that impact defined-contribution (DC) plans and defined-benefit (DB) plans.

The key points worth noting are the following (click on image):


Basically, historic low rates, record stock market volatility and the increase in lifespans are driving the costs of defined-benefit pensions up which explains the inexorable global shift to DC pensions.

And I've got some bad news for you. That deflation tsunami I've been warning you about is going to decimate all pensions, especially ones taking increasingly more risk to achieve their target rate-of-return.

But as I've repeatedly argued, the solution isn't to shift out of defined-benefit plans into defined-contribution plans. The brutal truth on DC plans is they will exacerbate pension poverty. The more we understand the benefits of well-governed DB plans, the better off we'll be over the long run.

I just finished writing a comment on Ontario's new pension plan going over these points. My former colleague, Brian Romanchuk, just wrote a comment on the difficulty of extending universal state pension which you all need to read. I sent that comment to Bernard Dussault, Canada's former Chief Actuary, to get his thoughts and will follow-up with a comment of my own in the near future.

My views are firmly entrenched in what I believe a well-functioning social democracy requires to thrive: free healthcare as a fundamental right for all, free education for all especially the poor and working poor, and a universal pension plan which covers the retirement needs of a huge subset of the population no matter what happens in the bloody stock market!

In short, I believe the entire world needs to go Dutch on pensions and even improve on its retirement system. But while the Dutch and Danes got it right on pensions, most European countries are struggling with chronic deficits that threaten their pension system.

Nowhere is this more acute than in Greece, the epicenter of Europe's deflation crisis. The Greek economy cannot escape a deep debt deflation crisis and its pension system has been teetering on collapse for a long time.

Not surprisingly, protests over Greek pension reforms are escalating, the country is a mess, and the FT reports Alexis Tsipras and Kyriakos Mitsotakis are clashing over Greek pensions:
Alexis Tsipras has fended off attacks from Kyriakos Mitsotakis, Greece’s newly elected opposition leader, by insisting that his Syriza government can rescue the country’s underfunded pension system without cutting benefits to retirees.

The prime minister and his rival went head-to-head on Tuesday night in a heated parliamentary debate, their first confrontation since Mr Mitsotakis, a pro-European reformer, was voted in to lead the centre-right New Democracy party this month.

“There will be no reductions in main pensions,” a defiant Mr Tsipras said. “One pension is a whole household’s income in the present [recessionary] circumstances.”

Syriza has resisted pressure from creditors — the EU and IMF — to impose hefty pension cuts by March. The move, postponed from last year, has become an urgent priority with bailout monitors due to return to Athens next week to assessing progress on the reforms agreed in return for a €86bn third international bailout.

Taking aim at Mr Mitsotakis, the son of a former conservative premier, Mr Tsipras asserted that state pension funds were poised to collapse because of “sustained looting” over decades by previous governments.

Mr Mitsotakis responded that the social security system was a victim of the Syriza government’s “incompetence” during a political roller-coaster last year that ended with Greece agreeing to a third bailout after defaulting on a sovereign debt repayment.

“It was accepted that the pension system was viable until 2060 — until Syriza came to power,” he said.

The debate came as thousands of farmers across Greece used tractors to block border crossings and main roads in protest at plans by the government to increase pension contributions and income tax for farmers. The farmers on Tuesday rejected Mr Tsipras’s call for dialogue, demanding immediate cancellation of the increases.

The premier argues that cuts to cover a projected €1.8bn pension deficit in this year’s budget can be avoided through a 1 per cent increase in contributions already agreed with employers and another 0.5 per cent raised from workers.

Syriza has dismissed criticism by creditors that increasing contributions will slow a return to economic growth by dissuading businesses from hiring and will also encourage small companies to employ workers without paying social insurance.

Mr Mitsotakis, who launched an overhaul of the civil service while serving as administrative reform minister in 2013 and 2014, said there were resources available to fund social security without resorting to increased contributions “if the public sector undergoes a restructuring”.

Lawyers, engineers and doctors have staged protests against large projected increases in contributions to a pension fund for self-employed professionals running an annual deficit exceeding €500m

New Democracy has proposed the fragmented social security system be streamlined into three funds covering employees, self-employed professionals and farmers with a basic pension guaranteed at the age of 67 after at least 20 years of employment.

“As a new political leader, I have recognised the mistakes of the past and I am committed not to repeat them,” Mr Mitsotakis said.
Greek journalists have now joined the strike against the pension reforms. The country is a mess and I foresee another Greek crisis in the not too distant future.

And Kyriakos Mitsotakis is right, it's high time Greeks wake up and stop the charade of public sector profligacy run amok. The Greek public sector is unsustainable and so are Greek pensions (I disagree with Mitsotakis's assertion that they were ever sustainable).

But what is going on in Greece can easily happen in Italy, Spain and even France. The entire eurozone system is built on unsustainable promises and unlike Canada, you'd be hard pressed to find websites on many large European pensions plans to understand how they invest and what governance models they use to manage pensions (with a few exceptions).

In fact, in Greece, there is no accountability, no transparency, no governance whatsoever on pensions and pretty much anything the government is involved with. It makes me sick and until Mitsotakis wins the next elections by knocking some sense into stubbornly foolish Greeks who think they can have their cake and eat it too, the situation will only get worse.

Let me leave it there. Greek pensions are teetering on collapse but this comment demonstrates that Europe's pensions aren't that much better and there's a very real risk that a prolonged deflation crisis will negatively impact them for years to come.

Below, a panel discussion at Davos on the future of Europe where Greek Prime Minister Alexis Tsipras sparred with German Finance Minister Wolfgang Schäuble on solidarity. Of course, Europe's pension time bomb wasn't discussed because that topic is kept strictly confidential. As far as the future, I agree with George Soros, Europe is on the verge of collapse.

And former Greek Finance Minister Yanis Varoufakis spoke on Bloomberg recently stating "God and his angels can't fix Greece."

What Varoufakis fails to mention is that "God and his angels can't fix Greece" because no Greek government ever had the courage to implement tough reforms and drastically cut the disgustingly bloated Greek public sector down to size. Instead, successive PASOK and New Democracy governments kept buying votes by expanding the public sector beast and even now with the economy teetering on collapse, SYRIZA refuses to make much needed drastic cuts to the public sector.

I also embedded an interesting TED talk Varoufakis gave in December on how capitalism will eat democracy unless we speak up. Whether or not you like him, take the time to listen to this speech as he raises some good points on rising inequality and the glut of unproductive global savings that can be put to good use.

Of course, here too, Varoufakis speaks of half truths and conveniently ignores his gravest mistake as the former finance minister, namely, when he underestimated the resolve of his European counterparts and went home to his wife triumphantly stating: "Honey, I closed the banks."

