Friday, January 23, 2015

Prepare For Global Deflation?

Koh Gui Qing of Reuters reports, China January factory growth stalls, deflation pressures build, bad debt rises:
China's manufacturing growth stalled for the second straight month in January and companies had to cut prices at a faster clip to win new business, adding to worries about growing deflationary pressures in the economy, a private survey showed.

The HSBC/Markit Flash Manufacturing Purchasing Managers' Index (PMI) hovered at 49.8 in January, little changed from December's 49.6 and just below the 50-point mark that separates contraction from growth on a monthly basis.

A Reuters poll had forecast a second month of contraction with a reading of 49.6.

Reflecting the tumble in oil prices, which have more than halved in the last six months, a sub-index for input prices sank to 39.9, a level not seen since the global financial crisis.

But companies also had to cut output prices for the sixth straight month to sell their products, and more deeply than in December, eroding their profit margins.

"Today's data suggest that the manufacturing slowdown is still ongoing amidst weak domestic demand," Qu Hongbin, a HSBC economist in Hong Kong said on Friday.

"More monetary and fiscal easing measures will be needed to support growth in the coming months."

Falling prices are a concern for China, which wants to avoid Japan's fate of sinking into a 20-year deflationary funk that has depressed consumption and economic growth.

The survey showed final demand for China's factory goods rose this month, but only modestly as the sub-indices for new orders and new export orders stood close to the 50-point threshold.

Factories laid off staff for the 15th consecutive month in January in the face of tepid demand, the PMI showed.


There are already some signs of stubborn deflationary pressure in China.

Producer prices have fallen for almost three straight years. That helped to drag China's annual consumer inflation to a near five-year low of 1.5 percent in December.

To contain deflationary risks, economists at state think-tanks who are privy to China's policy discussions said authorities are ready to cut interest rates further and pressure banks to step up lending. The central bank unexpectedly cut rates in November for the first time in more than two years.

Some Chinese consumers are already postponing purchases in anticipation that prices will fall further in the future, a classic warning sign of deflation that would deal another blow to the Chinese economy, where growth hit a 24-year-low of 7.4 percent last year.

Although 2014 economic growth data was not as bad as some had feared, it suggested that a steady series of policy easing had not sustained activity as much as policymakers had hoped.

In a sign of the times, separate data on Friday showed the bad debt ratio at Chinese banks climbed to a five-year high of 1.64 percent at the end of 2014 as companies struggled to repay their loans in the dour business climate.

Indeed, Sany Heavy Equipment International Holdings Co Ltd said on Friday its 2014 net profit could more than halve after falling coal prices dented demand for coal machinery.

That followed a more dire forecast from Zoomlion Heavy Industry Science and Technology Co Ltd, another heavy equipment maker, which said on Monday that its 2014 net profit may have plunged 80 percent. The profit warning was its fifth in 21 months.

"Right now, I'm more worried about investment," said Chang Chun Hua, an economist at Nomura in Hong Kong. "The financing cost of investment is getting higher with deflation. Real interest rates are going up."

Economists polled by Reuters expect the economy to slow further this year to around 7 percent, even with additional stimulus measures. A cooling property market, high financing costs and heavy corporate and local government debt loads will likely continue to drag on activity.

Chinese Premier Li Keqiang acknowledged on Wednesday that the world's second-largest economy will face downward pressures in 2015 but said it was not heading for a hard landing.
Chinese deflation is another source of great concern for global policymakers. If it continues, it means we're going to experience another wave of disinflation in the West and more deflationary pressure.

And China's deflation dragon is spreading throughout Asia, wreaking havoc on other economies. Gaurav Raghuvanshi of the Wall Street Journal reports, Singapore posts second straight month of deflation:
Singapore's consumer prices fell nearly in line with analyst estimates in December and the island nation reported a second consecutive month of deflation as housing and transport costs continued to ease.

The consumer price index fell 0.2% year-over-year in December, compared with the median estimate for a 0.1% decline in a Dow Jones Newswires poll of six economists, and a 0.3% fall in November.

The cost of transportation, which has an index weighting of 16%, fell 4.1% in December from a year earlier due to lower private road transport costs, the data showed. Private road transport costs fell by a more moderate 5.7% from a year earlier, compared with the 7.0% decrease in November.

Housing costs, which make up 25% of the index, fell 1.4% because of lower rents.

Food prices, which have a 22% weighting in the index, however, rose 2.9% from a year earlier, mainly due to more expensive cooked meals, the data showed.

For the whole year, the consumer price index rose 1.0% in 2014 from 2.4% in the previous year.

The Monetary Authority of Singapore's core inflation, which excludes the costs of accommodation and private road transport, was 1.5% higher from a year earlier in December, similar to the preceding month, because of stable services and food inflation. For the whole of 2014, MAS core inflation edged up to 1.9% from 1.7% in 2013.
And Gareth Hutchens of The Age reports, Is Australia's economy at risk of deflation?:
A few years ago conservatives in the United States were hyperventilating about the then-chairman of the US Federal Reserve, Ben Bernanke, because they believed his radical monetary policies were going to lead to an uncontrollable outbreak in inflation that would decimate the economy.

Remember these accusations?

Newt Gingrich, while running for the Republican presidential nomination in 2012, warned voters that Bernanke was "the most inflationary, dangerous" Fed chairman "in history".

Texas Governor Rick Perry, who also ran for the nomination, claimed Bernanke was "almost" treasonous.

"If this guy prints more money between now and the election, I dunno what y'all would do to him in Iowa, but we would treat him pretty ugly down in Texas," he thundered.

They were cynical statements then and they look ridiculous now – the US economy is actually showing signs of healthy life these days, while it still faces very little inflationary pressure. It's obviously too early to claim victory, but it looks like Bernanke's policies may have worked.

Looking around the world, other major developed economies aren't worrying about inflation at all, despite the amount of money printing that has gone on in recent years.

The thing they are more concerned about is deflation.

Shane Oliver, the chief economist of AMP Capital, felt deflation was enough of a concern that he sent a note to his clients this week explaining what it was and why Australia faced some deflationary risks.

I'll do my best to summarise what he says.

Firstly, he says the absence of inflationary pressures around the world is a good thing, because it means the global "sweet spot" of OK economic growth, low interest rates, and low bond yields can continue.

But a steep fall in bond yields over the last year, to record or near record lows, is warning us that the world may face a period of "sustained deflation".

What is deflation? It refers to persistent and generalised price falls, and it is not necessarily a bad thing. Whether deflation is good or not depends on the circumstances in which it occurs.

As Oliver explains, in the period 1870-1895 in the United States, deflation occurred against the background of strong economic growth, reflecting rapid productivity growth and technological innovation.

This was "good" deflation.

Australians have enjoyed this type of deflation for years in the prices of electronic goods. That's why so many of us can afford to have large flat-screen TVs and other things.

Deflation becomes "bad" when it is associated with falling wages, rising unemployment, falling asset prices and rising real debt burdens.

In the 1930s, and more recently in Japan, deflation reflected an economic collapse and rising unemployment, which was made worse by a combination of high debt levels and falling asset prices.

"[And] in the current environment sustained deflation could cause problems," Oliver says, speaking about the global economy.

"Falling wages and prices would make it harder to service debts. Lower nominal growth will mean less growth in public sector tax revenues, making still high public debt levels harder to pay off. And when prices fall people put off decisions to spend and invest, which could threaten economic growth."

He believes the decline in inflation globally has raised concerns that we may see sustained deflation around the world.

Annual inflation rates are low everywhere.

They are just 0.8 per cent in the United States, -0.2 per cent in Europe, 0.5 per cent in the UK, 0.4 per cent in Japan, and 1.5 per cent in China.

In Australia, annual inflation is still officially sitting at 2.3 per cent, which is much better than other economies, but it looks likely to fall below that next week when new figures come out.

And if that happens, things could get interesting.

The Reserve Bank is meeting in a couple of weeks to decide on interest rates, knowing full well that economists from major banks have been calling on it to cut rates further.

Its job is to try to keep inflation within a 2-3 per cent range, so if annual inflation falls below the 2-3 per cent target it will strengthen the case for the bank to cut rates again.

Rates are already at a historic low 2.5 per cent. If inflation falls below 2 per cent next week, all eyes will be on RBA governor Glenn Stevens.

But is there a risk that Australia faces bad deflation? Oliver thinks it's unlikely.

He says deflationary forces will be felt in Australia as global prices fall, for commodities such as oil and energy, but those forces won't be serious.

He believes a sustained 1930s or Japanese-style deflation is likely to be avoided globally, too.

That's because the US Fed is likely to delay its first interest rate hike if core inflation continues to fall. Japan will likely continue with its aggressive quantitative easing program for some time yet. And China and India look likely to ease monetary conditions further.

Oliver also believes a further interest rate cut is likely in Australia.

That loosely co-ordinated global monetary easing should help to ensure that global growth continues, and in turn prevent a slide into sustained deflation, Oliver argues.

