Thursday, June 22, 2017

GE Botches Its Pension Math?

Nir Kaissar of Bloomberg reports, GE Botches Its Pension Math:
It’s time for General Electric Co. to do some soul-searching about its pension problem.

As Bloomberg News reported last week, GE’s pension was underfunded by a staggering $31.1 billion at the end of 2016 -- the biggest shortfall among S&P 500 companies.

So far, GE seems to be pointing fingers at everything but itself. Company spokeswoman Jennifer Erickson has attributed the pension predicament to the 2008 financial crisis and subsequent low interest rates.

In fairness, GE’s pension was in good health before the financial crisis. It was overfunded every year from 1999 to 2007, and GE’s surplus was $15.2 billion at the end of 2007. But in 2008, the pension portfolio tumbled by roughly 28 percent, and suddenly it was underfunded by $6.8 billion.

Turning Point

GE's pension fell deeper into the red after the 2008 financial crisis (click on image):

That’s when GE made some classic blunders. First, it panicked when markets declined and sold its risky assets when it should have hung on to them -- or bought more of them. GE allocated 80 percent of its pension portfolio to risky assets during the boom years leading up to the crisis from 2003 to 2006. The decline in the value of those assets in 2008 reduced GE’s risk allocation to 68 percent. But after the recovery in 2009, GE lost its nerve and sold some risk assets. By the end of 2010, GE’s allocation to risk was 66 percent, which is roughly where it remains today.

All Shook Up

GE lost its taste for risk after the 2008 financial crisis (click on image):

GE also blundered by chasing alternative investments after the crisis. From 1999 to 2008, the pension had no alternative investments. But by the end of 2009, GE had allocated 14 percent of its portfolio to alternatives.

It’s easy to see why alternatives were appealing at the time. Alternatives held up far better than the market during the crisis, in large part because of their ability to short stocks. The HFRI Fund Weighted Composite Index was down 19 percent in 2008, while the S&P 500 was down 37 percent, including dividends. Overseas stocks fared even worse.

Traumatized by the crisis and dazzled by alternatives, GE sold more of its beaten-down risk assets to make room for alternatives -- a classic case of looking in the rear-view mirror instead of the windshield. The S&P 500 has returned 18 percent annually since March 2009 through May, while the HFRI Index has returned just 6.2 percent. Overseas stocks, too, have outpaced the HFRI Index by a wide margin.

GE’s biggest blunder, however, predates the financial crisis. A critical assumption in every pension plan is the expected return from the pension’s portfolio. The higher the expected return, the less the company must contribute to its pension to meet future obligations, and vice versa.

In 1999, GE assumed that its pension portfolio would return 9.5 percent annually. At first glance, that seems like a reasonable assumption. GE’s pension portfolio is highly correlated with a 75/25 portfolio of U.S. stocks and bonds, as represented by the S&P 500 and long-term government bonds. That correlation was 0.92 between 1999 and 2016.

This 75/25 portfolio returned 9.4 percent annually from 1926 to 2016, including dividends -- the longest period for which returns are available.

But the devil is hiding in that return. It happens that the two decades before GE chose its expected return of 9.5 percent in 1999 included one of the biggest bull markets in history. From 1981 to 1998, the 75/25 portfolio returned 16 percent annually. Before that, it had returned half as much, or 8.3 percent annually, from 1926 to 1980.

Given the moment, the prudent assumption in 1999 would have been that returns would be lower over the next two decades. And that’s exactly what happened. That 75/25 portfolio returned 6.4 percent annually from 1999 to 2016, far lower than GE’s expected return of 9.5 percent. GE’s portfolio returned roughly 6 percent annually over that period.

In Step

GE's pension portfolio has been highly correlated with a simple portfolio of U.S. stocks and bonds (click on image):

GE has since tempered its expectations. It now assumes a 7.5 percent annual return. But that may still be too high. Long-term government bonds currently yield 2.2 percent to 2.7 percent, depending on maturity. The S&P 500’s earnings yield is roughly 4 percent, based on 10-year trailing average positive earnings. Earnings yields are higher for overseas stocks, but even so, it’s hard to cobble together an expected return of 7.5 percent.

Lower Expectations

I suspect GE knows all this, which points to a bigger problem than basic arithmetic. A lower expected return would require GE to increase its pension contributions. That would strain GE’s financial condition in the near term -- and by extension its stock price. That’s not what shareholders want to hear.

But GE has little choice. The longer it puts off the hard decisions, the costlier its pension problem will become. The market will eventually acknowledge that reality, and perhaps it already has. Since Bloomberg reported GE’s pension woes last Friday, its stock is down 3 percent through Tuesday, while the S&P 500 is up 0.2 percent.

The right answer is simple. The only question is whether GE has the stomach to acknowledge it.
Michael Hiltzik of the Los Angeles Times also reports, GE spent lavishly on shareholders, shortchanged pensions and still landed in a deep hole:
It’s customary to laud a departing corporate chief executive as a giant of industry and a management genius. That’s the tongue bath General Electric’s Jack Welch received when he retired in 2001. Not so much his successor Jeffrey Immelt, whose legacy already is being panned weeks ahead of his Aug. 1 scheduled departure.

Among other things, a close look is being taken at Immelt’s lavish spending on stock buybacks, especially over the last two years at the behest of the company’s biggest and richest shareholders. A new analysis by Bloomberg contrasts the nearly $46 billion GE spent to appease those shareholders in 2015 and 2016 with its chronic and growing underfunding of its pension plans.

By Bloomberg’s reckoning, the $31-billion shortfall in all GE’s pension plans — about 30% — is the biggest among companies in the Standard & Poor’s 500 by far. Rectifying the shortfall could create a long-term drag on earnings for Immelt’s successor as CEO, John Flannery.

Despite that, Flannery delivered the obligatory paean to Immelt’s leadership when his ascension was announced. (Immelt will remain chairman until Dec. 31.) “I am privileged to have spent the last 16 years at the company working for Jeff, one of the greatest business leaders of our time,” Flannery said, praising Immelt for having “created a vision for the GE of the future.”

Yet Immelt’s tenure has been nothing for investors to laud. Since he took over in September 2001, GE shares have returned a total of about 18% in price appreciation and dividends. In the same period, the S&P 500 has returned 195%.

Immelt gained nothing by paying off investors such as Nelson Peltz, whose Trian Partners held a $2.5-billion stake in GE as of October 2015. Peltz proposed that GE return to shareholders as much as 40% of its market capitalization (then about $260 billion) by the end of 2018, a process he said would raise its share price to $40 to $45 by the end of this year.

As we write, GE is short of both goals: Its current share buyback program totals $50 billion, about half what Peltz advocated, though the company has said that buybacks, dividends and spinoffs will return $90 billion to investors by the end of next year. Its share price is just shy of $29, never having risen higher than $30.86 (last December).

The company’s share repurchases coincided with a distinct underfunding of its pension plans. The buybacks came to $23.7 billion in 2015, including the equivalent of $20.4 billion from its spinoff of much of its GE Capital unit as Synchrony, and $22 billion more in 2016. Meanwhile the pension plans received only about $2 billion.

