Monday, June 18, 2018

The Great Pension Train Wreck?

John Mauldin wrote a comment recently that caught my attention, The Pension Train Has No Seat Belts:
In describing various economic train wrecks these last few weeks, I may have given the wrong impression about trains. I love riding the train on the East Coast or in Europe. They’re usually a safe and efficient way to travel. And I can sit and read and work, plus not deal with airport security. But in this series, I’m concerned about economic train wrecks, of which I foresee many coming before The Big One which I call The Great Reset, where all the debt, all over the world, will have to be “rationalized.” That probably won’t happen until the middle or end of the next decade. We have some time to plan, which is good because it’s all but inevitable now, without massive political will. And I don’t see that anywhere.

Unlike actual trains, we as individuals don’t have the option of choosing a different economy. We’re stuck with the one we have, and it’s barreling forward in a decidedly unsafe manner, on tracks designed and built a century ago. Today, we’ll review yet another way this train will probably veer off the tracks as we discuss the numerous public pension defaults I think are coming.

Last week, I described the massive global debt problem. As you read on, remember promises are a kind of debt, too. Public worker pension plans are massive promises. They don’t always show up on the state and local balance sheets correctly (or directly!), but they have a similar effect. Governments worldwide promised to pay certain workers certain benefits at certain times. That is debt, for all practical purposes.

If it’s debt, who are the lenders? The workers. They extended “credit” with their labor. The agreed-upon pension benefits are the interest they rightly expect to receive for lending years of their lives. Some were perhaps unwise loans (particularly from the taxpayers’ perspective), but they’re not illegitimate. As with any other debt, the borrower is obligated to pay. What if the borrower simply can’t repay? Then the choices narrow to default and bankruptcy.

Today’s letter is chapter 6 in my Train Wreck series. If you’re just joining us, here are links to help you catch up.
As you will see below, the pension crisis alone has catastrophic potential damage, let alone all the other debt problems we’re discussing in this series. You are sadly mistaken if you think it will end in anything other than a train wreck. The only questions are how serious the damage will be, and who will pick up the bill.

Demographics and Destiny

It’s been a busy news year, but one under-the-radar story was a wave of public school teacher strikes around the US. It started in West Virginia and spread to Kentucky, Oklahoma, Arizona, and elsewhere. Pensions have been an issue in all of them.

An interesting aspect of this is that many younger teachers, who are a long way from retirement age, are very engaged in preserving their long-term futures. This disproves the belief that Millennial-generation Americans think only of the present. From one perspective, it’s nice to see, but they are unfortunately right to worry. Demographic and economic reality says they won’t get anything like the benefits they see current retirees receiving. And it’s not just teachers. The same is true for police, firefighters, and all other public-sector workers.

Thinking through this challenge, I’m struck by how many of our economic problems result from the steady aging of the world’s population. We are right now living through a combination unprecedented in human history.
  • Birth rates have plunged to near or below replacement level, and
  • Average life spans have increased to 80 and beyond.
Neither of these happened naturally. The first followed improvements in artificial birth control, and the second came from better nutrition and health care. Each is beneficial in its own way, but together they have serious consequences.

This happened quickly, as historic changes go. Here is the US fertility rate going back to 1960.


As you can see, in just 16 years (1960–1976), fertility in the US dropped from 3.65 births per woman to only 1.76. It’s gone sideways since then. This appears to be a permanent change. It’s even more pronounced in some other countries, but no one has figured out a way to reverse it.

Again, I’m not saying this is bad. I’m happy young women were freed to have careers if they wished. I’m also aware (though I disagree) that some think the planet has too many people anyway. If that’s your worry, then congratulations, because new-human production is set to fall pretty much everywhere, although at varying rates.

Breaking down the US population by age, here’s how it looked in 2015.


Think of this as a python swallowing a pig. Those wider bars in the 50–54 and 55–59 zones are Baby Boomers who are moving upward and not dying as early as previous generations did. Meanwhile, birth rates remain low, so as time progresses, the top of the pyramid will get wider and the bottom narrower. (You can watch a good animation of the process here.)


This is the base challenge: How can a shrinking group of working-age people support a growing number of retirement-age people? The easy and quick illustration to this question is to talk about the number of workers supporting each Social Security recipient. In 1940, it was 160. By 1950 it was 16.5. By 1960 it was 5.1. I think you can see a trend here. As the chart below shows, it will be 2.3 by 2030.


Similarly, states and local governments are asking current young workers to support those already in the pension system. The math is the same, though numbers vary from area to area. How can one worker support two or three retirees while still working and trying to raise a family with mortgage payments, food, healthcare, etc.? Obviously, they can’t, at least not forever. But no one wants to admit that, so we just ignore reality. We keep thinking that at some point in the future, taxpayers will pick up the difference. And nowhere is it more evident than in public pensions.

In a future letter, I will present some good news to go with this bad news. Several new studies will clearly demonstrate new treatments to significantly extend the health span of those currently over age 50 by an additional 10 or 15 years, and the same or more for future generations. It’s not yet the fountain of youth, but maybe the fountain of middle-age. (Right now, middle-age sounds pretty good to me.)

But wait, those who get longer lifespans will still get Social Security and pensions. That data isn’t in the unfunded projections we will discuss in a moment. So, whatever I say here will be significantly worse in five years.

Let me tell you, that’s a high order problem. Do you think I want to volunteer to die so that Social Security can be properly funded? Are we in a Soylent Green world? This will be a very serious question by the middle of the next decade.

Triple Threat

We have discussed the pension problem before in this letter—at least a half-dozen times. Most recently, I issued a rather dire Pension Storm Warning last September. I said in that letter that I expect more cities to go bankrupt, as Detroit did, not because they want to, but because they have no choice. You can’t get blood from a rock, which is what will be left after the top taxpayers move away and those who stay vote to not raise taxes.

This means city and school district retirees will take major haircuts on expected pension benefits. The citizens that vote not to pay the committed debt will be fed up with paying more taxes because they will be at the end of their tax rope. I am not arguing that is fair, but it is already happening and will happen more.

Let me say this again because it’s critical. The federal government can (but shouldn’t) run perpetual deficits because it controls the currency. It also has a mostly captive tax base. People can migrate within the US, but escaping the IRS completely is a lot harder (another letter for another day). States don’t have those two advantages. They have tighter credit limits and their taxpayers can freely move to other states.

Many elected officials and civil servants seem not to grasp those differences. They want something that can’t be done, except in Washington, DC. I think this has probably meant slower response by those who might be able to help. No one wants to admit they screwed up.

In theory, state pensions are stand-alone entities that collect contributions, invest them for growth, and then disburse benefits. Very simple. But in many places, all three of those components aren’t working.
  • Employers (governments) and/or workers haven’t contributed enough.
  • Investment returns have badly lagged the assumed levels.
  • Expenses are more than expected because they were often set too high in the first place, and workers lived longer.
Any real solution will have to solve all three challenges—difficult even if the political will exists. A few states are making tough choices, but most are not. This is not going to end well for taxpayers or retirees in those places.

Worse, it isn’t just a long-term problem. Some public pension systems will be in deep trouble when the next recession hits, which I think will happen in the next two years at most. Almost everyone involved is in deep denial about this. They think a miracle will save them, apparently. I don’t rule out anything, but I think bankruptcy and/or default is the more likely outcome in many cases.

Assumed Disaster

The good news is we’re starting to get data that might shake people out of their denial. A new Harvard study funded by Pew Charitable Trusts uses “stress test” analysis, similar to what the Federal Reserve does for large banks, to see how plans in ten selected states would behave in adverse conditions (hat tip to Eugene Berman of Cox Partners for showing me this study).

The Harvard scholars looked at two economic scenarios, neither of which is as stressful as I expect the next downturn to be. But relative to what pension trustees and legislators assume now, they’re devastating.

Scenario 1 assumes fixed 5% investment returns for the next 30 years. Most plans now assume returns between 7% and 8%, so this is at least two percentage points lower. Over three decades, that makes a drastic difference.

States are a larger and different problem because, under our federal system, they can’t go bankrupt. Lenders perversely see this as positive because it removes one potential default avenue. They forget that a state’s credit is only as good as its tax base, and the tax base is mobile.

Scenario 2 assumes an “asset shock” involving a 20% loss in year one, followed by a three-year recovery and then a 5% equity return for years five through year 30. So, no more recessions for the following 25 years. Exactly what fantasy world are we in?

Their models also include two plan funding assumptions. In the first, they assume states will offset market losses with higher funding. (Fat chance of that in most places. Seriously, where are Illinois, Kentucky, or others going to get the money?). The second assumes legislatures will limit contribution increases so they don’t have to cut other spending.

Admittedly, these models are just that—models. Like central banks models, they don’t capture every possible factor and can be completely wrong. They are somewhat useful because they at least show policymakers something besides fairytales and unicorns. Whether they really help or not remains to be seen.

