Friday, April 29, 2016

Resurrecting Global Inflation?

Will Martin of Business Insider reports, Europe is back in deflation:
The eurozone slipped back into deflation in April, according to the latest numbers released by Eurostat on Friday morning.

Eurostat’s latest flash data showed that consumer prices in the single currency area fell by 0.2% in April.

Economists had expected inflation to fall by 0.1%, slipping from the 0.0% at March’s reading, so the reading is troubling.

The number means that prices are once again falling, having come out of deflationary territory in March, and are well behind the 2% target set by the ECB for inflation.

On a year-to-year basis core consumer prices grew by 0.8%, against a forecast of 0.9% and a previous reading of 1%.

Core prices are an important measure because they strip out the most volatile items — things like fuel and food prices, which are subject to massive variations.

It is worth noting that Friday’s data is just a flash reading, meaning that it could be revised when the final numbers drop in mid-May.

Here’s an extract from Eurostat’s release accompanying the data:
Looking at the main components of euro area inflation, services is expected to have the highest annual rate in April (1.0%, compared with 1.4% in March), followed by food, alcohol & tobacco (0.8%, stable compared with March), non-energy industrial goods, (0.5%, stable compared with March) and energy (-8.6%, compared with -8.7% in March).
A large part of the eurozone’s extremely low inflation right now is down to the slump in the price of oil over the last year — but the core figure shows that other prices aren’t rising by as much as the ECB would like, either. Here’s a breakdown of the core areas of goods tracked by Eurostat (click on image):


The eurozone has been flirting with price deflation for the past year or so, largely hovering just above zero since early 2015, but slipping below zero a couple of times in early 2016.

Friday’s eurozone CPI figures are the third set to be released since European Central Bank and its president Mario Draghi announced a series of new monetary policy measures, including cutting all its base rates, and extending its programme of bond buying.

The measures are designed to try and boost stalling inflation, as well as growth, within the Eurozone. So far the ECB’s negative interest rate policy (NIRP) hasn’t managed to stimulate inflation, although Draghi said in an interview with German newspaper Bild this week that “our policy is working” when speaking about criticisms of the ECB.
Germany is back in deflation and France is stuck in deflation. Mario Draghi's worst nightmare is playing out right before his eyes, but no worries, Europe's Unilever is joining his deflation fight by deploying a $60 toothpaste to regrow damaged tooth enamel (just what those millions of unemployed in Europe need to spend on as they wait for job growth).

More worrisome, Australia saw deflation for the first time in seven years in the first quarter, as falling petrol, food, and clothing prices drove down the cost of a basket of goods and services.

Over in Japan, there is no end in sight for deflation:
It has become increasingly uncertain when the nation will realize its goal of ending deflation. This is because the Bank of Japan on Thursday pushed back the goal of achieving 2 percent inflation to sometime in fiscal 2017, the fourth such delay in about a year (click on image).

The monetary easing measures taken by the central bank have not been effective in raising prices.

On Thursday, the Bank of Japan issued the Outlook for Economic Activity and Prices Report, which states the recent economic situation and the outlook for prices. It said in the report that the achievement of its price stability target is “projected to be during fiscal 2017.” The bank formerly said the target would be achieved around the first half of fiscal 2017.

The Bank of Japan had previously postponed the timing for reaching the inflation target on the grounds of sharp falls in oil prices.

When the bank started its quantitative and qualitative monetary easing in April 2013, the benchmark crude oil price was around $100 per barrel.

However, the downward trend accelerated after prices peaked in summer 2014, and this year prices temporarily plunged below $30 a barrel — beyond the expectations of the central bank.

Lower crude oil prices drive down the costs of energy such as gasoline and electricity, pushing the prices down as a whole.

Each time crude oil prices dropped, the Bank of Japan reacted by extending the time frame, expecting that the price would slowly increase.

This time, however, Bank of Japan Gov. Haruhiko Kuroda said the bank would make another postponement mainly because of the slowdown in the overseas economy, which has negatively affected the nation’s growth rate as well as wage growth.

As crude oil prices have been increasing recently, the central bank’s past logic no longer explains the downward trend in prices.

However, Kuroda decided not to implement additional monetary easing policies, saying the bank needs to wait and see the effects of the negative interest rate policy.

“The contradictions in the BOJ’s policies are increasingly evident,” said Tsuyoshi Ueno, an economist at the NLI Research Institute. “I think the bank needs to reexamine its policies and start over from scratch.”
Making matters worse for the Bank of Japan, the yen hit an 18-month high versus the U.S. dollar, heightening fears of further deflation:
Analysts said the yen continued to surge in the aftermath of the BOJ's decision to hold monetary policy steady on Thursday in the face of soft global demand and a sharp rise in the yen, defying expectations for increased stimulus to fight deflation.

"It’s just a continuation of momentum after the BOJ policy announcement," said Vassili Serebriakov, currency strategist at BNP Paribas in New York. He said the dollar could weaken to 105 yen before June, when he said the BOJ would likely step in with increased stimulus.
At this writing the USD/YEN cross rate is at 106.88, down 1.2% after falling more than 2% when the BoJ disappointed on Thursday.

A strengthening currency, especially for an exporter like Japan, acts like an increase in rates, tightening financial conditions. It also lowers Japanese import prices and makes it that much tougher to get out of its deflation rut.

Why is the yen strengthening vs the U.S. dollar? Because as inflation expectations decline in Japan, real yields rise, making Japanese bonds that much more attractive to Japan's large pension and insurance companies. This helps explain the yen's puzzling surge.

But a rise in the yen isn't good news for Asian economies struggling with their own deflation demons. As I explained a few weeks ago, the surge in the yen can trigger another Asian crisis via a full-blown currency war in that region. And if this happens, it will mean exporting more deflation throughout the world, including the United States.

Interestingly, even though the U.S. dollar index (DXY) has been declining since the start of the year, helping boost oil prices to fresh new highs, U.S. inflation barely rose in March as consumer spending remained tepid, making it less likely that the Federal Reserve will be able to follow through on its projected two interest rate hikes this year.

The rise in the yen could also spell big trouble for global risk assets as hedge funds unwind the yen carry trade and deleverage out of risk assets. Michael Gayed wrote an interesting comment, Memories Of The Yen Signaling Risk-Off And Correction Ahead?, where he notes the following:
Does the yen's recent movement signal a potential risk-off environment to come in the next few weeks or months? Maybe. The blue line below is the price ratio of the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) to the SPDR S&P 500 ETF. Spikes in the ratio are typical, given that Treasuries have tended to end up having an inverse relationship to stocks in periods of high stress. The black line beneath it is the CurrencyShares Japanese Yen Trust (NYSEARCA:FXY). Note that there was a very tight correlation between the outperformance of Treasuries and the yen prior to the QE3 period of 2013, which distorted many historical signals.


Now, it appears that the movement is ready to sync back together as the rolling 13-week correlation hits the extreme lows of the last 5 years. Why does this matter? Because if the marketplace begins to seriously believe that Japan's fiscal and monetary stimulus is doomed, then the yen likely continues to rise and bring with it a risk-off scare globally. This would cause Treasuries to have another big potential spike against equities.

