Tuesday, September 27, 2016

Teachers' Cuts Computer-Run Hedge Funds?

Maiya Keidan of Reuters reports, Canada public pension plan ditches 10 computer-driven hedge funds:
Canada's third-largest public pension plan has halved the number of computer-driven hedge funds in its investment portfolio and put more money into the funds its sticking with, sources with knowledge of the matter told Reuters.

The Ontario Teachers' Pension Plan this summer pulled cash from 10 of the 20 hedge funds in its portfolio which use computer algorithms to choose when to buy and sell, two of the sources said.

Ontario Teachers' allocates $11.4 billion to hedge funds, making it the fourth-largest North American investor in the industry, data from research house Preqin showed.

Hedge funds worldwide are under increasing pressure in the wake of poor or flat returns as well as investors' efforts to cut costs. Data from industry tracker Eurekahedge showed that investors have pulled money from hedge funds globally every month in the four months to end-August.

One of the hedge funds that received more funds from the Ontario Teachers' Pension Plan said it had told them it was looking for funds which offered a different strategy from other funds.

"They expressed that a lot of strategies today you can mimic with a few exchange-traded funds or create synthetic products and there is no reason to pay management or performance fees," the source said.

Another hedge fund which the Canada fund dropped said the pension scheme had said it wanted to avoid funds invested in similar underlying assets.

Some of the computer-driven hedge funds the Ontario Teachers' pulled money from followed market trends, such as Paris-based KeyQuant, which has more than $200 million in assets under management, according to its website.

The Ontario scheme also withdrew $65 million in June from trend-follower Cardwell Investment Technologies, a move which ultimately led to it shutting its doors this summer, one of the sources said.

Those funds to receive a boost offered a more specialist set of skills, such as London-based computer-driven currency hedge fund Sequoia Capital Fund Management, in which the pension fund doubled its investment, a second source said.
I reached out to Jonathan Hausman, Vice-President, Alternative Investments and Global Tactical Asset Allocation at Teachers' in an email earlier today to discuss this latest move and copied Ron Mock on it.

But knowing how notoriously secretive Ontario Teachers' gets when it comes to discussing specific investments and investment strategies, especially their hedge funds, I doubt either of them will come back to me on this matter (if they do, I will edit my comment).

Those of you who never met Jonathan Hausman, there is a picture of him now sporting a beard on Teachers' website along with his biography (click on image):


Jonathan is in charge of a very important portfolio at Ontario Teachers. While most pensions are exiting hedge funds after a hellish year or seriously contemplating on exiting hedge funds, Teachers invests a hefty $11.4 billion in hedge funds, representing roughly 7% of its total portfolio.

While the absolute amount is staggering, especially relative to its peer group, you should note when Ron Mock was in charge of external hedge funds, that portfolio represented roughly 10% of the total portfolio and it had a specific goal: obtain the highest portfolio Sharpe ratio and consistently deliver T-bills + 500 basis every year with truly uncorrelated alpha (overlay strategy).

[Note: When Teachers had 10% invested in hedge funds and hit its objective, this portfolio added 50 basis points+ to their overall added-value target over the benchmark portfolio with little to no correlation to other asset classes. The objectives for external hedge funds are still the same but the overall impact of this portfolio has diminished over the years as hedge fund returns come down, other more illiquid asset classes like infrastructure, real estate and private equity take precedence and Teachers expands its internal absolute return strategies where it replicates these strategies internally, foregoing paying fees to external managers.]

So why is Ontario Teachers' cutting its allocation to computer-run hedge funds? I've already discussed some reasons above but let me go over them again:
  • Underperformance: Maybe these particular hedge funds were underperfoming their peers or not delivering the return objectives that was asked of them.
  • Strategy/ portfolio shift: Unlike other investors, maybe the folks running external hedge funds at Teachers think the glory days of computer-run hedge funds are over, especially if volatility picks up in the months ahead (read this older comment of mine). Maybe they see value in other hedge fund strategies going forward and want to focus their attention there. Teachers has a very experienced hedge fund group and they are very active in allocating and redeeming from external hedge funds.
  • Internalization of absolute return strategies: Many popular hedge fund strategies can be easily replicated internally at a fraction of the cost of farming them out to external hedge funds, foregoing big fees and potential operational risk (I used to work with a very bright guy called Derek Hulley who is now a Director of Data Science at Sun Life who developed such replication strategies for his former employer and since he traded futures, he had intimate and detailed knowledge of each contract when he programmed these strategies, which gave his replication platform a huge advantage over other more generic ones.)
  • Cut in the overall allocation to hedge funds: Let's face it, it's been a hellish few years for hedge funds and all active managers. If you're a big pension or sovereign wealth fund investing billions, do you really want to waste your time trying to find hedge funds or active managers that might outperform or "add alpha" or are you better off directly investing billions in private equity, real estate and infrastructure over the long run? 
That last question is rhetorical and I'm not claiming Teachers is cutting its allocation to hedge funds but many of its peers, including the Caisse, have drastically cut allocations to external hedge funds to focus their attention in highly scalable illiquid asset classes.

Now, we can argue whether we are on the verge of a hedge fund renaissance or whether active managers could be ready to shine again but the point I'm making is most large pensions and sovereign wealth funds are more focused on directly or indirectly investing huge sums in illiquid alternatives and I don't see this trend ending any time soon.

In fact, I see infrastructure gaining steam and fast becoming the most important asset class, taking over even real estate in the future (depending on how governments tackle their infrastructure needs and entice public pensions to invest).

I will end with a point Ron Mock made to me when I went over Teachers' 2015 results. He stressed the importance of diversification and said that while privates kicked in last year, three years ago it was bonds and who knows what will kick in the future.

The point he was making is that a large, well-diversified pension needs to explore all sources of returns, including liquid and illiquid alternatives, as well as good old boring bonds.