Crunching the numbers, the Pew study found the New Jersey and Kentucky state pension systems have the highest insolvency risk. Both were fully-funded as recently as the year 2000 but are now at only 31% of where they should be.


Other states in shaky conditions include Illinois, Connecticut, Colorado, Hawaii, Pennsylvania, Minnesota, Rhode Island, and South Carolina. If you are a current or retired employee of one of those states, I highly suggest you have a backup retirement plan. If you aren’t a state worker but simply live in one of those states, plan on higher taxes in the next decade.

But that’s not all. Even if you are in one of the (few) states with stable pension plans, you’re still a federal taxpayer, and that’s who I think will end up bearing much of this debt. And as noted above, it is debt. The Pew study describes it as such in this chart showing state and local pension debt as a share of GDP.

For a few halcyon years in the late 1990s, pension debt was negative, with many plans overfunded. The early-2000s recession killed that happy situation. Then the Great Recession nailed the coffin shut. Now it is above 8% of GDP and has barely started to recover from the big 2008 jump.

Again, this is only state and local worker pensions. It doesn’t include federal or military retirees, or Social Security, or private sector pensions and 401Ks, and certainly not the millions of Americans with no retirement savings at all. All these people think someone owes them something. In many cases, they’re right. But what happens when the assets aren’t there?

The stock market boom helped everyone, right? Nope. States' pension funds have nearly $4 trillion of stock investments, but somehow haven't benefited from soaring stock prices.

A new report by the American Legislative Exchange Council (ALEC) shows why this is true. It notes that the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America. The ALEC report is far more alarming than the report from Harvard. They believe that the underfunding is more than 67%.

There are several problems with this. First, there simply isn’t $6 trillion in any budget to properly fund state and local government pensions. Maybe a few can do it, but certainly not in the aggregate.

Second, we all know about the miracle of compound interest. But in this case, that miracle is a curse. When you compute unfunded liabilities, you assume a rate of return on the current assets, then come back to a net present value, so to speak, of how much it takes to properly fund the pension.

Any underfunded amount that isn’t immediately filled will begin to compound. By that I mean, if you assume a 6% discount rate (significantly less than most pensions assume), then the underfunded amount will rise 6% a year.

This means in six years, without the $6 trillion being somehow restored (magic beans?), pension underfunding will be at $8.4 trillion or thereabouts, even if nothing else goes wrong.

That gap can narrow if states and local governments (plus workers) begin contributing more, but it stretches credulity to say it can get fixed without some pain, either for beneficiaries or taxpayers or both.

I noted last week in Debt Clock Ticking that the total US debt-to-GDP ratio is now well over 300%. That’s government, corporate, financial, and household debt combined. What’s another 8% or 10%? In one sense, not much, but it aggravates the problem.

If you take the almost $22 trillion of federal debt, well over $3 trillion of state and local debt, and add in the $6 trillion debt of underfunded pensions, you find that the US governments from the top to bottom owe over $30 trillion, which is well over 150% of GDP. Technically, we have blown right past the Italian debt bubble. And that’s not even including unfunded Social Security and healthcare benefits, which some estimates have well over $100 trillion. Where is all that going to come from?

Connecticut, the state with the highest per-capita wealth, is only 51.9% funded according to the Wall Street Journal. The ALEC study mentioned above would rate it much worse. Your level of underfunding all depends on what you think your future returns will be, and almost none of the projections assume recessions.

The level of underfunding will rise dramatically during the next recession. Total US government debt from top to bottom will be more than $40 trillion only a few years after the start of the next recession. Again, not including unfunded liabilities.

I wrote last year that state and local pensions are The Crisis We Can’t Muddle Through. That’s still what I think. I’m glad officials are starting to wake up to the problem they and their predecessors created. There are things they can do to help, but I think we are beyond the point where we can solve this without serious pain on many innocent people. Like the doctor says before he cuts you, “This is going to hurt.”

We’ll stop there for now. Let me end by noting this is not simply a US problem. Most developed countries have their own pension crises, particularly the southern Eurozone tier like Italy and Greece. We’ll look deeper at those next week.

This is not going to be the end of the world. We’ll figure out ways to get through it as a culture and a country. The rest of the world will, too, but it may not be much fun. Just ask Greece.
Ah Greece, once land of great philosophers, heroes and warriors, now reduced to the land of pension haircuts and economic lost decades.

John Mauldin has done it again, writing a comment on pensions where he at once informs and misinforms us.

First, let me begin by where I agree with John. Public pension liabilities are debts we owe to people who are looking to retire with a safe, secure defined-benefit pension.

John is absolutely right that total US debt ($22 trillion) does NOT include state and local debt ($3 trillion) which doesn't include the $6 trillion in unfunded pension liabilities.

How does that old saying go, "a trillion here, a trillion there, pretty soon we're talking real money!".

And as I keep warning my readers, the pension crisis made up of unfunded public pension liabilities and lack of private savings in 401(k) type of plans, is deflationary.

In fact, excessive debt is deflationary as it detracts from future economic growth.

Add to this the aging of societies and you have the perfect cocktail for a long-term pension crisis.

The Montreal Gazette recently discussed a PwC study which claims the aging population is hurting Quebec's economy. Well, guess what? Other provinces and states aren't faring any better.

Remember the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create. One study found that 800 million people might be out of a job by 2030 because of automation.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

This is why I'm definitely not in the inflation camp and think rising rates are being capped by these structural forces which shouldn't be confused with cyclical swings in inflation due to a depreciating currency.

Anyway, the point is John is right to worry about the pension train wreck but he also misses a great opportunity to talk to you about things that can help sustain public pensions over the long run.

Importantly, unlike John, I do not see this as a hopeless situation. Why? Because sooner or later the US and rest of the world (minus Denmark and the Netherlands) are all going to adopt two critical factors that have led to the long-term success of Canada's mighty pension plans:
  1. Adopt world-class governance which separates public pensions from governments completely, have them overseen by an independent and qualified board and managed by industry experts who are paid to deliver long-term excess returns investing across public and private markets all over the world. Most of this can be done internally, saving a bundle on fees.
  2. Adopt a shared risk model which ensures intergenerational equity and shares the risk properly between active and retired members. This way, when pensions run into trouble, it's not just active members paying more in contributions but also retired members that receive less benefits (typically, a small adjustment in their cost-of-living adjustment, they'll go a brief period without full inflation portection until the plan's funded status is fully restored).
Go read my recent comment on why OMERS is reviewing its indexing policy which is the right thing to do, making its plan young again like OTPP is doing.

There's no secret sauce to pension solvency. Asset returns alone cannot bring a plan back to fully funded status, not in a low growth, low rate, low return world. You need to adopt conditional inflation protection too or else you'll be swimming against the current.

But in the US, state and local governments aren't interested in world class governance or shared risk models. The ones suffering from chronic pension deficits are kicking the can down the road, something I discussed last week in my comment on why CPPIB is issuing green bonds:
Why is CPPIB issuing green bonds? It has over $356 billion under management and doesn't need the money so why is it issuing green bonds?

Cynics will claim it's just a green gimmick, another case of Canadian pensions cranking up the leverage to boost their returns and executive compensation.

Now, let's all take a deep breath in and out. I'll explain to you exactly why CPPIB wisely chose to issue green bonds.

First, it has nothing to do with leverage. CPPIB will invest $3 billion out of a total $356 billion so leverage isn't the reason behind issuing green bonds.

Second, it has everything to do with efficient use of capital. When a corporation issues a bond, it uses that money to buy back shares, invest in capital equipment or make a strategic acquisition, among other things.

When a pension issues a bond, any bond, it incurs liabilities and needs to invest that money wisely to earn a higher rate of return.

In the US, rating agencies are targeting underfunded public pensions and many of these state and local governments with chronically underfunded pensions are responding by kicking the can down the road, issuing pension bonds to invest and try to make up their shortfall.

It works like this. US state or local governments emit $100 million in pension obligation bonds, pay out 4.5% (assuming rates don't rise a lot) to investors and their public pensions use the proceeds to invest in stocks, corporate bonds, private equity funds and hedge funds to try to earn more than than that 4.5% being paid out (typically targeting a 7.5 or 8% bogey) to try to close the gap between assets and liabilities to improve its funded status.

And because a lot of the US state and local governments emitting pension obligation bonds are fiscally weak, their credit rating isn't very good so they need to pay an extra premium to investors to entice them to buy these pension bonds.

It's nuts when you think about it because they're taking credit risk (their own balance sheet can significantly deteriorate) and market risk (if interest rates rise or assets get clobbered), hoping they will invest wisely to earn more than what they're paying out to bondholders. This is why experts warn to beware of pension obligation bonds.

Are you with me so far? Great, because unlike US public pensions, Canada's large public pensions operate at arm's length from the government, enjoy a AAA credit rating because they're fully funded or close to it, they have world class governance, and are very transparent.