I'm not fully convinced that will happen right here, right now. Other quantitative indicators we look at suggest things might well be okay in the near term, which is why our Tactical model is fully exposed to equities as of writing (click here to view). Having said that, there is little doubt in my mind stocks won't correct again this year. If the yen continues its march higher, and if indeed its historical role as a risk-off trade is back, then the time to get defensive may soon occur.
Like Michael, there is little doubt in my mind stocks won't correct again this year. Right now, algorithmic and quant traders are having fun ramping up metal & mining (XME), energy (XLE), industrial (XBI) stocks on every big dip, acting as if another global recovery is well underway. Even shipping stocks rallied in April but the reality is deflation is wreaking havoc in that industry and I wouldn't touch any of these stocks.

Why is there such a huge disconnect between actual economic reality (the deflation tsunami is going to hit us) and these stocks which are a play on global recovery?

Two things here. Oil prices have rebounded solidly and there are some smart traders who think they can go much higher from here. Then there is George Soros whose warning on China has thus far proved to be wrong.

But is Soros really wrong about China and have we really escaped the Great Crash of 2016? I wouldn't bet against Soros and I'm increasingly worried about China's big pension gamble and the commodity trading frenzy taking over there and whether a currency war in Asia will bring about another Big Bang which will clobber risk assets all around the world in the second half of the year.

I know, I'm way too pessimistic, the quantitative algos on Wall Street are running the show, it's no use being logical when analyzing risk assets, the "trend is your friend", don't fight central banks, they're on top of it all. Just close your eyes, hold your nose and buy any dash for trash and pray to God Soros is wrong on China.

I'm sharing my thoughts in this comment to make many of you think about downside risks. Sure, there is a lot of liquidity in the global financial system which can drive risk assets much higher (a bubble in commodities?), but be careful here and realize that global deflation is still the primary threat and if we get another financial crisis, it will obliterate oil, commodity and emerging market currencies, stocks, and corporate bonds. The only place to hide will be in U.S. bonds.

Below, CNBC's Becky Quick talks with billionaire investor Warren Buffett about the markets, interest rates and the deficits, telling people not to put too much stock in Icahn's market warning (see below).

Also, John Thornton, the former president of Goldman Sachs (GS), who likes to take the long view, says he’s “feeling uneasy” about the global economy right now and thinks we’re living on borrowed time.

It's Orthodox Easter weekend, so let me focus on the resurrection of Christ and less on resurrecting global inflation and risk assets. I embedded a clip below of someone singing that magical Easter hymn as we see images of Greece's beautiful monasteries.

I wish you all a great weekend and my fellow Orthodox Christians a Happy Easter. Christos Anesti!!




Thursday, April 28, 2016

Is Soros Wrong About China?

Hema Parmar and Saijel Kishan of Bloomberg report, The Hedge Fund Manager Betting Soros Is Wrong About China:
Bob Bishop, who once ran investments for billionaire George Soros, is betting his former boss is wrong about China. The world’s second-biggest economy has had its hard landing and is on its way up, according to Bishop.

Rising infrastructure spending, steel production and demand for metal and heavy-duty trucks are signs of improvement for the nation’s industrial and manufacturing sectors, said Bishop, a former chief investment officer at Soros Fund Management who runs $2.2 billion hedge fund Impala Asset Management. Soros said last week that China resembles the U.S. in 2007-08, when credit markets froze and triggered a global recession, and that its banking system is increasingly unstable.

“China already had the crash,” Bishop said in an April 18 interview. “It bottomed at the end of 2015. It’s going to feel like a much better economy in China over the next two years than people seem to think it will be.”

Policy makers in China talked up growth and added stimulus this year to re-energize the economy. In March, the purchasing managers index ticked above 50, signaling expanding factory activity for the first time since June. A recovering China, which is a key importer of steel, copper, iron ore and other metals, bodes well for commodity prices. The price of iron ore rose 44 percent this year as of 1:45 p.m. Tuesday in New York, and copper was up more than 5 percent.

If copper reaches $3.25 a pound, which Bishop expects will occur in 2017, Freeport-McMoRan Inc., the largest publicly traded copper miner, could earn $3 a share, he said. Impala initiated a “modest” investment in the stock in the past month and a half, according to Bishop. It also took a position in miner First Quantum Minerals Ltd.

Commodity Stocks

The firm has boosted its investments in commodity stocks to about 20 percent of the Impala Fund from 4 percent at the start of this year, Bishop said.

"What people often miss on commodity stocks is that their earnings leverage and stock sensitivity to price movements in the underlying commodity is very high, more so than any other sectors in the market," Bishop said.

The Standard & Poor’s Global Natural Resources Net Total Return Index has rebounded almost 40 percent since Jan. 20, its low point this year, after a slide that began in mid-2014 as China’s economic growth slowed.

Bishop, who worked at Soros between 2002 and 2003, started New Canaan, Connecticut-based Impala in 2004. Its main equity fund, which manages about $1.5 billion, gained 7.7 percent in March, bringing returns for the year to 2 percent, according to a person familiar with the matter.

Bishop declined to comment on performance or on Soros’s views.

Warning Sign

China’s March credit-growth figures should be viewed as a warning sign, Soros said at an Asia Society event in New York on April 20. The broadest measure of new credit in the nation was 2.34 trillion yuan ($360 billion) last month, far exceeding the median forecast of 1.4 trillion yuan in a Bloomberg survey.

Soros, a former hedge fund manager who built a $24 billion fortune, in January called a hard landing in China “practically unavoidable.” Soros returned outside capital in 2011 and his firm now manages his own wealth. Hedge fund managers including Crispin Odey at London-based Odey Asset Management and Kyle Bass at Hayman Capital Management in Dallas have been wagering on a slowdown in China. Bass is said to be starting a fund to focus on China-related investments.

Bishop isn’t the only U.S. hedge fund manager who’s bullish on China. In March, Jordi Visser, head of investments at $1.4 billion Weiss Multi-Strategy Advisors, said China’s Shenzhen Composite Index will beat most global peers by the end of this year.

Bishop spent at least a decade focusing on commodities and other cyclical stocks at hedge funds Maverick Capital, Kingdon Capital and Julian Robertson’s Tiger Management.

Impala said in a March 31 investor memo obtained by Bloomberg that energy prices have bottomed, and that improving U.S. demographic and consumer trends, loosening mortgage availability and tight supply are creating an environment in which the homebuilding cycle will accelerate.
You have to hand it to Bob Bishop, so far this year he's been right on the money on China and commodity stocks. You can view his fund's latest stock holdings here as well as those of Jordi Visser's fund here (as of Q4 2015; Q1 updates coming in mid May).

Bishop isn't the only one who made money betting big on a global recovery. Carl Icahn has made a killing so far this year on some of his top holdings like Freeport McMoran (FCX), Chesapeake Energy (CHK) and Transocean (RIG). (Icahn also just announced he dumped his Apple shares back in February, another good move).

And if you think that's impressive, check out some of the moves in names like Cliff Natural Resources (CLF), Teck Resources (TCK), Baytex Energy (BTE), Seadrill (SDRL) and Olympic Steel (ZEUS). There are many energy and commodity stocks that have doubled, tripled, and even quintupled since bottoming in mid January and showing no signs whatsoever of slowing down.

In fact, have a look at the S&P Metals and Mining ETF (XME) and you'll get a feel at how big the moves have been (click on image, as of Wednesday's close):


Looking at individual companies, the moves have been even more violent to the upside (click on images, as of Wednesday's close):



What is driving this huge move into commodities and energy names? Traders will tell you they were were extremely oversold in mid January but the violent surge is beyond scary, it's as if all the algos went long and have been steadily adding on every dip. When you see moves this violent, it's definitely being driven by algorithmic/ quant trading and it can persist longer than you think.