And unlike other pensions, Ontario Teachers has developed a sophisticated external hedge fund program which it takes seriously as evidenced by the highly trained team there which covers external hedge funds.

I was saddened however earlier this year when I found out Daniel MacDonald left Ontario Teachers to move to San Diego where he now consults institutions on hedge funds (his contact details can be found on his LinkedIn profile).

Daniel is unquestionably one of the best hedge fund analysts in the world and one of the sharpest and nicest guys I ever met at Teachers. aiCIO even called him one of the most influential investment officers in their forties (click on image):


He's even won investor intelligence awards for his deep acumen in hedge fund investing and none of this surprises me. His departure represents a huge loss for Ontario Teachers' external hedge fund group.

Below, CNBC's Kate Kelly reports hedge fund Perry Capital is closing its flagship fund after 28 years in the business. No surprise to me, it's a hellish year for hedge funds, and many marquee names are feeling the heat from investors who are fed up paying outrageous fees for mediocre returns.

Monday, September 26, 2016

Caisse Bets Big On India's Power Assets?

Abhineet Kumar of India's Business Standard interviewed Prashant Purker, Managing Director & CEO of ICICI Venture Funds, who said they will acquire power assets worth $3.5 billion:
This month, came up with a new investment platform to acquire conventional power assets. The fund comes at a time when capital goods maker Bharat Heavy Electricals (BHEL) is seeing 45 per cent of its Rs 1.1-lakh core order book face the challenge of stalled or slow moving projects. A large number of this are stuck due to financial constraints that ICICI Venture’s power platform plans to benefit from. Prashant Purker, managing director and CEO of ICICI Venture Funds, spoke to Abhineet Kumar on his plans for that. Edited excerpts:

What is the worth of assets you are targeting to acquire with your $850-million power platform?

We’re targeting to acquire $3-3.5 billion worth of (enterprise value) assets in the conventional power segment across thermal, hydel (hydro electric) and transmission businesses.

Clearly, there are a lot of power assets just getting completed or stuck in the last mile of completion with over leveraged situations at company or sponsor level. They need someone who can buy the assets out, inject equity to complete the project and have the capability to operate these assets on a long-term basis. This platform provides that — Tata Power bring operating capabilities and ICICI Venture provide fund management service as sponsors for the fund.

In return, these assets benefit those investors who need long-term yields. This is ideal for our investors such as Canadian pension fund CDPQ (Caisse de depot et placement du Quebec) as well as sovereign funds Kuwait Investment Authority and State General Reserve Fund of Oman.

As a funds-house, what is your strategy for platforms? Can we expect more such platforms to come in the future?

In 2014, we collaborated with Apollo Global Management to raise first special situation funds for India. We raised $825 million under our joint venture AION Capital Partners. Unlike funds, platforms are dedicated to some sort of investments where assets can be aggregated. Our strategy is to identify situations or opportunities in the market that require certain things to be brought together and then bring it with whatever it takes.

With the pedigree and group linkage, ICICI Venture is in a unique position to achieve this. Among domestic institutions, it is the only one which is truly multi-practice with four investment teams across private equity (PE), real estate, special situation and power assets. Across these four, we have $4.15 billion assets under management and it does not include the fund we raised in the venture capital era. Today, we have the largest dry powder of $1.5 billion across these funds.

It has come with our ability to spot opportunity earlier, and bring together whatever it takes. We will continue to look for new platform opportunities.

What is the update on your PE and real estate funds?

For real estate, we’ve total assets under management of $625 million with two funds fully invested. Now we plan to raise our third fund and have applied to the regulator for approval.

For PE, we are in the process of raising our fourth fund and have concluded interim closing as well as the first two investments. We have also started investing from our fourth fund with a couple of investments — Anthea Aromatics and Star Health Insurance — already made. Our PE fund will remain sector-agnostic and look for growth capital investment opportunities coming from rising consumption. In terms of exits, we have returned nearly half of our third fund to investors from various exits with Teamlease being the latest one where we used the IPO (initial public offering) route. Exit from the rest of the investee companies from the third fund is in the process of using multiple routes of IPOs, secondary sale, or strategic sell-off.

What is the sense you get on limited partners' view for investments in India as you raise your fourth PE fund?
Limited partners are today happier with exits position than they were a couple of years ago. Obviously, markets can’t just keep absorbing the capital; it has to return. With IPO markets opening up and given the increasing number of secondary deals, the sentiment for investments has improved. We are also seeing larger traction for strategic buy-outs as Indian promoters are fine with giving up controls. Is it that people are hundred per cent convinced to come to India - we are not in that position. People are looking for quality managers. Many funds would not be able to raise money as investors now want to gravitate to a few who have delivered returns and have a track record to show.

As disruption affects businesses across industries, how prepared are your investee companies to face it?


Today, every company has to be on its toes to look at technology – be it health-care or banking. At every company’s board, directors with grey hair are asking about social media presence and how customers are being acquired. So, technological disruption has become truly mainstream.

It is an ongoing process, and they are today definitely more prepared than they were two years back.
Good interview with a bright person who is obviously very well informed on what is going on in India and the opportunities that exist there across private markets.

I bring this particular interview to your attention not because I know Prashant Purker or want to plug but because they have some very savvy investors on board including the Caisse and Kuwait Investment Authority. 

Why are these two giant funds investing in India's power assets? Because it's an emerging market that is growing fast and if pensions find the right partners, they can benefit from this growth investing in public and private markets. 

Power assets are in line with the Caisse's philosophy under Michael Sabia's watch, ie. slow and steady returns, which is why it doesn't surprise me that they opted to invest in this new platform which will invest in power assets that provide a steady long-term yield. 