Yes he did which is why Greeks now despise him and why he's hitting the lecture circuit and getting ready to release a "tell all book" to make him look like he was the virtuous one and everyone else was stupid (for a Marxist, Varoufakis sure knows how to capitalize on capitalism!).

I stated this before and will state it again, despite his somewhat intelligent but hopelessly pompous rhetoric, Yanis Varoufakis will go down in Greek history as the worst finance minister ever. And despite his capitulation, Alexis Tsipras will go down in history as the worst Greek prime minister, surpassing his childhood hero, Andreas Papandreou who began this Greek culture of entitlement that has literally crippled the country till this day.



Wednesday, January 27, 2016

Ontario's "Wynning" Pension Strategy?

Matt Scuffham of Reuters reports, Ontario pushes ahead with new government pension plan:
Ontario, Canada’s most populous province, said on Tuesday it will push ahead with the launch of a new government pension plan rather than counting on an expansion of the country’s existing federal plan.The Ontario Retirement Pension Plan (ORPP) is set to be introduced in 2017 and is designed to benefit the two-thirds of workers in Ontario who do not have an employer pension plan, provincial officials said.

“Our government is unwavering in its focus on ensuring a financially secure retirement for every worker in our province through the Ontario Retirement Pension Plan,” province Premier Kathleen Wynne said.

Ontario has taken a two-track pension strategy since 2013, preparing to introduce the ORPP while also waiting for a possible expansion of the Canada Pension Plan (CPP), the federal plan that covers most working Canadians.

However, Ontario Finance Minister Charles Sousa said it had so far proven too difficult to get the necessary agreement required among Canada’s provinces to expand the CPP.

“We advocated strongly for a CPP enhancement, as did the federal government, but the consensus was not to be had,” Sousa told reporters.

Like other governments around the world, Canada faces a challenge to provide for its aging population. By 2024, more than 20 percent of Canadians are expected to be age 65 or older, the traditional retirement age, according to federal government data.

“Changes in the nature of work are compounding the problem. The working world is no longer dominated by single job careers and guaranteed workplace retirement plans,” Wynne told reporters.

Under the new Ontario plan, by 2020 every eligible worker in Ontario will be part of either the ORPP or a comparable workplace pension plan. The lowest-income earners will not be required to contribute.

The plan, which will start paying benefits in 2022, is designed to pay out up to 15 percent of individuals’ earnings over their career if they contribute to it for over 40 years.

It particularly targets younger workers at smaller companies who may be well paid but are not offered a pension as part of their benefits because it is too expensive for their employer to provide one. Wynne said it will only have a limited benefit for older workers.
Ashley Csanady of the National Post also reports, Ontario pension plan going full steam ahead toward 2017 launch — just don’t ask the cost to run it:
Deductions from the Ontario Retirement Pension Plan will start coming off paycheques in less than a year, but the province still can’t say how much it will cost to run.

Premier Kathleen Wynne was joined by two ministers Tuesday to announce more details of the pension plan, including the fact spouses or a designated beneficiary can reap its benefits after a contributors dies. And like the Canada Pension Plan, those benefits will be indexed to increases in wages and the cost of living.

An independent actuary will be able to approve 0.2 per cent contribution increases if the fund runs low on cash and anyone earning less than $3,500 a year will be exempt from enrolling.

Those tidbits and some technical details prompted Wynne and Associate Finance Minister Mitzie Hunter to proclaim the design of the ORPP is “now complete.”

That design, however, excludes one key point: how much the administration of the plan will cost. CPP, for example, costs about 1.2 per cent each year to run, and many private sector pension plans costs between two and three per cent, though it can be higher.

Hunter said the ORPP is “going to mirror the CPP as closely as possible” but couldn’t yet pin an exact number on its costs. She said large, public-service pension plans in Ontario are very successful and are helping to determine how the ORPP will be administered.

“We expect that it will be very much in the similar range as CPP and those very large plans,” she said.

Pension expert Ian Lee, an assistant professor at Carleton University’s Sprott School of Business, is one of many prominent economists to ring alarm bells about the ORPP. Like Kevin Milligan at the University of British Columbia and Jack Mintz at the Calgary School of Public Policy he questions the very assumption that a mandatory savings scheme is necessary. He also doubts the ORPP can be run as efficiently as the much larger CPP, as the government hopes.

“I do not think it’s possible (to) bring the cost anywhere near that of the Canada Pension Plan, simply because it won’t have the economies of scale,” Lee said, simply because there won’t be enough people — even with six million expected enrolees — for the ORPP to match its federal counterparts efficiencies.

A Conference Board of Canada report released in December found the ORPP would, over the long run, benefit the Ontario economy, and that for many workers it would prove a more cost-effective form of savings than private investment. The report found someone earning $60,000 a year and contributing to the ORPP for 40 years would, on average, see $188,000 more in pension benefits by retirement age than someone who invested privately.

“I have a great deal of respect for the Conference Board of Canada but until we see those numbers (from the province) I don’t think they can make such a statement,” Lee said.

The ORPP will start a phased roll out in 2017 and the province expects six million Ontarians to be enrolled by 2020. Benefits are expected to start flowing in 2022. Anyone without a comparable workplace and their employer will be required to contribute 3.8 per cent of their income for the first $90,000 earned annually. Someone making $45,000 would pay about $16 a week into the plan to be matched by his employer for a total of $1,710 a year, which after 40 years would make him eligible for $6.410 in annual benefits.

Business groups and the provincial Progressive Conservatives maintain the ORPP will amount to a “payroll tax” that will hurt employment.

I began this comment with articles from the Globe and Mail and the National Post so you can get a feel of how politicized the debate on Ontario's new pension plan (ORPP) has become.

Where do I stand on this debate? My title pretty much says it all and let me tell you that Canadian newspapers are doing a lousy job explaining the advantages of this new pension plan as well as that of enhancing the CPP for all Canadians.

First, some of the pension experts quoted in the National Post article are completely clueless. In particular, when Ian Lee states “I do not think it’s possible (to) bring the cost anywhere near that of the Canada Pension Plan, simply because it won’t have the economies of scale,” he simply doesn't know what he's talking about.

Yes, the CPPIB is huge and can use its size to negotiate fees and costs down, but the ORPP is going to be a young plan which is just getting started. As such, it has the luxury to take a different approach from CPPIB and emulate Canada's top pension plan, the Healthcare of Ontario Pension Plan (HOOPP) which does everything internally and has the lowest administrative costs of any large public or private defined-benefit pension plan.

As the ORPP gets much bigger and needs to start investing in external managers, it can then start taking the approach Ontario Teachers' Pension Plan or CPPIB takes, but this debate on administrative costs is just plain silly until we get more details of who will be hired to run the pension plan and what approach they will take.