So even though global inflation will remain low, it is unlikely to collapse into sustained deflation.

But a key thing to watch will be the success of the European Central Bank and the Bank of Japan in boosting their countries' growth rates with looser monetary policy.

"The most likely outcome is that inflation will remain low over the year ahead, with improving growth helping it bottom [out], but still significant spare capacity preventing much of a rise [in inflation]," he argues.

"[And] as the generally easy global and Australian monetary environment continues, it will help underpin further gains in growth assets like shares, albeit with more volatility."

Australian interest rates will obviously remain low for the rest of the year.
In my opinion, the Reserve Bank of Australia will follow the Bank of Canada, which just shocked markets with a rate cut, and proceed with its own interest rate cut (keep shorting the Aussie and loonie!).

In fact, Australia is even more cooked than Canada because of its closer trading relationship with China. And just like Canada, it's in the midst of a huge real estate bubble that will eventually burst, a point recently underscored by Australian economist Steve Keen:
Steve Keen, head of economics, politics and history at London’s Kingston University, envisages the RBA making a couple of cuts this year - "and possibly more than that".

"The unemployment in Australia now is the worst it’s been in 10/15 years, and the only thing keeping it up is the housing bubble because that is pumping borrowed money into the economy, people are spending that money, and of course also foreign buyers pumping money and buying real estate," he told Lelde Smits from the Finance News Network .

"Those are really the only two massive inflow sources into the economy.

"If the housing bubble pops then that inflow also stops and we therefore have a downturn driven by having finally a housing bubble bursting.

"So those dangers are there, you can see plenty of reasons for the cash flow spigot to be turned off, I can’t see many ways of turning it on anymore."

He would be surprised to see it below the 2%, but wouldn’t be amazed.

He suggests what he sees as the bubble could keep going, "but what it means is we are more and more fragile on the bubble continuing indefinitely".

Asked for the catalyst for the property bubble to pop, Keen sees two things.

"Partly the economy itself slowing down so much that the negative returns in rental become excessive.

"Those people are having carrying costs and of course passing those carrying costs on to the Australian public through negative gearing, but they none the less have those carrying costs to handle.

"And also, if there is anything going wrong in China.

"Things going wrong in China can go in both directions, we have a serious downturn in China, then it’s quite possible Chinese capital could respond by going offshore and do more buying overseas.

"So a slowdown in China, because it is a speculative slowdown, doesn’t have to mean a slowdown in demand for Australian real estate."
I strongly doubt a slowdown in China will mean a boon for real estate in Australia, Canada and other hot spots, like London.

As far as the argument that Shane Oliver made in the previous article, that loosely co-ordinated global monetary easing should help to ensure that global growth continues and prevent a slide into sustained deflation, I think this is wishful thinking.

As I stated in my last comment, the ECB's new QE measures are a day late and a euro short.  And if the Fed makes the silly mistake of raising rates this year, Larry Summers is right, it will risk a deflationary spiral and a depression-trap that would engulf the world for decades.

Unfortunately, no matter what the Fed does, deflation is coming to America. Bond markets around the world have been telling us this for a long time. DoubleLine's Jeffrey Gundlach, the new bond king, explained why this time it's different. The inexorable slide in rates is telling us that the world will face a prolonged period of debt deflation.

Most institutional and retail investors are not prepared for what lies ahead. Some investors are preparing for a deflationary boom, but they're not ready for the eventual deflationary bust that will happen when global investors start questioning the Fed and other central banks. This will be our Minsky moment and will engender a major crisis in capitalism as we know it.

But for now, don't worry, there is still plenty of liquidity to drive risk assets much higher in the next couple of years. This is why in my Outlook 2015, I'm still bullish on bonds and stocks, but I also warned you to choose your stocks and sectors very carefully.

Given deflationary pressures around the word, I'm not surprised to see utilities (XLU), healthcare (XLV) and telecoms (XLT) continuing to do well but I'm far more bullish on technology (XLK) and especially biotech (XBI) because I think defensive stocks are getting stretched and their valuations will make asset allocators take money off the table. Then again, in a deflationary environment, you might see bubbles in high dividend defensive sectors but my bet remains on tech and biotech.

As far as pensions are concerned, I openly question whether their risk departments are preparing for global deflation and what devastation this could mean across public and private markets. I think it's nice to take the long, long view when it comes to managing pension assets, but I would agree with OMERS and others that are worried about deflation.

Finally, I ask many of you who regularly read me to show your financial support and donate or subscribe to this blog via PayPal at the top right-hand side, right under my bio. I thank the institutions and individuals that have donated and subscribed but I would appreciate a lot more of you to step up to the plate and pay up for the great insights I regularly provide you on pensions and investments. If you take the time to read my comments, please take the time to send me money.

Below, Kyle Bass, Hayman Capital Management, shares his thoughts on the ECB's bond-buying plan and its impact on the euro. Bass thinks euro parity is coming and I agree and warned my readers not to bet against the mighty greenback for now (until the Fed takes a step back).

Interestingly, Bass was featured in Chapter 1 of Steven Drobny's new book, The New House of Money, which has yet to be released. However, you can read Charter 1 by clicking here, and read Bass's take on why he's short Japan and why U.S. pensions are in big trouble (I agree with the latter, not the former). 

Thursday, January 22, 2015

ECB: A Day Late and a Euro Short?

Paul Carrel and John O'Donnell of Reuters report, ECB launches last-ditch program to revive euro economy:
The European Central Bank took the ultimate policy leap on Thursday, launching a government bond-buying programme which will pump hundreds of billions of new money into a sagging euro zone economy.

The ECB said it would buy government bonds from this March until the end of September 2016 despite opposition from Germany's Bundesbank and concerns in Berlin that it could allow spendthrift countries to slacken economic reforms.

Together with existing schemes to buy private debt and funnel hundreds of billions of euros in cheap loans to banks, the new quantitative easing programme will pump 60 billion euros a month into the economy, ECB President Mario Draghi said.

By September next year, more than 1 trillion euros will have been created.

"The combined monthly purchases of public and private sector securities will amount to 60 billion euros," Draghi told a news conference. "They are intended to be carried out until end-September 2016 and will in any case be conducted until we see a sustained adjustment in the path of inflation."

Bonds will be bought on the secondary market in proportion to the ECB's capital key, meaning the largest economies from Germany down will see more of their debt purchased by the ECB than smaller peers.

The prospect of dramatic ECB action had already prompted the Swiss central bank to abandon its cap on the franc while Denmark, whose currency is pegged to the euro, was forced to cut interest rates in anticipation of the flood of money.

The Danish central bank intervened to weaken the crown ahead of the announcement.

Former ECB policymaker Athanasios Orphanides said action was long overdue. "The ECB should have already embarked on QE," he said. "Now that the situation has deteriorated, the ECB will have to do much more."

The euro fell, European shares jumped and bond yields in Italy, Spain and Portugal fell with the single currency dropping a full cent against the dollar to $1.1511.

Draghi has had to balance the need for action to lift the euro zone economy out of its torpor against German concerns about risk-sharing and potentially being left to foot the bill.

Tensions broke out as the meeting got underway with French Finance Minister Michel Sapin firing a broadside at Berlin.

"The Germans have taught us to respect the independence of the European Central Bank," he told France Info radio. "They must remember that themselves."

A German lawyer who has been prominent in attempts to halt euro zone bailouts said he was already preparing a legal complaint against an ECB bond-buying programme.


Draghi said 20 percent of the asset purchases would be subject to risk-sharing, suggesting the bulk of any potential losses will fall on national central banks.

Critics say that calls the euro zone concept of risk sharing into question and countries with already high debts could find themselves with further liabilities.

Euro zone inflation turned negative last month, far below the ECB's target of close to but below 2 percent, raising fears of a Japan-style deflationary spiral.

But there are doubts, and not only in Germany, over whether printing fresh money will work.

Most euro zone government bond yields are already at ultra-low levels while the euro has already dropped sharply against the dollar. Lower borrowing costs and a weaker currency could both help to boost growth but there is a question about how much downside there is for either.

"It is a mistake to suppose that QE is a panacea in Europe or that it will be sufficient," former U.S. Treasury Secretary Larry Summers said at the World Economic Forum in Davos on Thursday.

"There is every reason to expect that QE will be less impactful in a context like the present one in Europe than it was in the context of the United States."

A plunge in the price of oil has thrown central bankers into a spin worldwide. Canada cut the cost of borrowing out of the blue on Wednesday while two British rate setters at the Bank of England dropped calls for tighter monetary policy as inflation has evaporated.

The ECB has already cut interest rates to record lows. Earlier, it left its main refinancing rate, which determines the cost of euro zone credit, at 0.05 percent.

Greece and Cyprus, which remain under EU/IMF bailout programmes, will be eligible but subject to stricter conditions.

"Some additional eligibility criteria will be applied in the case of countries under an EU/IMF adjustment programme," Draghi said.