And the Caisse isn't the only large Canadian pension fund investing in India. Many other Canadian pension funds invest in India, including the Canada Pension Plan Investment Board (CPPIB) which opened a new office in Mumbai last year to focus on investment opportunities across the Indian subcontinent.

Are there risks investing in India? Of course there are. Extreme poverty, gross inequality, rampant corruption and war with Pakistan are perennial concerns, but this emerging market has tremendous long-term potential even if the road ahead will undoubtedly be very bumpy. And unlike China, India is a democracy with favorable demographics but its infrastructure is nowhere near as developed as it is in China.

As you can see below, one thing India has in common with China is problems with its pension system. The Real News Network reports on why 150 million Indians recently took to the streets to protest in of the largest one day strike in history.

I think India should follow China which is seeking aid from Canada's CPPIB to reform its state pensions.

Also, Press TV reports that bilateral ties between India and Pakistan have further deteriorated following the recent attack on Indian army soldiers in north Kashmir. New Delhi accused Islamabad of being behind the attack, with Pakistan rejecting the accusation.

Let's hope this situation doesn't disintegrate any further than it already has and that these two neighboring countries can coexist peacefully for many more decades.



Friday, September 23, 2016

CPPIB to Aid China With Pension Reform?

Rob Kozlowski of Pensions & Investments reports, CPPIB to aid China with pension reform, other issues:
Canada Pension Plan Investment Board, which manages the assets of the C$287.3 billion ($217.4 billion) Canada Pension Plan, Ottawa, signed a memorandum of understanding with the National Development and Reform Commission of the People’s Republic of China to offer its expertise to the country on a variety of issues, a CPPIB news release said Thursday.

The memorandum of understanding includes the CPPIB assisting China’s policymakers “as they address the challenges of China’s aging population, including pension reform and the promotion of investment in the domestic senior care industry from global investors,” the news release said.

“As we continue to deploy capital in important growth markets like China for the benefit of CPP contributors and beneficiaries, there is significant value for a long-term investor like CPPIB in sharing information, experience and successful practices with policymakers as they work toward improving policy frameworks,” said Mark Machin, CPPIB’ president and CEO, in the news release. “We are (honored) to have the opportunity to share our perspective and expertise with Chinese policymakers to tackle the issues of providing for an aging population.”

CPPIB will offer joint training, workshops and pension reform research as well, the news release said.

The memorandum was signed Thursday as part of bilateral agreements between China and Canada. In January, the CPPIB was designated by the China Securities Regulatory Commission for renminbi qualified foreign institutional investor status, granting it broad access to China’s capital markets.
Jacqueline Nelson of the Globe and Mail also discusses this agreement here (subscription required). You can read the news release on CPPIB's website here.

What are my thoughts? I generally think any bilateral trade agreement with China is a good thing, and the fact the Chinese seized this opportunity to forge stronger ties with Canada's largest pension fund speaks volumes on the respect they have for Canada's large, well-governed pensions.

A couple of weeks ago, I discussed the global pension crunch, highlighting the problems Chinese policymakers face with their state pensions, many of which are chronically underfunded and need to be shored up as the population ages and benefits need to be paid out.

And this at a time when China has a $2 trillion black hole to deal with.

In April, I discussed China's pension gamble, criticizing the use of pensions to inflate stock prices higher as an irresponsible policy which will hurt the Chinese market in the long run.

What can the Chinese learn from CPPIB? A lot. First and foremost, they cam learn the benefits of good governance and why it's crucial for their state pensions' long-term success. Admittedly, good governance isn't something that comes easily in China where the government interferes in everything but this is something that needs to be changed.

Second, they can learn all about the benefits of three major structural advantages that are inherent to the CPP Fund – long horizon, scale, and certainty of assets; and three developed advantages that result from strategic choices they have made – internal expertise, expert partners, and Total Portfolio Approach (click on image below).


Together, these advantages provide CPPIB with a distinct perspective for investment decision-making.

Most importantly, China's large pensions can forge ties with CPPIB and invest alongside it in big private market deals in China, Asia and elsewhere. This is a win-win for all parties which is why I'm glad they signed this memorandum of understanding.

Unfortunately, all is not well between Canada and China. In particular, I'm a bit concerned when I read Joe Oliver, the former Conservative minister of finance, writing a comment in the National Post saying, We have no choice but to slap a tax on Toronto houses being bought by foreigners.

Really? Apart from being discriminatory against foreigners (ie., Chinese), these taxes don't address the root cause of lack of affordable housing in Vancouver and Toronto -- the lack of supply!! -- and they were hastily implemented to appease the poor and middle class without careful consideration how they will negatively impact the economies of British Columbia and Ontario.

A friend of mine who lived in Vancouver and moved back to Montreal put it succinctly when he read CIBC said that Ontario will need to implement foreign buyer tax on housing:
No surprise. This is now a political issue. It is about fighting for the poor rather than protecting the wealth generated by the influx of Chinese. The government has now started the snowball and it will be difficult to reverse.

Very shortsighted thinking. There were many ways to tackle the problem which could have accomplished both objectives (protect wealth and restore some balance to the market). It would have taken longer and been less dramatic.

Everyone outside of Vancouver assumes that this is simply a demand-side issue and that by curbing "Chinese" demand, the problem will go away.  It won't. It will certainly cause a temporary haircut at the upper end of the market but even after a 50% haircut, the average Joe will not have the means to buy property.

The only way to solve this is to create supply and to do this, the government needs to release land from the agricultural land reserve for development of affordable single family housing.  They have done it before (in White Rock).

They also need to allow construction up and over the mountains on the North Shore. Yes this means cutting down trees and laying havoc to the landscape but there really is not a lot of choice here.