Partially as a result, the company’s financial disclosures show the shortfall growing within its main plan, covering 231,000 retirees and families and about 242,000 current and former workers and other plans, including those inherited via acquisitions, covering about 120,000 current and former workers. In 2015, the pension obligations of those plans came to about $90.3 billion and their assets to $63.1 billion, for a shortfall of about 30%. Last year, obligations had grown to about $94 billion and assets to about $63 billion, for a shortfall of about 33%.

As Bloomberg observes, GE’s options for closing the gap are limited. It could borrow to cover the expense, except it’s already a highly leverage corporation. And its expectation for long-term growth within the pension portfolio is 7.5% annually, which implies it will have to keep the portfolios heavily stocked with equities, which currently constitute about 56% of their holdings. One analyst cited by Bloomberg suggests that, given the ramp-up in premiums being charged on underfunded plans by the government’s Pension Benefit Guarantee Corp., which insures corporate pension plans, it may be worthwhile for GE to spend less on share buybacks and use the money to close the pension gap.

As a final irony, consider that Immelt has little to worry about in his own pension. As part of his retirement package, according to corporate disclosures, he’s due personal pension benefits worth nearly $82 million.
Of course, what else is new? Corporate America's CEOs have discovered the value of pensions -- their own pension -- as a source of lucrative compensation to add on top of their already egregious compensation package which they manipulate through share buybacks, all part of profits without prosperity.

Now, I'm not going to castigate Jeff Immelt the outgoing CEO. GE is a monster conglomerate and I personally think even if God was its CEO, it wouldn't have made much of a difference. In my opinion, GE is way too big, too bulky, too lethargic and needs to rethink its entire strategy, talk to Blackstone and other PE shops to sell off more assets and refocus its strategy.

But GE's pension problem won't go way. I read Bloomberg's analysis on the $31 billion pension hole and I'm afraid to say, it's only going to get worse in the next few years as rates plunge and stay at ultra-low levels, and risk assets get clobbered.  The pension storm cometh and it will impact all pensions, public and private.

This is why it's hard for me to get excited about GE's stock (GE) going forward. Yes, the company pays out a decent dividend but a slowing US and global economy and growing pension problem don't bode well for its shareholders in the future, which is why I would be cautious buying shares at these levels (click on image):

Sure, the company can increase share buybacks but not if its pension deficit keeps growing and not if credit markets get roiled, which will make it more difficult for a highly levered GE to borrow to buy back shares or to contribute to its pension plan.

While GE needs to rethink its pension strategy, I strongly believe America needs to rethink its pension policy as public and private pensions crater, leaving millions exposed to pension poverty.

Let me be blunt. In order to "make America great again", you need to bolster corporate and public defined-benefit plans, introduce realistic investment assumptions, improve governance, and adopt some form of risk-sharing when plans run into trouble (read more about this in my comment on the pension prescription).

Is the solution to GE's pension woes more hedge funds and more private equity funds? I actually would beef up alternatives in a deflationary environment but I would choose my partners and strategies very carefully.

But let me be clear, more alternative investments won't cure America's growing pension crisis. I personally think the time has come to enhance Social Security to adopt a similar model to what we have in Canada with CPP assets being managed by the CPPIB. In order to to do this properly, they need to get the governance right.

In fact, I envision a future where all corporations get out of the pension business to focus only on their core business and retirement will be handled by the federal and state (provincial) governments using large, well-governed public pension plans. There will be resistance to such change but it's the only way forward and it makes good pension and economic sense to do this.

One thing is for sure, the status quo isn't working and is leaving too many Americans exposed to pension poverty. It's not just GE's botched pension math that worries me, it's that of the entire country where too many public and private pensions are chronically underfunded.

Below, Bloomberg reports GE's new head will focus on cash and growth. Mr. Flannery will need to focus on a few things, including the pension time bomb. I suggest he talks with the folks at the Caisse who just signed a deal with GECAS. They are in a better position to guide him on how to address the company's growing pension woes. All I can say is don't ignore this problem, it will get much worse.

Wednesday, June 21, 2017

PSP Pushes Further Into Renewables?

Benefits Canada reports, PSP to become largest shareholder of U.S. renewable energy company:
The Public Sector Pension Investment Board is moving to become the largest shareholder in U.S.-based Pattern Energy Group Inc. as part of a series of transactions aimed at supporting a major expansion of the renewable energy company.

According to the details announced yesterday, the pension fund will purchase about 10 per cent of Pattern Energy stock and will co-invest US$500 million in projects acquired by the renewable energy company.

“With these exciting initiatives, we have created an extraordinary opportunity to continue our growth,” said Mike Garland, chief executive officer of Pattern Energy.

“Pattern Energy’s investment in the development business allows us to improve our margins and secure access to a tremendous pipeline of new projects,” he added. “The strategic relationship with PSP Investments provides us with increased capital flexibility for new opportunities, while allowing us to meet our growth targets.”

Pattern Energy’s investment plans include developments focused on wind, solar, transmission and storage projects in the United States, Canada and Mexico. “This relationship grants us access to a portfolio of projects and a source of new assets in renewables, and we believe it will provide good and stable returns for our contributors and beneficiaries,” said Patrick Samson, managing director for infrastructure investments at PSP Investments.

The co-investments include the acquisition of a wind project in each of British Columbia and Quebec. The federal public sector pension fund will also acquire a 49 per cent stake in a Texas wind project from Pattern Energy. Pattern Energy has a portfolio of 20 wind power facilities, including the two projects it’s acquiring, with a total owned interest of 2,736 megawatts in the United States, Canada and Chile.

In other investment news, the Ontario Teachers’ Pension Plan is investing in recruitment company CareerBuilder. According to a news release issued yesterday, an investor group led by Apollo Global Management, along with the Ontario Teachers’ Pension Plan, will acquire a majority of the outstanding equity interests in CareerBuilder.
Karl-Erik Stromsta of Recharge News also reports, Canadian pension fund PSP to buy largest stake in Pattern Energy:
Canada’s Public Sector Pension Investment Board will acquire nearly 10% of the shares of Pattern Energy, becoming the wind-focused US yieldco’s largest shareholder, in a deal Pattern says underscores growing investor confidence in the renewables sector.

PSP Investments, among Canada’s largest pension investment managers, will acquire 8.7 million shares of Pattern Energy from its privately held sponsor company, worth $206m at their closing price of $23.69 on Friday.

PSP Investments will also co-invest $500m in projects being acquired by Pattern Energy, including stakes in the recently completed Meikle wind farm in British Columbia and the Mont Sainte-Marguerite project in Quebec due for completion later this year.

PSP is part of a growing body of Canadian investment funds and energy companies moving aggressively into renewables. San Francisco-based Pattern, whose shares are listed in both the US and Canada, is a sizeable player in the wind markets of both countries.

Pattern Energy was the 11 th largest owner of US wind capacity at the end of 2016, with 1.8GW, according to data compiled by the American Wind Energy Association. The yieldco owns 2.6GW of renewables capacity overall, and has targeted 5GW by 2020.

“This relationship grants us access to a portfolio of projects and a source of new assets in renewables, and we believe it will provide good and stable returns for our contributors and beneficiaries,” says Patrick Samson, PSP Investment’s managing director for infrastructure investments, noting that renewables are “the fastest growing market of power generation”.