The move comes just three days before an election in Greece where anti-bailout opposition party Syriza is on track to gain roughly a third of the vote.
David Jolly and Jack Ewing of the New York Times also report, E.C.B. Stimulus Calls for 60 Billion Euros in Monthly Bond-Buying:
The European Central Bank said on Thursday that it would begin buying hundreds of billions of euros worth of government bonds in an ambitious — though some say belated — attempt to prevent the eurozone from becoming trapped in long-term economic stagnation.

The bank’s president, Mario Draghi, said the central bank would begin buying bonds worth 60 billion euros, or about $69.7 billion, a month. That is more spending than the €50 billion a month that many analysts had been expecting.

The long-awaited program, known as quantitative easing, comes after inflation in the 19 countries of the eurozone fell below zero and raised the specter of deflation, a sustained decline in prices that can lead to higher unemployment and that is notoriously difficult to reverse.

As a further stimulus step, the European Central Bank also said it was cutting the interest rate it charges on loans to commercial banks, as long as the banks commit to lending that money to companies or individuals. The new rate would be 0.05 percent, down from 0.15 percent.

“We believe the measures taken today will be effective,” Mr. Draghi said at a news conference.

Financial markets greeted the news favorably. The benchmark Euro Stoxx 50 index was up 1 percent. Bond yields in some eurozone countries hit new lows, including countries that might benefit most from the central bank’s program. The yields on 10-year government bonds in Italy dropped to 1.58 percent and in Spain to 1.42 percent.

The euro weakened further against the dollar, falling about 0.6 percent to $1.1543, a move that could help European exporters.

Top officials of the central bank had signaled clearly that a quantitative easing program was in the offing. But there remained, before the central bank meeting on Thursday, many questions about how large the program would be and whether it would be powerful enough to reverse a two-year decline in inflation.

Programs of quantitative easing by the Federal Reserve in the United States and by the Bank of England in Britain have helped the economies of those two countries recover from the global financial crisis more successfully than the eurozone has been able to.

If successful, quantitative easing would push down market interest rates in the eurozone and make it easier for businesses and consumers to borrow money, helping to stimulate the economy and restore inflation. Quantitative easing could also have a psychological impact, helping to raise expectations that inflation will begin to rise and thus encourage people to spend now rather than wait.

Mr. Draghi said Thursday that the bond buying would continue through September 2016 or “until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2 percent over the medium term.”

The decision to begin buying government bonds on the open market came after a debate that lasted months. Mr. Draghi sought to overcome resistance from German members of the governing council and the broader German public, which regards quantitative easing as a form of wealth transfer to countries like Italy.

Mr. Draghi acknowledged on Thursday that there had been intense discussion by the bank’s governing council about how to share the risk if a country later defaults on its debt. Mr. Draghi said that concerns about risks being transferred from some countries to others was legitimate. The compromise preserves some risk sharing, he said.

The European Central Bank will coordinate the buying, Mr. Draghi said, but will delegate some of it to the central banks of national central banks. In a further compromise, some of the risk from bond buying will be taken by the European Central Bank and some by national central banks.

Anticipating critics who might say that the European Central Bank is not in full control of the eurozone’s monetary policy if it shares the risk of its program, Mr. Draghi said, “The singleness of monetary policy remains in place.”

He said that the central bank would begin buying government bonds based on each country’s share of the central bank’s capital, which is commensurate with their population and gross domestic products.

He said that the central bank would not buy more than 33 percent of any country’s outstanding bonds, nor more than 25 percent of any bond issue. The central bank will buy the bonds on the open market, he said, to allow the market to set the price. Those conditions appear intended to address legal challenges to bond buying by the central bank.

Asked about Greece — a special case because of the political uncertainties there and because the country continues to labor under an international bailout program overseen in part by the European Central Bank — Mr. Draghi said that the bank could buy Greek bonds. But in practice, he noted, such purchases might be limited.

Greece, he said, would have to continue adhering to the terms of its bailout program, which is also being administered by the International Monetary Fund and the European Commission. That adherence is currently uncertain, as Greece awaits national elections this weekend that could result in a new government seeking to revise the terms of the bailout.

In addition, the European Central Bank already owns a large proportion of Greek bonds and would not hold more than 33 percent of the total. But in July, Mr. Draghi said, redemptions of Greek bonds could allow the central bank to buy more.

In another crucial provision, the European Central Bank would have equal status to other bond holders — rather than holding itself above other investors and expecting to be paid back first in the event of problems. That will be important to private investors, because if the central bank held itself out as a privileged bondholder, effectively passing more risk on to other bond holders, other buyers might undermine the stimulus program by demanding higher interest rates.

Although the Federal Reserve and the Bank of England used quantitative easing to rejuvenate their economies, such a program would be more complicated in the eurozone. There is no widely traded, Pan-European government bond similar to United States Treasury securities, which were the main vehicle for the Fed’s program.

Another question is whether quantitative easing can help fix the eurozone economy, especially since it has taken so long for the central bank to begin a large-scale bond-buying program. Many economists and businesspeople are skeptical.

“I do not believe it will have a major effect whatever will be announced,” said Karl-Ludwig Kley, chairman of Merck, a German pharmaceutical and chemicals company that is separate from Merck & Company in the United States.

“I do not believe bond buying or whatever is the remedy,” Mr. Kley said in an interview at the annual meeting of the World Economic Forum in Davos, Switzerland. “I do not see, because of these programs, consumers buying more. I do not see companies investing more.”
If you ask me, the ECB's new QE measures while much needed, are a day late and a euro short. I've long argued the ECB is way behind the deflation curve and the way they're going about it won't make a dent in the euro deflation crisis.

Why? Because once deflation becomes entrenched, it's almost impossible to break the cycle. Moreover, apart from the dysfunctional politics and lack of a Pan-European government bond similar to United State, the transmission mechanism isn't the same in Europe where the wealth effect from rising stocks is a fraction of what it is in America (fewer people own stocks).

I'm not the only one who is skeptical. In Davos, the Telegraph's Ambrose Evans-Pritchard reports, Larry Summers warns of epochal deflationary crisis if Fed tightens too soon:
The United States risks a deflationary spiral and a depression-trap that would engulf the world if the Federal Reserve tightens monetary policy too soon, a top panel of experts has warned.

"Deflation and secular stagnation are the threats of our time. The risks are enormously asymmetric," said Larry Summers, the former US Treasury Secretary.

"There is no confident basis for tightening. The Fed should not be fighting against inflation until it sees the whites of its eyes. That is a long way off," he said, speaking at the World Economic Forum in Davos.

Mr Summers said the world economy is entering treacherous waters as the US expansion enters its seventh year, reaching the typical life-expectancy of recoveries. "Nobody over the last fifty years, not the IMF, not the US Treasury, has predicted any of the recessions a year in advance, never."

When the recessions did strike, the US needed rate cuts of three or four percentage points on average to combat the downturn. This time the Fed has no such ammunition left. "Are we anywhere near the point when we have 3pc or 4pc running room to cut rates? This is why I am worried," he told a Bloomberg forum.

Any error at this critical juncture could set off a "spiral to deflation" that would be extremely hard to reverse. The US still faces an intractable unemployment crisis after a full six years of zero rates and quantitative easing, with very high jobless rates even among males aged 25-54 - the cohort usually keenest to work - and despite America's lean and efficient labour markets.

Mr Summers warned that this may be a harbinger of deeper trouble as technological leaps leave more and more people shut out of the work-force, and should be a cautionary warning to those in Europe who imagine that structural reforms alone will solve their unemployment crisis.

"If the US is in a bad place, we are short of any engine at the moment, so I hope you are wrong," said Christine Lagarde, the head of the International Monetary Fund.

Mrs Lagarde said the IMF expects the Fed to raise rates in the middle of the year, sooner than markets expect. "This is good news in and of itself, but the consequences are a different story: there will be spillovers. One thing for sure is that we are in uncharted territory," she said.

Worries about the underlying weakness of the US economy were echoed by Bridgewater's Ray Dalio, who said the "central bank supercycle" of ever-lower interest rates and ever-more debt creation has reached its limits. Interest rate spreads are already so compressed that the transmission mechanism of monetary policy has broken down. "We are in a deflationary set of circumstances. This is going to call into question the value of holding money. People may start putting it in their mattress."

Mr Dalio said the global economy is in a similar situation to the early Reagan-era from 1980-1985 when the dollar was surging, setting off a "short squeeze" for those lenders across the world who borrowed in dollars during the boom.

There is one big difference today, and that is what makes it so ominous. "Back then we could lower interest rates. If we hadn't done so, it would have been disastrous. We can't lower interest rates now," he said.

“We’re in a new era in which central banks have largely lost their power to ease. I worry about the downside because the downside will come,” he said.

Mr Dalio said Europe is already in such a desperate predicament that it may have to go beyond plain-vanilla QE and start printing money to fund government spending - what is known as "helicopter money" in financial argot. "Monetisation is a path to consider," he said.