For me, it all boils down to governance. Ontario has some of the best pension talent in the world, and if they place the right board of directors in there and pay pension fund managers properly, they will have no problem attracting competent people who can manage assets internally and keep costs low.

In fact, the ORPP is in a great spot to use the same governance model that has helped Ontario Teachers, CPPIB  and most of Canada's top ten pensions to succeed and it can go a step further and improve on the existing governance to get better alignment of interests over the long run.

Second, the reason why Ontario is going it alone on the ORPP is because Canadian politicians are petrified to expand the CPP once and for all, especially now that the economy is going through a crisis. In my opinion, this is the stupidest, most shortsighted decision that our politicians are making and they're squandering a golden opportunity to enhance the CPP once and for all.

Importantly, and I can't overemphasize this, good pension policy makes for good economic policy. Bolstering a country's retirement system to provide more defined-benefits will end up bolstering economic activity over the long run, lower social welfare costs of pension poverty, and reduce the debt by increasing sales and other taxes. These are all advantages of well governed DB plans.

There is a more important political and philosophical argument to be made here. When Democratic candidate Bernie Sanders talks about "healthcare being a fundamental right," Canadians from all political parties understand exactly what he's talking about.

A well functioning social democracy should provide three basic pillars: free healthcare, free education and retirement benefits people can count on till they die no matter what happens in the volatile stock market dominated by big hedge funds, big banks and high-frequency traders.

Right now in Canada, we have the first two pillars but are lacking any initiative on tackling that third pillar. The debate has become so politicized to the point of absurdity. It's high time Canadians realize the brutal truth on defined-contribution plans and accept the fact that the current path isn't working and will only condemn more people to pension poverty.

As I've stated before, there shouldn't be four or more views on defined-benefit plans, there should only be one view, we need to bolster public DB plans for all Canadians. And I emphasize public because apart from a few exceptions (HOOPP, CN, Air Canada and a few others), most private DB plans are crumbling and failing to deliver on their pension promise.

I think it's high time we create a few more large public defined-benefit plans in Canada and get rid of private DB plans altogether. We can staff these new plans with existing talent pool across public and private DB plans and bolster the retirement security of all Canadians. 

I realize my views aren't going to sit well with right-wing nuts who constantly fret over "big government" or small business groups that oppose "payroll taxes" (even if pension contributions aren't taxes!). But I've thought long and hard about pensions, have worked at two of Canada's largest public pension funds, and have dedicated eight years of my life writing a blog on pensions and investments to educate many clueless Canadians on what goes on in markets and at big pensions and why a sound pension policy is so important.

I'll share something else with you. My brutally honest comments on pensions haven't won me many friends at Canada's top ten. Sure, a few subscribe to my blog, but nobody is hiring me even though they know I have MS and I'm the best damn senior pension analyst who produces more in a week than most of their senior analysts do in a year (I'm not saying this to sound arrogant, it's the brutal truth!).

What else? Despite having progressive multiple sclerosis (and doing well) and defending the rights of the poor and disabled on my blog, I'm actually a fiscal conservative at heart, believe in free markets, competition and responsible and accountable governments that spend wisely. My views on expanding the CPP have nothing to do with my politics even if I can make a solid economic case for it over the very long run.

In fact, a friend of mine, a die hard Conservative, had this to share with me in a recent email exchange where I told him rising inequality is very deflationary (we were talking about 5 books billionaires don't want you to read):
There is no doubt that it is. Extreme inequality also breeds civil unrest and, as much as the extremely wealthy think they are untouchable, it is difficult to stop a lynch mob.

The "win at all costs" mentality is really shortsighted.

Same concept goes for the debate between DC and DB pensions. In the long term, DC pensions transfer retirement risk to the government because if people do not save enough, social systems will need to step in and make up the difference.
Now, if my friend who is a die hard Conservative (who like me, thinks Harper bungled our economy up!) gets it, I'm shocked that many Liberal and NDP politicians still don't get it.

As such, I applaud Premiere Kathleen Wynne and her team for going it alone and introducing a new pension plan that will bolster the retirement security of all Ontarians. The rest of Canada's leaders should stop dragging their feet on enhancing the CPP and follow Ontario's lead and introduce real change to Canada's pension plan (thus far, Justin Trudeau's Liberals have failed to impress me with their asinine, populist pension gaffes).

Below, Ontario Premier Kathleen Wynne and Minister of Finance Charles Sousa share structural details on the proposed Ontario Retirement Pension Plan. BNN’s Paul Bagnell reports on those details.

Again, take what you read and see on the ORPP with a shaker of salt. There's so much nonsense being spread out there by so-called pension experts which are truly clueless. Canada's politicians need consistency in the national pipeline debate but much more importantly, they need consistency on the national pension debate.

Tuesday, January 26, 2016

The Only Game in Town?

Ray Dalio, founder of Bridgewater, wrote an op-ed for the Financial Times, Pay attention to long-term debt cycle:
I have a controversial view that is based on my alternative economic template, and I feel a responsibility to share at this precarious time.

In brief, the Federal Reserve’s template, and that of most economists and market participants, reflects the business cycle.

Based on it, tightening should occur when a) the rate of growth in demand is greater than the rate of growth in capacity and b) the usage of capacity (as measured by indicators such as the GDP gap and the unemployment rate) is becoming high.

As a result, tightening now makes sense.

However, as I see it, there are two important cycles to pay attention to — the business cycle, or short-term debt cycle, and the debt supercycle, or long-term debt cycle.

We are seven years into the expansion phase of the business/short-term debt cycle — which typically lasts about eight to 10 years — and near the end of the expansion phase of a long-term debt cycle, which typically lasts about 50 to 75 years.

It is because of the long-term debt cycle dynamics that we are seeing global weakness and deflationary pressures that warrant global easing rather than tightening.

Since the dollar is the world’s most important currency, the Fed is the most important central bank for the world as well as the central bank for Americans, and as the risks are asymmetric on the downside, it is best for the world and for the US for the Fed not to tighten.

Since the long-term debt cycle issue is the biggest issue that separates my view from others, I’d like to briefly focus on its mechanics.

What I am contending is that there are limits to spending growth financed by a combination of debt and money. When these limits are reached, it marks the end of the upward phase of the long-term debt cycle. In 1935, this scenario was dubbed “pushing on a string”.

This scenario reflects the reduced ability of the world’s reserve currency central banks to be effective at easing when both interest can’t be lowered and risk premia are too low to have quantitative easing be effective.

Since we commonly understand why lowering interest rates stimulates debt and economic growth, and less commonly understand how QE works, I’d like to explain it.