Their strong balance sheet and exceptional long-term track record allows them to emit bonds, any bonds, at a competitive rate as they receive a AAA rating, and then they can use those proceeds to target global investments across public and private assets all over the world.

So, issuing green bonds is nothing new, it's something old that only targets green investments, but the media reports make it sound like CPPIB is doing something way out of the ordinary.

It isn't. It's doing what it has done all along, what all of Canada's large pensions are doing, using their great balance sheet and long-term track record to emit bonds as rates are still at historic lows and use those proceeds to invest across global public and private markets to earn a better rate of return.

And they're not jacking up the leverage, at least CPPIB isn't relative to its overall portfolio. It simply boils down to efficient use of capital. That's it, that's all.
The pension obligation bond scam is going to come crashing down when the next financial crisis hits.

When will that be? That's the multi-trillion question but like John, I worry that the next "Big One" will be a lot rougher and last a lot longer.

Right now, it's steady as she goes, everyone keeps buying those FAANG stocks. I was listening to CNBC earlier today that Netflix (NFLX) is up almost 100% year-to-date and some analyst was saying it's going much, much higher and the same thing goes for Amazon (AMZN):



"Son, those are mighty bullish charts there, don't fight the trend, do what all the big hedge funds are doing and buy more of them FAANG stocks!"

Have you ever seen the movie "The Untouchables" where Robert De Niro plays mob boss Al Capone and takes out a baseball bat as he discusses "teamwork" with his lieutenants?



It's a gruesome scene but sometimes I think a lot of portfolio managers laughing it up, buying these FAANG stocks, playing momentum are going to get whacked so hard when they least expect it, it's going to clobber them and their unsuspecting investors.

But as we all know, markets can stay irrational longer than you can stay solvent, so keep dancing as long as the music is playing, just make sure you're hedging accordingly and taking money off the table when your positions run up a lot.

As far as the great pension train wreck, nothing to worry about yet, however, the sooner people realize the current course of action in the US isn't sustainable and they need to adopt elements of Canadian success (world class governance, shared risk model), the better off the US will be.

One thing I can tell you, beware of pension obligation bonds, they're bad for your fiscal and financial health. While CPPIB issues green bonds, US state and local governments are issuing more pension bonds. Watch Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

And don't believe all the bad news on US Social Security. Former Social Security Commissioner Mike Astrue discusses reports that Social Security is dipping into its reserves for the first time since 1982. Great discussion, he addresses many myths and alludes to the success of other countries "privatizing" their Social Security but doesn't talk about the success of the Canada Pension Plan.

Bottom line: The great pension train wreck is headed our way but the situation isn't as dire as John Mauldin and others make it out to be, at least not yet (that can easily change if a crisis whacks us).


Friday, June 15, 2018

Who's to Blame For Bumpy Markets?

Jeff Cox of CNBC reports, Trump's contradictions are swinging the stock market this year:
Looking for a reason why the market's been so bumpy this year? Blame Trump. Looking for a reason why the market has held up so well this year? Blame Trump.

There's been a overriding paradox this year for investors: President Donald Trump has been both a blessing and a curse, goosing stocks through tax cuts and vexing the market with a seemingly endless stream of gut-churning headlines.

"We don't recall a President who has been simultaneously so bullish and bearish for stocks," Ed Yardeni, head of Yardeni Research, told clients in a note earlier this week. "That might explain why the S&P 500 has been zigging and zagging since the start of this year."

Actually, the market's done pretty well for itself lately.

After a wickedly volatile first quarter that saw major averages foray into correction territory, stocks have bounced back nicely. The S&P 500 is now up 4 percent for the year, thanks to a nearly 8 percent jump since early April, and the Dow industrials have posted a 1.8 percent increase.


Tech stocks continue to lead the market, with the Nasdaq surging 12.4 percent.

Yardeni, an economist and market strategist, said actions and policies specific to Trump can be tied to the market's ups and downs. He cited a J.P. Morgan report that looked at market behavior and determined that tariff threats by the administration had held stocks back by 4.5 percent since March, resulting in a $1.25 trillion slice in market cap.

"I guess we can blame Trump for that loss thanks to his protectionist saber-rattling. On the other hand, he deserves credit for enacting a HUGE corporate tax cut at the end of last year," Yardeni wrote.

Republicans pushed the largest tax cut in U.S. history through Congress in December, a $1.5 trillion reduction that Yardeni said lowered taxes by 36 percent for nonfinancial corporations in the first quarter.

"We think the market is telling us that the signal is earnings that have been supercharged by the tax cut, while the noise is protectionist saber-rattling," he added. "That's been great for cyclical and growth stocks."

In fact, Yardeni said the Federal Reserve and its interest rate hikes have rattled the market more than Trump.

The central bank enacted its second interest rate increase of 2018 on Wednesday and indicated that two more quarter-point increases are on the way before the end of the year. In addition, the Fed is tightening monetary policy further through the reduction in bond holdings on its balance sheet.

However, the market looked to be headed for a loss Friday after Trump announced tariffs on Chinese technology imports that would amount to about $50 billion.

Overall, though, Trump has fared better than most of his predecessors at this point in his term.

Earlier this month, he observed his 500th day in office with the best Dow performance of any president since George H.W. Bush in 1989-90, and sixth-best among the 20 presidents since the turn of the 20th century, according to LPL Research.

Investors remain skittish, though, and have pulled $60.3 billion out of funds that focus on U.S. stocks, according to Investment Company Institute data through April.
Love him or hate him, President Trump has been very busy lately warming up to North Korea's leader as he rebuffs his G7 allies and he was back at it on Friday, slapping 25% tariffs on up to $50 billion of Chinese goods.

So what gives? I must admit, people don't understand Trump but as far as I'm concerned, he's as transparent as you can get.

First, he passed the largest tax cut in US history which mostly benefitted large corporations. That's the number one reason why the stock market keeps rising and that's why even though corporate America hates any prospect of a trade war, CEOs are not publicly criticizing Trump's administration.

Second, his protectionist saber-rattling is just feeding his base, working-class Americans who lost or are scared of losing their well-paid manufacturing jobs. We can argue whether these policies are doing more harm than good, but for Trump, it's all about optics and garnering votes.

In early April, I wrote a comment on whether trade wars will crash the market and I said "no". I still think trade wars are being blown way out proportion and while it's possible they escalate and have a material impact on the global economy, I still believe cooler heads will prevail before we reach the point of no return.

However, that's where my good news ends.

The problem right now isn't Trump or trade wars, the problem is the Fed hiking rates and signaling it will continue hiking rates.

People get all emotional on Trump but they're missing the bigger picture, the global economy is slowing and there's not a damn thing Trump can do about it. He's running out of fiscal bullets.

Have a look at the chart below, courtesy of Denis Ouellet's Edge and Odds blog, a great blog to track even if I don't agree with all his contrarian calls (click on image):


Denis got this chart from Angel Talavera on Twitter and it basically shows you what I'm worried about, the global economy is slowing with Eurozone leading the way and emerging markets and the US not far behind.

No wonder ECB president Mario Draghi was dovish in his statement this week, walking a very fine line between the end of QE as he tries to manage market expectations:



The euro (FXE) got crushed on Thursday and so did a lot of other currencies as the US dollar (UUP) surged close to 52-week highs:


The greenback's strength was something I predicted last year when everyone was short US dollars but it's getting a bit overdone here and along with Draghi's dovish comments, it's been wreaking havoc on emerging market currencies, stocks (EEM) and bonds (EMB) (click on images):




Now, the carnage in emerging markets isn't pretty and definitely signals a Risk-Off market. And there could be more pain ahead for emerging market stocks (EEM) and bonds (EMB) especially if trade wars escalate (click on images):



Those 5-year weekly charts above make a lot of emerging market bulls very nervous as these charts are definitely not bullish.

But Mehran Nakhjavani, Partner, Emerging Markets at MRB Partners thinks talk of an EM debt crisis is just plain silly:
There is no imminent threat of an EM debt crisis. While EM international bonds outstanding are indeed at historic highs, expressed as a share of GDP, the growth of issuance is primarily from the private sector, the latter dominated by China. For ex-China EM economies, the most recent growth has come from government issuers, with Saudi Arabia, Qatar and the UAE accounting for much of it.

As a general rule, history suggests that debt crises result from a loss of momentum of the denominator of the typical debt ratios. In other words, a deterioration in the overall ability of an economy to sustain debt and its servicing. A growth of the numerator, for example as a result of rising interest rates, is typically not the trigger for crisis, except in extreme cases.

Even if the current synchronized global economic expansion were to slow down, the debt fundamentals of many EM economies are far superior to what prevailed prior to previous EM debt crises. There will be a case to be made for impending crises in some vulnerable EM economies, but absent a 2008-style global credit crunch it is hard to see any meaningful overall threat to EM debt on a 6-12 month investment horizon.
If Mehran is right, the sell-off in emerging market stocks (EEM) and bonds (EMB) is another buying opportunity for long-term investors looking to increase their exposure to emerging markets.