What they are doing now is basically driving away the Chinese and their investment dollars. When you look at the BC economy, they really cannot afford to do this.
No kidding. Bloomberg reports, Foreign Buying Plummets in Vancouver After New Property Tax:
Foreign investors dropped out of Vancouver’s property market last month after the provincial government imposed a 15 percent surcharge to stem a surge in home prices:

Overseas buyers accounted for less than 1 percent of the C$6.5 billion ($5 billion) of residential real estate purchases between Aug. 2 to 31 in Metro Vancouver, according to data released by British Columbia’s Ministry of Finance on Thursday. In the roughly seven weeks prior to that, they’d represented 17 percent of transactions by value.

The Canadian city, nestled between the water and soaring mountains, has long been a favored destination among global property investors, who have been blamed for fomenting escalating prices. The new tax went into effect Aug. 2 amid public pressure in the region, where home prices are almost double the national average of C$473,105.

The plunge in foreign participation joins other signs of a slowdown in Canada’s most expensive property market. Vancouver home sales fell 26 percent in August from a year earlier, while the average price of a detached property declined to C$1.47 million, the lowest price since September 2015, according to the Real Estate Board of Greater Vancouver.

The latest data shows that overseas buyers snapped up C$2.3 billion of homes in the seven weeks before the tax was imposed, and less than C$50 million in the next four weeks. The government began collecting data on citizenship in home purchases on June 10. The ministry said auditors are checking citizenship or permanent residency declarations made by buyers and also reviewing transactions to determine if any were structured to avoid tax.

Across the province, the participation of foreigners dropped to 1.4 percent of transactions by value in August, from 13 percent in the preceding seven weeks.

British Columbia has raised C$2.5 million in revenue from the new levy since it took effect. Budget forecasts released last week indicated that the Pacific coast province expects foreign investors to scoop up about C$4.5 billion of real estate through March 2019.
I bring this issue up because while critics love pointing the finger at Chinese policymakers when they make dumb decisions, maybe we Canadians need to reflect more on the bonehead moves our policymakers take to "defend the poor and working class" (exactly the opposite will happen as Chinese move to Seattle but maybe this will boost Calgary and Montreal's real estate market).

Anyways, enjoy your weekend and remember, behind the trade agreement with China, there's an equally important agreement on the pension front which will also benefit Canadians and the Chinese. This is undeniably great news for both countries.

Below, Chinese Premier Li Keqiang is on Parliament Hill for the first visit to Canada by a Chinese leader in six years. Canadian Prime Minister Justin Trudeau says Canada is exploring a free trade agreement with China, as he hosts his Chinese counterpart in Ottawa.

And take the time to listen to an AVCJ interview with Mark Machin, President and CEO of CPPIB, which took place last year when he was head of international and Asian investments. Listen carefully to his comments and you will realize why China is forging ties with CPPIB to reform its pensions.




Thursday, September 22, 2016

Twilight of the Central Bankers?

Gina Chon, a Reuters Breakingviews columnist, wrote an op-ed, Fed “forward guidance” blows too much smoke:
The U.S. Federal Reserve is still enabling financial markets. The central bank on Wednesday again declined to raise rates, despite recent remarks from Chair Janet Yellen suggesting an increase was becoming more likely. The Fed counts talking to the market – what it calls giving “forward guidance” – as one of its tools, but the story has changed so often that Yellen and her colleagues might do better being less chatty.

The Fed initially signaled four rate hikes in 2016 after raising the range for the federal funds rate to 0.25 percent to 0.5 percent last December, the first increase since the financial crisis. Falling unemployment and an improving housing sector helped push the central bank to make the move. At that time, the jobless rate was at 5 percent. U.S. GDP increased by 2.4 percent last year.

In March, rate-setting officials scaled back the central forecast to two hikes this year. GDP growth had fallen to a tepid 1.1 percent in the first quarter and despite signs of labor-market tightening, the central bank’s 2 percent inflation target was nowhere in sight. Yellen said the slowdown in the global economy warranted caution.

Maybe that remains the case, but central banks around the world are facing questions about the continued effectiveness of loose policy given that in many markets interest rates are already ultra-low or in negative territory. The Bank of Japan tried another tack with its decision earlier on Wednesday, saying it would aim to keep 10-year government bond yields at zero.

Moreover, the U.S. economy is in better shape than the rest of the world. That is most evident in the healthy pace of job growth, which averaged 232,000 new positions over the last three months, and an unemployment rate of 4.9 percent. In late August, Yellen said the case for a rate hike had “strengthened in recent months.”

She hasn’t yet followed through. The Fed’s latest forecast shows just one increase this year. In its statement, the bank said the case for higher rates was stronger but it wanted to wait for more evidence of progress. The central bank’s story morphed once again. No wonder Third Point hedge-fund founder Dan Loeb, speaking at a Reuters Newsmaker event earlier on Wednesday, argued that loose monetary policy was like a drug and “we must take the crack pipe away.”
I don't understand why portfolio managers, journalists and bloggers get so emotional about the Fed not raising rates. They obviously never read my comment last September that there is a sea change at the Fed.

The Fed didn't raise rates in September which in my opinion is a good thing. The BOJ is another story, not sure exactly what it's doing but it's so far behind the deflation curve that it's desperate to try anything new. It's now attempting to stoke inflation expectations higher by artificially steepening the yield curve. I'm highly skeptical these measures will work because deflation is so ingrained in the Japanese economy that they're fighting a lost cause.

Some journalists think central bank tools are losing their edge while others feel central bankers are throwing in the towel and are now waiting for policymakers to crank up fiscal stimulus.

I wouldn't go that far but clearly monetary policy alone won't be enough to address structural issues weighing down global growth and pushing inflation expectations ever lower. In July, I discussed these structural factors when I went over the bond market's ominous warning.

Speaking of the bond market, Bill Gross came out after the Fed meeting on Wednesday to say don't fight central bankers and long bonds will lead the way:
There’s one message that Bill Gross took away from a day dominated by two of the world’s most important central banks: longer-dated debt is back in vogue.