QE works because those “risk premia” — which are the spreads between the expected return on cash and the expected returns on other assets such as bonds, stocks, real estate and private equity — draw the buying of investors who sell their bonds to the central banks during QE.

You see, our whole capital allocation system — banking and investing — is driven by spreads so that when they are large, QE works better than when they are small.

When there are good spreads — in other words a large risk premia — and those who sold their bonds take their newly acquired cash to buy those assets that offer attractive spreads, bid up their prices and drive down those expected return spreads (ie risk premia) of those assets.

That is where things now stand across the world’s reserve currencies, where the expected returns of bonds (and most asset classes) are relatively low in relation to the expected returns of cash.

As a result, it is difficult to push the prices of these assets up and it is easy to have them fall. And when they fall, there is a negative impact on economic growth.

When this configuration exists — and it is also the case that debt and debt service costs are high in relation to income, so that debt levels cannot be increased without reducing spending — stimulating demand is more difficult, and restraining demand is easier, than is normally the case.

At such times the risks are asymmetric on the downside and it behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening.

That, in my opinion, is now the case.
This is an important op-ed by the founder of the world's largest hedge fund. The key passage for me was that last one I highlighted where Dalio states: "it behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening."

In September 2012, I wrote a comment looking at whether the titanic battle over deflation will sink bonds where I noted: "I'm far from convinced that the bond bull market has ended and see this 'titanic battle over deflation' playing out for several more years, leading to more volatility in the stock market."

Interestingly, in that comment, I embedded a clip at the end where Dalio warned too much monetization could trigger inflation and a possible downturn in the US. Also, Mohamed El-Erian, then Pimco's co-CIO and CEO, weighed in with his thoughts on the outlook on the US economy. More on El-Erian and the only game in town below.

In December 2013, I openly worried that Fed tapering will lead to deflation and a year later I wrote about deflation coming to America where I noted:
...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.
Then, exactly one year ago, I warned my readers to prepare for global deflation and then in September warned there is no end to the deflation suspercycle and investors better prepare for an era of lower returns. This all led up to my recent Outlook 2016 where I warned the deflation tsunami is coming and there's not much we can do to stop it.

Importantly, deflation is a central theme of mine and it's been so long before I started this blog. I was talking about deflation/ deleveraging and the bursting of the U.S. housing bubble when Gordon Fyfe and I met Ray Dalio and Bob Prince back in 2004 when I pushed Dalio on it and he blurted out: "Son, what's your track record???"

Gordon Fyfe got a real kick out of that response but Dalio didn't say it to shut me up or piss me off, he said it to explain why he's agnostic on the future and why he thinks risk parity strategies and his All Weather portfolio are the best thing since sliced cheese. He was basically peddling his investment philosophy and his all-weather approach.

But last year proved to be a difficult one for Bridgewater's All Weather fund which was down 7% as mad money wreaked havoc on risk parity strategies. I think Dalio is worried about his track record and rightfully so as his fund manages billions of pension and sovereign wealth fund money.

Let me not be too tough on Ray, after all, I agree with him, there's no "locomotive" to drive global growth, the world is awash in debt and there's a real risk we're heading into a long debt-deflation cycle à la Japan or worse.

In this environment, the Fed would be foolish to continue tightening and Jeffrey Gundlach is right, if it does continue raising rates, the market will humiliate Janet Yellen, Stanley Fisher and company.

Importantly, there's no reason to raise rates at a time when global deflation remains the clear and present danger. I don't give a damn what the Fed says, if it continues raising rates, it will all but ensure the next financial and economic crisis and a long period of global deflation. 

The market is telling the Fed: "Back off stupid or we will force you to back down." Period. Anyone who thinks otherwise better be prepared for those asymmetric downside risks Dalio is warning of.

Right now, the Fed and other central banks are the only game in town, to borrow the title from Mohamed El-Erian's latest book which I picked up over the weekend. I'm not done reading it but it's a brilliant book you should all read to understand the macro deficiencies that plague this world and what can be done to address them.

 El-Erian wrote this exclusive excerpt for the UAE's National:
Reinvigorated path

The well-being of current and future generations depends on successfully addressing the 10 big issues just outlined. By now, I suspect or at least hope that they are on the radar screens of every major central bank around the world. If they had the tools, they would be addressing them more effectively, conscious of how much is at stake. I would even venture that central bankers would willingly embark on a reinvigorated policy path even if they were initially incapable of identifying the entirety of the required response and its consequences.

I also suspect that central banks agree that time is of the essence. The longer these issues persist, the more entrenched they become in the global economy, the greater the adverse feedback loops and, consequently, the harder the solutions become. The longer we wait, the harder it gets.

Self-interest also plays a role here. Being “the only game in town” means that central banks are especially vulnerable to the winds of political backlash should economic mediocrity continue and financial instability return. This is particularly important in a world in which unconventional monetary policy is also altering the configuration of financial services, actively taxing one segment of the population to subsidise another, and visibly inserting public sector institutions in the pricing of financial markets and the resulting allocation of resources. Rather than just act as referees, central banks have also taken the field in quite a range of sports.

In the United States, there are already mounting legislative attempts – unsuccessful so far – to subject the Federal Reserve to greater scrutiny, auditing and accountability. Should any of these attempts gain traction, these institutions’ operational autonomy and policy responsiveness would almost certainly be undermined. With that, yet another important component of policy management would be unduly constrained, limiting the ability of the system to address challenges to its economic and financial well-being. It would be the equivalent of a boxer competing with both hands tied behind his back.

Across the Atlantic, an even greater sense of irritation is visible and growing, fuelled by economic underperformance and the horrid crisis in Greece. In Germany, for instance, politicians increasingly feel that the ECB has gone too far in constantly trying to support governments that delay reforms and instead are enabled to act on their inclination to overspend. They also do not like the way that the ECB is perceived to be following the Fed in taxing savers in order to subsidise borrowers. And being inherent savers, they lament the extent to which artificially repressed interest rates are undermining institutions that provide longer-term financial services, be it life insurance or pensions.

Rumblings are also evident within the halls of monetary institutions themselves. Already, some “hawkish” central bankers on both sides of the Atlantic have publicly expressed concerns about institutional mission creep. For them it is not just about the extent to which central banks have had to venture into experimental policy space, using untested instruments and doubling down on them. It is also about what they perceive as a tendency by the central banks to expand beyond their traditional policy purview, taking on too many responsibilities.

Before stepping down in March 2015 as president of the Philadelphia Fed, Charles Plosser stated that he worries about “the longer-term implications for the institution. Part of my criticism has been that we have pushed the boundaries into fiscal rather than monetary policy ... What happens to our independence? What happens to our ability to do things effectively?” Other figures, including some not already known for hawkish tendencies, stated similar opinions.