Of course, there are many ways to play emerging markets here like going long the Canadian dollar (FXC) or buying US stocks like Caterpillar (CAT), Deere & Company (DE), Freeport McMoRan (FCX) or just follow Warren Buffett and buy Apple (AAPL).

But China is making people very nervous these days, including the folks at Variant Perception who think it's presenting headwinds to industrial commodities (h/t: Dan Esposito):
Our macro-driven model of expected industrial commodity returns (the CRB Raw Industrials Index includes non-exchange traded commodities such as burlap, rubber and lead scrap) has turned persistently negative, triggering the regime to shift to bearish from neutral (top left chart). This has been driven by tight Chinese liquidity conditions and the peak in global growth. The top-right chart shows that our BCFI Index has peaked and turned down, suggesting headwinds for global growth and commodity prices. Slowing EM real money growth (bottom-left chart) will also be a headwind, as is slower Chinese growth indicated by our leading indicators (bottom right chart).

So far this year, commodity markets have held up very well despite rising real yields and the recent rebound in the US dollar. This is likely reflective of late-cycle inflationary dynamics which tend to help commodities outperform as the economic cycle matures going into recessions. However, given the negative signal given by our forecast model and weak China leading indicators, for investors with industrial commodity exposures, it makes sense to buy puts to hedge against industrial-commodity price falls over the next 6 months (click on image to enlarge).


If you look at China's Large-Cap ETF (FXI), it's sitting on its 50-week moving average (click on image):


The chart isn't telling me to panic just yet, in fact, it could reverse course and head higher but all that remains to be seen.

One thing I can tell you is emerging market currencies getting slaughtered is actually good for many emerging markets relying on exports for growth. The problem, of course, is rising US protectionism can exacerbate this sell-off.

But there's a limit to what Trump and more importantly, the Fed, can do without risking a much bigger surge in the US dollar, sowing the seeds of the next global financial crisis. If Trump keeps laying tariffs and the Fed keeps raising rates, the US dollar will keep surging to new highs and that could unleash unbearable global pain.

Capiche? So take all this talk of trade wars and the Fed hiking rates a couple of more times this year with a grain of salt. If they continue on this trajectory, it's game over and they know it.

This is why I maintain that in the short run, the surge in the US dollar and sell-off in emerging markets is a bit overdone and we might see a relief rally this summer.

Longer term, however, I see a global slowdown ahead which is why I maintain a more cautious stance, especially in Q4 where we will see the creeping effects of the Fed's rate hikes start to bite.

Also, trade tensions are giving a much-needed boost to defensive stocks like Kraft Heinz (KHC), Campbell Soup (CPB)  and other consumer staple stocks (XLP) but if this turns out to a rough and not soft patch, only US long bonds (TLT) will save your portfolio from being clobbered.

One thing I can tell you, it's still a bull market in stocks but you need to pick ‘em well. Have a look at shares of Canada Goose (GOOS) today as it beat on its top and bottom line (click on image):


Its shares have more than tripled over the last year but don't chase this hot stock now (never chase any hot stock or you'll get burned alive!!).

The point I'm trying to make is turn off CNN, FOX, and CNBC, there's a lot of noise out there but in my universe, there are plenty of stocks to trade and some are doing very well (click on image):


So stop blaming Trump for everything, focus here, the market isn't breaking down just yet, there's still plenty of liquidity driving risky shares higher, you just have to pick your spots very carefully and hope the tide doesn't turn anytime soon. And again, don't chase stocks here, any stocks, because you risk being burned!

On that note, enjoy your weekend and please remember to kindly donate to this blog via PayPal on the right-hand side under my picture.

Today, I quietly celebrate my ten-year anniversary. It's been quite a journey and I want to thank those of you who have supported my efforts in every way and helped this blog achieve its success. Writing a daily blog isn't easy, far from it. It takes tremendous discipline, dedication and it's nice to see people appreciate the work that goes into it, so thank you for your support.

I will also ask many of you who regularly read this blog to please donate to the Montreal Neurological Institute here. I was diagnosed with MS exactly 21 years ago and even though it hasn't been easy, I count myself very lucky. The folks at the MNI are doing a great job helping patients with all neurological diseases so please help them any way you can. Thank you.

Below, Paul Tudor Jones, founder of Tudor Investment Corporation and the Robin Hood Foundation, speaks with CNBC's Andrew Ross Sorkin on the market reaction to US talks with North Korea, his forecast for the Federal Reserve and his take on socially responsible investing.

I don't agree with Tudor Jones's forecast on rates but this was an excellent interview, one well worth watching as he discusses many interesting topics and not just markets.

And in an exclusive interview, top-ranked portfolio strategist François Trahan explains the changing market leadership and why it’s predictable. He speaks with Consuelo Mack of WealthTrack. Great interview, I have learned a lot reading François's research at Cornerstone Macro, it's truly fantastic.


Thursday, June 14, 2018

Ontario's New Kid on the Block?

Rick Baert of Pensions & Investments reports, Ontario provincial manager sees progress made, more work ahead:
Imagine an institutional money management startup — one seeded with about C$56 billion ($43.6 billion) to invest and a potential client base of as many as 75 public pension funds, endowments and foundations, and other asset pools in Canada’s largest province.

That’s been what Bert Clark has been overseeing as he leads the Investment Management Corp. of Ontario, Toronto, through its formative first year. Created by the Ontario Parliament in 2016, it was launched last July and now manages money for the C$29.4 billion Workplace Safety and Insurance Board and the Ontario Pension Board, which administers the C$26.4 billion Public Service Pension Plan, Toronto. The two asset owners have provided assets and investment staffs to create the foundation for the new firm, which operates independently from the Ontario government.

Mr. Clark’s first order of business since becoming IMCO’s president and CEO in October 2016 was combining the investment management cultures of two somewhat disparate public agencies — a pension plan and workers’ compensation organization.

“I spent my first six months merging, frankly,” Mr. Clark said in an interview at IMCO’s Toronto offices; “merging two organizations with all of the types of challenges that are typical in any merger, regardless of the type. We had two compensation schemes, two different risk systems, employees were in two different benefit programs, we had two different IT systems, we had two different segregated portfolios. And so we had to figure out how to bring all those people and capabilities into one organization. Effectively, what we were negotiating was a joint venture agreement to establish IMCO between WSIB and OPB.”

With that well underway, Mr. Clark now can direct IMCO’s attention to its prescribed goal of managing assets — not for the large Toronto-based provincial plans like the C$189.5 billion Ontario Teachers’ Pension Plan, Toronto, but for the 75 pension plans, endowments and other public institutions in Ontario, each with assets in the hundreds of millions of dollars, that are targeted by IMCO as prospective clients, Mr. Clark said.

“We completed what I would call Phase I of the project, which was merge the two organizations,” Mr. Clark said.

The second and third phases, which in some cases are happening at the same time, are now underway with a goal of bringing on external clients sometime in 2019.

“Phase II is to take what we inherited and turn it into an institutional asset manager capable of taking on more clients,” Mr. Clark said. “That’s no small task because what we inherited was investment capabilities from two organizations, but not the full suite of capabilities you would expect from an asset manager. Phase III is enhancing our investment capabilities. We want to provide a better platform, but to go beyond that, to have great portfolio construction capabilities that offer more asset classes than (asset owner clients) have today. There’s a big appetite for infrastructure, for example ... also to provide great risk reporting. That’s going to take a few years, to be honest.”

IMCO was modeled after government-created public money managers like the C$298.5 billion Caisse de Depot et Placement du Quebec, Montreal; C$135.5 billion British Columbia Investment Management Corp., Victoria; and the C$103.7 billion Alberta Investment Management Corp., Edmonton. But unlike those organizations, which are mandated to manage assets for all public asset owners in their provinces, membership among asset owners in the Ontario corporation is voluntary, Mr. Clark said. So IMCO executives have to learn how to market the organization.

“For example, (WSIB and OPB) didn’t have a head of client service. They had no external clients; they were internal investment teams. But if you’re going to solicit clients, you better have someone to interact with clients. They didn’t have a standardized way of reporting to clients. Why would they? They had internal reporting documentation, which looks quite different from what you’d need to construct for clients. So we had to build up that capability. ... We needed to develop products for clients. We didn’t have any products; we had two segregated portfolios. We had to take what we got and turn that into a full set of products. So that’s Phase II, which we’re in right now.”

IMCO clients will control their own asset allocation, similar to the model in Alberta, British Columbia and Quebec, and like them, IMCO will provide advice on any allocation questions. “They can’t delegate 100% discretion to us,” Mr. Clark said, “but it’s important to use our investment expertise to provide advice on allocations, risk tolerance, time horizons.”