“If the moderates of Europe do not get together and change things in a meaningful way, I believe there is a risk that the political extremists will be the biggest threat to the euro," he said.

Mr Summers said QE in Europe will not do any harm - and might help a little - but comes too late to lift the region off the reefs on its own. “I am all for European QE, but the risks of doing too little far exceed the risks of doing too much. It is a mistake to suppose it is a panacea or that it will be sufficient."

He said QE in America packed the biggest punch at the start, when 10-year rates where around 3pc and there was still scope to drive them lower. Germany's 10-year Bunds are already down to historic lows of almost 0.4pc. The Fed's stimulus worked through US capital markets but most of the lending in Europe is conducted through banks, which are still "clogged".

Mr Summers said the root cause of Europe's woes is a "strategy of austerity", with grudging and belated monetary stimulus, in the misguided hope that this would somehow bring about invigorating reform. The result is instead economic malaise and a surge in political extremism.

He accused Germany's leaders of succumbing to Keynes's "fallacy of composition", seemingly unable to grasp that fiscal tightening and cuts may allow one country to steal a march on others in a currency union, but if everybody cuts spending together, it turns into a vicious spiral that holds back everybody in the end.

The eurozone states, taken together, have plenty of room for fiscal stimulus, and indeed should take advantage of negative rates to rebuild their infrastructure and invest in new technologies.

The headline reduction in budget deficits is yet another EMU fallacy, he said, accusing Europe's leaders of pursuing "fetishized" debt targets that ultimately undermine future growth and raise the future debt burden. "They are repressed budget deficits," he said.

What is holding them back is the "irresponsible decision" to launch a currency union without a fiscal union to back it up, leading to a refusal to share liabilities and a chronically dysfunctional system.

"It is a failure to recognize that the one-off model of export-led growth that worked for Germany, will work for everybody. It is a failure of generalisation. That is the central error running much of European economic thought. As long as continues to drive policy, prospects for success are very limited," he said.
I think Lawrence Summers and Ray Dalio spell it out perfectly. Go back to read my comment, Don't Fight the Fed?, where I noted the following:
The key here is whether the market perceives the Fed do be behind the deflation curve, not the inflation curve. As I've repeatedly warned, the real concern is about the Euro deflation crisis and whether it will spread to the United States. For now, global stock markets are not worried, bouncing back vigorously from the latest selloff, but this could change and the future of the eurozone remains very fragile.

In my recent comment on whether it's time to plunge into stocks,  I openly questioned Dallas Fed president Richard Fisher for dismissing the contagion effects from eurozone's deflation crisis and how it's influencing U.S. inflation expectations. 

Importantly, the biggest policy mistake the hawks on the FOMC are making is ignoring global weakness, especially eurozone's weakness, thinking the U.S. domestic economy can withstand any price shock out of Europe. If eurozone and U.S. inflation expectations keep dropping, the Fed will have no choice but to engage in more QE. And if it doesn't, and deflation settles in and markets perceive the Fed as being behind the deflation curve, then there is a real risk of a crisis in confidence which Michael Gayed is warning about. Perhaps this is the real reason why big U.S. banks are loading up on bonds (not just regulatory reasons).
In my more recent comment on why OMERS is worried about deflation, I went a step further and stated:
I want you all to keep Makin's brilliant comment in mind because as I stated in my last comment on the Swiss currency tsunami, I'm betting the Fed won't raise rates this year and might even be forced to engage in more aggressive QE if a financial crisis emerges (that's when the real fun begins!).
One thing is for sure, even if it won't make a big difference in the real economy, more QE from the ECB will help propel risks assets all over much higher, especially in the United States. Go back to read my Outlook 2015,and try to understand why even though deflation is coming, there is plenty of liquidity to drive risk assets much higher.

But Ray Dalio is absolutely right, there will come a time when more QE simply won't work and might even reinforce deflationary pressures. That's when we'll see huge downside risks materialize.

On that note, please go back to read my last comment on why the Bank of Canada shocked markets and cut rates. I added some comments from Brian Romanchuk who thinks this was a policy error, but if you ask me, Bank of Canada Governor Steve Poloz has a deep understanding of the risks of deflation spreading throughout the world and the bank was right to cut rates.

Also, markets will now be focusing on Greece and whether we'll avert another euro crisis. There will be more anxiety but I remain confident we will not see a major crisis from Greece, even if Syriza wins and manages to form a minority government.

Below, IMF Managing Director Christine Lagarde, former U.S. Treasury Secretary Lawrence Summers, Goldman Sachs Group Inc. President Gary D. Cohn, Banco Santander SA Chairman Ana Botin and Bridgewater's Ray Dalio, speak on a Bloomberg Television debate on quantitative easing. Francine Lacqua moderates the session at the World Economic Forum's annual meeting in Davos, Switzerland.

Wednesday, January 21, 2015

Bank of Canada's Turn to Shock Markets?

Barrie McKenna of the Globe and Mail reports, Bank of Canada shocks market with rate cut:
The Bank of Canada announced a surprise quarter-percentage-point cut to its key interest rate Wednesday – a move it calls “insurance” against the potentially destructive effects of the oil price collapse.

The reduction in the bank’s overnight rate to 0.75 per cent from 1 per cent – its first move since September, 2010 – comes as a precipitous drop in the price of crude slams Canada’s oil-dependent economy.

The oil shock will be “negative for growth and underlying inflation in Canada,” the bank warned in a statement.

Bank of Canada Governor Stephen Poloz is expected to explain his dramatic decision at an 11.15 a.m. news conference in Ottawa Wednesday.

The rate move, which few analysts anticipated, is an attempt by Mr. Poloz to shield highly indebted Canadian households from an oil-induced hit to their jobs and incomes – signs of which are already evident in Alberta.

The rate cut is a signal to private-sector banks to lower their own rates on mortgages and other loans.

It’s also likely to accelerate a slide in the Canadian dollar, now at roughly 83 cents (U.S.).

Cheaper crude, while good for the U.S. and global economies, is unequivocally bad for Canada.

The bank warned that lower oil prices would take a sizeable bite out of economic growth in 2015, delay a return to full capacity and hurt business investment – a trend that has already triggered mass layoffs and production cuts in Alberta’s oil patch.

But the effects could spread further, threatening financial stability as a result of possible losses to jobs and incomes, according to the central bank.

“The oil price shock increases both downside risks to the inflation profile and financial stability risks,” the bank acknowledged. “The Bank’s policy action is intended to provide insurance against these risks.”

The bank’s new forecast assumes a price of “around” $60 per barrel for Brent crude, more $10 above where it is now. But the central bank said prices “over the medium term are likely to be higher” than $60.

As recently as June, oil was selling for $110 a barrel.

The bank also lowered its bank rate and the deposit rate by a quarter percentage point Wednesday, to 1 per cent and ½ per cent, respectively. And it removed any indication of which way rates might go next.

The bank’s decision coincides with a much more pessimistic economic forecast than the bank issued just three months ago.

Following the lead of most private-sector forecasters, the bank slashed its GDP growth forecast to 2.1 per cent this year (from 2.4 per cent), before rebounding to 2.4 per cent in 2016. The worst effects of the oil collapse will be felt in the first half of this year, when the bank expects annualized growth of 1.5 per cent, nearly a full percentage point lower than its October forecast.

The Canadian economy grew at an estimated rate of 2.4 per cent in 2014.

The bank said the economy won’t return to full capacity until the end of 2016, several months later than its previous estimate of the second half of next year. Among other things, the central bank pointed to significant “labour market slack.”

Crude’s effects on the economy will be broad and profound, the bank warned. Investment in the oil and gas sector will decline by as much as 30 per cent this year, while lower returns on energy exports will eat into Canadian incomes, wealth and household spending.

The bank also hinted at a possible spread to other parts of the country of a real estate slump already underway in Alberta. “The extent to which the downturn already evident in Alberta will spill over into other regions remains to be seen,” the bank pointed out in its monetary policy report.

“The ramifications of the oil-price shock for household imbalances will depend importantly on the impact of the shock on income and employment,” the bank added.

The bank also expressed growing angst about the impact that oil could have on inflation, which it said has been propped up by temporary effects, such as the “pass-through” effect of the lower Canadian dollar.

Consumer price increases, now running at roughly 2 per cent a year, are “starting to reflect the fall in oil prices,” the bank said.

The bank’s new forecast calls for overall inflation to fall well below its 2-per-cent target this year, averaging just 0.6 per cent. Core inflation, which strips out volatile food and energy prices, is expected to average 1.9 per cent in 2015.
You can read January's Monetary Policy Report for more details as to why the Bank of Canada decided to cut its overnight rate, but one thing is for sure, it caught a few folks off-guard.

Pamela Heaven of the National Post recently reported, Don’t expect a rate hike before 2016, Canada, because 2015 already seriously sucks:
The sour start to the new year is prompting more economists to push back their forecasts for a Bank of Canada rate hike and lower their forecasts for growth and the Canadian dollar.