Speaking in London on March 23, 2015, James Bullard, the thoughtful president of the St Louis Fed, warned on the risk of artificially low interest rates causing damaging financial bubbles. “Zero is too low in that kind of environment.” In saying so, he was reinforcing one of the messages that Fed vice chair Stanley Fischer had delivered on several occasions; indeed, Stanley Fischer had just reiterated it that week in his speech to the Economic Club of New York, warning that markets would be ill-advised to behave as if zero rates were anything other than an anomaly that needs to be corrected.

Yet none of this has been decisive in stopping central banks from being the only game in town – so much so that it has become quite common for them to be even more dovish than what they have conditioned financial markets to expect. Just look at how, to the surprise of many given the controversial nature of the policy step and the divided set-up in the governing council, the ECB opted in January 2015 for a new large-scale asset purchase programme that was larger and more open-ended than consensus market expectations. And look at how, in removing the word “patient” from its policy statement in March 2015, the Fed went out of its way to remind markets that this did not mean it would be impatient.

What can they do?

At every occasion, central banks have erred on the side of short-term caution, almost irrespective of the longer-term consequences. And this will not change any time soon. Indeed, even when they embark on removing all the exceptional monetary policy stimulus – a process that the Federal Reserve will lead given the more advanced stage of economic healing in the United States – the result will be what I have called the “loosest tightening” in the history of modern central banking.

Whichever way you look at it, there should be little doubt about central banks’ motivation and therefore willingness to take action to generally maintain the current path until reinvigorated growth helps address the 10 issues discussed in the previous part. Both are huge. But central banks also know well that these are not just their issues – the global system as a whole is in play and multiple policies are required, including crucial ones that go beyond central banks. And it is just a matter of time before the realisation sinks in that motivation and willingness, no matter how strong, may not be sufficient to deliver effectiveness and, therefore, the desired outcomes.

It needs to be stressed that the fundamental problem confronting central banks is their ability to effect systemic and lasting change. And here there are grave uncertainties.

No one should doubt that if they remain “the only game in town,” there is a very real chance that central banks will go from being part of the solution to being part of the problem. Moreover, the destiny and future standing of central banks are no longer in their own hands.

There isn’t much central banks can do to improve countries’ growth engines. These institutions have neither the expertise nor the mandate to pursue reforms in education and labour markets. They are not in a position to lead national and regional infrastructure drives. They simply do not have the power to influence fiscal reforms, let alone impose them.

So what can they do? A few small things, though they are limited and unlikely to prove decisive as long as other policymaking entities remain on the sidelines.

Central banks can do a little bit more when it comes to the problems of inadequate demand and debt overhangs – though, again, we need to understand that because they are just one part of the required policy response, their efforts come with unintended consequences, including increasing the risk of financial instability down the road.

A few small central banks can also try to facilitate economic recovery by making their individual currencies more competitive – though you will never hear them say so. Indeed, even when some G7 member countries de facto embarked on such an approach, they found it necessary to obfuscate the issue by stating that they were not in fact pursuing such a path!

Despite some obfuscation (meant essentially to stop any talk of “currency wars”), the policy approach is quite straightforward. A weaker exchange rate is meant to boost activities of both export-orientated companies and those whose domestic sales compete with foreign-supplied goods and services. But again, effectiveness is far from complete, and, again, there are costs involved as noted above, including the risks of triggering a currency war. After all, and critically, not every country can devalue at the same time.

Finally, when it comes to policy coordination, the problem is not with central banks. Of all the economic agencies across the globe, they remain the gold standard when it comes to consultation, sharing ideas, and, when needed, applying coordinated action. And what they do is greatly facilitated by one of the best-kept policy secrets in the world of policy coordination – those highly effective and regularly scheduled meetings held in Switzerland.

Having been invited as an external speaker to a few of these meetings, I have come to appreciate their effectiveness, and this despite the fact that I have been only partially exposed to what goes on in that circular building across from the train station in the Swiss city of Basel. Held away from the cameras and fanfare of the press, the BIS (Bank for International Settlements) gatherings are said to provide for a rather candid exchange of views that in recent years has involved a larger number of systemically important countries. They have also greatly facilitated the critical emergency institutional phone calls that are required during periods of crises. Indeed, I have yet to meet a central bank official who has not praised BIS as the best gatherings for frank and effective policy exchanges.

The problem with the central banks is not lack of a venue or a conductor. It’s that those present in the room lack a full orchestra – their instruments are limited. No matter how well they discuss and coordinate, they can offer only partial solutions to vast and deeply entrenched problems.

But one thing they can do, and have been doing, is to continue to try to intelligently buy time for other policymaking entities, with tools better suited to implement the four policy components discussed above to get their act together. As these entities are already quite late, and as central bank bridging is far from a costless or riskless exercise, our current circumstances will yield a rather unusual distribution of potential outcomes for the next few years, ones that will challenge our comfort zones, whether we are individuals, companies or governments.
Go back to read my comments on whether central banks can save the world and whether the Martingale casinos are about to go bust. Also read my comment on why negative rates are coming to Canada and maybe the United States.

My problem with El-Erian's book is that it fails to address some big structural issues that I've been warning of like the global pension crisis and rising inequality, both of which are deflationary. There's also the problem of corporate leaders fixing the game to benefit their needs, something which Roger Martin discusses in his book published a few years ago (read that one too but take his comments on hedge funds with a grain of salt).

But El-Erian is right, central banks remain the only game in town and while we can debate the merits of more quantitative easing (QE), it's hard to see how the Fed will escape such a course of action, especially if global deflation becomes entrenched.

On this last point, Gerard MacDonell, who was an economist at Point72 Asset Management, (previously SAC) from 2004 through 2015, and my former colleague/ sort of boss at BCA Research, wrote a widely read guest comment on Noahpinion, So Much For QE.

Gerard's comment isn't an easy read but it's an important one and he ends it by stating the following:
The only way LSAPs (large scale asset purchases) could be considered a quantitative operation would be if the scale of them communicated something about the tolerable inflation rate. But this was specifically excluded in 2012 when Bernanke and colleagues on the FOMC formalized 2% as the unchanged inflation objective.

The Fed leadership has come a long way from believing that QE had something to do with the power of the printing press to a recognition that the program is a combination of an indirect and transitory rates signal, a confidence game, and a duration take out that probably achieved much less than was advertised. But at least the journey has been made, which has reduced the risk of a contractionary policy error.
I'm not sure the risk of any policy error has been reduced. In fact, quite the opposite, I agree with those who think the Fed making a monumental mistake and will need to reverse course fast to avoid making the greatest policy error of our era.