Shares of Pattern Energy rose 3.4% in early trading Monday on the news, to $24.50, their highest point since mid-2015.

For much of the past two years, Pattern's shares have traded below their 2013 initial public offering price of $22, amid persistent investor concerns about renewables yieldcos in the wake of SunEdison's bankruptcy.

But the tides have been turning for yieldcos this year, with Pattern’s shares up more than 28% in 2017.

Pattern Energy invests in Pattern Development 2.0

PSP’s investment comes as part of a flurry of deals and reshuffling within the Pattern family of companies, which includes the publicly listed yieldco Pattern Energy and two privately held developers – Pattern Development 1.0 and Pattern Development 2.0, which are owned by US private-equity firm Riverstone Holdings.

Late last year a single development company – Pattern Development, known as Pattern Energy's "sponsor" – was split into two companies: Pattern Development 1.0 and Pattern Development 2.0.

Pattern Development 2.0 owns the bulk of the early- and mid-stage renewables projects in the development portfolio, while Pattern Development 1.0 has held the controlling stake in Pattern Energy and most of the late-stage projects expected to be sold – or “dropped down” – to the yieldco.

The thinking behind separating Pattern Development 2.0 into its own early-stage development company was that it would be easier to raise capital for new projects and expand the development pipeline.

Since the creation of the separate development companies, Pattern Energy has signaled the likelihood that it would invest directly in Pattern Development 2.0.

On Monday Pattern Energy confirmed it will make an “initial” $60m investment into Pattern Development 2.0 – giving it a 20% stake – with an option to invest up to $300m and acquire the entire company. In doing so, Pattern would tie together the early-stage development and project operations activities into a single publicly-listed company.

As a result of the transaction, PSP will indirectly become an owner of Pattern Development 2.0 through its stake in Pattern Energy.

Meanwhile, Pattern Development 1.0 will "gradually wind up its business", selling its remaining projects to Pattern Energy over time, the company says.

“Pattern Energy’s investment in the development business allows us to improve our margins and secure access to a tremendous pipeline of new projects,” says chief executive Mike Garland, chief executive of both Pattern Energy and the development companies.

Pattern Energy’s direct investment in Pattern Development 2.0 comes alongside a $724m package of long-term capital commitments announced for the developer from an entity managed by Riverstone, which includes money from pension, sovereign wealth, endowments, family office, and investment funds.

Pattern Development 2.0 says it has expanded its project pipeline to 10GW, encompassing wind, solar, transmission and storage projects in the US, Canada and Mexico.
PSP Investments put out a press release which you can read here. It partnered up with Riverstone Holdings, an energy and power-focused private investment firm founded in 2000 by David M. Leuschen and Pierre F. Lapeyre, Jr. with approximately $36 billion of capital raised.

This is a huge deal which will help PSP bolster and diversify its renewable energy portfolio. In order to get a sense as to why, read about Pattern Development below:
Pattern Development is a leader in developing renewable energy and transmission assets. With a long history in wind energy, our highly-experienced team has developed, financed and placed into operation more than 4,000 MW of wind power projects. We have a global footprint currently spanning the United States, Canada, Mexico, Chile and Japan and a strong commitment to promoting environmental stewardship drives our dedication in working closely with communities to create renewable energy projects.

We have earned our position as an industry leader by combining creativity, focus and a scientific approach to discover patterns that unlock important opportunities. As a result, our company history shows consistent, groundbreaking work.

Our portfolio is full of industry firsts. Our team was the first to successfully develop a utility-scale wind energy project:
  • on Native American lands in the United States
  • on the Gulf Coast of Texas
  • in the State of Nevada
  • in the Commonwealth of Puerto Rico
We are also currently pioneering transmission projects to deliver wind energy to the Southeastern United States.

Additionally, our portfolio gives us the distinction of working with the Bureau of Land Management (“BLM”) to install a large amount of the wind power projects found on their land.

The transformational partnership structure innovated by our finance team has become the dominant model used in the wind and solar energy sectors over the last decade.

All of these accomplishments have been possible because of the way that we get the job done at every stage of the development process.

By re-examining established practices, we discover new ways to approach our projects. We discern patterns through a systematic and scientific approach, but we count on our practical know-how and industry experience to convert them into projects that perform. When we find profitable patterns, we repeat them. This cycle of discovery, deduction and development is a pattern we’ll keep repeating.
Obviously, this company is an industry trendsetter and leader in utility-scale wind energy projects. PSP made a long-term strategic investment in this sector with experts in the field.

Are there risks? There are always risks with any investment and any deal but clearly renewable energy and wind farms in particular have garnered the attention of many large Canadian pensions, not just PSP.

Renewables are the future of energy. Of course, they remain expensive. In his latest Absolute Return Letter, Oil Price Target: $0 (by 2050), Niels Clemen Jensen argues this point and ends with this comment:
As fossil fuel exploration and production ties up more and more capital, productivity growth continues to decelerate, with GDP growth ultimately turning negative. However, that is only if we cannot find a new and cheaper energy form such as fusion energy.

I am often confronted with the view that we don’t need fusion energy to fix our problems. Renewables – solar in particular – can do precisely the same. Whilst correct that greenhouse gasses will be greatly reduced as we ramp up energy production through renewables, it is still far too expensive a solution to address the productivity problem.

If governments around the world were half as smart as they claim to be, research budgets into commercialising fusion would be multiplied. It is by far the best medication for a struggling global economy, as fusion will have a much more dramatic impact on productivity and hence on GDP growth than anything automation can ever deliver.

However, it is a race against time. The global economy could quite possibly sink well before fusion reaches a state where commercialisation becomes viable – a point we won’t reach for many years. Scientists say fusion on a commercial scale is still 30 years away, but the joke is that they said exactly the same 30 years ago. Hence the need for more research resources.

Finally, before I wrap this letter up, an important point. When I say that, one day, we will no longer demand any fossil fuels, it is not entirely correct. Some residual demand for oil for various purposes (e.g. classic cars) will always exist and will probably keep oil prices above $0 for many decades, but I am sure you get my point.
I have heard plenty of people argue similar points, we need to commercialize fusion, but we're far from there. In the meantime, renewables are growing and the cost of production is falling, making wind and solar energy viable renewable energy sources.

If you have any thoughts on this topic, feel free to share them with me via my email: Don't forget to read my comment going over PSP's fiscal 2017 results.

One final note on PSP. Earlier this week, I found out its CIO Daniel Garant left the organization, which surprised me. I heard rumors he might replace Roland Lescure as the next CIO of the Caisse but there has been no official confirmation. I reached out to Mr. Garant via LinkedIn but received no response which is understandable.

Below,  CEO of Pattern Energy, Mike Garland, discusses new developments in wind energy. Also, the Ocotillo Express Wind Energy Project contains over 100 Siemens SWT-2.3-108 wind turbines and is located on BLM land outside of Ocotillo, California. The equipment is maintained by Pattern Energy Group LP. This video is a composite of 1100 frames that were each shot at f/2.8 6 sec ISO 2000 15 mm.

Tuesday, June 20, 2017

OTPP Building New Careers?