Plunging oil prices, down more than 50% since June, have been joined by record low yields for 10-year Canadian bonds, a six-year low for the loonie and declines in a host of other commodities.

“It’s not unusual to have a lot of bad news packed early into January, because the post-holiday period often ushers in some changes in strategy — but this year has already seen more than its fair share of very tough decisions,” said BMO chief economist Doug Porter in a recent report.

The bad news prompted economists at BMO Capital Markets to push their call for the next rate hike into 2016 — even though the Fed is still expected to hike three times this year.
The bank also reduced its outlook for the Canadian dollar, which has already fallen below their previous 2015 forecasts, and now sees it testing 80 cents US by mid-year.

“Finally, we are also taking another long look at trimming our below-consensus GDP forecast of 2.1% this year, which is already a full percentage point below our U.S. call of 3.1%, and would represent a highly unusual underperformance by Canada,” said Mr. Porter.

BMO joins a growing chorus of economists who now see the Bank of Canada remaining in interest-rate hibernation for at least another year.

A rate hike in 2016 is now the median forecast in Bloomberg’s monthly survey, which previously predicted the Bank would lift rates later this year. Economists also cut two-year yield forecasts by the most on record. Some forecasters don’t see a rate hike until 2017.

Bets are also increasing that Bank of Canada Governor Stephen Poloz will cut rates, rather than raise them, with swaps trading signalling about a one in three chance of a reduction to 0.75% by December.

The central bank hasn’t raised its benchmark interest rate since 2010 — the longest pause since the Second World War — as it awaits an economic recovery, but instead of getting closer that goal seems further away.

Wednesday, the Bank of Canada will update its growth expectations, along with its monetary policy decision, and nobody expects it to be good. October’s forecast was based on oil prices at US$85. It was trading at $46 Tuesday.

“They are definitely going to have to acknowledge that there is a large downside risk from falling oil prices,” in the new economic forecast, Emanuella Enenajor, senior Canada economist at Bank of America Corp. told Bloomberg. Last week she pushed her rate-increase forecast to the third quarter of 2016 from the first quarter.

If that’s not enough, January has brought an extra heavy dose of bad news: Here are the highlights, according to BMO:

Target exits Canada: The troubled American retailer stunned Canadians when it announced last week it will close all 133 stores at a loss of 17,600 jobs after less than two years in the country. Mr. Porter says the move, however, says more about the retailer than it does about Canada’s economy where retail sales have kept pace with the U.S.

Suncor cuts 1,000 jobs and capital spending: Capex cuts have become common in the oil patch, but jobs cuts by Canada’s largest oil company is a darker omen that doesn’t auger well for Alberta’s economy. “We look for growth in the province to drop to around 0.5% this year after leading the country with 3.5% growth in 2014, and that’s based on a partial recovery in oil in the second half of the year. The housing markets in Calgary and Edmonton look to be softening notably, with the high possibility of outright price declines in both cities this year. The oil plunge has skewered provincial finances, leaving Premier Prentice to openly talk about the possibility of introducing a provincial sales tax to help stabilize revenues—now, that would be a tough decision,” wrote BMO.

Finance Minister Oliver delays the federal budget: Ottawa is suddenly sounding more cautious about lower oil prices. BMO’s analysis sees the government needing “to use its full $3 billion contingency reserve to balance the books in the coming fiscal year, leaving zero room for any new measures in this year’s budget.”

The Swiss National Bank releases the cap on the franc: The move shocked markets and sent the franc soaring 30%. This is important to Canada because such a huge move in a major currency creates unintended shockwaves which only become obvious in days to come, writes Mr. Porter. The move pushed global yields down and gold up, “the one commodity that is thriving in today’s uncertain backdrop.”

Update: Tuesday the loonie sunk almost a penny below $83 cents US after Canadian factory fell 1.4%, the third drop in four months — and way below economists’ expectations.
But not everyone was caught off-guard. Bloomberg reported that Canada’s dollar weakened to the lowest in more than five years on speculation the central bank may signal it’s more likely to lower interest rates than raise them when it releases a growth outlook.

Other economists thought Bank of Canada Governor Stephen Poloz can hit rate snooze as markets do the work:
Poloz, who delivers the central bank's next rate decision on Wednesday, will hold off raising borrowing costs until 2016, according to the median forecast in a Bloomberg monthly survey, which previously predicted the governor would lift rates later this year. Economists also cut two-year yield forecasts by the most on record.

The central bank hasn't raised its benchmark interest rate since 2010 as it awaits an economic recovery that's in danger of fading. Crude oil, Canada's biggest export, is trading below $50 a barrel, from $107 in the summer. The slump is already crimping exports, weakening investment and playing havoc with prairie housing markets. The last thing the economy needs is higher interest rates.

"Markets are doing the dirty work for the Bank of Canada," Emanuella Enenajor, senior Canada economist at Bank of America, said Jan. 15 by phone from New York. "We are still going to see the Bank of Canada holding on to their assertion that the recovery is proceeding, perhaps it's just proceeding a bit slower than they thought."

Along with the rate decision, Poloz will release the bank's quarterly set of inflation and growth projections that will be updated to factor in cheaper crude oil. The bank's October forecasts were underpinned by an assumption U.S. benchmark crude would trade at an average of $85 a barrel.

The oil slump means it may take longer than expected to return the world's 11th-largest economy to full potential, Deputy Governor Tim Lane said in a Jan. 13 speech. He reiterated Poloz's December estimate that weaker oil may shave a third of a percentage point off 2015 growth. Oil extraction accounts for about 3 percent of Canada's gross domestic product and crude oil about 14 percent of exports, Lane said.

"They are definitely going to have to acknowledge that there is a large downside risk from falling oil prices," in the new economic forecast, Enenajor said. Last week she pushed her rate-increase forecast to the third quarter of 2016 from the first quarter.

The yield on Canadian government bonds due in two years will end 2015 at 1.45 percent, according to the Bloomberg survey's median forecast, down from a December projection of 1.8 percent.

Economists also cut forecasts for the 30-year yield, to 2.96 percent from 3.38 percent last month.

"Investors are willing to receive no increase in purchasing power for three decades," Sal Guatieri, a senior economist at BMO Capital Markets in Toronto, wrote in a Jan. 16 research note. "How bad of a mess do investors think the global economy is in?"

The Bank of Canada has kept its benchmark rate at 1 percent since September 2010, predating Poloz taking the governor job, and is the longest stretch since World War II.

Bets are increasing that Poloz will cut rates, rather than raise them, with swaps trading signaling about a one in three chance of a reduction to 0.75 percent by December.

International investors are adding to their Canada bond holdings even in a low-rate world, while selling stocks for the first time in 15 months, a Statistics Canada report Monday showed. Foreigners bought C$4.75 billion of bonds in November while divesting C$580 million of stocks.

The Bank of Canada's Lane cautioned in his speech against too much pessimism, noting policy makers won't react to the temporary drop in inflation triggered by oil's plunge. He also pointed out the offsets including the benefits to consumers from cheaper prices at the pump, and the advantage some exporters will gain from a weaker currency, he said.

"We will continue to work to bring the Canadian economy back to its potential and return inflation sustainably to our 2 percent target," Lane said. "However things play out, we have the tools to respond."

Tell that to Calgary property owners. Homes sales in the nation's oil hub and Alberta's largest city plummeted 24.6 percent in December from the previous month, the Canadian Real Estate Association said last week. That was the worst drop since the 2008 bankruptcy of Lehman Brothers Holdings Inc. sparked the global credit crunch.
Indeed, Calgary's real estate market is cooked, and nobody knows this better than Garth Turner whose blog, The Greater Fool, has gained quite a following as over-indebted Canadians are increasingly worried about the value of their home.

But Garth Turner and I differ quite a bit on what will rock Canada's residential real estate market. He buys the Wall Street fairy tale that the U.S. economy is doing so well that the Fed will raise rates later this year, forcing the Bank of Canada to raise rates which will spell the end of Canada's long real estate boom. I think rates are heading lower as global deflation picks up steam and unemployment will soar in Canada, and this will be the death knell for our real estate market.

On Friday, I wrote a comment on why OMERS is worried about deflation, where I explained in detail why I'm betting the Fed won't raise rates this year and might even be forced to engage in more aggressive QE if a financial crisis emerges.

And let me tell you, Steve Poloz isn't stupid. Far from it, he's one of the smartest and nicest guys I've ever had the pleasure of working with and understands extremely well why the Fed is backed in a corner and increasingly worried about deflation coming to America.

This is one reason why I agree with Ted Carmichael who recently wrote the Bank of Canada should open the door to a rate cut now where he noted the following:
I believe that, in this debate, David Wolf's view is more likely to prove accurate. While I am in broad agreement with his assessment, in my opinion, he fails to mention one important link in the virtuous cycle that has turned vicious. When the price of oil [and other commodities] falls, Canada's terms of trade (ToT) weakens. When the price of commodities falls relative to the price of other goods and services, the price of Canada's exports falls relative to the price of its imports.