As far as the merits of QE, in their latest quarterly review and outlook, Van Hoisington and Lacey Hunt note the following:
Since the introduction of unconventional and untested monetary policy operations like quantitative easing (QE) and forward guidance, an impressive amount of empirical evidence has emerged that casts considerable doubt on their efficacy. The historical facts regarding the grand experiment by the Federal Reserve Open Market Committee (Fed) are worth considering.

The trend in economic growth in this expansion has been undeniably weak and perhaps unprecedentedly so. Real per capita GDP grew only 1.3% in the current expansion that began in mid-2009; this is less than one half the growth rate in the expansions since 1790.
All beautiful but none of these economic commentators discuss what other options the Fed had except to engage in massive QE following the 2008 crisis???

A much better understanding of quantitative easing and its advantages and limits was provided by Graham Turner of GFC Economics in his seminal book, No Way to Run an Economy. On page 75 of that important book you all need to read, Turner states the following:
Much of the misunderstanding over quantitative easing reflected the same confusion that bedevilled monetary authorities after the money market crisis had erupted in the summer of 2007. Wrongly, central banks had assumed injecting liquidity would be enough, and ignored the importance of lowering debt servicing costs. Ironically, the Bank of England was guilty of this misapprehension, even though it was the first central bank to commit to quantitative easing. 
More than any other economist, Graham Turner understands the dynamics of debt deflation and what central banks need to do to avoid a total economic collapse. He's been writing on Japan's deflationary woes for years and if you're not subscribed to GFC Economics, get to it already and familiarize yourself with his unique economic commentaries and great chart packs (he's also a very nice and brilliant guy who has a hearing impairment so make sure you talk clearly when you meet him and let him read your lips).

Anyways, as we all await the Fed to deliberate over the next couple of days, I wanted to discuss this topic which I think confuses most people, including many so-called economic experts.

Below, Ray Dalio's favorite economist (mine too), Larry Summers, discusses fracking technology and why we're in a new world where the price of oil will stay low for a very long time.

Summers is bang on: "Globally, the thing people have to look at is what the long term fixed income markets are saying. And they're saying that nowhere in the industrial world are we really going to get solidly to the 2% inflation target over the course of a decade and that real interest rates, the neutral rate, are going to remain epochally low."

Second, Mohamed El-Erian, Allianz chief economic adviser and author of The Only Game in Town, discusses efforts by the Federal Reserve in uncertain economic times and the impact to the financial markets, stating "it's the end of an era and the path we're on is ending."

El-Erian also discusses why more volatility is guaranteed and key issues investors need to keep in mind. Listen to his comments below.

Lastly, while Ray Dalio warned the Fed's next move is QE, not tightening at Davos last week, Yves Lamoureux, president of macroeconomic research firm Lamoureux & Co came out yesterday to say the Dow will reach 25,000 because QE4 is coming.

Yves loves making big, bold calls and he might be right on QE4, but he's dreaming if he thinks the Dow will head to 25,000 when global deflation risks are rising. Read my recent comments on why the bloodbath in the stocks is over and why oil's nightmare dominated Davos to get a more realistic view on where these markets are headed in the short, intermediate and long term.    






Monday, January 25, 2016

Private Equity's Not So Golden Age?

David Carey and Devin Banerjee of Bloomberg report, Private Equity's Golden Age Wasn't So Golden After All:
Henry Kravis called it private equity’s golden age. From 2005 to 2007, buyout firms paid fat prices to buy about 20 supersized companies, from Hilton Worldwide Holdings Inc. to Hertz Global Holdings Inc.

Now, a decade later, the results of that debt-fueled spree can be tabulated -- and it’s hardly golden. The mega-deals produced mostly mediocre returns, falling well short of the profits that leveraged buyout shops typically seek, according to separate compilations by Bloomberg and asset manager Hamilton Lane Advisors. In more than half the deals -- each valued at more than $10 billion -- the firms would have been better off if they had put their investors’ money into a stock index fund.

Have the Masters of the Universe learned a lesson? They say they have. Caution is now a watchword and less is more. TPG Capital has sworn off buyouts as large as $30 billion, people with knowledge of its thinking said, while other shops will consider enormous deals only if the price is right. But so far none has led a $10 billion or bigger transaction since the financial crisis (click on image).

“The big deals were done more out of ego than economic sense,” said David Fann, chief executive officer of TorreyCove Capital Partners, which advises pension plans that invest in buyout funds. “People paid steep prices and put on too much debt.”

Representatives for Kravis’s KKR & Co. and TPG declined to comment.

Buying Frenzy

Private equity firms make money by charging investors -- pensions and other institutions -- an annual management fee equal to 1.5 percent to 2 percent of the funds they raise. They also keep 20 percent of any profits when a company they acquired is later sold.

The firms typically want to, at least, double investors’ money within three to five years. But a decade ago, a buying frenzy stoked by low borrowing costs saw firms pay sometimes twice as much for companies as dictated by traditional sales and cash flow multiples. That behavior almost guaranteed so-so returns, buyout executives now say.

Private equity firms led 19 purchases worth more than $10 billion from 2005 to 2007, according to data compiled by Bloomberg. As of Dec. 31, the deals earned the firms a median profit of 40 percent above their investment cost -- well below their goals.
Smaller Deals

The results also pale when compared with the 70 percent median return yielded by all private equity transactions during that period, the Hamilton Lane study shows. That group includes thousands of smaller deals.

On an annualized basis, the largest deals generated a median 4 percent return, according to the Hamilton Lane study, which looked at 25 transactions from the era. The Standard and Poor’s 500 Index, by comparison, returned 7.3 percent a year from the start of 2006 through 2015.

“This crop of deals dragged down private equity returns,” said Joe Baratta, global head of private equity at Blackstone Group LP. “The entire industry has become more disciplined.”

The private equity shops justified the high prices at the time by saying big and established companies could weather a possible downturn. But the post-2008 meltdown dashed that conviction, imperiling companies big and small.

KKR was the most active player, leading or joining in nine of the deals valued at more than $10 billion. Its record was mixed. Four of those transactions notched solid returns of 2.2 to 5.1 times the firm’s money. KKR co-led the highest-returning jumbo-deal, that of hospital owner HCA Holdings Inc.
$8.3 Billion Bet

But KKR also participated in four deals posting modest returns of 1.1 to 1.6 times what investors put in. Then there was the record $48 billion buyout of TXU, now called Energy Future Holdings Corp., which was the only total equity wipeout of the 19 mega-deals. The company’s 2014 bankruptcy vaporized an $8.3 billion bet led by KKR, TPG and Goldman Sachs Group Inc. 
TPG had a subpar record for its seven buyouts, totaling $160 billion. On top of its Energy Future debacle, TPG suffered a loss in its purchase of casino operator Harrah’s, now Caesars Entertainment Corp., and gained nothing in participating in buying Freescale Semiconductor Ltd. In four other deals, it eked out a profit of half or less what it invested.
Most Profitable

Blackstone and Carlyle Group LP, the two biggest buyout firms, and Bain Capital distinguished themselves among the group by doing multiple deals and dodging any losses. Blackstone led the $26 billion purchase of Hilton, a deal that has morphed into the most profitable leveraged buyout ever in dollar terms -- a $10.8 billion partly realized gain as of Dec. 31, for an annualized return of about 15 percent.