Rishika Sadam of Reuters reports, Apollo Global-led investor group to buy CareerBuilder:
A group of investors led by U.S. private equity firm Apollo Global Management LLC (APO) and Ontario Teachers' Pension Plan Board will buy a majority stake in job portal CareerBuilder, the companies said on Monday.

CareerBuilder LLC is owned by Tribune Media Co (TRCO), TV station operator Tegna Inc (TGNA) and newspaper group McClatchy Co (MNI). These current owners will all retain a minority stake, Apollo said.

Apollo did not disclose financial details of the deal.

Reuters reported last month that Apollo was negotiating a deal that would value CareerBuilder at more than $500 million, including debt.
OTPP put out a press release, Apollo Global Management-affiliated Funds and Ontario Teachers’ Agree to Acquire a Controlling Interest in CareerBuilder:
Certain affiliates of investment funds managed by affiliates of Apollo Global Management, LLC (together with its consolidated subsidiaries, "Apollo") (NYSE: APO), the Ontario Teachers' Pension Plan Board ("Ontario Teachers'") and CareerBuilder, LLC ("CareerBuilder") announced today that they have entered into a definitive agreement, pursuant to which an investor group led by Apollo along with Ontario Teachers' will acquire a majority of the outstanding equity interests in CareerBuilder. CareerBuilder's current owners, TEGNA Inc. ("Tegna"), Tribune National Marketing Company, LLC ("Tribune") and McClatchy Interactive West ("McClatchy") will retain a minority interest.

"CareerBuilder is a global leader in human capital solutions, and we are excited to work with the Company in the next phase of its growth and development," said David Sambur, Senior Partner at Apollo. "Matt Ferguson and his team have done an exceptional job capitalizing on CareerBuilder's iconic brand to create an integrated solutions software-as-a-service (SaaS) platform, and we look forward to working with the team to support the Company's continued growth and innovation."

Matt Ferguson, CEO of CareerBuilder, added, "This is an exciting next chapter for CareerBuilder. We are very proud of the work we did during our partnership with Tegna, Tribune and McClatchy, and we look forward to collaborating with Apollo and Ontario Teachers' to continue the successful transformation of our business."

The transaction includes committed financing from Credit Suisse, Barclays, Deutsche Bank, Citigroup Global Markets and Goldman Sachs & Co. LLC; all are also acting as financial advisors to Apollo, along with LionTree Advisors and PJT Partners. Morgan Stanley & Co. is acting as financial advisor to CareerBuilder. Akin Gump Strauss Hauer & Feld LLP and Paul, Weiss, Rifkind, Wharton & Garrison LLP are acting as legal advisors to Apollo. Wachtell, Lipton, Rosen & Katz LLP is acting as legal advisor to the sellers.

The proposed transaction is expected to close in the third quarter of 2017, subject to regulatory approvals and customary closing conditions. Apollo's investment is being made by the Apollo-managed Special Situations I fund.

About CareerBuilder

CareerBuilder is a global, end-to-end human capital solutions company focused on helping employers find, hire and manage great talent. Combining advertising, software and services, CareerBuilder leads the industry in recruiting solutions, employment screening and human capital management. It also operates top job sites around the world. CareerBuilder and its subsidiaries operate in the United States, Europe, South America, Canada and Asia. For more information, visit

About Apollo

Apollo is a leading global alternative investment manager with offices in New York, Los Angeles, Houston, Chicago, St. Louis, Bethesda, Toronto, London, Frankfurt, Madrid, Luxembourg, Mumbai, Delhi, Singapore, Hong Kong and Shanghai. Apollo had assets under management of approximately $197 billion as of March 31, 2017 in private equity, credit and real estate funds invested across a core group of nine industries where Apollo has considerable knowledge and resources. For more information about Apollo, please visit

About Ontario Teachers'

The Ontario Teachers' Pension Plan (Ontario Teachers') is Canada's largest single-profession pension plan, with C$175.6 billion in net assets at December 31, 2016.  It holds a diverse global portfolio of assets, approximately 80% of which is managed in-house, and has earned an average annualized rate of return of 10.1% since the plan's founding in 1990. Ontario Teachers' is an independent organization headquartered in Toronto. Its Asia-Pacific region office is located in Hong Kong and its Europe, Middle East & Africa region office is in London. The defined-benefit plan, which is fully funded, invests and administers the pensions of the province of Ontario's 318,000 active and retired teachers. For more information, visit and follow us on Twitter @OtppInfo.
In other related news, Cision PR Newswire reports, CareerBuilder Teams Up with Google to Help Connect More Americans with Jobs:
CareerBuilder's evolution into an end-to-end human capital solutions company began with operating leading job boards around the world – something it has done for more than two decades. Today, CareerBuilder is excited to announce a powerful collaboration that will bring even more visibility to its clients' job listings and help job seekers find those opportunities faster.

CareerBuilder is joining forces with Google to help power a new feature in Search that aggregates millions of jobs from job boards, career sites, social networks and other sources. CareerBuilder is fully integrated with Google to feed content to them, and will include all of its jobs from its job sites and talent networks in this new feature.

"CareerBuilder has been working closely with Google on this from the very beginning when Google was first reaching out to content providers," said Matt Ferguson, CEO of CareerBuilder. "We saw a big opportunity to increase exposure for our clients' jobs and today we stand as one of Google's biggest suppliers of jobs content. Google has enormous reach and excellent search capabilities, so why not leverage these strengths for the benefit of our clients?"

Over the last 20-plus years, CareerBuilder's model has always been to serve up jobs wherever job seekers are on the Internet, and today CareerBuilder's job search engine is on more than 1,000 sites. CareerBuilder is embracing this new feature as another distribution channel for its clients that will capture even more potential candidates.

CareerBuilder has been working with Google on different initiatives and is exploring ways in which the two companies can further collaborate.

"CareerBuilder has always had an open ecosystem because it speeds innovation and produces better outcomes," Ferguson said. "Our product portfolio has expanded so significantly – now covering everything from recruiting and employment screening to managing current employees. We think there is a great opportunity to work with Google as we grow our business."

Google has been a traffic source for CareerBuilder for several years. Six months ago, CareerBuilder announced plans to use the Google Cloud Jobs API to power searches on its job site. CareerBuilder is pairing its deep knowledge in recruitment with Google's expertise in machine learning to provide faster, more relevant results for workers looking for jobs on See the announcement here.
I don't have much to add on this deal. I'm pretty sure the folks at Apollo know how to unlock the value in CareerBuilder. Moreover, if the company is working with Google to improve its products and services, that is a huge vote of confidence in my book.

Of course, if you ask me, Microsoft's acquisition of LinkedIn will change the job search industry in ways we don't even know yet, and this represents a major threat to traditional job search companies.

How traditional job search companies respond to this emerging threat remains to be seen. Will Google try to compete head on with Microsoft and potentially acquire CareerBuilder in the future? It certainly wouldn't surprise me given the two companies are working closely together.

Below, a short clip from CareerBuilder's YouTube channel on the top jobs in America today. What about the defined-benefit industry? Oh yeah, it's shrinking, much to my dismay!

Monday, June 19, 2017

Caisse Enters Aircraft Leasing Business?