When the commodity terms of trade weaken, Canada's gross domestic income weakens. This negative shock to income is shared across the corporate sector, the government sector and the household sector. While some energy consuming industries will benefit, total corporate profits will fall. Government revenues will fall, causing most governments to curtail discretionary spending.
While commuters will benefit from lower gasoline prices, the lower Canadian dollar will make imports of finished consumer goods and services more expensive. As housing and other asset prices weaken against a backdrop of record high household debt-to-income ratios, consumers will be reluctant to spend any windfall bestowed by lower energy prices. Many will prefer to save rather than spend the temporary boost to disposable income.

What is noteworthy about the chart above is that the depreciation of the Canadian dollar, significant as it has been, has not kept pace with the deterioration of the commodity terms of trade. Even if oil and other commodity prices stabilize at current levels, the Canadian dollar needs to fall further, to below 80 US cents (or alternatively USDCAD needs to rise above 1.25), to have a chance to offset the negative impact of the terms of trade deterioration on growth and inflation.

The Bank of Canada will make a policy rate decision and release an updated projection for the Canadian economy on January 21. The biggest change will be in the inflation projection. The table below shows the Bank of Canada's Total CPI inflation projection made in its October Monetary Policy Report (MPR) and JP Morgan's latest Canadian inflation forecast which incorporates most of the recent decline in crude oil prices.

The JP Morgan forecast anticipates that CPI inflation will turn negative in 2Q15 (as I predicted here) before edging back toward 1% by 4Q15 assuming that the price of oil rebounds toward $90 per barrel by the end of 2015. If, as I believe likely, crude oil prices remain depressed for a much longer period of time, say well into 2016 or 2017, inflation will likely fall into negative territory in early 2015 and remain there for some time.

With such an outlook, the Bank of Canada needs to pay full attention to defending its inflation target and supporting inflation expectations around 2%. The most effective way to do this in the near term is to provide guidance in the January 21 policy rate announcement and the Monetary Policy Report that the BoC stands ready to cut the policy rate if inflation moves persistently below the 1-3% target band.
I completely agree with Carmichael's excellent analysis. In fact, I would have urged the Bank of Canada to really shock markets and cut rates by more than 50 basis points even if it would have sent the loonie plunging to new lows (I see the loonie falling back below 70 cents US in less than a year).

Why am I so pessimistic on Canada? Because we live in a bubble here. Most Canadians have been lulled into believing our economy is invincible and can weather any global storm because of our proximity to the U.S. and our resources which up until recently were being snapped up like crazy by China and other emerging markets.

Unfortunately, Canada's crisis is just beginning, and there will be considerably more pain ahead. Never mind what those smart economists from Canada's big banks tell you, listen to Leo Kolivakis and Leo de Bever who warned all of you in December 2013, long before oil prices plunged, that it's time to short Canada.

I don't know, maybe I'm being too cynical and too pessimistic. My friend Brian Romanchuk wrote an excellent comment on why Canada is still debalancing, noting the following:
The rather rapid depreciation of the Canadian dollar should allow for rebalancing within the economy. In addition to exporters becoming more competitive, imports are more expensive and so there may be substitution away from foreign suppliers. Based on past experience, the impact on Canadian consumer price inflation will be muted; exchange rate moves are typically absorbed within profit margins. Additionally, the fall of gasoline prices benefits consumers across the country, although this will not buoy spirits in Calgary.

The question is: can Canada avoid the messy unwinding of its housing bubble that was experience in other countries? Differences in how mortgages are financed means that the banking system should avoid a crisis. However, the real risk is in the labour market. Construction job losses will have a multiplier effect, dragging down demand-sensitive sectors like Retail. Finally, health spending is under the control of Provinces, which have much larger economic footprints than American States, but do not have direct access to the central bank. The Canadian financial press worships at the altar of fiscal rectitude, and a pro-cyclical fiscal tightening is highly possible.

At present, all one can safely say is that the downward spiral has not yet started.

Policy Response

Unless the economy makes a very dramatic downturn, there is little reason to expect policy changes over the coming year.

The Bank of Canada is unlikely to move rates in either direction in 2015. If the Fed hikes rates, the Bank of would only follow with a lag. This would put the earliest rate hike in 2016, and we will have another year's worth economic data to digest. Going the other way, there is almost no scope to cut rates. A token cut of 50 basis points is possible, but the Bank of Canada has found that zero rates is not compatible with a proper functioning of the Canadian money markets.

Fiscal policy is unlikely to be helpful, although the Federal Government may decide to loosen the purse strings ahead of an election. (Although the Conservative Party positions itself as fiscally conservative, they were certainly Keynesian during the financial crisis.) Analysts are now giving up on forecasts of a Federal fiscal surplus, which is what I said would happen last year in "Canada: Enjoy The Projected Surpluses While They Last". The real risk is that Provincial governments will be forced to tighten policy, but that would not happen until after there is a visible downturn and their deficits blow out.
In a follow-up comment, Brian questioned the decision to cut rates, calling it a policy error:
The Bank of Canada surprised markets (and me) and cut the overnight rate to 0.75% from 1% today. Even though I have been saying that the Canadian economy is doomed for a long time, I think this was a policy error. Interest rates 25 basis points lower will have no measurable effect upon the economy, but it will most likely be interpreted as the beginning of a (very short) rate cut cycle. Since rate cut cycles are almost invariably associated with recessions, the correct question to ask: what does the Bank know? The biggest risk facing the economy is a loss of confidence in the ability of Canadian households to service their debts; increasing uncertainty is the last thing Canada needs. The weaker Canadian dollar will take quarters or even years to help growth (as a result of the J-curve), but confidence within the housing market could be lost within weeks.
Obviously the Bank of Canada is more worried about the Canadian economy than most and I believe justifiably so. Pay attention here folks, Canada's crisis is just beginning, and that's the real reason Canada's large public pension funds are snapping up Canadian government bonds, even at record low yields.

Below, Stephen S. Poloz, the Governor of the Bank of Canada, speaks before the Economic Club of New York on Speculating on the Future of Finance. Listen carefully to Steve, he's a very sharp guy and we're lucky to have him at the helm of our central bank during these turbulent times.

Tuesday, January 20, 2015

Canada's Overstaffed Public Pensions?

Barry Critchley of the National Post reports, Brian Gibson’s take on Canada’s overstaffed public pension plans:
Given his role as a senior investments adviser to the chief investment officer of the US$91 billion University of California pension fund, there’s no real surprise that Canadian Brian Gibson has strong views of the structure of a model pension fund.

Gibson, the former senior vice president of public equities at both Ontario Teachers Pension Plan Board and AIMCo, has advanced a number of suggestions as to how the UC fund should operate. Those suggestions have been made to Jagdeep Singh Bachher, the fund’s relatively new chief investment officer.

In essence the suggestions focus on filling knowledge or skill set gaps in the organization with a series of hires, culling some staff and giving more assets to a smaller group of external managers.

In this way returns should improve and costs (to the extent that the fund can negotiate lower fees with the managers with more assets) should be reduced.

And Gibson, who spent about 14 years at Teachers and about five years at AIMCo. has fairly strong views on the large Canadian public sector pension funds. He feels that some of them have too many staff and argues that better results could be generated by a smaller, higher quality group of employees. In other words more could be done with less.

“The Canadian firms are way too top heavy with staff and [that] causes median results,” he said Monday.

Gibson did make an exception, noting that under Michael Sabia, Caisse de dépôt et placement du Québec is “not overstaffed. They are reasonably well organized now since Michael Sabia reorganized things,” added Gibson.
You might not know him but Brian Gibson is very well known in the Canadian pension industry. He delivered strong results in public equities at Ontario Teachers and even at AIMCo and is well respected, highly regarded and considered to be a hard working intelligent portfolio manager.

But Gibson also has a reputation of not being the best manager of people, which is one reason he left AIMCo. From that respect, it doesn't surprise me that he thinks Canada's public pensions are way overstaffed. Typically people that don't like managing people or aren't good at it, are not big fans of large staffs.

Having said this, I haven't met Brian Gibson nor do I completely disagree with him. I have worked at two of the largest public pension funds in Canada, large crown corporations and federal government organizations and have seen enough "dead weight" to make my blood boil.

When I was working at the Business Development Bank of Canada, replacing their senior economist who went on mat leave, someone exasperated with the lack of work from another group shared a French Québécois expression which I love: "Ils brassent de l'eau avec leur doigt, tabernac!" which literally means "they're stirring water with their finger, god damn it!".

Unfortunately, the person who mentioned this to me had an exaggerated sense of importance of his own group and didn't realize that they too were pretty much dead weight and replaceable, which is why I found his comments amusing.