Of course, fundamentalists will argue that the world is in much better shape than doomsayers think. And there are some top oil traders like Pierre Andurand who was shorting oil during the last two years now calling for a multiyear rally in crude prices.

Even after Doha, Andurand remains resolute, warning of rising Mideast tensions:
Pierre Andurand, the money manager who made 38 percent betting against oil in 2014, warned that signs of tension at a meeting of the world’s biggest producers this month in Doha point to increasing Middle East unrest that could eventually lead to supply disruptions.

The failure of oil ministers to reach an agreement at meetings in the Qatari capital “clearly revealed deep disagreement within the Kingdom and rising tensions between Saudi Arabia and Iran,” the manager wrote in a monthly letter to clients of his hedge fund, Andurand Capital Management. “As a result, we believe that the current escalation in Middle Eastern sectarian conflicts will likely result in more proxy wars that will eventually create more supply disruptions.”

Andurand’s firm has more than doubled to $1 billion in assets from $430 million about a year ago. His main fund rose 2.2 percent in March, bringing gains to 5.8 percent in the first quarter, according to the letter obtained by Bloomberg.

The fund manager said earlier this year that he thought oil prices had bottomed, ending a decline that began in June 2014. Andurand sees oil prices rallying to $60 to $70 a barrel by year-end, he reiterated in the letter, before they reach $85 in 2017.

Supply disruptions in the Middle East “would come at a time when the market is already rebalancing quickly which would add a large upside potential to our current crude oil price forecast,” Andurand wrote, adding that lower prices may have taken a long-lasting toll on production infrastructure.

“We continue to believe that we are only at the beginning of a structural multiyear rally in oil prices,” he said.
Rising oil prices have boosted commodity and emerging market currencies and fueled big moves in Energy (XLE), Oil Services (OIH) and Oil Exploration (XOP) stocks this year (click on images, as of Wednesday's close):




Now, a lot of equity fund managers underperforming this year, not to mention hedge fund managers getting obliterated, are all asking themselves the same question: Should I close my eyes, hold my nose and just buy these sectors, even after this huge move?

Any trader will tell you "YES! BUY THE BREAKOUT!" but if you're a money manager worried about downside risk, it's very hard to justify buying these breakouts after such an extraordinary non-stop run-up. Sure, the charts tell you to buy but your gut tells you hold on a second, is this rally sustainable, especially after such a hard run-up?

The problem again is these breakout moves are being driven by high frequency quants and algos, pushing prices up based on technical levels, making life miserable for ordinary fund managers trying to figure out whether these big moves are justified and sustainable.

Then there's Soros. Some think he's wrong on China, but others agree with him and think there are rising risks in that country. In fact, Australia's Super is now warning of Chinese bubble risks:
Australia’s largest industry super fund, the $90 billion Australian Super, has delivered a stark warning on the risks in the Chinese economy, warning that the country had a credit bubble which “looks pretty scary.”

“The China credit bubble could well be the biggest issue facing China in the next five years,” Australian Super’s chief investment officer, Mark Delaney, told a conference in Sydney today hosted by The Economist magazine.

“When you look at the data in countries that have had credit bubbles, the data is really poor and the policy response is uncertain,” he said.

He said it would be “a big deal for everybody” if China were to have a financial crisis in the next five years.

But he said “no one has a really good handle on it.”

He said Australian Super, which has had an office in Beijing for several years, had been looking at investing directly in China for some time, but it had held off because of the deteriorating economic outlook.

“China has been in a downturn for two years. Profit growth has been terrible and asset prices have been very expensive,” he said.

“It hasn’t been a very good cyclical environment to be involved in.”

But he said there was concern about the credit bubble in China, including growing levels of federal government and local government debt, as well as questions about the bad debt exposure of the country’s banks.

He said Chinese bank shares were only selling at single digit multiples of their returns “not because they don’t make a lot of money, but because people don’t trust their balance sheets.”

“No one really knows how this is going to be sorted out.”

Mr Delaney was speaking after the International Monetary Fund estimated that China may have as much as $US1.3 trillion in loans to borrowers who did not have enough income to meet their repayments.

It estimated that this could mean potential losses of as much as 7 per cent of China’s gross domestic product. In its latest Global Financial Stability Report, the IMF estimated that loans “potentially at risk” could reach as much as 15.5 per cent of total bank commercial lending – some three times the level reported by the Chinese bank regulator.

Mr Delaney said Chinese regulators cut back on credit growth in the past year but had now changed their tune and were now trying to stimulate credit.

His comments followed another bearish comment on the outlook for the Chinese economy by Credit Suisse regional economist, Dong Tao.

He said Australian businesses he had spoken to were “living on a different planet” in their view of the changing Chinese economy.

He said the heyday of Chinese investment in infrastructure, housing and its strong exports had ended.

“The golden age of stimulus of the economy by the Chinese government is over.”

But he said the next Chinese business cycle would be the Chinese consumption boom.

He said demand in China was changing from steel and cement to baby food, organic foods and cosmetics.

“Australia is well positioned to take advantage of Chinese demand but it is changing.”

He said the Chinese government should stop trying to produce economic growth levels of more than 6.5 per cent and be prepared to live with growth levels closer to 4 per cent.

He said adopting growth targets of around 4 per cent would be a lot more credible and “will save a lot of anxiety.”
When you think of China's big pension gamble and the commodity trading frenzy taking over there, you have to question how long this China bubble can go on and whether another Big Bang will clobber risk assets all around the world in the second half of the year.

Then there is Japan. The Bank of Japan stunned everyone on Thursday by keeping its policy steady and not surprisingly, the Nikkei tanked and yen soared. Keep your eyes glued on the yen and emerging market currencies as another Asian crisis could be on the horizon.

All this to say that while some are betting George Soros is wrong on China and the global recovery will continue unabated, I think Mr. Soros will get the last laugh and the Great Crash of 2016 that has thus far alluded us might still be in play.

Below, Bill Gross of Janus Capital Group talks about the Federal Reserve's decision to leave rates unchanged and gives insight into his global investment strategy. Gross also recommended a preferred bank share ETF (PFF) but that was cut out of this clip.

And Antonin Jullier, global head of equity trading strategy at Citi, discusses the market's reaction to the Bank of Japan's vote against further stimulus.

Also, Philipp Hildebrand, vice chairman at BlackRock, talks with Caroline Hyde about European banking profitability, the impact of post-crisis regulation on bank business models, and why he thinks a China derailment is the biggest risk to the global economy. He speaks on "Bloomberg Surveillance."

Fourth, Joshua Crabb, Old Mutual Global Investors head of Asian equities, discusses the outlook for China's economy with Bloomberg's Angie Lau on "First Up."

Lastly, Carl Icahn, Chairman of Icahn Enterprises, discusses his thoughts on the U.S. markets and the economy. He says "there will be a day of reckoning unless we get fiscal stimulus." Listen to his views and what he says about specific commodity stocks he owns.





Wednesday, April 27, 2016

Pensions Should Brace for Lower Rates?

Andy Blatchford of the Canadian Press reports, Pensions should brace for new normal of lower neutral interest rates:
Bank of Canada governor Stephen Poloz is recommending pension funds get ready for a new normal: neutral interest rates lower than they were before the financial crisis.

Poloz told a Wall Street audience Tuesday that the fate of neutral rates — the levels he said will prevail once the world economy recovers — remain unknown, but they will almost certainly be lower than previously thought.