On Monday morning, the Caisse de dépôt et placement du Québec (CDPQ) put out a press release, CDPQ & GE Capital Aviation Services to join forces in creating USD 2-billion global aircraft financing platform:
  • CDPQ to provide strategic capital over four years to create an aircraft leasing and financing platform alongside world class operator GECAS
  • Platform will provide GECAS with increased flexibility to support future growth
  • Investment marks new milestone in the strategic relationship between CDPQ and GE
Caisse de dépôt et placement du Québec (CDPQ), a leading institutional asset manager, and GE Capital Aviation Services (GECAS), a world leading aircraft leasing company, announced today that they have signed a commitment letter to create a USD 2-billion global aircraft financing platform. The transaction is subject to conditions including any required regulatory approvals.

This new platform, to be named Einn Volant Aircraft Leasing (EVAL), will be involved in the acquisition of modern fuel efficient aircraft from a diverse set of global airlines and in leasing them back to such airlines under long-term leases. GECAS will source the transactions and, under a sistership condition, will invest in aircraft ownership opportunities alongside the platform to further align its interests with those of EVAL. GECAS will also act as servicer for the platform.

EVAL will provide GECAS with the flexibility to finance future growth and opportunities, while serving as an entry point for CDPQ into the aircraft leasing and financing industry. In addition, it represents a key step in the expansion of the strategic relationship between GE and CDPQ, which has been built over several years.

“This platform will provide financing solutions to airlines to help support the growth of their fleet and answer essential industry needs. The high-quality aircraft will be chosen for their ability to withstand short-term cyclicality in a sector underpinned by strong long-term growth drivers,” said Michael Sabia, President and Chief Executive Officer of CDPQ. “Through this platform, CDPQ’s stable capital and GECAS’ extensive expertise and network will combine to identify the best opportunities globally. Working with world class operators such as GE is a fundamental part of our investment strategy, and this announcement is yet another example of this strategy in action.”

“This new platform will enable continued growth and development of our global customer relationships,” said Alec Burger, President & CEO of GECAS. "We are delighted CDPQ will be our strategic partner in this exciting venture, which is a natural expansion of the relationship between the highly regarded pension fund manager and GE.”

Goldman Sachs & Co. LLC and Bank of America Merrill Lynch advised GECAS on the transaction. Clifford Chance, Milbank, Tweed, Hadley & McCloy, Torys, Walkers and Lavery provided legal advice. E&Y provided tax advice.


Caisse de dépôt et placement du Québec (CDPQ) is a long-term institutional investor that manages funds primarily for public and parapublic pension and insurance plans. As at December 31, 2016, it held C$270.7 billion in net assets. As one of Canada's leading institutional fund managers, CDPQ invests globally in major financial markets, private equity, infrastructure and real estate. For more information, visit, follow us on Twitter @LaCDPQ or consult our Facebook or LinkedIn pages.


GE Capital Aviation Services (GECAS) is a world leader in aviation leasing and financing. With 50 years of aviation finance experience, GECAS offers a wide range of aircraft types including narrow-bodies, wide-bodies, regional jets, turboprops, freighters and helicopters, plus multiple financing products and services including operating leases, purchase/leasebacks, secured debt financing, capital markets, engine leasing, airframe parts management and airport/airline consulting. GECAS owns or services a fleet of over 1,950 aircraft (1,660 fixed wing/ 306 rotary wing) in operation or on order, plus provides loans collateralized on an additional ~400 aircraft. GECAS serves 264 customers in over 75 countries from a network of 26 offices.

GE (NYSE: GE) is the world’s Digital Industrial Company, transforming industry with software-defined machines and solutions that are connected, responsive and predictive. GE is organized around a global exchange of knowledge, the "GE Store," through which each business shares and accesses the same technology, markets, structure and intellect. Each invention further fuels innovation and application across our industrial sectors. With people, services, technology and scale, GE delivers better outcomes for customers by speaking the language of industry.
With this deal, the Caisse is entering the aircraft leasing business with a great partner (GECAS) that has extensive experience in this field.

The Caisse isn't the first large Canadian pension to enter aircraft leasing. Ontario Teachers', CPPIB and PSP have all done major deals in this space.

In April, I discussed how CPPIB is preparing for landing and how it and its co-investors, which included Terra Firma, announced the sale of Dublin-based aircraft leasing company AWAS to Dubai Aerospace Enterprise Ltd.

In its press release, CPPIB's  Ryan Selwood,Managing Director, Head of Direct Private Equity, stated the following:
“We are pleased with the outcome of this transaction. We continue to believe that the aircraft leasing industry is a highly attractive market for CPPIB over the long term and look forward to exploring future opportunities to invest in the sector at scale, subject to market conditions.”
In other words, CPPIB still finds the aircraft leasing sector attractive over the long term and its managers are not ruling out reentering the space, but the price was right to sell AWAS to Dubai Aerospace Enterprise, so they jumped on the opportunity.

Now, as far as the Caisse is concerned, I bring to your attention what its CEO Michael Sabia stated in the press release:
“This platform will provide financing solutions to airlines to help support the growth of their fleet and answer essential industry needs. The high-quality aircraft will be chosen for their ability to withstand short-term cyclicality in a sector underpinned by strong long-term growth drivers,” said Michael Sabia, President and Chief Executive Officer of CDPQ. “Through this platform, CDPQ’s stable capital and GECAS’ extensive expertise and network will combine to identify the best opportunities globally. Working with world class operators such as GE is a fundamental part of our investment strategy, and this announcement is yet another example of this strategy in action.”
In other words, Michael acknowledges this is a cyclical business that can get hurt during global economic downturns and explicitly states that "high-quality aircrafts will be chosen to withstand short-term cyclicality."

Again, this is a great platform where the Caisse partnered up with a very experienced operator in the sector, one of the largest in the world.

So what is it about aviation financing that attracts institutional investors? Here I will refer you to an excellent paper EY put out in April, Aviation finance: an interesting prospect for long-term investors.

Below, I provide the Executive Summary:
A sustained low-yield environment and demanding regulatory requirements have placed considerable pressure on insurance companies and pension schemes over the last few years. In response, investors have looked to less liquid, alternative investments that offer a higher risk- adjusted return. Increased investor appetite has led to a reduced yield on more “traditional” loans and a search for more unconventional opportunities. This paper looks at one such opportunity: aviation finance.

There is considerable demand for finance in the aviation space, and institutions such as insurance companies and pension schemes can play an important role in meeting this need. Funding is provided in various forms, from traditional shares and loans to aviation specialist products such as enhanced equipment trust certificates.

The characteristics and investor rewards vary widely across different products. We believe that some of these characteristics may appeal to institutional investors — in particular, the opportunity to access investment grade debt collateralized on a long-lasting asset. However, there are also a number of operational and analytical challenges that can either be performed in-house or outsourced to external parties. These include the need for sector-specific expertise, the complexity around asset valuations under various regulatory regimes, and also the potential requirement for system developments.