U.S. 30-year Treasuries led a rally Wednesday after the Federal Reserve held off on raising interest rates. Officials indicated a hike later this year is likely, although they lowered projections for 2017 and beyond. In Japan, longer-maturity obligations also fared best after the Bank of Japan shifted the focus of its monetary stimulus to controlling bond yields. The central bank said it would aim to keep 10-year yields around current levels.

For Gross, who runs the $1.54 billion Janus Global Unconstrained Bond Fund, the latest round of policy decisions give fixed-income investors a clear signal: extend duration. That’s been the best approach for traders during the three-decade bond bull market, and this year has been no different. Thirty-year Treasuries have returned 14.5 percent in 2016, Bank of America Corp. index data show.

“The timing of a bond bear market has certainly been delayed,” Gross said in an interview on Bloomberg Television. The BOJ’s plan “provides what I call a soft cap on Treasuries and on gilts and on bunds,” and signals limited downside in terms of price. “You can’t fight central banks.”

The yield on U.S. 30-year bonds fell six basis points, or 0.06 percentage point, to 2.38 percent at 5 p.m. in New York, according to Bloomberg Bond Trader data. Yields on two-year notes, the coupon securities most sensitive to Fed policy expectations, were unchanged at 0.77 percent (click on image).


With the BOJ’s new policy, Gross sees a “soft cap” of about 1.8-1.85 percent on 10-year U.S. notes, compared with 1.65 percent at present.

His comments underscore the interconnectedness between global bond markets. Even with Wednesday’s rally, 30-year Treasuries are still on pace for their worst month since June 2015 after losses the past two weeks fueled in part by speculation the BOJ was poised to reduce purchases of long-term debt.

Over the past five years, though, investors have won by buying the longest-dated debt amid persistent signs of slow economic growth globally and subdued inflation. Longer maturities have a higher duration, meaning they gain more in price when interest rates decline. The difference between two- and 30-year Treasury yields fell Wednesday to about 1.6 percentage points. In 2011, it exceeded 4 percentage points.
Gross isn't the only one who sees opportunities in the bond market. Prudential Financial's Michael Collins also appeared on Bloomberg stating the Bank of Japan’s decision to freeze the yield on its 10-year government bond near zero will continue to fuel opportunities in the US debt market amid a global hunt for yield:
The BOJ’s decision "is going to keep the U.S. 10-year pegged and lower the volatility of that, which presents an opportunity," Collins, Prudential’s senior investment officer for fixed income, said on Bloomberg TV. "It exacerbates the reach for yield."

A divided Federal Reserve left its main interest rate unchanged at 0.5 percent Wednesday, while projecting that a hike is possible by year-end. It meets Nov. 1-2 and Dec. 13-14.

The decisions by central banks to leave rates "lower for longer" mean the quest for yield in the U.S. credit sector, including corporate and high-yield bonds, and asset-backed securities, will continue, said Collins.

He said he sees opportunities in U.S. banks, consumer products and smaller companies that have not increased their borrowing, even though corporate America’s leverage is at record high.

"I’m underweight on average all those big high-quality industry companies that are levering up, and overweight the part of the economy that have actually de-levered and in the early innings of their own cycle," Collins said. "One of our favorite parts of the bond market is the asset-backed world, commercial mortgage-backed securities, collateralized loan obligations, kind of esoteric stuff."
Interestingly, bank stocks around the world surged on Wednesday as investors cheered the prospect that the Bank of Japan’s policy adjustments will translate into improved profitability for the industry, but the response was far more muted in the US after the Fed's decision as it signaled rates will be lower for longer.

I've said it before, I think banks, insurance companies and other financials (XLF) have a big problem ahead dealing with what increasingly looks like a prolonged debt deflation cycle where ultra low and negative rates are here to stay. Jim Keohane is right, some big banks are cheap using a price-to-book metric, but there's a reason why they're cheap (and might be getting a whole lot cheaper).

Also, Collins mentions that one of their favorite part of the bond market is commercial mortgage-backed securities but back in March I wrote a comment on cracks in US commercial real estate and during her press conference, Fed Chair Janet Yellen specifically mentioned the Fed is monitoring developments in commercial real estate and other assets:
"I would say in the area of commercial real estate, while valuations are high, we are seeing some tightening of lending standards and less debt growth associated with that rise in commercial real estate prices. But more generally we are not seeing signs of leverage building up or maturity transformation in the way that we saw in the run-up to the crisis and we are keeping a close eye on it."

Yellen on moderate threats to financial stability:

"The threats to financial stability I would characterize at this point as moderate. In general I would not say that asset valuations are out of line with historical norms."
Of course, some money managers beg to differ with her assessment of financial risks. Zero Hedge posted this comment from Tad Rivelle of TCW, an $195 billion asset manager. Rivelle thinks "the time has come to leave the dance floor":
While every asset price cycle is different, they all end the same way: in tears. As obvious as this truth is to investors, when the sad end to the credit cycle comes, it always comes as a big surprise to many, including the central bankers who, reliant on their models, confidently tell you that no recession is (ever) in the forecast. But, successful, long-term investing is predicated on not just knowing where the happening parties are during the reflationary parts of the cycle but, even more importantly, knowing when the time has come to leave the dance floor. In our view, that time has already come.

Allow us to properly explain ourselves. Consider the chart below which plots the trajectory of cumulative asset prices (stocks, bonds, real-estate) against that of aggregate income (GDP):

Source: Bloomberg, TCW

The chart reveals something rather extraordinary: over the course of the past 25 years, the traditional business cycle has been replaced with an asset price cycle. Rather than let recessions run their painful but necessary course, central bankers move forthwith to dispense the monetary morphine. The Fed’s playbook on this is well worn: first, policy rates are lowered. This triggers a daisy-chain of events: low or zero rates promote a reach for yield; the reach for yield lowers capitalization rates across a variety of asset classes which, in turn, spurs a rise in asset prices. Rising asset prices – the so-called wealth effect – “rescues” the economy by rebuilding balance sheets and restoring the animal spirits. And voila! Aggregate demand rises, businesses invest, and a virtuous growth process is launched.