With notable exceptions -- Energy Future, Caesars and Intelsat SA -- the deals clawed their way back to profitability thanks to a resurgent stock market, debt restructurings and streamlining. But that wasn’t enough to produce buoyant returns. One reason is that big public companies tend to trade at higher multiples than smaller firms.

“The fundamental flaw with large public-to-private deals is you pay the full market rate,” said Scott Sperling, co-president of Thomas H. Lee Partners, which ponied up an above-average 16 times cash flow for Univision Communications Inc. “That decreases the odds you can sell the company later for a higher multiple.” He declined to discuss the performance of his firm’s deals.
PE Playbook

Another problem, said Blackstone’s Baratta, was that many of the big companies were well run, leaving less room for operational improvement -- a key element of the private equity playbook.

“You’ve got to know going in that you can drive up growth and margins,” as Blackstone did with Hilton, said Baratta. With Biomet Inc., by contrast, “there was less we could do to transform the business.”

The companies also were too big to sell for cash. That left a public offering or a sale, paid for in stock, to a publicly traded buyer as the only paths to an exit. But unloading shares takes time, eroding annualized returns.

A mega-deal revival is also being deterred by curbs the Federal Reserve has set on loans tied to buyouts, executives said.

While buyout titans are exercising caution, whether they remember the lessons is an open question, said Josh Lerner, a Harvard Business School professor who researches the private equity industry.

“Memories often last a decade” after a crash, Lerner said. “Getting them to last two decades may be over-optimistic.” (click on image)

Indeed, in this business, memories never last over a decade, but I think it's safe to assume the era of private equity mega deals is over. And that's a good thing for investors and general partners.

As far as private equity's (not so) Golden Age, it's long gone and times will get much tougher in the years ahead. In late November, a former Carlyle employee Sebastien Canderle,wrote a guest comment on a bad omen for private equity, highlighting the growing number of inexperienced GPs entering the industry.

As I discussed in that 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.
There's a lot more pressure on private equity funds and hedge funds to adhere to the rigorous standards institutions are imposing on them. The best and most experienced private equity investors are grilling their GPs, making sure alignment of interests are there and going over all hidden fees as well as going over how private equity funds are generating their returns.

In a nutshell, if you want to raise funds from big institutions, you need to conform to their standards. That goes for everyone, including Blackstone, Carlyle, KKR, TPG and other top PE funds.

What else? The governance of top private equity funds is increasingly being discussed at large limited partners. I had a conversation with a major pension fund investor in private equity who told me if they don't see a solid governance framework where all the senior partners share in the big decisions, they walk away.

Interestingly, he was telling me how he had serious concerns with TPG's governance but liked that of KKR. He even told me: "TPG's governance is all wrong, too much power concentrated in too few hands." This was a couple of years ago. Others like Mark Wiseman think David Bonderman is a private equity god, so it's hard to know who to believe.

The guys that impress me the most are Blackstone. They are a small group of great investors who know how to print money in private equity, real estate, hedge funds, and anything in between. A huge reason behind Blackstone's success is its governance model where power isn't concentrated in one or two hands.

But the landscape in private equity is changing for everyone, including the Blackstones of this world. Record low rates, sluggish growth, strategics flush with cash, pension funds with longer investment horizons competing for deals, and a lot more uncertainty in a world there the risks of deflation are rising and making it a lot more difficult to generate returns of the past.

Still, all these factors haven't stopped the Blackstone machine from garnering ever more assets. In October of last year, it gathered $15.8 billion for the largest fund to invest in global real estate:
The firm collected more than 90 percent of the pool, its eighth fund for global property, from institutions in about four months, a person with knowledge of the matter said in March. The remainder was raised from individual investors, a process that takes longer to complete because of the paperwork involved, the person said.

Blackstone has already committed 20 percent of the fund to deals, according to a statement Thursday. The New York-based firm in April agreed to a $14 billion transaction to buy real estate assets being divested by General Electric Co., and last month agreed to buy Strategic Hotels & Resorts Inc., the manager of properties including Manhattan’s Essex House and the Ritz-Carlton Half Moon Bay, for about $3.9 billion.

Blackstone has built the largest real estate investing business, overseeing $92 billion in assets as of June 30. Its seven previous global property funds have doubled their invested capital, with annualized returns of 18 percent after fees since 1994, according to the firm’s most recent earnings statement.

The real estate group is led by Jon Gray, 45, considered a possible successor to Chief Executive Officer Steve Schwarzman. Gray’s group also manages an $8.2 billion fund investing in European property and a $5 billion pool for deals in Asia.

“The size of this fund gives us the ability to commit capital in scale with speed and certainty,” Gray said in the statement.
Jonathan Gray is a real estate superstar, one of the best real estate investors in the world. He's also deeply committed to charity and a shoo-in to succeed Steve Schwarzman once he steps down.

One thing that struck me last week was Schwarzman's comments in Davos stating he was bewildered about why Americans seem so unhappy. With inequality and healthcare costs rising, it doesn't surprise me at all that Donald Trump and Bernie Sanders are rising in the polls and I think a lot of people are underestimating Sanders's gains in the polls (it's making Hillary Clinton very nervous and probably Mike Bloomberg too).

Of course, Schwarzman is one of the world’s richest men, so it doesn't surprise me that he's bewildered by America's growing discontent. He needs to watch an episode of Undercover Boss and maybe try it himself to see how most hard working people are struggling to get by. It's also time he follows Pete Peterson, Blackstone's co-founder, who wisely discovered the meaning of enough after Blackstone went public and signed The Giving Pledge along with a group of billionaires who realize rising inequality has reached extreme and dangerous levels.

As far as large pensions investing in private equity, real estate and hedge funds, they too need to think of the long term imperative and how they're fueling rising inequality, which is extremely deflationary over the long run. Nobody wants to tackle inequality, which is one reason why a guy like Bernie Sanders is rising in the polls (he's actually talking about it and it's resonating with voters).

Lastly, Bruce Flatt, chief executive officer of Brookfield Asset Management Inc., is putting Blackstone Group, Carlyle Group, KKR & Co., and others on notice that his Toronto– based firm is about to make a major push into private equity:
Flatt says his buyout firm will earn comparisons to the largest of Wall Street’s alternative-asset managers.