This paper begins by exploring the aviation finance landscape, including why there is a demand for finance, who has met this demand historically and what forms financing can take. The paper continues to consider the investment opportunity from the point of view of an institutional investor and asks: why would an insurer or pension scheme want to invest in aviation finance, and what are the challenges of doing so?
Again, take the time to carefully read the entire paper here, it is excellent. If you are wondering why the Caisse partnered up with GECAS, the paper states one of the operational challenges:
"Aviation debt is a niche asset that requires extensive market knowledge to access markets and assess contractual features and collateral offerings."
So the Caisse will partner up with GECAS for operational reasons, finance its operations and enjoy a cut of the revenues, long-term revenues that match the Caisse's long-dated liabilities.

Below, a short clip citing the top 5 facts of GE Capital Aviation Services (2015). And an older clip (2014) when GE Capital Aviation Services (GECAS), the commercial aircraft leasing and financing arm of GE, signed a contract with Myanma Airways, the flag carrier of Myanmar (Burma), to lease 10 new Boeing narrow bodies.

Also, back in April 2015,  The Street reports GE sold most of GE Capital. Most of GE Capital Real Estate was sold to funds managed by Blackstone (BX), and Wells Fargo (WFC) bought a portion of the performing loans at closing. GE kept parts of its financing business related to its industrial operations, like GE Capital Aviation Services, Energy Financial Services and Healthcare Equipment Finance.

And lastly, a nice clip from KPMG Ireland which discusses why they are global leaders in aviation finance. And Aircraft Leasing is one of the least known, but one of Ireland's greatest global success stories in the financial services world. Find out more about this exciting industry and the new MSc in Aviation Finance at UCD Smurfit School.

Friday, June 16, 2017

Is The Fed Making a Huge Mistake?

Neel Kashkari, President of the Minneapolis Fed explains, Why I Dissented Again:
I have been focused on looking for signs that the labor force participation story of the past year or so is coming to a conclusion: The economy had been creating a lot of jobs, but there was little movement downward in the headline unemployment rate. More people than we had expected were interested in working when jobs became available. We knew this couldn’t go on forever, and indicators that this trend was reaching its eventual conclusion would include a significant move downward in the unemployment rate, a move upward in core inflation and/or a move upward in inflation expectations.¹

We have seen a meaningful drop in the unemployment rate since the Federal Open Market Committee (FOMC) voted to increase rates in March, from 4.7 percent to 4.3 percent. That drop in unemployment suggests that we are getting closer to maximum employment, which by itself would have supported an increase in rates this week. But at the same time the unemployment rate was dropping, core inflation was also dropping, and inflation expectations remained flat to slightly down at very low levels. We don’t yet know if that drop in core inflation is transitory. In short, the economy is sending mixed signals: a tight labor market and weakening inflation.

For me, deciding whether to raise rates or hold steady came down to a tension between faith and data.

On one hand, intuitively, I am inclined to believe in the logic of the Phillips curve: A tight labor market should lead to competition for workers, which should lead to higher wages. Eventually, firms will have to pass some of those costs on to their customers, which should lead to higher inflation. That makes intuitive sense. That’s the faith part.

On the other hand, unfortunately, the data aren’t supporting this story, with the FOMC coming up short on its inflation target for many years in a row, and now with core inflation actually falling even as the labor market is tightening. If we base our outlook for inflation on these actual data, we shouldn’t have raised rates this week. Instead, we should have waited to see if the recent drop in inflation is transitory to ensure that we are fulfilling our inflation mandate.

When I’m torn between faith and data, I look at decisions from a risk management perspective.

The risk of raising rates too soon is a continuation of the FOMC’s track record of coming up short of our inflation objective. As this Atlanta Fed survey² recently indicated, many people already believe that our 2 percent inflation goal is a ceiling rather than a symmetric target. Raising rates will just further strengthen that belief. And if inflation expectations drop, as we’ve seen in some other countries (and there are signs it might be happening here in the United States), it can be very challenging to bring them back up.

The risk of not moving soon enough generally doesn’t appear to be large. If inflation does start to climb, that will actually be welcome. We will move toward our target, and I believe the FOMC will respond appropriately. And if it leads to a moderate overshoot of 2 percent, that shouldn’t be concerning since we say we have a symmetric target and not a ceiling.

So what’s the downside risk of waiting to see if the recent inflation moves are transitory? I can only think of one really concerning downside risk: a sudden, rapid unanchoring of inflation expectations. A slow drift upward of inflation expectations doesn’t concern me too much, because I believe the FOMC will respond and keep them in check.

The scenario to worry about is that somehow we break inflation expectations: We wake up one morning and instead of 2 percent, they jump to 4 percent. The FOMC would have to respond very powerfully to re-anchor them at 2 percent. I believe we would do what was necessary, but the short-term economic costs might be large.

Policymakers are concerned about this risk, but it is a risk based on faith in a sudden return of the Phillips curve and not a risk that we can detect in economic, financial or survey data. Because it is based on faith and not on data, it is a difficult risk to quantify.

Though inflation expectations became unanchored during the Great Inflation of the 1960s and 1970s, that episode is not particularly useful to help us understand this risk. As I’ve looked at data from those decades, I see wage and price inflation climbing, but the FOMC lacking the conviction to bring inflation back down. They cut rates first in 1967 and then again in 1970 without having brought inflation back under control. Some reasons why they didn’t maintain aggressive monetary policy were that they put too much emphasis on the Phillips curve and underappreciated the role of inflation expectations: High unemployment would help bring inflation down — reducing the need for monetary policy to do the job.

The outcome that the current FOMC is so focused on avoiding, high inflation of the 1970s, may actually be leading us to repeat some of the same mistakes the FOMC made in the 1970s: a faith-based belief in the Phillips curve and an underappreciation of the role of expectations. In the 1970s, that faith led the Fed to keep rates too low, leading to very high inflation. Today, that same faith may be leading the Committee to repeatedly (and erroneously) forecast increasing inflation, resulting in us raising rates too quickly and continuing to undershoot our inflation target.

This balance of risks led me to believe we should rely on the data to guide us. And that means we should have waited to see if the recent drop in inflation is transitory and if inflation is actually moving toward our 2 percent target.

My Analysis (An Update to the Framework Published in February 2017)

Let me acknowledge up front that the analysis that follows is somewhat detailed and complex; yet it is still not comprehensive: FOMC participants look at a wider range of data than I capture in this piece. I am focusing on the data that I find most important in determining the appropriate stance of monetary policy.

I always begin my analysis by assessing where we are in meeting the dual mandate Congress has given us: price stability and maximum employment.

Price Stability

The FOMC has defined its price stability mandate as inflation of 2 percent, using the personal consumption expenditures (PCE) measurement. Importantly, we have said that 2 percent is a target, not a ceiling, so if we are under or over 2 percent, it should be equally concerning. We look at where inflation is heading, not just where it has been. Core inflation, which excludes volatile food and energy prices, is one of the best predictors we have of future headline inflation, our ultimate goal. For that reason, I pay attention to the current readings of core inflation.