Well, maybe not so much. If it were all so simple, then why is it that after ninety something months of zero or near zero rates, growth is sputtering, the corporate sector is in an earnings recession, and productivity growth is negative?
I will let you read the rest of this bearish comment here but it basically states central bankers have done all they can, the music has stopped and you better leave the dance floor or risk a serious morphine withdrawal. All I can state is the notion of a "central bankers' bubble" is just as silly as a bubble in bonds.

And Bloomberg's Simone Foxman reports, Tiger Cub Citrone Sees Market in Biggest Correction Since 2008:
Robert Citrone, the Tiger cub who now runs one of the best-known macro hedge funds, is warning investors that the market moment they’ve been anticipating is at hand.

“We believe we are in the midst of the market correction we have been expecting," Citrone, founder of Discovery Capital Management, told investors in an e-mail obtained by Bloomberg. “It will likely persist over the next 3-4 months and be the largest correction since the 2008 crisis,” he said. The firm managed about $12.4 billion at the start of 2016.

Money managers including Paul Singer have signaled that the markets may be on the precipice as central banks reexamine monetary policy. In remarks last week at the CNBC Institutional Investor Delivering Alpha Conference, Singer said years of easing had created "a very dangerous time in the global economy and global financial markets." Carl Icahn, who warned of risks at the same event, described predicting the moment of a correction as "sort of a guessing game."

Market volatility returned on about Sept. 9, when concern that central bankers may be losing their appetite for further stimulus efforts spurred the biggest slump since the U.K. secession vote in June, ending the summer’s calm. The CBOE Volatility Index has increased about 19 percent this month through Sept. 20.

Citrone, whose fund specializes in making wagers on macroeconomic events, tempered his view by describing the correction as a "healthy adjustment from overvalued market levels, which are primarily a result of exceptionally easy monetary policies." One of the many hedge fund managers dubbed Tiger cubs after working at Julian Robertson’s Tiger Management, Citrone founded Discovery in 1999.

Patrick Clifford, an external spokesman for Discovery, declined to comment.
Scary stuff but my advice is to ignore all these Delivering Alpha doomsayers as well as anyone who tells you central bankers are powerless and focus on selectively plunging into stocks even if it will be a rough and tumble ride. I'm still trading shares in the biotech sector (XBI and IBB) and continue to recommend bonds (TLT) as the ultimate diversifier in a deflationary world.

Will there be a major correction at some point? Sure, it might happen after the Fed hikes rates in December (if it hikes again this year that month) but there's a reason why there is a crisis in active management, many active managers don't understand the macro environment and it's costing them huge performance.

Below, Jeffrey Gundlach, DoubleLine Capital LP, shares his reaction to the latest Fed speak from yesterday's FOMC meeting. Listen carefully to his comments on "WIRP" and the likelihood of a December rate hike.

I also embedded the entire press conference after the FOMC meeting where Fed Chair Janet Yellen answered many questions, including whether there is a bubble in commercial real estate (minute 26).


Wednesday, September 21, 2016

Did the BOJ Save or Kill DB Pensions?

Robin Harding of the Financial Times reports, BoJ launches new form of policy easing:
The Bank of Japan has launched a new kind of monetary easing as it set a cap on 10-year bond yields and vowed to overshoot its 2 per cent inflation target on purpose.

Its decision demonstrates that even eight years after the global financial crisis, central bankers are still willing to experiment with monetary policy tools as they struggle to escape from low inflation around the world.

The move marks another effort by Haruhiko Kuroda, BoJ governor, to surprise market expectations by expanding his monetary policy toolkit to signal his determination that Japan escape its decades of on-and-off deflation.

But the question for Mr Kuroda is whether three-and-a-half years of slow progress on prices have damaged the BoJ’s credibility too much for promises of higher inflation to be taken seriously by the public.

“The price stability target of 2 per cent has not been achieved … [and] this is largely due to developments in inflation expectations,” said the BoJ on Wednesday. “Inflation expectations need to be raised further in order to achieve the price stability target.”

Markets initially reacted positively, with the yen losing 1 per cent to ¥102.7 against the dollar, spurring a 1.9 per cent rally in the exporter-sensitive Nikkei 225 equity average, with banks and insurers leading the gains. But scepticism about the BoJ’s overhaul set in and the yen reversed its early losses, appreciating by 1 per cent by mid-afternoon in London.

The BoJ kept interest rates on hold at minus 0.1 per cent — describing further rate cuts as a “possible option for additional easing” — but announced a framework with two main elements.

The first is a pledge to cap 10-year government bond yields at zero per cent. In essence, that means the BoJ is promising to buy any bonds offered for sale at that price.

It will maintain its government bond buying “more or less in line with the current pace” of ¥80tn a year. However, the BoJ will buy fewer very long-term bonds, which should make it easier for banks to earn profits by allowing the yield curve to steepen.

Second, the BoJ has pledged to continue buying assets until inflation “exceeds the price stability target of 2 per cent and stays above the target in a stable manner”.

Although that commitment is vague, it marks a departure for global monetary policy, following the logic of economists such as Paul Krugman by making a deliberate “commitment to be irresponsible”.

If the pledge is credible then it should raise public expectations of the price level in the future. That, in turn, should lower real interest rates and stimulate the economy because loans will be paid back in a devalued currency.

But the BoJ’s credibility is a big question given its struggle to raise inflation over the past three years, with headline inflation running at minus 0.4 per cent in July. Public expectations of future inflation have steadily declined over the past 18 months.