In fact, every group has an exaggerated sense of how instrumental they are to the success of their organization. It's quite comedic and often just downright sad to listen to their comments and how they perceive their importance to the overall well-being of their organization.

To be fair to employees, however, often times they're dead weight or demotivated because their team leader lacks leadership skills or the organization lacks focus. In other words, the problem of a "lazy" or "demotivated" employee often has nothing to do with them but it has to do with other factors that explain their behavior.

Now, let me get back to Gibson's comments. His focus is mainly on the investment staff at Canada's large public pension funds. He thinks they can do more with less and then fill the gap by hiring a few external managers, using their size to negotiate down the fees. And in many cases, he's absolutely right.

But one can easily make the case for hiring more, not less people, and paying them properly to invest the assets internally, doing away with external manager fees as much as possible. This is the model that Canada's large public pensions have adopted across public and private assets and it has contributed to their success which others try to emulate.

We should also note the benefits of Canada's top ten extend way beyond their investment performance, they also contribute directly into the economy, hire a lot of smart people, and play an important socioeconomic role in the cities they're based in.

I also take exception to Gibson's assertion that “the Canadian firms are way too top heavy with staff and [that] causes median results.” Ok, I invite Gibson to show me the proof by posting his fidngs on a blog so they can be openly discussed and duly scrutinized. Don't just talk to some journalist at the National Post who doesn't have a clue about how large pension funds really work and the added value they deliver over public market benchmarks.

Worse still, he cites the Caisse as an example of a large fund that is "not overstaffed" and delivering above average returns. Really? Is he consulting the Caisse? I can list you a lot of top senior analysts and portfolio managers that were let go or left that organization in disgust even after Michael Sabia took over and cleaned up the shop. There's still way too much dead weight at the Caisse and a few huge frigging egos who think they're god's gift to the investment management industry (they're not, they're just blowhards who are sitting in a cushy chair; once they lose that seat, they're dead).

And I certainly don't agree with the Caisse's hiring binge on so-called "industry experts" to provide "top research" in various industries and long-term results. I would hire people with market knowledge and trading experience any day of the week over some industry expert with a "PhD in mining engineering" or some other obscure field who couldn't manage money if their life depended on it.

Now, I don't want to be overly critical of the Caisse because they're hyper sensitive of things I write on my blog. There are a lot of good people there working across public and private markets, but don't tell me the Caisse is better than CPPIB, Ontario Teachers' or HOOPP. In some things (like real estate), they most certainly are top in the industry but not in public markets (the jury is still out on life after benchmarks and whether their shift to industry experts and a global value portfolio will provide meaningful long-term results over public market benchmarks).

Are there arguments and valid concerns on the size of the staff at Canada's large pension funds? Yes, every one of them has HR issues across all their groups, which includes HR, back office, front office, risk management, finance and IT. Last I heard, IT makes up almost 50% of the staff at PSP Investments (now over 800 employees), which is insane if true (albeit, as funds grow they need more and more IT support).

One pension expert who wishes to remain anonymous shared these insights with me:
IT might cause you to look at the facts as they show up in annual reports. Be careful, however, unlisted assets are not always reported consistently in terms of costs. Some take costs out of returns.

In many pension funds internal costs per dollar of AUM are about 1/3 or 1/4 of external costs. That suggests to me Brian Gibson does not have things quite right.

As to whether Michael Sabia is doing better than most, I doubt that. He has all the challenges of the other funds and probably a few extra ones.
So true! My biggest beef at these large pension funds is not the size of their staff but that the groups still work in silos and they don't have enough people like me or Brian Romanchuk who can connect the dots and see the bigger picture. That is where you'll get the biggest bang for your buck, not by indiscriminately firing a bunch of people because some brainless consultant told you to do so, but by finding the right people with the right attitude and brains who truly understand how all the moving parts at your organization work together and where the real risks lie ahead.

On that note, I would urge the Caisse, PSP and others to take a much closer look at the people they hire and respect diversity in the workplace and even publish diversity stats publicly every year and set lofty goals there just like Intel just did. When it comes to staffing, there's a lot more work ahead at all of Canada's large pension funds but I'm sorry to say Brian Gibson doesn't have the pulse on the real issues that matter.

Below, Brian Krzanich, Intel CEO, discusses how his company plans to address diversity issues in the workplace. I think all of Canada's CEOs at large public pension funds, large Crown corps and other public and private organizations should listen carefully to his comments.

Take it from a guy who has been shunned and let go from jobs because of Multiple Sclerosis, when it comes to diversity in the workplace, Canada and especially Quebec's large public and private organizations still have a lot more work ahead of them.

It's actually quite worrisome and not reported because the media prefers focusing on other trivial staffing issues, completely ignoring the plight of all minorities, especially persons with disabilities, in securing full-time employment with benefits.

Monday, January 19, 2015

Taming New Jersey's 'Insatiable Beast'?

Samantha Marcus of NJ Advance Media reports, How did N.J. get into this pension mess?:
Some 800,000 people, working and retired, are beneficiaries of New Jersey’s pension system, a collection of funds going deeper into the red.

It’s a system that Gov. Chris Christie, in his State of the State address last week, called “an insatiable beast.

In boom years, New Jersey leaders shortchanged the pension system, and those “sins of the past,” Christie said, “have made the system unaffordable.”

Fully funding the pension system this fiscal year would cost $3.9 billion, but Christie cut the pension payment to just $700 million to balance the budget — a move that landed him in court, battling an attempt by unions to force him to pay more.

Union leaders accuse the governor of going back on his word to have the state make full payments in exchange for higher contributions from workers. It’s a hot issue in Trenton made even bigger with Christie considering a White House run.

The governor has called for more changes to the system to bring down costs, and over the summer assembled a bipartisan commission to issue recommendations.

That commission, which has yet to release its final report, echoed Christie’s call for additional reforms.

Here’s a recap of what’s happening with New Jersey’s pension mess.
What went wrong?

New Jersey’s pension funds were flush at the turn of the 21st century. But since 1996, governors from both parties have been underfunding the system, making payments far below what actuaries recommend.

The state skipped payments altogether from 2001 to 2004, when the annual required contribution called for $2.8 billion. And while the state was taking a pension holiday, it increased benefits for employees.

Every time the state doesn’t make a full payment, it’s like paying only the minimum on your credit card bill while continuing to charge stuff. So while the ultimate cost of pensions grows, partial payments by the state in one year makes the next payment even bigger — and harder for the state to make. It’s multiplied like crazy for the last decade.

The stock market had a hand in it, too. New Jersey lost $20 billion in the dot-com bust between 2000 and 2003, according to the Hall Institute of Public Policy, and was knocked around again by the Great Recession.

Is it true that Christie has contributed more than any other governor?

After skipping a $3.1 billion payment in fiscal year 2011, Christie contributed $484 million in 2012, $1 billion in 2013 and $696 million in 2014 — more than any of his five predecessors. He’s expected to make a $681 million payment this year.

Former Gov. Christie Whitman’s payments totaled roughly $1 billion, while the state contributed $100 million under James E. McGreevey and $2.1 billion under Jon Corzine.

But Christie’s payments are still a fraction of what is needed to keep the pension system from piling up even more debt.
What did the 2011 pension law do?

The Legislature adopted and Christie signed into law a pension reform package to gradually increase the state’s pension contribution over seven years until it reached the full annual required contribution.

Employees had to make concessions too: the law raised the retirement age, suspended cost-of-living increases for retirees, and required workers to contribute more toward their pensions and health benefits.

The contribution rate for workers enrolled in the Public Employees’ Retirement System and Teachers’ Pension and Annuity Fund increased will increase from 5.5 percent to 7.5 percent over seven years.

Police and firemen’s rates increased from 8.5 percent to 10 percent of pay, and state police’s contribution jumped from 7.5 percent to 9 percent. Judicial employees will phase in an additional 9 percent of their salary.
I thought those changes were going to save the system. What happened?

The state got bad news last spring, when tax collections came in much lower than the Christie administration expected, blowing holes in the previous and current fiscal years’ budgets.

Christie reduced the pension payment for the fiscal year that ended June 30 from $1.6 billion to $696 million and the payment for the current fiscal year from $2.25 billion to $681 million.

The remaining payments are enough to cover employees currently receiving benefits, but it doesn’t leave anything for the unfunded liability.

But even before the revenue emergency, Christie was warning that pensions and benefits needed to be revised again because their costs would swallow up a bigger chunk of the state budget each year.

The unions have taken Christie to court over both pension cuts, and lost the first round in June. Superior Court Judge Mary Jacobson said the fiscal emergency backed the governor into corner, and making the full pension payment would produce “severe and immediate impacts on vulnerable populations.”

The unions have taken Christie to court over both pension cuts, and lost the first round in June. Superior Court Judge Mary Jacobson said the fiscal emergency backed the governor into corner, and making the full pension payment would produce “severe and immediate impacts on vulnerable populations.”