The following chart shows both headline and core inflation since 2010. The rebound in energy prices lifted headline inflation earlier this year, but it has since moved back down below 2 percent. You can see that both inflation measures have been below our 2 percent target for several years. Twelve-month core inflation has fallen in recent months to 1.5 percent and shows no sign of consistently trending upward. It is still below target and, importantly, even if it met or exceeded our target, 2.5 percent should not be any more concerning than the current reading of 1.5 percent, because our target is symmetric. Since the March FOMC meeting, when the Committee last raised the target federal funds range, both headline and core inflation have declined notably; headline inflation has fallen from 1.9 percent to 1.7 percent, while core inflation dropped from 1.8 percent to 1.5 percent. This is concerning. Some have attributed the recent decline in core inflation to transitory factors. That is possible, but I need to see more data before I am convinced that it is only transitory.

Next let’s look at inflation expectations — or where consumers and investors think inflation is likely headed. Inflation expectations are important drivers of future inflation, so it is critical that they remain anchored at our 2 percent target. Here the data are mixed. Survey measures of long-term inflation expectations are flat or trending downward. (Note the Michigan survey, the black line, is always elevated relative to our 2 percent target. What is important is the trend, rather than the absolute level.) The Michigan survey has been trending downward over the past few years and is now near its lowest-ever reading. In contrast, professional forecasters seem to remain confident that inflation will average 2 percent. While the professional forecast ticked upward slightly earlier this year, these readings are essentially unchanged since the March FOMC meeting.

Market-based measures of long-term inflation expectations jumped a bit immediately after the election. I’ve argued that the financial markets are guessing about what fiscal and regulatory actions the new Congress and the Trump Administration will enact, and markets seem to be less confident of those changes now than they were a few months ago. The markets’ inflation forecasts have come down in recent months and remain at the low end of their historical range.

But perhaps inflationary pressures are building that we aren’t yet seeing in the data. I look at wages and costs of labor as potentially early warning signs of inflation around the corner.³ If employers have to pay more to retain or hire workers, eventually they will have to pass those costs on to their customers. Ultimately, those costs must show up as inflation. But we aren’t seeing a lot of movement in these data. The red line is the employment cost index, a measure of compensation that includes benefits and that adjusts for employment shifts among occupations and industries. It has been more or less flat over the past six years, though it ticked up modestly since the March FOMC meeting. The blue line is the average hourly earnings for employees. The growth rate of hourly earnings has fallen since the March meeting — from 2.8 percent to 2.5 percent — and remains low relative to the precrisis period. In short, the cost of labor isn’t showing signs of building inflationary pressures that are ready to take off and push inflation above the Fed’s target.

Now let’s look around the world. Most major advanced economies have been suffering from low inflation since the global financial crisis. It seems unlikely that the United States will experience a surge of inflation while the rest of the developed world suffers from low inflation. Since the March FOMC meeting, headline inflation has increased in the United Kingdom due to last year’s sterling depreciation resulting from Brexit, but headline inflation has been roughly flat in other advanced economies. With the exception of the U.K., core inflation rates in advanced economies continue to come in below their inflation targets.

In summary, inflation has moved further below our target, and market-based measures of inflation expectations have fallen from already low levels. Some argue that the recent decline in inflation is transitory, but we don’t know that for certain.

Maximum Employment

Next let’s look at our maximum employment mandate. One of the big questions I have been wrestling with is whether the labor market has fully recovered or if there is still some slack in it. Over the past couple of years, some people repeatedly declared that we had reached maximum employment and no further gains were possible without triggering higher inflation. And, repeatedly, the labor market proved otherwise. The headline unemployment rate has fallen from a peak of 10 percent to 4.3 percent, below the level it was at before the financial crisis. But we know that measurement doesn’t include people who have given up looking for a job or are involuntarily stuck in a part-time job. So we also look at a broader measure of unemployment, what we call the U-6 measure, which includes those workers. The U-6 measure peaked at 17.1 percent in 2010 and has fallen to 8.4 percent today, which is close to its precrisis level.

One of the big surprises during late 2015 through early 2017 was how strong the job market was (creating an average of 200,000 net jobs per month, which is much higher than the 80,000 to 120,000 jobs per month needed to keep up with (trend) labor force growth); yet the unemployment rate remained fairly flat near 5 percent. This surprised us a bit because it suggests that there were many more people who were interested in working than historical patterns predicted. That storyline has lost some steam in recent months: Job gains have slowed to 121,000 per month over the past three months, while the unemployment rate has fallen to 4.3 percent as labor force growth has declined. Some other measures we look at are the employment-to-population ratio and the labor force participation rate, which capture what percentage of adults are working or in the labor force. We know these are trending downward over time due to the aging of our society (as more people retire, a smaller share of adults are in the labor force). To adjust for those trends, I prefer to look at these measures by focusing on prime working-age adults. The next chart shows that in both measures, there still appears to be more labor market slack than before the crisis.

The bottom line is the job market has improved substantially, and we are getting closer to maximum employment. But we still aren’t sure if we have yet reached it. In 2012, the midpoint estimate among FOMC participants for the long-term unemployment rate was 5.6 percent — the FOMC’s best estimate for maximum employment. We now know that was too conservative — many more Americans wanted to work than we had expected. If the FOMC had declared victory when we reached 5.6 percent unemployment, many more workers would have been left on the sideline. Since the March FOMC meeting, the headline unemployment rate has fallen from 4.7 percent to 4.3 percent. The labor force participation rate for prime working-age adults fell from 81.7 percent to 81.5 percent, while the employment-population ratio increased slightly to 78.4 percent. The story of a growing labor force, either by workers re-entering or choosing not to leave, has clearly slowed, but with few signs of pushing wages higher.

We also know that the aggregate national averages don’t highlight the serious challenges individual communities are experiencing. For example, today while the headline unemployment rate for all Americans is 4.3 percent, it is still 7.5 percent for African Americans and 5.2 percent for Hispanics. The broader U-6 measure, mentioned above, is roughly double the headline rate for each group.

Current Rate Environment

OK, so we are still coming up short on our inflation mandate, and we are closer to reaching maximum employment. Let’s have a look at where we are now: Is current monetary policy accommodative, neutral or tight?

I look at a variety of measures, including rules of thumb such as the Taylor rule, to determine whether we are accommodative or not. There are many versions of such rules, and none are perfect.

One concept I find useful, although it requires a lot of judgment, is the notion of a neutral real interest rate, sometimes referred to as R*, which is the rate that neither stimulates nor restrains the economy. Many economists believe the neutral rate is not static, but rises and falls over time as a result of broader macroeconomic forces, such as population growth, demographics, technology development and trade, among others. There are a range of estimates for the current neutral real rate. Having looked at them, I tend to think it is around zero today, or perhaps slightly negative. The FOMC raised rates by 0.25 percent in March, moving the target range for the nominal federal funds rate to between 0.75 percent and 1.00 percent. With core inflation around 1.5 percent, the real federal funds rate was between -0.75 percent and -0.50 percent. Combined with a neutral rate of zero, that means monetary policy was only about 50 to 75 basis points, or 0.50 percent to .75 percent, accommodative going into this week’s FOMC meeting. Monetary policy has been at least this accommodative for several years, including the effects of the Federal Reserve’s expanded balance sheet, without triggering increasing inflation. This further confirms my view that monetary policy has been only moderately accommodative over this period.

Financial Stability Concerns

Please see my recent essay on how I think about monetary policy and financial stability.⁴ In short, while some asset prices appear elevated, I don’t see a correction as being likely to trigger financial instability. Investors would face losses from a stock market correction, but it’s not the Fed’s job to protect investors from losses. Our jobs are to achieve our dual mandate and to promote financial stability.