Ultimately, IMCO will offer 15 strategies “that clients can assemble the way that suits their particular investment beliefs and liabilities,” Mr. Clark said. “It’s actually anything but a one-size-fits-all platform. We’re trying to construct a set of products they can assemble in a variety of permutations and combinations. ... We’re trying to see what range of products you could offer a client, sit down with them and meet almost everyone’s liabilities.”

Currently IMCO has eight asset-class strategies that came from WSIB and OPB: public equities, fixed income and money market, real estate, diversified markets, infrastructure, absolute return, private equity and private debt. Neil Murphy, IMCO spokesman, said the seven asset classes that will be part of the new product suite are still being formed but will “evolve” from those that currently exist.

In alternative investments, Mr. Clark said IMCO won’t necessarily have a disadvantage in generating returns or in competing for deals with the large public plans in Ontario that have been internally managing private markets, infrastructure and real estate for years. “The alternative asset classes are less ‘alternative’ today than they were 15 to 20 years ago,” Mr. Clark said. “They’ve become pretty accepted as parts of a typical portfolio. Twenty-five years ago, what was cutting edge at (Ontario) Teachers, to get involved in infrastructure, private equity, real estate in a direct way, is no longer a distinguishing investment strategy. All the large Canadian institutions are doing it and doing it directly. I think it’s still worth us being in those asset classes, but nobody should expect too much ifferentiation in returns for merely being in those asset classes.”

He said IMCO will set itself apart from the other provincial public plans on alternatives by creating its own specializations.

“It’s not enough to just say, ‘I’m going to be doing infrastructure, I’m going to be doing it internally.’ You have to say, ‘I’m going to be doing infrastructure, I’m going to be doing it internally, and I’ve got some differentiating expertise,’” he said. “We’re comfortable with construction risk in greenfield infrastructure, and we’ve developed an expertise in that regard. That makes you different from everybody else. We will show up if we can bring something distinctive to ownership of that asset class or that particular investment. ... That’s one of the advantages of showing up 25 years after everyone else ... Our organization doesn’t reflect the strategies of 10, 15 years ago that may be less powerful now.”
I want to first thank IMCO's Andrea DiNorcia for bringing this article to my attention. Andrea works in HR and Communications and posts a lot of great material on LinkedIn.

Bert Clark is a smart man. Having helped Gordon Fyfe ramp up private equity, infrastructure and timberland at PSP and warning the Board back in 2005 to steer clear of commodities as an asset class, my best advice to him is don't follow the pension herd and don't be scared to think and act differently.

But in order to do this, IMCO has to hire top talent and it's lucky because it's based in Toronto, the heart of Canada's pension ecosystem. There is a lot of talent on the street right now in Toronto (and Montreal) looking to join an organization like IMCO.

So far, the timing hasn't been right but I think things are slowly changing and I expect some announcements in the weeks and months ahead (you can track IMCO's news releases here).

IMCO first had to deal with the merger of two distinct entities, WSIB and OPB, but that seems to be almost done and they can now focus on Phase II which is taking on more clients and Phase III which is managing assets.

My advice to IMCO's clients is to delegate 100% discretion to IMCO's staff when it comes to asset allocation. Sure, you can work with your actuaries and consultants but at the end of the day, you need to trust your investment managers.

Having many clients isn't always easy, nor efficient. Ontario Teachers' has an advantage over an AIMCo, BCI or Caisse because its clients are all teachers, it's much easier managing assets and liabilities when you have one client.

Part of the challenge IMCO will have is to juggle competing sets of interests and recommending the right strategies to its clients depending on their liabilities and risk tolerance.

In this regard, IMCO is acting like a multistrategy hedge fund which offers bespoke strategies to each of its clients, not a single multistrategy fund for all clients.

As far as strategies, Mr. Clark is already signalling he's not afraid to venture into terrain Canada's large pensions typically avoid, like greenfield projects. Keep in mind, Bert Clark was the former CEO of Infrastructure Ontario, so if it's one thing he knows very well is PPPs and taking on construction risk.

I recently wrote about the Caisse's greenfield revolution, discussing the massive $6.3 billion REM project where I said the Caisse is doing something no other pension has done and if successful, will likely transform the way governments finance, construct and operate their infrastructure projects.

I barely had time to end that comment when all the naysayers came at me with skeptical emails questioning Michael Sabia's 8-9% return expectations and also questioning the governance of this project. One guy even asked me: "Why didn't the government do a big RFP for this REM project?".

My simple answer is nobody would have done it. The typical PPPs are much smaller in scale and the construction companies get big subsidies to construct, they also put down no or negligible equity, get financed by banks (debt) and incur no revenue risk.

The Caisse is putting down 55% equity, bears construction and  revenue risk so if something goes wrong, it will need to put more money into the project. In other words, the Caisse has significant skin in the game which is what you want when investing in a greenfield infrastructure project.

There's no way a Macquarie or even Brookfield would have assumed such risk, they would have piled on the debt and walked away at the first sign of trouble (at least Macquarie).

As far as other governance matters, it's not Michael Sabia and Claude Bergeron calling the shots. Of course there are external verifications taking place and it's public knowledge the Auditor General of Quebec is looking into all aspects of this project and will shortly come out with a public report.

And Sabia's 8-9% figure for the REM project is pretty conservative if you ask me. Again, it's a greenfield project so the Caisse is incurring construction and revenue risk, but if all goes well, it should be able to deliver 200-300 basis points premium above brownfield infrastructure investments which yield 5-6% in this environment.

Bert Clark knows all this. I'm not saying he's going to go out and bet the farm on one huge greenfield infrastructure project but given his experience, he's right to look into greenfield projects in an environment where brownfield assets are being bid up to nosebleed levels, negatively impacting their future returns.

What other strategies will IMCO engage in? That all remains to be seen but I'm getting very nervous on credit strategies including private debt or alternative lending which everyone is jumping on these days as they reach for higher yield.

Below, take the time to watch AIG's CIO Doug Dachille who appeared on CNBC earlier today. Great interview, I love this guy, he knows what he's talking about. "I'm in the business of trying to earn spread on where I price liabilities and where to invest." (sorry, only Pro subscribers can watch the full interview so I added a brief clip of him providing perspective to the fixed income space in a low-rate environment.)

He said AIG has long-dated liabilities and a very large commercial loan portfolio lending to businesses where banks don't lend but he noted that illiquidty spreads in this space have come down considerably as many new players (like Canada's large pensions) enter the space.

Like I said, private debt makes me very nervous, too many players chasing fewer and fewer deals.

As far as Ontario's new kid on the block, I wish Bert Clark and the folks at IMCO all the best as they get ready to roll out Phase II and III. If you're looking for some consulting advice, feel free reach out to me and I'll be glad to chat with you.

Update: Mathieu St-Jean brought to my attention that Jean Michel, the former Executive VP,  Depositors and Total Portfolio at the Caisse, was just named CIO at IMCO (click on image):


I am happy for Jean Michel and think this is a great decision on IMCO's part. Mr. Michel did wonders turning Air Canada's Pension around (bringing it back to fully funded status) and I think his knowledge and experience will prove invaluable at IMCO.


Wednesday, June 13, 2018

PSP Investments Gains 9.8% in Fiscal 2018

Benefits Canada reports, PSP Investments posts 9.8 per cent return for fiscal 2018:
At the end of its 2018 fiscal year, the Public Sector Pension Investment Board posted a net return of 9.8 per cent, representing $13.5 billion in income.

While the result wasn’t as hefty as last year’s 12.8 per cent, the fund beat its benchmark portfolio return of 8.7 per cent. The increase in assets marks a 12.9 per cent jump from the prior fiscal year.

“This is a year we can be proud of,” said Neil Cunningham, president and chief executive officer at PSP Investments, in a press release. “We sustained performance over a year marked by market volatility, which shows clearly that our strategic focus on increased diversification is generating returns.

“Once again, our people highlighted the possible in their active commitment to our shared purpose: to contribute to the financial security of the contributors and beneficiaries who have served Canada throughout their careers.”

PSP Investments saw an 8.3 per cent return from public equities, the largest component of its portfolio at 50.1 per cent. It experienced strong gains for most of the year with increased volatility coming into play largely in the fourth quarter, the release noted.

The fund’s $15 billion of infrastructure investments was also a standout, yielding a 19.3 per cent return, with real estate also posting a particularly strong result of 13.6 per cent. Private equity fared much better than the previous fiscal year when it posted an overall loss of 3.4 per cent. This year, it returned 12.9 per cent, with $19.4 billion under management. The fund attributes the stronger results to valuation gains, primarily in the financial and industrial sectors.

PSP Investments’ private debt portfolio, which returned 8.2 per cent, more than doubled in the 2018 fiscal year, to $8.9 billion from $4.5 billion. Notably, the fund significantly increased its debt allocation in Europe, which now accounts for 24 per cent of its global private debt portfolio, up from eight per cent the previous year.