The central banker made the comment during a question-and-answer period that followed his speech on global trade growth.

Among the reasons, Poloz pointed to the more-pessimistic outlook for potential long-term global growth. The forecast was lowered to 3.2 per cent from four per cent, he said.

"That downgrade means the neutral rate of interest will be lower for sure — for a very long time," said Poloz, who added it could go even lower if economic "headwinds" continue.

"Those in the pension business need to get used to it. They need to adapt to it."

Since the 2008 global financial crisis, pension funds around the world have had to contend with market uncertainty, feeble growth and record-low interest rates.

Pension funds use long-term interest rates to calculate their liabilities. The lower the rates, the more money plans need to have to ensure they will be able to pay future benefits.

A December report by the Organization for Economic Co-operation and Development said the conditions have "cast doubts on the ability of defined-contribution systems and annuity schemes to deliver adequate pensions."

To cushion the Canadian economy from the shock of lower commodity prices, Poloz lowered the central bank's key rate twice last year to 0.5 per cent — just above its historic low of 0.25.

Poloz linked the higher neutral interest rates of the past to the baby boom, which he described as a 50-year period of higher labour-force participation and better growth.

"Well, that's behind us," Poloz told the meeting of the Investment Industry Association of Canada and the Securities Industry and Financial Markets Association.

"We don't have numbers for all this, but you need to be scenario-testing those pension plans and the needs of your clients because the returns simply won't be there."

But with all the unpredictability Poloz said it remains possible current headwinds could convert into positive forces that would push interest rates back to "more-normal levels" seen prior to the crisis.

Earlier Tuesday, Poloz's speech touched on another aspect of the post-crisis world.

He told the crowd they shouldn't expect to see a return of the "rapid pace of trade growth" the world saw for the two decades before the crisis.

Poloz was optimistic, however, that the "striking weakness" in international trade wasn't a sign of a looming global recession.

He said the renewed slowdown in global exports is more likely a result of the fact that big opportunities to boost global trade have already been largely exploited.

As an example, he noted China could only join the World Trade Organization once.

Poloz expressed confidence that most of the trade slump will be reversed as the global economy recovers — even if it's a slow process.

"The weakness in trade we've seen is not a warning of an impending recession," said Poloz, a former president and CEO of Export Development Canada.

"Rather, I see it as a sign that trade has reached a new balance point in the global economy — and one that we have the ability to nudge forward."

He said there's still room to boost global trade through efficiency improvements to international supply chains, the signing of major treaties such as the Trans-Pacific Partnership and the creation of brand new companies.

Poloz's speech came a day after Export Development Canada downgraded its outlook for the growth of exports.

EDC chief economist Peter Hall predicted overall Canadian exports of goods and services to expand two per cent in 2016, down from a projection last fall of seven per cent.
Well, if President Trump takes over after President Obama, you can expect more protectionism and trade wars, which isn't good for global trade.

But Bank of Canada Governor Stephen Poloz is absolutely right, pensions need to brace for a new normal of lower neutral interest rates. I've long warned my readers that ultra low rates are here to stay and if global deflation sets in, the new negative normal will rule the day.

Thus far, Canada has managed to escape negative rates but this is mostly due to the rebound in oil prices. If, as some claim, oil doubles by year-end, you can expect the loonie to appreciate and the Bank of Canada might even hike rates (highly doubt it). On the other hand, if the Great Crash of 2016 materializes, oil will sink to new lows and the Bank of Canada will be forced to go negative.

Interestingly,  on Wednesday, the Australian dollar plunged almost 2 per cent after a lower-than-expected inflation print  and deflation fears put a rate cut back on the agenda for next week's Reserve Bank meeting. Keep an eye on the Aussie as it might portend the future of commodity prices, deflation and what will happen to the loonie.

You should also read Ted Carmichael's latest, Why Does the Bank of Canada Now Believe that Fiscal Stimulus Works?. I agree with him, all this talk of fiscal stimulus is way overblown and in my opinion, it's a smokescreen for what really lies behind the Bank of Canada's monetary policy: it's all about oil prices. And like it or not, the loonie is a petro currency, period.

[As an aside, Ted also shared this with me: "I'd be ok with the budget if they stuck with carefully thought out infrastructure with private sector and/or pension fund participation, but they have blown up the deficit with middle income transfers and operational spending."]

The rise in oil prices alleviates the terms of trade shock and if it continues, the Bank of Canada won't need to cut rates this year. It's that simple, no need to torture yourself trying to figure out the Bank of Canada's monetary policy, it's all about oil, not fiscal policy.

South of the border, the Fed will do a cautious dance to avoid volatility:
The Fed is expected to do a cautious dance when it releases its statement Wednesday, as it leaves the door open for a rate hike in June but is not signaling one.

After two days of meetings, the Fed will release a 2 p.m. statement Wednesday. The statement is not expected to be much changed from its last one, but Fed watchers say the nuances will be important. There is no press conference where Fed chair Janet Yellen can provide further clarification, so markets will have only the statement to respond to.

The Fed is expected to be dovish in its statement, but the bond market clearly has been fearing it will be a bit more hawkish, and yields have been rising. Market expectations are for the next rate hike to come early next year, but the Fed has said it expects two rate hikes before then, so there is tension around any statement it would make.

"I don't think they're going to tip their hand on the policy section of it. I think the hawkishness might come in their description of the economy, because credit spreads have come back and are no longer a worry. The stock market is no longer down 10 percent on the year. Even the G-20 was less concerned about the economic outlook for the world," said Chris Rupkey, chief financial economist at MUFG Union Bank.

But the U.S. economic data has been spotty, with more than a few misses recently. Durable goods was weaker than expected Tuesday, and first quarter GDP, expected Thursday, is predicted to be just barely positive.

Fed officials have also been sending mixed messages about rate hikes. For instance, Boston Fed President Eric Rosengren, viewed as a dove, has said the markets have it wrong and are not pricing in enough rate hikes.

"The problem is you've got disagreement. The gap has widened," said Diane Swonk, CEO of DS Economics. "You've got dissents. When you have dissents, you have volatility." Cleveland Federal Reserve President Loretta Mester is expected to join Kansas City Fed President Esther George in dissenting Wednesday, as they object to the Fed's lack of rate hikes.

"I don't think they can put the balance of risk back in, because they can't agree what the balance of risks are," said Swonk. "It just means continued uncertainty, continued uncertainty for the market."

Michael Arone, chief investment strategist at State Street Global Advisors, also said the Fed is unlikely to suggest that risks are balanced.

"If they tell you it's nearly balancing, that'll be a signal that June is on the table," said Arone, adding he does not expect to see that.

Arone said the Fed will want to leave options open. "I don't think this Fed, and Yellen in particular, likes to paint themselves into a corner," said Arone. "The statement will acknowledge that growth in the economy is modest. They haven't seen the flow through to inflation and they'll remain data dependent going forward."

He said he will be watching to see if Yellen's view is dominant in the statement. "My view is what Yellen did with her Economic Club of New York speech (March 29), she was saying: 'I'm the chairperson. This is my view. We're going to go slow and gradual.' At the time, other Fed officials were talking about how April was still on the table," Arone said. "I think what markets are going to be looking to see is if that remains the message or if we're back in this kind of limbo."

It will also be important to see if the Fed gives any nod to stability in international markets now that China has calmed some of the fears around its economy.

Besides the Fed, there is the trade deficit data at 8:30 a.m. EDT and pending home sales at 10 a.m. EDT. There is a 10:30 a.m. EDT government inventory data on oil and gasoline, and the Treasury auctions seven-year notes at 1 p.m. auction.