“If you don’t mention it today, you should,” Flatt said in an interview at his New York office with Bloomberg Television’s Erik Schatzker.

That may take time. While Brookfield Asset Management oversees a total of more than $225-billion (U.S.) in assets, its private-equity arm, Brookfield Business Partners, has just $7.7-billion. Blackstone’s buyout business has $91-billion, while Carlyle has $63-billion.

Flatt has history on his side. Brookfield, which grew out of the Canadian billionaire Bronfman family’s Brascan Corp. holding company, has increased book value by almost 10-fold since Flatt became CEO in 2002, more than twice as fast as Warren Buffett’s Berkshire Hathaway Inc. Over the same period, Brookfield shares have returned more than 800 per cent versus about 170 per cent for Berkshire.

Owner-Operators

Flatt says Brookfield retains the Brascan approach to investing, and that sets it apart from rivals such as KKR and Blackstone, whose founders were bankers. “They’re all savvy and they’re all excellent organizations,” he said. “We’re owner-operators. We buy businesses we hold for long periods of time. We earn greater multiples of capital. We’re just a little different.”

Until now, Flatt has been content to build his businesses with little fanfare. Brookfield’s personality, he said, is “generally low key, generally conservative, worried about downside protection.”

Flatt says the company’s private-equity arm, which is expected to be spun out from the parent in the next few months, could one day be as big as Brookfield’s other investment units, which run as much as $138-billion.

Commodity Rout

The current turmoil in global markets that has sent stocks and commodities reeling, isn’t a deterrent for long-term investors like Brookfield. The company is intentionally counter– cyclical, and is excited about opportunities in volatile markets like China and Brazil. Flatt said the oil and gas and broader commodity sector present buying opportunities, making them net buyers in those places, along with Europe, Canada and India, and net sellers in the U.S. after strong gains there.

“We’re a net buyer in anything that is out of favour,” he said. “As contrarian investors we’re always trying to find those spots around the world.”

Economic Backbone

That conservative model of investing in “economic backbone assets” has served the parent company well over the years as it amassed $220-billion worth of assets under management. The Canadian company, which was established in 1899 in Brazil as Brascan, is now larger than the biggest pension funds in the country, including Canada Pension Plan Investment Board, taking into consideration currency conversion, which has about $273-billion (Canadian) under management.

The company’s value has soared along with its assets. Brookfield shares have risen fourfold since the end of the financial crisis in 2009, for a market value of more than $28-billion. That’s in line with Blackstone, and more than twice as big as New York-based KKR.

Brookfield is in the midst of raising an additional $25-billion to fund future acquisitions. Flatt said the pace of growth at Brookfield is largely due to its scale and its presence in more than 30 countries across four diverse investment areas including power, infrastructure, real estate and private equity.

China Rebound

Brookfield is devoting “significant” resources and people in China to reap the benefits of long-term growth in the world’s second-biggest economy.

“Five years from now and 10 years from now there will be amazing opportunities to be in the country” Flatt 50, said. “It will be great to be there.”

Flatt has a similar take on Brazil, which he describes as a “mess” right now, with the currency and economy plunging.

“This country is going to come around,” Flatt said. “We’ve continued to put money into the country over the last while.”

Bridge to Canada

One area that is once again showing promise is at home in Canada, where the weak Canadian dollar is creating some buying opportunities, Flatt said. Canada has pledged to double its infrastructure spending over the next decade to $125-billion. Brookfield would consider participating in that, Flatt said.

“Canada is still a great place to invest,” he said. About 10 per cent of Brookfield’s portfolio is in the country, compared with about 50 per cent in the U.S, he said. “It probably ranks as good or better than the United States, in particular because of our heritage.”

“I’d say maybe for the first time in a long time, there may be opportunities for us to put more money into work in Canada,” he added.
You can actually invest in Brookfield Infrastructure Partners L.P. (BIP), Brookfield Renewable Energy Partners LP (BEP) and of course the flagship firm, Brookfield Asset Management (BAM) which along with other alternative asset management stocks, got hit lately during the market sell-off

These, along with Blackstone (BX), Carlyle Group (CG) and KKR (KKR), are all great stocks to own in any retirement portfolio as they pay out decent dividends and are long term plays. They've all taken a hit lately but private equity and alternative investments are here to stay as underfunded pensions struggle to make their target rate of return.

Before I forget, Aaron Vale of Caledon Capital Management sent me a message to highlight an event the Toronto CFA Society will be hosting on February 11th:
The event is titled Mexican Infrastructure and Energy Opportunities. I think the topic is extremely timely and useful for anyone interested in learning more about the Mexican infrastructure and energy landscape. The panel will include two local participants with relevant government and private sector transactional experience. I personally have worked with both gentlemen and can attest to their knowledge and credibility. The event will also allow for networking and Q&A. Further details are in the link below:

https://www.cfatoronto.ca/cfast/Content/Site_Navigation/Events___Courses/Event_Detail.aspx?title=16MEXICAN

I am organizing so it would mean a lot to me if you were able to pass along to anyone that you think might be interested.
Mark the date, February 11th, and if you're interested in Mexican infrastructure and energy opportunities, please support Aaron and attend this conference.

Below, Brookfield Asset Management CEO Bruce Flatt oversees the world's second-largest alternative asset manager. Bloomberg anchor Erik Schatzker sat down with Flatt for an exclusive interview about his firm's investments in real estate, infrastructure, renewable energy and private equity. Great company and a true Canadian and global powerhouse. Listen to Flatt's comments below.

Also, regulators failed banks before the financial crisis, then stifled the industry’s recovery in Europe, according to Blackstone Group LP Chief Executive Officer Steve Schwarzman.

Schwarzman, speaking at the World Economic Forum in Davos, Switzerland, sparred with Dutch Finance Minister Jeroen Dijsselbloem over the effect of rules imposed on financial markets. The panel also featured Brian Moynihan, CEO of Bank of America Corp., Standard Chartered Plc CEO Bill Winters and Min Zhu, the International Monetary Fund’s deputy managing director.

Schwarzman also talked with Bloomberg's Erik Schatzker about the 2016 presidential race, Bernie Sanders, and Donald Trump, stating the rise of Sanders is even more stunning than that of Trump." Not really, Americans are fed up of gross inequality backed by Congress and I think professor Cornel West is right, "brother Bernie" will surprise everyone in 2016.

Lastly, Schwarzman appeared on CNBC and Fox Business stating it would be an overreaction to say the current global economic conditions in China are reminiscent of the financial crisis in 2008. Listen to his comments below, all very interesting.