Natural resources also saw double-digit returns, yielding 11.2 per cent versus its 3.1 per cent benchmark. In the 2018 fiscal year, the fund increased its allocation to agriculture within that segment, which now accounts for $2 billion in assets.

PSP Investments also made a number of appointments in the last fiscal year, including Pierre Gibeault as managing director and head of real estate investments, Simon Marc as managing director and head of private equity, Patrick Samson as managing director and head of infrastructure investments and Marc Drouin as managing director and head of natural resources.

“Our talented, high-performing people and expanded global footprint have allowed us to spot the edge and deliver solid and consistent results,” said Cunningham. “Our vision is to be a leading global institutional investor, a partner of choice to the investment world and an enabler of complex investments.”
James Comtois of Pensions & Investments also reports, PSP Investments returns 9.8% for fiscal year, tops benchmark:

PSP Investments, which manages the assets of the C$153 billion ($118.2 billion) Public Sector Pension Investment Board, Ottawa, returned a net 9.8% in the fiscal year ended March 31, above the policy benchmark of 8.7%, a news release said.

The best-performing asset class was infrastructure, which returned a net 19.3% compared to its 12.1% benchmark return, followed by real estate at a net 13.6% return, vs. its 12.3% benchmark return; private equity, 12.9% vs. its 17.6% benchmark; natural resources, 11.2% vs. its 3.1% benchmark; public markets, 8.3% vs. its 7.7% benchmark; and private debt, 8.2% vs. its 2.3% benchmark.

The overall five-year annualized net return was 10.5%, above the policy benchmark's 9.4% return. Its 10-year net annualized return of 7.1% was above the return objective of 5.8%.

As of March 31, the actual allocation was 50.1% public markets, 15.2% real estate, 12.7% private equity, 9.8% infrastructure, 5.8% private debt, 3.2% natural resources, and the rest in cash and cash equivalents.
And Steve Randall of Wealth professional reports, PSP chief: "This is a year we can be proud of":
The boss of Canada’s Public Sector Investment Board has expressed his pride in its annual results which have seen a 12.9% growth in net assets.

PSP Investments ended the fiscal year March 31, 2018 with net assets of $153.0 billion, compared to $135.6 billion the previous fiscal year; a one-year total portfolio net return of 9.8% on its investments; and generated $13.5 billion of net income, net of all PSP costs. This return is significantly greater than the Policy Portfolio benchmark return of 8.7%.

"This is a year we can be proud of," said Neil Cunningham, President and Chief Executive Officer at PSP Investments. "We sustained performance over a year marked by market volatility, which shows clearly that our strategic focus on increased diversification is generating returns."

Where PSP gained the most

The results show that PSP Investments saw gains across its portfolio, smashing benchmarks:
  • Public Markets had net assets under management of $76.7 billion, a decrease of $0.5 billion from fiscal year 2017, and generated investment income of $6.3 billion, for a one-year return of 8.3%, compared to a benchmark of 7.7%.
  • Real Estate had $23.2 billion in net assets under management, up by $2.6 billion from the previous fiscal year, and generated $2.8 billion in investment income, resulting in a 13.6% one-year return versus 12.3% for the benchmark.
  • Private Equity had net assets under management of $19.4 billion, $3.5 billion more than in fiscal year 2017, and generated investment income of $2.1 billion, for a one-year return of 12.9%—versus a 3.4% loss in fiscal year 2017—compared to a benchmark return of 17.6%.
  • Infrastructure had $15.0 billion in net assets under management, a $3.9 billion increase from the prior fiscal year, and generated $2.3 billion of investment income, leading to a 19.3% one-year return, relative to the benchmark return of 12.1%.
  • Private Debt had net assets under management of $8.9 billion, an increase of $4.5 billion from the prior fiscal year, and generated net investment income of $569 million, resulting in an 8.2% one-year return, compared to a benchmark of 2.3%.
  • Natural Resources had net assets under management of $4.8 billion, an increase of $1.1 billion from the previous fiscal year, and generated record investment income of $450 million, for a one-year return of 11.2%, versus the 3.1% benchmark.
Talented people helping vision of leading global investor

"Our talented, high-performing people and expanded global footprint have allowed us to spot the edge and deliver solid and consistent results," Mr. Cunningham said. "Our vision is to be a leading global institutional investor, a partner of choice to the investment world and an enabler of complex investments. We have the knowledge, talent, systems and flexibility to seize global opportunities as they arise."
PSP Investments put out a press release, PSP Investments posts strong performance in fiscal year 2018. Net return of 9.8% brings net assets to $153.0 billion:
  • One-year total portfolio net return of 9.8% generated $13.5 billion of net income, net of all PSP costs.
  • Five-year annualized net return of 10.5% which is 1.1% above the Policy Portfolio benchmark return.
  • Ten-year net annualized return of 7.1% generated $23.8 billion of cumulative net investment gains above the return objective of 5.8%.
The Public Sector Pension Investment Board (PSP Investments) announced today that it ended its fiscal year March 31, 2018 with net assets of $153.0 billion, compared to $135.6 billion the previous fiscal year, an increase of 12.9%. The investment manager reported a one-year total portfolio net return of 9.8% on its investments and generated $13.5 billion of net income, net of all PSP costs. This return is significantly greater than the Policy Portfolio benchmark return of 8.7%.

“This is a year we can be proud of,” said Neil Cunningham, President and Chief Executive Officer at PSP Investments. “We sustained performance over a year marked by market volatility, which shows clearly that our strategic focus on increased diversification is generating returns. Once again, our people highlighted the possible in their active commitment to our shared purpose: to contribute to the financial security of the contributors and beneficiaries who have served Canada throughout their careers.”

Net assets increased by $17.4 billion in fiscal year 2018, attributable to net income of $13.5 billion and net contributions of $3.9 billion. All asset classes saw strong returns.

Asset Class Highlights (click on image)


As of March 31, 2018:

Public Markets had net assets under management of $76.7 billion, a decrease of $0.5 billion from fiscal year 2017, and generated investment income of $6.3 billion, for a one-year return of 8.3%, compared to a benchmark of 7.7%. Public Markets continued to generate significant returns in fiscal year 2018, despite increased geopolitical risk, market volatility and rising interest rates, mainly during the fourth quarter. At fiscal 2018 year-end, net assets managed in active strategies totalled $45.8 billion, up from $38.8 billion the previous year, while net assets managed in internal active strategies totalled $31 billion, up from $24.6 billion.

Real Estate had $23.2 billion in net assets under management, up by $2.6 billion from the previous fiscal year, and generated $2.8 billion in investment income, resulting in a 13.6% one-year return versus 12.3% for the benchmark. Fiscal year 2018 was a year of stabilization and consolidation, reflecting the maturity of the Real Estate portfolio. The group achieved strong performance despite an ongoing low-yield environment. During fiscal year 2018, Pierre Gibeault was appointed Managing Director and Head of Real Estate Investments.

Private Equity had net assets under management of $19.4 billion, $3.5 billion more than in fiscal year 2017, and generated investment income of $2.1 billion, for a one-year return of 12.9%—versus a 3.4% loss in fiscal year 2017—compared to a benchmark return of 17.6%. The strong increase in fiscal year 2018 performance was mainly driven by strong valuation gains, notably in the financial and industrial sectors, but was partially offset by underperformance of certain investments. However, investments completed in the last three years, representing $9.9 billion of assets, have generated returns significantly above benchmark. Private Equity deployed a total of $4.4 billion (including $2.3 billion in new direct investments and co-investments) and committed a total of $4.1 billion for future deployment through 17 funds, 11 of which are with new fund partners. During fiscal year 2018, Mr. Simon Marc was appointed Managing Director and Head of Private Equity.

Infrastructure had $15.0 billion in net assets under management, a $3.9 billion increase from the prior fiscal year, and generated $2.3 billion of investment income, leading to a 19.3% one-year return, relative to the benchmark return of 12.1%. The group deployed $3.3 billion in fiscal year 2018, including $2.2 billion in direct investments. During fiscal year 2018, Mr. Patrick Samson was appointed Managing Director and Head of Infrastructure Investments.

Private Debt had net assets under management of $8.9 billion, an increase of $4.5 billion from the prior fiscal year, and generated net investment income of $569 million, resulting in an 8.2% one-year return, compared to a benchmark of 2.3%. The group deployed net $4.3 billion across over 30 transactions, including investments in revolving credit facilities, first and second lien term loans, and secured and unsecured bonds. The group’s London team made great strides toward its long-term portfolio allocation target, with European assets under management accounting for 24% of the global Private Debt portfolio, up from 8% the prior year.

Natural Resources had net assets under management of $4.8 billion, an increase of $1.1 billion from the previous fiscal year, and generated record investment income of $450 million, for a one-year return of 11.2%, versus the 3.1% benchmark. The increase in net assets under management resulted primarily from $864 million in net deployments and $332 million in valuation gains. Income was driven by strong cash flows and valuation gains. The group made significant progress again this year in diversifying its investments into the agriculture sector, which now account for $2 billion of assets under management. During fiscal year 2018, Mr. Marc Drouin was appointed Managing Director and Head of Natural Resources.