Earnings before the bell include Boeing, Comcast, GlaxoSmithKline, Mondelez, United Technologies, Anthem, Northrop Grumman, Dr Pepper Snapple, Nasdaq OMX, Nintendo, State Street, Tegna, Garmin, Six Flags and General Dynamics. After the bell, reports are expected from Facebook, PayPal, Marriott, SanDisk, Cheesecake Factory, La Quinta, Rent-A-Center, First Solar, Texas Instruments and Vertex Pharmaceuticals.
The only earnings that matter on Wednesday are those of Apple (AAPL). Its shares are down 7% at this writing as it feels the pain of the end of iPhone 6 cycle (they better come up with a great marketing campaign for iPhone 7 to bring the stock back over $120 this fall).

As far as the Fed, I don't expect any major surprises today but who knows how markets react if the statement turns out to be more hawkish than expected.

More interestingly, Jeffrey Gundlach, the reigning bond king, visited Toronto recently and spoke with Financial Post reporter Jonathan Ratner. Here is an edited version of their discussion which you all MUST read as Gundlach talks about why debt deflation is a real threat, why the Fed capitulated in March and why negative rates are 'horror' (read this interview carefully).

Lately, Gundlach has been legging into Treasuries which shows you he's not worried about any rout in the bond market.

So, if low rates are here to stay, how are pensions going to adapt? More hedge funds? Good luck with that strategy. More private equity, real estate and infrastructure? This seems to be the reigning strategy but pensions have to be careful taking on illiquidity risk, especially if global deflation sets in. And when it comes to private equity funds, they have to monitor fees and performance carefully and also realize real estate has its own set of challenges in this environment.

This is why in Canada, large public pensions are gearing up to bankroll domestic infrastructure, ignoring critics calling this the great Canadian pension heist. By investing directly in mature and greenfield infrastructure, Canada's large public pensions can put a lot of money to work in assets that offer stable, predictable long-term cash flows, essentially better matching assets with their long dated liabilities without paying huge fees to private equity funds and without taking currency or regulatory risks (still taking on huge illiquidity risk but they have a long horizon to do this).

Below, listen to the speech Bank of Canada Governor Stephen Poloz gave on Tuesday at the Investment Industry Association of Canada and Securities Industry and Financial Markets Association in New York.

I worked with Steve at BCA Research years ago and think very highly of him. Take the time to listen to this speech and the Q&A where he discusses what lower neutral rates mean for pensions.

Also, CNBC contributor Richard Fisher, Harvard University Economics Professor Martin Feldstein and CNBC's Steve Liesman look ahead to Wednesday's Fed meeting. A very interesting discussion (too bad CNBC didn't post all of it) where Fisher and Feldstein claim inflation pressures are picking up as service sector inflation keeps rising and this could spell trouble ahead. Too bad the bond market doesn't agree with either of them.

Lastly, Columbia University Professor of Economics and Nobel Laureate Joseph Stiglitz discusses the problem of extreme income inequality in the United States and the negative economic impact of monetary policy. He speaks on "Bloomberg Surveillance."

Like I said, I don't pity hedge fund managers but I do pity millions who will retire in pension poverty, unable to cope with the new normal of lower rates. Pensions and savers better prepare for lower returns ahead.



Tuesday, April 26, 2016

The Great Canadian Pension Heist?

Andrew Coyne of the National Post warns, Funding government projects through public pension plans a terrible idea:
The federal government, it is well known, is determined to spend $120 billion on infrastructure over the next 10 years. If traditional definitions of infrastructure are insufficient to get it to that sum, then by God it will come up with whole new definitions.

Ah, but whose money? From what source? The government would appear to have three alternatives. One, it can pay for it out of each year’s taxes. Two, it can borrow on private credit markets. Or three, it can finance capital projects like roads and bridges by charging the people who use them. Once these would have been known as user fees or road tolls; in the language of today’s technocrats, it’s called “asset monetization” or “asset recycling.”

Governments at every level and of every stripe have been showing increasing interest in this option, and with good reason. Pricing scarce resources encourages consumers to make more sparing use of them, while confining ambitious politicians and bureaucrats to providing services people actually want and are willing to pay for.

Moreover, by charging users where possible, scarce tax dollars are freed up to pay for the things that can only be paid for through taxes: public goods, like defence, policing and lighthouses.

Of course, if it is possible to charge users, it raises the question of whether the service need be provided, or at least financed, by the state at all. Rather than front the capital for a project themselves, governments can open it to private investors to finance, in return for some or all of the revenues expected to flow from it. As with user fees, this need not be limited to new ventures: “asset recycling” can also mean selling existing government enterprises — what used to be called “privatization.”

Again, there’s much to recommend this. If a project can be financed privately, it usually should, as this provides a truer measure of the cost of capital. (This point eludes many people: since the government has the best credit and pays the lowest interest rate, they ask, doesn’t it make sense to borrow on its account? But by that reasoning we should get the government to borrow on everybody’s behalf. If not, then it is privileging some investments over others, in the same way as if it were to directly subsidize them, and subject to the same critiques.)

The further removed from government, moreover, the less the chances of politicization. There’s a reason we set up Crown corporations at arm’s length from the government of the day, in the hopes of insulating them from politically-minded meddling.

Privatization simply takes that one step further. At the same time, a company in private hands can be regulated in a more disinterested fashion, without the inherent conflict of interest of a government, in effect, regulating itself. Last, experience teaches that when people own something directly, and have an interest in its value, they tend to take better care of it — whereas when the state owns something, no one does.

Yet government and private sector alike are too willing to blur this distinction. Rather than simply put a project out to private tender, with investors bearing all of the risk in return for all of the profit, public and private capital are frequently commingled. All too often, this means public risk for private profit.

That, alas, seems where we are headed — with an extra twist of malignancy. For, as the Canadian Press recently reported, the “private” investors the feds have their eyes on are in fact the country’s public pension plans, notably the Canada Pension Plan’s $283-billion investment fund and Quebec’s Caisse de dépot et placement — much as the Ontario government had earlier suggested it would use its planned provincial equivalent.

This is a truly terrible idea. On the one hand, it offers governments a way to finance their spending on the quiet, without subjecting their plans to the scrutiny of either the credit markets or Parliament. On the other hand, it opens pension funds to pressure to invest in ways that may not be in the best interest of pensioners, but rather of their political “partners.”

I know, I know: the public pension plans are independent of government, at arms’ length, and all that. But the history of the Caisse is rather less than reassuring in this regard, while the presence of the CEOs of both the Caisse and the CPP Investment Board on the Finance minister’s new economic advisory council does not quite scream independence.

Even more disquieting is the Caisse’s latest venture, a $5.5-billion light rail project in Montreal, of which the Caisse itself would put up a little more than half — with the remainder, it hopes, to come from the federal and provincial governments.

Is it too hard to imagine, in the negotiations to come, the governments in question suggesting a little quid pro quo: we’ll fund yours if you’ll fund ours?

Well now. If I lend you $100 and you lend me $100, are either of us $1 better off? Now suppose you and I are basically the same person, and you have some idea of the nonsense involved here. The pension plans will fund government infrastructure projects with the money they make on investments funded in part by governments out of the return on investments that were financed by the pension plans and so on ad infinitum.