Some analysts were downbeat about the BoJ’s decision not to cut interest rates or expand asset purchases, seeing it as a signal that the central bank has little scope for further easing.

“We are quite sceptical that this change in the framework will loosen financial conditions in any meaningful manner,” said Kiichi Murashima at Citi in Tokyo. “Monetary policy has effectively reached its limit, in our view, and today’s decision appears to show that policymakers share this assessment.”

Masaaki Kanno, at JPMorgan in Tokyo, said the BoJ had “disappointed” by failing to cut rates. He said the pledge to overshoot the inflation target had come too late, at a time “when few people in the market believe that 2 per cent inflation will be achieved anytime soon”.

James Athey at Aberdeen Asset Management added: “The BoJ has reaffirmed its inflation target and will try to overshoot it. This in spite of the fact that it hasn’t hit its current inflation target, doesn’t seem likely to and hasn’t announced anything that might help it get there or beyond any time soon.

“The Bank has effectively told markets that it has a royal flush and the markets are questioning Kuroda’s poker face.”
Tracy Alloway and Sid Verma of Bloomberg also report, The Way the World Thinks About Easy Monetary Policy Is Changing:
It happened so quickly.

While analysts and economists had long debated the efficacy of quantitative easing — the central bank bond purchase programs aimed at lowering borrowing costs to stimulate the economy and stoke inflation — the narrative surrounding such efforts is rapidly shifting. In recent months, there's been a growing recognition of the limits and downsides to this particular form of monetary easing, underscored by the Bank of Japan's policy changes announced on Wednesday.

Some 15 years after first experimenting with QE, the BOJ announced that it intends to shift the focus of its policy framework to better finesse borrowing costs by, in effect, anchoring longer-term rates higher, and moving away from a rigid target for expanding the money supply. While market participants expect the central bank to further expand bond purchases and take the rate on a portion of bank balances deeper into negative territory in upcoming meetings, the BOJ's move is a recognition that its daring strategy to dramatically expand the money supply to fight deflation has delivered a blow to the financial sector's profitability.

"The biggest takeaway here is that the BOJ is now leading the world into a new era of central banking and is essentially making long-term interest rate, 10-year Japanese government bond yields a focal point in its central banking platform instead of negative interest rate policy," analysts at TD Securities Inc. led by Mazen Issa, wrote in a note today. "The yield curve control program is an interesting but untested concept. It is one attempt to provide relief for pension funds, [life insurance companies], and banks."

The program announced on Wednesday helped propel Japanese lenders' stocks higher, underscoring the evolution in easy monetary policy. The BOJ plans to buy enough 10-year government bonds to keep the yield close to zero percent, while potentially purchasing fewer longer-dated bonds, in a move expected to boost profits for the financial sector and encourage them to lend and invest.


The Bank of Japan had doubled-down on its QE program in February with the surprise introduction of a negative interest-rate policy on a portion of bank reserves, sharply lowering long-term rates — as well as bank stock prices — amid a squeeze on net interest margins for lenders.

Despite the shock-and-awe strategy early in the year, the yen appreciated in the aftermath of the move, while deflation risk remains unabated — with CPI at minus 0.5 percent year-on-year in July — and long-term inflation expectations remain stubbornly low.

Though the BOJ has maintained the minus 0.1 percent charge on some bank balances, its yield-curve commitment — similarly deployed by the Federal Reserve from 1942 to 1951 to lower the U.S. Treasury's post-war financing costs, but which remains unprecedented in modern times — represents a sea-change in the central bank's thinking.

The BOJ's newfound embrace of a yield-curve target is a belated recognition that NIRP can negatively impact financial intermediation and inflation expectations, say analysts.

"The good news is that BOJ has finally acknowledged that NIRP does have some negative impact on intermediation and potentially on inflation expectations – which the BoJ puts at the center of its policy goal," Morgan Stanley economists led by Takeshi Yamaguchi wrote in research published last week, for instance. "The fear is that this negative impact will wax and positive impact wane. Once the evidence is clear, the result may already have had serious adverse consequence for the real economy."

Hans Redeker, strategist at the U.S. bank, reckons a negative-yielding flat yield curve has reduced monetary velocity and pushed the yen higher, while a steeper yield curve — allowing financial intermediaries to borrow at low rates and invest at longer maturities — might unleash the animal spirits needed to increase risk-taking.

In a report last week, amid indications from officials that the BOJ would anchor long-end yields higher, Redeker wrote: "Financial sector balance sheets have been dismissed by central banks for too long," adding that the central bank's newfound focus on financial-sector profitability represents a belated recognition of banks in aiding the transmission of monetary policy to the real economy.

Tomoya Masanao, head of Japanese portfolio management at Pacific Investment Management Co LLC, in a research note last week, called on the BOJ to scale back JGB purchases at the long-end to steepen the yield curve and aid financial intermediation, arguing that negative long-end rates had facilitated the refinancing of existing debt rather than stimulating new productive investments.

Bankers argue low longer-dated yields and negative rates deliver a blow to their return on assets, offsetting the benefits of lower funding costs — and the BOJ's apparent capitulation might embolden critics of monetary policy in other advanced economies.

Questions over the effects of QE have already extended away from policymakers at the BOJ. In the U.K., Monetary Policy Committee Member Kristin Forbes suggested in the aftermath of the Brexit referendum that further easing could end up tightening financial conditions rather than loosening them.

"People will earn less on their hard-earned savings — potentially cutting back on spending to reach a target savings pot. Banks will make less money on lending," she wrote in an op-ed. "Pension and life insurance funds will have a harder time meeting their commitments. Companies may need to put more money into pension schemes — leaving less to spend on workers and investment."
So the BOJ surprised everyone by not cutting rates or expanding asset purchases further. Instead, it chose to anchor long-term rates higher in an attempt to stoke "animal spirits" and hopefully finally lift inflation expectations higher.