Corporate Highlights
  • Our Board of Directors appointed Neil Cunningham as President and CEO on February 7, 2018. Prior to this appointment, Mr. Cunningham served as PSP’s Senior Vice President, Global Head of Real Estate and Natural Resources at the organization.
  • We launched our Inclusion & Diversity (I&D) Forum and initiated an I&D Council co-chaired by Mr. Cunningham, for whom an active commitment to inclusion and diversity is a top priority.
  • We also received an important accolade by being recognized as one of MontrĂ©al’s Top Employers.
  • This year’s annual report marks the launch of PSP’s new brand, Spot the Edge, which embodies our passion for exploring every angle, across asset classes, markets and industries, to broaden our perspectives and hone in on opportunities.
  • We continued to integrate environmental, social and governance factors into our investment decision-making process across asset classes. Significant progress was made on all pillars of our responsible investment strategy. Our second annual Responsible Investment Report can be consulted here.
“Our talented, high-performing people and expanded global footprint have allowed us to spot the edge and deliver solid and consistent results,” Mr. Cunningham said. “Our vision is to be a leading global institutional investor, a partner of choice to the investment world and an enabler of complex investments. We have the knowledge, talent, systems and flexibility to seize global opportunities as they arise.”

For more information on PSP Investments’ fiscal year 2018 performance, please visit our dedicated microsite at www.investpsp.com or download the annual report here.

About PSP Investments

The Public Sector Pension Investment Board (PSP Investments) is one of Canada's largest pension investment managers with $153 billion of net assets as of March 31, 2018. It manages a diversified global portfolio composed of investments in public financial markets, private equity, real estate, infrastructure, natural resources and private debt. Established in 1999, PSP Investments manages net contributions to the pension funds of the federal Public Service, the Canadian Forces, the Royal Canadian Mounted Police and the Reserve Force. Headquartered in Ottawa, PSP Investments has its principal business office in Montréal and offices in New York and London. For more information, visit investpsp.com or follow us on Twitter and LinkedIn.
Before I begin my analysis, take the time to peruse PSP's revamped website here and more importantly, take the time to read the fiscal 2018 annual report which is available here.

At a minimum, you should take the time to review the highlights (pages 6-7), mindful investing through the ESG lens (pages 8-10), main corporate objectives (pages 10-11) and then take the time to read the Chair's message (pages 14-15) as well as the President's report (pages 17-18).

Martin J. Glynn, PSP's Chair of the Board, discussed three key Board projects:
Policy Portfolio

The Board of Directors approves, and annually reviews, the Statement of Investment Policies, Standards and Procedures (SIP&P), which governs the strategic allocation of assets, known as the Policy Portfolio. This year, the Treasury Board of Canada communicated to PSP a lower 10-year real rate of return target. The Board reviewed and approved adjustments proposed by management, which reduce the pension funding risk, while maintaining the Policy Portfolio’s ability to generate a comfortable return margin above the Reference Portfolio. (See the MD&A on p. 34 for more details.)

Succession planning

With the departure of two directors and the terms of other directors having expired or ending in the near future, the Governance Committee and the Board focused considerable energy in fiscal year 2018 on ensuring that a strong succession planning and director onboarding process is in place for individual directors, as well as committee chairs. The HRCC also supported the organization’s mandate toward top-tier practices in succession planning for management.

The management succession plan was put to the test this year, and it proved successful, in allowing us to appoint Neil as President and CEO.

Climate change

The Board worked closely with the organization’s Responsible Investment team to initiate a review of the portfolio’s exposure to climate change risk and developed tools to ensure those risks are incorporated into PSP’s underwriting and decision-making. This entails developing and implementing investment policies and processes to make the portfolio more resilient to the impacts of climate change, as well as encouraging enhanced disclosure on climate change risks by companies in which PSP invests. Read more about this in our separate 2018 Responsible Investment Report.
The most important thing that caught my eye in the Chair's message was that the Treasury Board of Canada communicated to PSP a lower 10-year real rate of return target.

One of the most important pages in the annual report is page 36 which explains the link between the Return Objective, Reference Portfolio, Policy Portfolio and Active Portfolio (click to enlarge):


As you can read, In fiscal year 2018, TBS lowered the long-term Return Objective to 4.0%, down from 4.1%. TBS also introduced a real Return Objective of 3.3% for the next 10 years.

It's my understanding that important discussions took place between the Treasury Board, the Office of the Chief Actuary and PSP in regards to the real return target over the last few years and basically it was communicated that we will be in a low rate, low return world for a prolonged period and the return objective must be lowered to achieve targets taking an acceptable level of risk.

As far as Policy Portfolio benchmarks, I note the following on page 39:
During fiscal year 2017, as part of the review of our compensation framework, we reviewed the benchmarks of many asset classes to improve their alignment with their respective investment strategies and market performance. The revised benchmarks came into effect on April 1, 2017 and were used to evaluate our performance for fiscal year 2018.

The benchmarks in the table below were used to measure fiscal year 2018 relative performance for each asset class set out in the SIP&P as well as for the overall Policy Portfolio (click on image).


Benchmarks are very important, they have to reflect the underlying risks being taken and must be in line with the overall return long-term return target of the organization.

I would have liked to have seen a detailed discussion on benchmarks in regards to PSP's private market asset classes: private equity, infrastructure, real estate and natural resources.

Instead, the first footnote states: "Thee customized benchmark is determined as the sum of the asset class’ Long-Term Capital Market Assumptions and a market adjustment to capture short-term market fluctuations."

Now, from the press release, let's focus on the performance of private markets including private debt:
  • Real Estate had $23.2 billion in net assets under management, up by $2.6 billion from the previous fiscal year, and generated $2.8 billion in investment income, resulting in a 13.6% one-year return versus 12.3% for the benchmark.
  •  Private Equity had net assets under management of $19.4 billion, $3.5 billion more than in fiscal year 2017, and generated investment income of $2.1 billion, for a one-year return of 12.9%—versus a 3.4% loss in fiscal year 2017—compared to a benchmark return of 17.6%. The strong increase in fiscal year 2018 performance was mainly driven by strong valuation gains, notably in the financial and industrial sectors, but was partially offset by underperformance of certain investments. However, investments completed in the last three years, representing $9.9 billion of assets, have generated returns significantly above benchmark.
  • Infrastructure had $15.0 billion in net assets under management, a $3.9 billion increase from the prior fiscal year, and generated $2.3 billion of investment income, leading to a 19.3% one-year return, relative to the benchmark return of 12.1%.  
  • Private Debt had net assets under management of $8.9 billion, an increase of $4.5 billion from the prior fiscal year, and generated net investment income of $569 million, resulting in an 8.2% one-year return, compared to a benchmark of 2.3%.
  • Natural Resources had net assets under management of $4.8 billion, an increase of $1.1 billion from the previous fiscal year, and generated record investment income of $450 million, for a one-year return of 11.2%, versus the 3.1% benchmark.  
The table below from page 42 of the annual report provides the portfolio returns by asset class (click on image):


It should be noted PSP doesn't hedge currency risk which hurts it in years where foreign currencies (mostly US dollar) underperform the Canadian dollar (click on image).


Just by quickly glancing the asset class return table above and the press release, I can tell PSP reworked its private market benchmarks to make them more reflective of the underlying risks of each portfolio but I still have questions on the benchmarks for Private Debt and Natural Resources which both seem way too easy to beat relative to the benchmarks for Real Estate, Private Equity and Infrastructure.

Let me be clear here, all the private market asset classes at PSP performed exceptionally well in fiscal 2018, including Private Equity which underperformed its benchmark by 470 basis points. PSP's Private Equity is ramping up its direct investing through more co-investments, and Simon Marc, the head of Private Equity, is doing a great job there.

My point is to highlight important nuances and that we need more information on these private market benchmarks to be able to evaluate the performance of each portfolio relative to their benchmark and some are obviously much harder to beat than others. You cannot just look at one-year results to pass judgment.

And let let be clear, benchmarks are not as easy as you think, especially in private markets. Go read my recent comment on whether Vestcor's benchmarks are a joke where I went over the history of PSP's Real Estate benchmark which has changed for the better and also added this:
[...] when you're working at a public pension fund, I have an issue with people gaming their benchmark, especially in private markets where things aren't always straightforward when it comes to benchmarks.

Somebody told me that Ontario Teachers' has a "Benchmark Committee" steered by its CEO, Ron Mock, and is made up of him, the CIO and Barbara Zvan, the head of Strategy & Risk. This committee makes sure nobody is gaming their benchmark in any investment activity. (Note: In a subsequent discussion, Barb Zvan told me the head of HR and CFO also sit on this committee and for good reasons).