A government that borrows from others acquires a liability, but a government that borrows from itself may be accounted a calamity.
Poor Andrew Coyne, he just doesn't get it. Before I rip into his idiotic comment, let's go over another equally idiotic comment by an economist called Martin Armstrong who put out a post, Asset Recycling – Robbing Pensions to Cover Govt. Costs:
We are facing a pension crisis, thanks to negative interest rates that have destroyed pension funds. Pension funds are a tempting pot of money that government cannot keep its hands out of. The federal government of Canada, for example, is looking to reduce the cost of government by shifting Canada’s mounting infrastructure costs to the private sector. They want to sell or lease stakes in major public assets such as highways, rail lines, and ports. In Canada, they hid a line in last month’s federal budget that revealed that the Liberals are considering making public assets available to non-government investors, such as public pension funds. They will sell the national infrastructure to pension funds, robbing them of the cash they have to fund themselves. This latest trick is being called “asset recycling,” which is simply a system designed to raise money for governments. This idea is surfacing in Europe as well as the United States, especially among cash-strapped states.

This is the other side of 2015.75; the peak in government (socialism). Everything from this point forward is a confirmation that these people are in crisis mode. They are rapidly destroying Western culture because they are simply crazy and the people who blindly vote for them are out of their minds. They are destroying the very fabric of society for they cannot see what they are doing nor where this all leads. Once they wipe out the security of the future, the government will crumble to dust to be swept away by history. We deserve what we blindly vote for.
Wow, "peak government socialism", "destroying the very fabric of society", and all this because our federal government had the foresight to approach Canada's big, boring public pension funds to invest in domestic infrastructure?

These comments are beyond idiotic. Forget about Martin Armstrong, he sounds like a total conspiratorial flake worried about the end of humanity as we know it (not surprised to see him publishing doom and gloom articles on Zero Hedge).

Let me focus on Andrew Coyne, the resident conservative commentator who also regularly appears on the CBC to discuss politics. People actually listen to Coyne, which makes him far more dangerous when he spreads complete rubbish like the article he penned above (to be fair, I prefer his political comments a lot more than his economic ones).

In my last comment on pensions bankrolling Canada's infrastructure, I praised the federal government's initiative of "asset recycling" and stated why it makes perfect sense for Canada's large pensions to invest in domestic infrastructure:
  • Federal, provincial and municipal governments are cash-strapped and they need funds to invest in infrastructure. Increasing taxes to do this is simply not a viable option when the economy is weak.
  • Unlike other investments, investing in infrastructure has huge long-term economic benefits to any country and infrastructure jobs pay well, which means there is an important multiplier effect to the overall economy from these jobs.
  • Pensions need yield. They can invest in public and private markets or in hedge funds. Increasingly, they're avoiding volatile public markets where bond yields are at historic lows and they're even starting to shun hedge funds which promise absolute returns but have failed to keep up with simple stock and bond indexes. 
  • Where are pensions turning to? Private equity, real estate and infrastructure. But unlike private equity, Canada's large pensions invest directly in infrastructure, avoiding hefty fees to general partners (GPs), and unlike real estate, the duration of infrastructure assets is a better match to the duration of their long dated liabilities which typically go out 75+ years. 
  • What else? infrastructure assets are highly scalable, meaning these large pensions can put a huge chunk of money to work in one infrastructure investment instead of many private equity or hedge funds which charge big fees and don't offer safe, predictable returns.
  • Most of Canada's large public pensions target an actuarial rate of 6.3% (nominal), so if Michael Sabia is right and infrastructure offers a stable, predictable and low-risk return of 7-9%, then why not invest directly in infrastructure? It makes perfect sense.
  • Canada's large public pensions are internationally renowned infrastructure investors, investing in airports, highways, ports, and other infrastructure investments all around the world. Their focus has mainly been in Britain and Australia where the rule of law is similar to the one in Canada. 
  • But if the federal government makes public infrastructure available to them here, either through long-term leases or outright sales, then why not invest in domestic projects, foregoing any currency risk or foreign regulatory risk? Again, it makes perfect sense, it's simple logic, not rocket science. 
  • Of course, if the federal government opens public infrastructure assets to Canada's large pensions, it has to do so for international mega pension and sovereign wealth funds too, introducing competition and leveling the playing field. 
  • Typically Canada's large pensions invest in mature infrastructure investments that have been operational for years and offer well-known cash flows, avoiding riskier greenfield projects with uncertain cash flow projections.
  • But the Caisse is dipping into greenfield projects here in Quebec. It can do so because it has hired an experienced team of infrastructure professionals with actual operational experience who have project management experience and have overseen previous greenfield projects.
I also stated the following:
No doubt, greenfield infrastructure projects carry bigger risks but they also offer bigger rewards down the road. Will everything go smoothly in this project? Of course not, there isn't one major greenfield infrastructure project that goes off without a hitch but the people working on this project have actual operational experience and a track record of delivering on such projects below budget (which isn't easy) easing my concerns about recouping operating and capital costs.

So, I would tell the media and critics to ease up and have faith in Macky Tall and his team at CDPQ Infra. They are all very experienced and highly ethical individuals who will deliver on this and other greenfield projects if they are asked to in the future. And trust me, there will be no Charboneau Commission on this project which is great news for Quebec's taxpayers.
Now, let's get back to Coyne's article. He states the following:
This is a truly terrible idea. On the one hand, it offers governments a way to finance their spending on the quiet, without subjecting their plans to the scrutiny of either the credit markets or Parliament. On the other hand, it opens pension funds to pressure to invest in ways that may not be in the best interest of pensioners, but rather of their political “partners.”
And follows up right away with this:
I know, I know: the public pension plans are independent of government, at arms’ length, and all that. But the history of the Caisse is rather less than reassuring in this regard, while the presence of the CEOs of both the Caisse and the CPP Investment Board on the Finance minister’s new economic advisory council does not quite scream independence.
First of all, it's arm's length, but leaving that typo aside, what is Coyne talking about? Canada's large public pensions have a fiduciary mandate to invest in the best interests of their beneficiaries by maximizing their return without taking undue risk. It is stipulated in the law governing their operations and it's part of their investment policy and philosophy.

Second, Canada's large public pensions operate at arm's length from the government precisely because they want to eliminate government interference in their investment process. Importantly, the federal government isn't forcing Canada's large public pensions to invest in infrastructure, it's consulting them to see if they can strike a mutually beneficial policy which will allow the government to deliver on its promise to invest in infrastructure and public pensions to meet their actuarial target rate of return by investing in domestic as opposed to foreign infrastructure (lest we forget their liabilities are in Canadian dollars and there is less regulatory risk investing in domestic infrastructure).

Here you have world class pension experts investing directly in infrastructure assets all around the world and Andrew Coyne thinks it's shady that Mark Wiseman and Michael Sabia are sitting on the Finance Minister's economic advisory council? If you ask me, our Finance Minister would be a fool if he didn't ask them and others (like Leo de Bever, AIMCo's former CEO and the godfather of investing in infrastructure) to sit on his advisory council.

In the height of the 2008 crisis, I was working as a senior economist at the Business Development Bank of Canada (BDC) and I clearly remember our team preparing that organization's former CEO, Jean-René Halde, for his Friday morning discussions with then Finance Minister Jim Flaherty. Other CEOs of major Crown corporations (like Steve Poloz the current Governor of the Bank of Canada who was the former CEO of Export Development Canada), were on that call too looking at ways to help banks provide credit and invest in small and medium sized enterprises. There was nothing shady about that, it was a very smart move on Flaherty's part.