Will it work? I'm highly skeptical and so is the market. As of this writing on Wednesday morning, the yen reversed course and is surging relative to the USD, up 1%, hovering around 100.68 (click on image; this can abruptly change this afternoon if the Fed raises rates):


Remember my warning to always keep an eye on a surging yen as it could trigger a crisis, including another Asian financial crisis because a stronger yen reinforces deflationary headwinds in Asia which can spread all over the world.

This is yet another reason why the Fed shouldn't raise rates now but we shall see what it decides to do later today. One currency trader I talk to thinks the fact the BOJ didn't cut rates or expand its asset purchases is a sign the Fed will surprise markets and raise rates on Wednesday.

And while the Bloomberg article above quotes someone as saying "it is one attempt to provide relief for pension funds, [life insurance companies], and banks," I'd put the emphasis on banks and lifecos, less on pensions (central bankers don't really care about pensions but they should if they want to stave off deflation).

In fact, if the BOJ fails to stoke inflation expectations higher, it will be forced to cut rates further into negative territory and this will negatively impact banks, life insurers and Japan's pensions, especially defined-benefit pensions which are already reeling.

Garath Allan and Shingo Kawamoto of Bloomberg recently reported, Negative Rates Not All Bad as Mizuho Sees Pension Business Boost:
Negative interest rates aren’t necessarily all bad news for Japanese banks, as companies flock to lenders for advice on how to manage their pension programs under the policy, according to Mizuho Financial Group Inc.

The Tokyo-based bank sees an opportunity to earn more fees from employers that are shifting toward 401(k)-style retirement plans as sub-zero rates make it more difficult for them to meet existing pension obligations. It’s seeking to expand the 1.7 trillion yen ($16.6 billion) of defined-contribution plans it manages for companies’ employees by 30 percent over the next three years, according to Koji Imuta, a senior manager in the asset-management business development department.

Pension Strain

The Bank of Japan’s negative-rate policy is driving momentum for companies to reconsider their employee pension arrangements, Imuta said in an interview in Tokyo. “Our customers are acutely aware of this as an issue and inquiries are growing,” he said.

Even before the BOJ announced negative rates in January, years of plunging bond yields squeezed returns from retirement funds in a nation where the aging population is also placing a strain on the pension system. Imuta’s goal to increase retirement assets reflects a push by Chief Executive Officer Yasuhiro Sato to boost non-interest income amid the risk that the central bank may take rates further below zero, crimping loan profits.

By arranging pension plans for employers and investing the funds on their behalf, Mizuho will earn fees that could help to reduce the impact of negative rates on profit, Sato said in May, without providing specific targets. The bank has forecast the BOJ’s policy will crimp its net income by 40 billion yen in the year ending March.

More firms are seeking to switch to defined-contribution plans from defined-benefit arrangements because swelling retirement liabilities are jeopardizing their financial health, Imuta said. “We see this as an opportunity,” he said.

The total pension shortfall for listed companies in Japan expanded about 43 percent over the past year to 25.6 trillion yen as of March 31, according to Nomura Holdings Inc. Japanese government bonds with maturities as long as 10 years are yielding less than zero even after a recent steepening of the curve.

Making Switch

Defined-contribution plans exist on top of Japan’s public pension system, allowing employees to select how their money is invested. The amount retirees receive fluctuates depending on returns, unlike traditional defined-benefit pensions where employers must pay out a set amount regardless of how much they earn from investing the pooled funds.

Employers are tailoring their pension programs, with some fully making the shift and closing defined-benefit plans and others maintaining aspects of their existing arrangements, Imuta said.

A total of 5.5 million company employees had defined-contribution plans as of March, up 8.5 percent from a year earlier, according to Ministry of Health, Labour and Welfare figures. More than 5,000 companies including Skylark Co. and Panasonic Corp. offered these to their employees as of July, the data show.

Mizuho plans to take advantage of its April 2016 conversion to an internal company structure to bolster cooperation between its bank and trust units on the pension business, Imuta said. About 250 employees work in Mizuho’s retirement operation across the two units, which previously conducted the business separately.
As you can read, negative rates aren't all bad news for some Japanese banks as they have been collecting huge fees as companies opt out of defined-benefit pensions into defined-contribution pensions.

Unfortunately this shift out of DB into DC pensions will only exacerbate Japan's long-term deflation problem because it will shift retirement risk from employers to employees which will succumb to pension poverty once they outlive their savings. This is all part of the global pension crunch I recently discussed and it's a frightening trend which policymakers will be grappling with for decades.

Below, Chris Rupkey, MUFG Union Bank, explains how the Bank of Japan adjusted its monetary policy, and shares his thoughts on the likely outcome from today's FOMC meeting.

And CNBC's Rick Santelli speaks with Former Federal Reserve Governor Mark Olson about the upcoming FOMC decision and the Bank of Japan's policy meeting.

Lastly, Michael Contopoulos, Bank of America Merrill Lynch head of high yield, explains why he thinks the Bank of Japan decision is more important than the Fed meeting, and how its outcome could hurt markets. Interesting discussion, listen to his comments on flow of funds and high yield credit (HYG).

Now we can all wait for the Fed decision at 2:00 pm sharp. Even though the market isn't expecting a rate hike, the recent actions from other central banks suggest the Fed might hike now. Stay tuned.

Update: A divided Federal Reserve left its policy rate unchanged for a sixth straight meeting, saying it would wait for more evidence of progress toward its goals, while projecting that an increase is still likely by year-end.

“Near-term risks to the economic outlook appear roughly balanced,” the Federal Open Market Committee said in its statement Wednesday after a two-day meeting in Washington. “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”