I asked him why doesn't anyone from the Board sit on this committee and he replied: "The Board approves the benchmarks but it's up to management to make sure they are strictly adhered to in terms of risk. If management doesn't do its job, the Board can change the benchmark and even fire the CEO."

Good point. This person also told me that CPI + 400 or 500 bps is a fine benchmark to use in private markets and most deals aim to ensure CPI + 700 to have an "extra cushion". He added: "Private markets aren't liquid, there is a lot of time and energy involved in deals, so it's ok to want an extra premium over benchmark in deals."

As far as the risk, he stated: "The biggest risk in private market deals is permanent loss of capital but if the compensation is structured over a four or five-year rolling return period, the manager is aligned with the organization's objective not to take excessive risk by gaming the benchmark."

That is an important point, there are no perfect benchmarks in alternative investments, you want pension fund managers to take risk but not to go crazy and risk losing a ton of money on any given year. If the compensation is structured to primarily reward long-term performance, you can do away with a lot of these private markets benchmark gaming issues.

And remember, benchmarks can be gamed everywhere, including public markets and hedge funds, it's not just a private markets problem. If a manager is taking excessive or stupid risks, be it liquidity or leverage or whatever, it should be reflected in their benchmark. Period.
By the way, PSP's Public Markets had net assets under management of $76.7 billion, a decrease of $0.5 billion from fiscal year 2017, and generated investment income of $6.3 billion, for a one-year return of 8.3%, compared to a benchmark of 7.7%.

That 60 basis points of outperformance in Public Markets is decent, nothing extraordinary, but it doesn't tell us whether it comes from portable alpha activities  (ie. swap into a bond index and invest in external hedge funds) or from internal absolute return strategies.

My contacts tell me PSP invests huge sums in big asset managers and hedge funds, writing minimum tickets of $250 million a shot, and they do this because the fund needs scalability to move the needle.

The problem with that strategy is the big hedge funds all focus on the same trades and you risk having concentrated positions that can go against you during a market dislocation.

Also, apparently PSP's Public Markets tried doing Relationship Investing internally, taking large positions in fewer companies, but it didn't go well and the Board wasn't comfortable with the volatility (if true, I think the Board and the Public Markets team need to revisit this activity).

Still, I'm being picky here, there is nothing glaringly wrong at PSP's Public Markets or Private Markets. Overall results fell well short of CPPIB's 11.6% return in fiscal 2018 but they are still solid and above the Policy Portfolio benchmark (remember, you cannot easily compare the performance between two pension funds without understanding asset allocation and risks being taken).

It's also worth noting PSP had a change of leadership late in its fiscal year. In February, André Bourbonnais announced he is leaving to head to BlackRock to work with his old boss, Mark Wiseman, and help Larry Fink beef up private markets there.

Neil Cunningham is more than capable leading PSP during the next five or ten years which I believe will be much tougher than the last ten years including the great recession.

PSP's Board made a great choice in placing Neil as head of PSP. He's smart, solid, experienced and knows that tough times lie straight ahead in both public and private markets. He's also a good leader who wants to leave his footprint on this organization.

If you read his message (pages 16-18), you will see he's very focused on delivering on the strategic plan (click on image):


As you can read, one of the objectives of the strategic plan is Inclusion & Diversity:
"We also launched our Inclusion & Diversity (I&D) Forum in November and initiated an I&D Council, which I co-chair, alongside Giulia Cirillo, Senior Vice President and Chief Human Resources Officer. The Council focuses on creating awareness of our individual unconscious biases and we established several affinity groups to help foster inclusivity at PSP."
I applaud these efforts and prefer the word inclusion over diversity.

In fact, Lindsey Walton, Director, National Programming and Engagement at Women in Capital Markets, posted a Harvard Business Review article on LinkedIn, Diversity Doesn’t Stick Without Inclusion, which made a very valid point:
Part of the problem is that “diversity” and “inclusion” are so often lumped together that they’re assumed to be the same thing. But that’s just not the case. In the context of the workplace, diversity equals representation. Without inclusion, however, the crucial connections that attract diverse talent, encourage their participation, foster innovation, and lead to business growth won’t happen. As noted diversity advocate Vernā Myers puts it, “Diversity is being invited to the party. Inclusion is being asked to dance.”

Numerous studies show that diversity alone doesn’t drive inclusion. In fact, without inclusion there’s often a diversity backlash. Our research on sponsorship and multicultural professionals, for example, shows that although 41% of senior-level African-Americans, 20% of senior-level Asians, and 18% of senior-level Hispanics feel obligated to sponsor employees of the same gender or ethnicity as themselves (for Caucasians the number is 7%), they hesitate to take action. Sponsors of color, especially at the top, are hobbled by the perception of giving special treatment to protĂ©gĂ©s of color and the concern that protĂ©gĂ©s might not “make the grade.” The result: Just 18% of Asians, 21% of African-Americans, and 25% of Hispanics step up to sponsorship (and 27% of Caucasians).

Another difficulty in solving the issue is data. It’s easy to measure diversity: It’s a simple matter of headcount. But quantifying feelings of inclusion can be dicey. Understanding that narrative along with the numbers is what really draws the picture for companies.
Said another way, diversity is easy, any bean counter can count how many minorities are hired in any organization but inclusion takes it a step further: Are minorities actively engaged and being given the same opportunities at all levels of the organization? Are there hidden biases we need to examine?

In PSP's case, they've done a great job promoting women to upper management but I did note each of the senior managing directors at the major asset classes (except Public Markets run by Anik Lanthier) is a French Canadian white male.

I have nothing against French or English Canadian white men and I have no doubt all these men are highly qualified for these leadership jobs but I bring this up because a) it's my blog and b) I don't shy away from pointing out stuff that many others have pointed out to me in private conversations and it's time that all of Canada's large pensions realize this country is multiethnic and multicultural and when I see the senior managers at these places (and other large federal Crown corporations), I ask myself where is the representation?

Now, don't send me hate emails blasting me for bringing this up but us Greeks, Italians, Jews, Arabs, Latinos, Chinese, Indians, Africans, Haitians, Lebanese, Iranians, Pakistanis, you name it, we talk among each other and sometimes we openly wonder whether there is discrimination going on at these places, especially in the upper managerial positions. (I know, there is no discrimination, only the best get hired for the top jobs, but even there, people need to be cognizant of the optics).

Anyway, as I told you, there are exceptional women in PSP's senior levels, and that includes Anik Lanthier, SVP Public Markets, Giulia Cirillo (nice Italian name), the head of HR working with Neil on Inclusion & Diversity and Nathalie Bernier, the CFO who won an award for Canada's CFO of the year in 2018:



Good for her, she deserves this recognition and being CFO is a very demanding and important job, especially at PSP.

There are many other senior women like Stéphanie Lachance, VP Responsible Investing who is doing a great job, and Dominique Dionne, VP Public Affairs and Strategic Communications which I follow on Twitter as she posts interesting stuff on PSP, like PSP's new brand and an interview with Patrick Samson, Managing Director of Infrastructure at PSP:





Alright, I'm at the end of my rope, quite literally, and it's time to wrap things up.

I want people to focus their attention on long-term results (click on image):


Importantly, over the past 10 years, PSP Investments has recorded a net annualized rate of return of 7.1%, compared to 5.8% for the Return Objective. "Considering the size and timing of contributions, this outperformance amounts to $23.8 billion in net investment gains above the Return Objective over this 10-year period."

That is the most important measure of success and that's why PSP's senior executives are very well compensated (click on image, from page 69 of annual report):



You need to read the footnotes to understand this table properly and remember, it's mostly based on long-term results (Mr. Garant also received a nice severance package and then joined Gordon at BCI where he's shaking things up in public markets).

Lastly, I did reach out to Neil yesterday to get his feedback and chat about PSP's fiscal 2018 results but he told me he wasn't giving any interviews. It's too bad, maybe next year and Neil, whenever you want, let's grab a lunch together and catch up.

Below, a clip from AIM CROIT explaining what it means to accommodate people with disabilities and why certain myths need to be addressed once and for all. The clip is only available in French but I saw it earlier today and really liked it.

I also embedded a clip where Jim Sinocchi, Head of Disability Inclusion at JPMorgan Chase, explains his theory of the four As in creating an inclusive work environment.

Unfortunately, very few organizations take the plight of people with disabilities seriously when it comes to equal opportunity in employment. It's a national travesty, one that I will keep referring to because it's grossly unjust and it affects me and thousands of others who unlike me don't have a widely read blog as a platform to voice their concerns and frustrations.

I want all the leaders at large organizations reading this blog to ask yourselves: What have you done to engage and recruit people with disabilities and if the answer is "nothing", ask yourself why.

On that note, I congratulate the folks at PSP for another solid year. Get ready, the next five years won't look anything like the last five years, so be prepared for a long, tough slug ahead.