Speaking of shady activity, I have more confidence in the people at the Caisse overseeing the $5.5 billion light rail project than I do with anyone working in the municipal, provincial or federal government in charge of our infrastructure assets. If you want to cut the risk of corruption, you are much better off having the tender offers go through CPDQ Infra than some government organization which isn't held accountable and doesn't have skin in the game.

That brings me to another topic. Canada's large public pensions aren't in the charity business, far from it. If they're investing in domestic infrastructure, it's because they see a fit to meet their long dated liabilities and make money off these investments. And let's be clear, they all want to make money taking the least risk possible because that is how they justify their hefty compensation.

The notion that any provincial or even the federal government is forcing public pensions to invest in infrastructure is not only ridiculous, it's downright laughable and shows complete ignorance on Coyne's part as to the governance at Canada's large public pensions and their investment mandate and incentive structure.

Andrew Coyne should stick to political commentaries. When it comes to public pensions and the economy, he's just as clueless as the hacks over at the Fraser Institute claiming CPP is too costly. It isn't, we should build on CPPIB's success.

By the way, if you want to see a really terrible idea, check out China's pension gamble. That is a perfect example of a country where there's no pension governance whatsoever (either you follow the government's instructions or your head is chopped off).

There's another bubble going on in China, a great ball of money rushing into commodities. Below, CNBC reports on how China just raised transaction costs to cool commodities frenzy. God help us!!

If I was Andrew Coyne, I'd be far more worried about Chinese speculating in the stock and commodities markets than Canada's large public pensions investing in domestic infrastructure. Then again, Coyne loves hearing himself speak even when he doesn't have a clue of what he's talking about.

Monday, April 25, 2016

Pensions Bankrolling Canada's Infrastructure?

Andy Blatchford of the Canadian Press reports, Liberal government to consider public pension funds to help bankroll mounting infrastructure costs:
The federal government has identified a potential source of cash to help pay for Canada’s mounting infrastructure costs — and it could involve leasing or selling stakes in major public assets such as highways, rail lines, and ports.

A line tucked into last month’s federal budget reveals the Liberals are considering making public assets available to non-government investors, like public pension funds.

The sentence mentions “asset recycling,” a system designed to raise money to help governments bankroll improvements to existing public infrastructure and, possibly, to build new projects.

For massive, deep-pocketed investors like pension funds, asset recycling offers access to reliable investments with predictable returns through revenue streams that could include user fees such as tolls.

“Where it is in the public interest, engage public pension plans and other innovative sources of funding — such as demand management initiatives and asset recycling — to increase the long-term affordability and sustainability of infrastructure in Canada,” reads the sentence in the new Liberal government’s first budget.

Asset recycling is gaining an increasing amount of international attention and one of the best-known, large-scale examples is found in Australia. The Australian government launched a plan to attract billions of dollars in capital by offering incentives to its states and territories that sell stakes in public assets.

Like the Australian example, experts believe monetizing Canadian public assets could generate much-needed funds for a country faced with significant infrastructure needs.

The Liberal budget paid considerable attention to infrastructure investment, which it sees as way to create jobs and boost long-term economic growth. The Liberals have committed more than $120 billion toward infrastructure over the next decade.

Proponents of asset recycling say enticing deep-pocketed investors to join can help governments avoid amassing debt or raising taxes.

“Asset recycling is a way to attract private-sector investment into activities that were formerly, exclusively, in the public realm,” said Michael Fenn, a former Ontario deputy minister and management consultant who specializes in the public sector.

“It’s something that we should pay a lot of attention to and I’m really pleased to see the federal government is looking seriously at it.”

Fenn serves as a board member for OMERS pension fund, which invests in public infrastructure around the world. He stressed he was not speaking on behalf of OMERS or its investments.

Two years ago, Fenn wrote a research paper for the Toronto-based Mowat Centre think-tank titled, Recycling Ontario’s Assets: A New Framework for Managing Public Finances.

In Canada, he said there have been a few examples that resemble asset recycling, including Ontario’s partnership with Teranet to manage its land registry system and the province’s more recent move to sell part of the Hydro One power company.

For the most part, Canada’s big pension funds have been focused on international infrastructure investments because few domestic opportunities have been of the magnitude for which they tend to look.

Australia’s asset-recycling model has been praised by influential Canadians such as Mark Wiseman, president and chief executive of the Canada Pension Plan Investment Board.

“With growing infrastructure deficits worldwide … we often reference this model with our own government and others as one to follow to (incentivize) and attract long-term capital,” Wiseman said in prepared remarks of a September speech in Sydney to the Canadian Australian Chamber of Commerce.

The massive CPP Fund had $282.6 billion worth of assets at the end of 2015. Wiseman’s speech noted more than 75 per cent of its investments were made outside Canada, including about $7 billion in Australia.

Last month, Wiseman was named to Finance Minister Bill Morneau’s economic advisory council, which is tasked with helping the government map out a long-term growth plan. The council also includes Michael Sabia, CEO of Quebec’s largest public pension fund, the Caisse de dépôt et placement du Québec.

In a prepared speech last month in Toronto, Sabia said financial institutions like pension plans have tremendous potential to drive growth through infrastructure investment. For the investor, Sabia said that infrastructure offers stable, predictable, low-risk returns of seven to nine per cent.

A spokeswoman for Morneau’s office was asked about Ottawa’s interest in asset recycling, but she referred back to the budget and said there was nothing new to add on the issue, for the moment.
Last year, I discussed this idea of opening Canada's infrastructure floodgates. Since then, the idea has taken off and there has been a vigorous push from Ottawa to court pensions on infrastructure.

Why does this initiative of "asset recycling" make sense? I've already mentioned my thoughts here but let me briefly make a much simpler case below:
  • Federal, provincial and municipal governments are cash-strapped and they need funds to invest in infrastructure. Increasing taxes to do this is simply not a viable option when the economy is weak.
  • Unlike other investments, investing in infrastructure has huge long-term economic benefits to any country and infrastructure jobs pay well, which means there is an important multiplier effect to the overall economy from these jobs.
  • Pensions need yield. They can invest in public and private markets or in hedge funds. Increasingly, they're avoiding volatile public markets where bond yields are at historic lows and they're even starting to shun hedge funds which promise absolute returns but have failed to keep up with simple stock and bond indexes. 
  • Where are pensions turning to? Private equity, real estate and infrastructure. But unlike private equity, Canada's large pensions invest directly in infrastructure, avoiding hefty fees to general partners (GPs), and unlike real estate, the duration of infrastructure assets is a better match to the duration of their long dated liabilities which typically go out 75+ years. 
  • What else? infrastructure assets are highly scalable, meaning these large pensions can put a huge chunk of money to work in one infrastructure investment instead of many private equity or hedge funds which charge big fees and don't offer safe, predictable returns.
  • Most of Canada's large public pensions target an actuarial rate of 6.3% (nominal), so if Michael Sabia is right and infrastructure offers a stable, predictable and low-risk return of 7-9%, then why not invest directly in infrastructure? It makes perfect sense.
  • Canada's large public pensions are internationally renowned infrastructure investors, investing in airports, highways, ports, and other infrastructure investments all around the world. Their focus has mainly been in Britain and Australia where the rule of law is similar to the one in Canada. 
  • But if the federal government makes public infrastructure available to them here, either through long-term leases or outright sales, then why not invest in domestic projects, foregoing any currency risk or foreign regulatory risk? Again, it makes perfect sense, it's simple logic, not rocket science. 
  • Of course, if the federal government opens public infrastructure assets to Canada's large pensions, it has to do so for international mega pension and sovereign wealth funds too, introducing competition and leveling the playing field. 
  • Typically Canada's large pensions invest in mature infrastructure investments that have been operational for years and offer well-known cash flows, avoiding riskier greenfield projects with uncertain cash flow projections.
  • But the Caisse is dipping into greenfield projects here in Quebec. It can do so because it has hired an experienced team of infrastructure professionals with actual operational experience who have project management experience and have overseen previous greenfield projects.
On this last point, the Caisse announced plans on Friday for its Réseau électrique métropolitain (REM), an integrated, world-class public transportation project. Jason Magder of the Montreal Gazette reports, Electric light-rail train network to span Montreal by 2020:
It will be the biggest transit project since the Montreal métro, but this one will be built and mostly funded by a pension fund.