Christie’s administration challenged the legality of the 2011 pension law during a hearing Thursday, with lawyers calling it unconstitutional and saying Christie doesn’t have to pay. Jacobson has not issued a ruling.
How bad is it?

New Jersey faces $37 billion in unfunded pension liabilities, according to a report from Christie’s pension commission. Each household would have to write a check for $12,000 to close the gap, the commission said.

An actuarial rule change that assumes less optimistic investment returns doubled the unfunded liability figure to $83 billion, and pushed the dates that two of the largest pension funds will go broke to 2024 and 2027.

The state has $40 billion in assets, covering 32.6 percent of its $122.8 billion in liabilities.
How does that compare to the rest of the country?

New Jersey’s pension shortfall ranks fourth worst in the country, behind Illinois, Connecticut and Kentucky.

Two-thirds of states contributed at least 90 percent of full funding in fiscal year 2013, according to Moody’s. New Jersey contributed 28 percent.
What about unfunded health care benefit liabilities?

Retiree health benefits add another $53 billion in unfunded liabilities.

Those costs consume 8 percent of the state budget, and according to Christie’s commission, could grow to 14 percent of the budget within 10 years.

Part of the problem, the commission says, is that 80 percent of public workers are enrolled in what would be considered a “platinum” plan under the Affordable Care Act.

“The state health programs provide generous benefits with little pricing incentive for employees to select anything but plans with the most comprehensive coverage and highest cost to the state,” the report says.

“In addition, the commission noted that beginning in 2018, the federal government will impose a 40 percent excise tax on such plans that would cost the state another $58 million that year and $284 million by 2022.
What about the municipalities?

Local government portions of the pension plans are much better funded than the state’s. Moody’s Investors Service said late last year that these local governments “currently are not affected by the state’s severe pension underfunding problem.”

Local funding for the Public Employees’ Retirement System is 73.9 percent, and it’s 77 percent for the Police and Firemen’s Retirement System — the two state and local government shared plans. The state government portions are funded at 46 percent and 48.6 percent, respectively.

“Cities and counties have historically contributed to PERS and PFRS at much higher rates than the state,” Moody’s said. “These local governments’ annual rates determined contributions., determined by state statute, have ranged from 84 percent to 92 percent of (annual required contribution) in recent years, versus the state’s very low 4 percent to 28 percent.
What’s next?

Trenton waits for Christie’s commission to make its recommendations, and Jacobson’s ruling on whether or not Christie had the right to knock out $1.5 billion from the current budget. With his eyes on the White House, Christie has been taking aim at public employee pension and health benefits. Democrats have said they won’t discuss making workers pay more without guarantees that the state will make full payments, perhaps by changing the state constitution.
I commend Samantha Marcus for writing this excellent article which discusses the historical developments that have led to New Jersey's pension mess.

Importantly, the biggest driver of New Jersey's pension deficit is successive state governments that failed to contribute the required amount.

In an other article, David Sirota commented on how New Jersey paid fees to a well-known hedge fund, Angelo Gordon, which hired Mary Pat Christie, the wife of Gov. Chris Christie back in 2012 as a managing director. She now earns $475,000 annually, according to the governor's most recent tax return.

As Sirota notes:
The disclosure that New Jersey taxpayers have been paying substantial fees to a firm that employs the governor's spouse -- years after state officials said the investment was terminated -- emerged in documents released by the Christie administration to International Business Times through a public records request.

A spokesman for the New Jersey Treasury Department, Christopher Santarelli, said via email that while New Jersey “ended its investment” with Angelo Gordon in 2011, the payments were legitimate because the state continues to hold an “illiquid” investment in the firm. Christie officials declined to disclose details of what exactly that illiquid investment is and the justification for continuing to pay fees to Angelo Gordon. The governor, Mary Pat Christie and executives at Angelo Gordon all declined to comment.

Pension overseers and financial experts characterized the appearance of the arrangement as deeply troubling. They saw it as symptomatic of a lack of transparency plaguing the management of public pension funds at a time when states and municipalities are entrusting increasingly hefty sums (and paying substantial fees) to Wall Street managers.

“This is extremely problematic,” Tom Bruno, the chairman of the board of trustees of one of New Jersey's three major pension funds, said. “This governor talks about what he is supposedly doing to help the pension system, but the possibility of him and his family deriving any kind of personal benefit from a deal like this raises some truly serious ethical red flags.”
I discussed these and other factors impacting state pension deficits in my last comment on New Jersey's pension GASBing for air:
The biggest factor explaining the pension deficit in New Jersey and other states is how successive state governments failed to make their pension contributions, using the money to fund other things (no doubt in an effort to buy votes).

But there are plenty of other factors that didn't help, like lack of sensible pension reforms, lousy investment performance and poor governance.

On this last point, Michael B. Marois of Bloomberg reports, California Pension Fund Bonus Payouts Climb 14% From Prior Year:

The $300 billion California Public Employees’ Retirement System, the largest U.S. public pension, paid $9 million in bonuses last fiscal year, up 14 percent from a year earlier as earnings exceeded benchmarks.

The fund, known as Calpers, paid $8.7 million in bonuses to investment staff in the year ended June 30, and almost $300,000 to four non-investment executives, according to data provided by the system. The rewards are based on three-year performance verses a benchmark, as well as the earnings of each asset class and individual portfolios, said spokesman Brad Pacheco.

“These awards are part of the overall compensation we provide to recruit and retain skilled investment professionals needed to ensure success of the fund,” Pacheco said.

Public-pension funds are recouping investment losses suffered during the 18-month recession that ended in June 2009, which wiped out a third of Calpers’ value. Still, the crisis left U.S. pensions short more than an estimated $915 billion needed to cover benefits promised to government workers. Taxpayers have been asked to make up the shortfall.

The biggest bonus earner was Ted Eliopoulos, the chief investment officer who recorded a $305,810 bonus last year in addition to his $412,039 base pay.

Top Job

That bonus was paid when Eliopoulos was acting chief investment officer after his predecessor Joe Dear died in February from cancer. Prior to that, Eliopoulos headed the fund’s real estate portfolio. He now earns $475,000 in base pay after he was tapped for the top investment job in September.

Eliopoulos announced in September that the fund was divesting all $4 billion it had in hedge funds, saying they were too expensive and too complicated and not worth the returns.

The pension fund earned 18.4 percent last fiscal year, 12.5 percent a year earlier and 1 percent in 2012. It estimates it need 7.5 percent annually to meet its long-term obligation to pay benefits promised to state and local government workers.

Calpers is still short $103.6 billion needed to cover those promises based on market value as of June 30, 2012, the latest figure that was available. That shortfall is up 19 percent from a year earlier.

The California fund says it must grant bonuses to help compete with the pay that employees could make if they went to work on Wall Street. Pacheco said spending money on in-house investment management saves about $100 million a year that otherwise would be paid to Wall Street in fees.

Wall Street bonuses, which rose 15 percent on average last year to $164,530 -- the highest since 2007 -- may climb again as a result of payments deferred from previous years, New York Comptroller Thomas DiNapoli said last month.

Four executives outside the Calpers investment office were paid a total of $295,930 in bonuses last year, the fund said. Anne Stausboll, chief executive officer, got $113,679; Chief Actuary Alan Milligan earned $75,748 and Chief Financial Officer Cheryl Eason was paid $89,703, almost double a year earlier.

Calpers paid a total of $7.9 million in bonuses in the prior fiscal year.
Compensation is part of pension governance and if you ask my expert opinion, CalPERS' compensation is fair and accurately reflects the market, their performance and their ability to attract and retain professionals to manage billions. The only thing I would change is base it on four-year rolling returns, like they do at Canadian public pension funds.

All this hoopla on compensation at U.S. public pension funds is totally misdirected. I happen to think most U.S. public pension fund managers are grossly underpaid, just like I think some Canadian public pension fund managers are grossly overpaid (read my comment on PSP's hefty payouts and the subsequent ones on its tricky balancing act and its FY 2014 results which were likely padded by skirting foreign taxes).

Getting compensation right is critical to the long-term health of any public pension fund but supervisors of these funds should make sure they're paying their senior investment staff properly based on benchmarks that truly reflect the risks they're taking. I believe in paying people for performance, not for taking dumb risks to trounce their silly benchmark.
I stand by every word in that comment and think too many people are losing focus when it comes to the coming war on pensions. We need to introduce proper reforms on public pensions and bolster them, not spread myths and misinformation to destroy them, replacing them with terrible defined-contribution plans which will expose millions more Americans to pension poverty.

Below, Gov. Chris Christie delivered the 2015 State of the State Address to 216th Session of the N.J. State Legislature, Tuesday January 13, 2015 in Trenton. In his speech Christie highlighted his administration’s work in pension reform and called the sate pension an "insatiable beast."

It's ironic how Gov. Christie portrays New Jersey's pension given the conflicts of interest with his wife's employer expose their insatiable greed to profit off this so-called beast. He should be much kinder to his state's pension, it's been very generous to his family.