The Caisse de dépôt et placement du Québec, the province’s pension fund manager, unveiled on Friday a light-rail network it intends to build, with the first stations coming online in 2020.

“Every time you take this train, you’ll be paying into your retirement,” said Michael Sabia, the CEO of the Caisse.

Answering decades of demands for an airport link from downtown, the $5.5-billion Réseau électrique métropolitain will be a vast network linking the South Shore, the West Island and Deux-Montagnes to both the airport and the downtown core.

“What we’re announcing today is the most important public transit project in Montreal in the last 50 years,” said Macky Tall, the president of CDPQ Infra, the Caisse’s infrastructure arm.

Leaving from Central Station, the 67-kilometre network will use the track running through the Mount Royal tunnel, taking over the Deux-Montagnes line — which already runs electric trains — from the Agence métropolitaine de transport. New tracks will be built over the new Champlain Bridge, and link to the South Shore, ending near the intersection of Highways 30 and 10 in Brossard. Two other dedicated tracks will be built, branching off from the Deux-Montagnes line, where Highway 13 meets Highway 40. One track will head to Trudeau airport, with a stop in the Technoparc in St-Laurent. Another will follow Highway 40 toward Ste-Anne-de-Bellevue. The existing Vaudreuil-Dorion train line won’t be affected by the project.

Light rail trains are smaller and carry fewer passengers, but the service will be more frequent than the current AMT service, Tall said.

This is not the pension manager’s first foray into public transit. The Caisse is one of the builders of the Canada Line, a train that links Vancouver’s airport to the downtown area and the suburb of Richmond. It was built in time for the 2010 Olympic Games.

However, Sabia admitted this project represents a much greater risk, since the Caisse is the principal investor and has to recoup both its capital investment and its operating costs. But he’s confident the Caisse will achieve “market competitive returns” on the project.

“We are taking the traffic risk here,” Sabia said. “This is unusual because generally, it’s governments that take that risk.”

Matti Siemiatycki, an associate professor of urban planning at the University of Toronto, said this is a first for Canada, so it’s an untested funding model.

“Internationally, there have been privately funded and financed commuter rail lines, but in most cases, they don’t recover their operating costs, let alone their capital costs,” Siemiatycki said.

He said because it has holdings in engineering, train manufacturing and train operating companies, the pension fund does have an advantage. But he’s not sure it will be enough.

“It’s possible they can realize economies, but it doesn’t take away the fact that most transportation systems in North America are not recovering their operating costs, let alone their capital costs, so that will be the Caisse’s challenge,” he said.

Sabia said the Caisse intends for most of the revenue to come from fares, which he said will be similar to the ones currently charged by the AMT.

“That’s a big chunk of it but, of course, as you know municipalities today have made a public policy decision to encourage people to use public transit,” Sabia said. “We would expect that current practice would continue and contribute to the overall financing of the project.”

Because the trains will be fully automated, Sabia said the operating cost of the network will be low.

The Caisse, which has a real-estate investment division, will also try to recoup some of the investment through development along the line, but Sabia said the bulk of the revenue will come from ridership. The Caisse expects a daily ridership of 150,000, compared with 85,000 that currently use the Deux-Montagnes line, the 747 airport bus and buses across the Champlain Bridge.

The Caisse has promised trains will leave every three to six minutes from the South Shore and every six to 12 minutes on the West Island and Deux Montagnes Line, for the duration of its 20-hour operation schedule from 5 a.m. to 1:20 a.m. The Caisse estimates it will take 40 minutes to take the train from either Ste-Anne-de-Bellevue or Deux-Montagnes to downtown. It will take 30 minutes to go from Central Station to the airport. It will take between 15 and 20 minutes to travel from Brossard to downtown.

Tall said the decision to follow Highway 40 was made because of work going on in the Turcot Interchange. That work would have prevented crews from building dedicated lines for the next five years. He said building along that corridor would also cost $1 billion more because it would require a track dedicated to passenger traffic.

The thorny issue of parking remains unsolved, however. Currently, many stations along the Deux-Montagnes line are over capacity and there is no space to build new parking spots.

Tall said the Caisse will speak with municipalities about this issue and hopes to come up with a solution.
Michael Sabia has gone from being an outsider to a rainmaker in Quebec. When he took over the provincial pension fund, it was $40 billion in the hole. He's managed to grow its asset base by $130 billion since then and is now looking to invest directly in Quebec's infrastructure with this "risky" foray into a greenfield project.

I put "risky" in quotations because unlike that associate professor of urban planning quoted in the article above, I'm more optimistic and think he is underestimating Macky Tall, CEO of CDPQ Infra and his senior team, many of whom have worked on greenfield infrastructure projects and know what they're doing when it comes to managing such large scale projects. No other large Canadian pension fund has as much operational experience when it comes to greenfield infrastructure projects, which is why they typically avoid them.

So, while Sabia garners all the attention, there are a lot of people under him who deserve credit and praise for this huge project. One of them is a friend of mine who has nothing but good things to say about Michael Sabia, Macky Tall, CDPQ Infra's team and the Caisse in general.

No doubt, greenfield infrastructure projects carry bigger risks but they also offer bigger rewards down the road. Will everything go smoothly in this project? Of course not, there isn't one major greenfield infrastructure project that goes off without a hitch but the people working on this project have actual operational experience and a track record of delivering on such projects below budget (which isn't easy) easing my concerns about recouping operating and capital costs.

So, I would tell the media and critics to ease up and have faith in Macky Tall and his team at CDPQ Infra. They are all very experienced and highly ethical individuals who will deliver on this and other greenfield projects if they are asked to in the future. And trust me, there will be no Charboneau Commission on this project which is great news for Quebec's taxpayers.

Below, Jason Magder of the Montreal Gazette discusses the Caisse's $5.5-billion Réseau électrique métropolitain (REM) project. Talk about "Making Quebec Great Again" (my girlfriend came up with that playing on Trump's campaign logo).

Speaking of Making America Great Again, David Walker, former U.S. comptroller general, and former Gov. Howard Dean, (D-Vt.), discussed which candidate has the best tax plan for voters and corporate America on Monday morning on CNBC Squawk Box.

Listen closely to David Walker's response to Gov. Dean's question at the end of this clip where he states the need to "pursue public-private partnerships" and tap into the trillions of "patient capital" from U.S. pensions to invest in America's crumbling infrastructure.

In Canada, we're already there and unlike in the United States, our large public pensions operate at arms-length from the government (got the governance right) and invest directly in mature and now greenfield infrastructure projects. This will hopefully make not only Quebec but Canada great again. I'll end it on that optimistic note.