Fiscal Outlook

I didn’t adjust my economic outlook when the markets made optimistic assumptions about future fiscal and regulatory policy changes following the election. Markets seem less optimistic than they were a few months ago about those future actions. Until we know more from Congress and the White House, I believe it is prudent to assume no change in the fiscal outlook.

Global Environment

The world is large and complex. There is virtually always something concerning going on somewhere. But, overall, global economic and geopolitical risks do not seem more elevated than they have been in recent years. In fact, some global risks appear to have diminished, and the outlook for global growth is somewhat stronger than it was a few months ago. The world economy is expected to grow at 3.5 percent in 2017. Developing economies are expected to grow at 4.5 percent and advanced economies at 2.0 percent.⁵ While the dollar has declined modestly this year, it has increased about 20 percent over the past three years. The strong dollar will likely continue to put some downward pressure on inflation. Overall, the global environment doesn’t seem to be sending a strong signal for a change in U.S. interest rates.

Policy Tools

I have been calling for the FOMC to put out detailed plans for when and how we will begin to normalize our balance sheet. I supported releasing the details that we published following this week’s meeting. It was an important, positive step. I would have liked us to go further and also announced a start date for the balance sheet roll-off later this year. This would give markets as much advanced notice as possible so that when the roll-off actually begins, it is as close to a non-event as possible.

What Might Be Wrong?

What might my analysis be missing? Some economic or financial shock could hit us, from within the U.S. economy or from outside. That is always true, and we need to be ready to respond if necessary. In addition, if we are surprised by higher inflation than we currently expect, we might need to raise rates more aggressively. Some argue that gradual rate increases are better than waiting and having to move aggressively. It isn’t clear to me that one path is obviously better than the other.


The labor market has tightened since we raised rates in March, but inflation has fallen. It doesn’t appear that we are moving closer to our inflation target. Inflation expectations appear flat or may even be drifting lower. Monetary policy is currently only somewhat accommodative. There don’t appear to be urgent financial stability risks at the moment. The global environment seems to have a fairly typical level of risk. From a risk management perspective, we have stronger tools to deal with high inflation than low inflation. Looking at all of this together led me to vote against a rate increase. We should have waited for more data to see if the recent drop in inflation is transitory.


1. The views I express here are my own and not necessarily those of the Federal Open Market Committee.

2. See the April 2017 question.

3. The truth is there is not much of a correlation between high wage growth and future inflation but, intuitively, they must be linked.

4. See Monetary Policy and Bubbles.

5. See the International Monetary Fund’s April 2017 World Economic Outlook.
This is an excellent comment from Neel Kashkari, probably one of the best comments I have read from any Fed official in a very long time.

In fact, I have to go back seven years ago to when James Bullard wrote a paper, Seven Faces of "The Peril", where he warned long-term deflation is a possibility.

I've been warning of the risks of debt deflation for a very long time, long before I began writing this blog in 2008 right before the financial crisis hit full force.

In a recent comment of mine where I discussed why Citadel's Ken Griffin is warning of inflation, I went over yet again six structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  • The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  • Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  • 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.
  • Excessive private and public debt: Rising government debt levels and consumer debt levels are constraining public finances and consumer spending.
  • 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.
  • Technological shifts: Think about Amazon, Ubber, Priceline, AI, robotics,  and other technological shifts that lower prices and destroy more jobs than they create.
Now, we can argue about the importance of each structural factor but there is no arguing that an aging population, a less-than-spectacular labor market, the global pension crisis, excessive public and private debt, rising inequality and technological shifts are all deflationary.

All this to say that I agree with Neel Kashkari, I think it's silly for the Fed to raise rates in a deflationary environment, especially now that the US economy is slowing. Not surprisingly, institutional investors are "increasingly uncomfortable" with the Fed tightening during a slowdown.

But the market was expecting the Fed to tighten so there was no major negative surprise earlier this week after the Fed doubled down on a bet the hot job market will stoke inflation.

You might be wondering what is the Fed thinking? Are they that dumb not to recognize what Kashkari is warning of? Of course not. It is my belief the Fed knows full well the US economy is slowing but has a small window to raise rates to "store up ammunition" to lower them again when the next crisis inevitably hits us later this year or early next year.

The problem is if the Fed raises rates one more time and the US dollar takes off, inflation expectations will continue to decline, and then you have the real risk that deflation comes to America, which is what I warned of back in November 2014.

And Kaskari is right, once inflation expectations sink to dangerously low levels, they remain "sticky" and could stay low for a lot longer than policymakers expect, making their job a real nightmare (look at Japan and Europe).

In contrast, it's much easier to nip inflation in the bud once it rears its ugly head. Yes, the adjustment is painful but swift, as opposed to dealing with a prolonged bout of debt deflation. This is why I agree with Kashkari, it's better for the Fed to err on the side of inflation.

Will the Fed raise rates one more time this year? Maybe but I doubt it, especially if we get a negative deflationary shock out of China or elsewhere. I remember very well what happened after China's Big Bang two years ago, markets got massacred and for good reason, inflation expectations plunged, the yield curve flattened and financials and other cyclical stocks got clobbered. Following that event, it was one big Risk-Off market.

Even if we don't get a global deflationary shock, as the US economy continues to slow, it will be increasingly harder for the Fed to justify raising rates one more time.

No wonder well-known bond gurus Bill Gross and Jeff Gundlach came out this week warning investors to cut risk and raise cash. Bond managers see a huge disconnect between the real economy and the financial market, and rightfully so.

But as we all know by now, markets (especially these central bank manipulated markets) can stay irrational longer than you and I can stay solvent. There is a lot of liquidity out there chasing risk assets higher, so don't be surprised if things remain crazy for longer.

Still, I've been warning my readers since the start of the year, it's not the beginning of the end for bonds, if you want to sleep well at night, you should be loading up on US long bonds (TLT) on every pullback. And so far, I've been right on that call:

And I believe the best is yet to come for US long bonds, especially if another major financial crisis hits us in the fall or in 2018. Remember, in a deflationary world, US government long bonds are the ultimate diversifier, and will protect your portfolio from huge losses

It's funny, when people talk about long bonds, they look at the low yield and think why invest in bonds? Wrong way of thinking. You invest in bonds to lower the volatility in your portfolio and limit the downside risk that is inherit in stocks and other risk assets.

As far as stocks, given my views on the reflation trade and the US dollar, I remain underweight and/ or short emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE)  and Financial (XLF) shares on any strength. 

The only sector I like and trade now, and it's very volatile, is biotech (XBI) but technology stocks (XLK) in general continue to do well despite the recent selloff in FANG stocks (click on images):

Will the momentum continue in the summer months? Who knows? I think it's fair to assume a lot more volatility or some consolidation here, but don't be surprised if these sectors keep making new highs (remember, it took several rate hikes back in 2000 before stocks got clobbered).

So, just to recap, I think there may be more juice in the stock market but in this deflationary environment, I would definitely hedge my risk with good old US long bonds and prepare a potential negative shock later this year or early next year (who knows, the shock might come earlier or later).

As far as the US dollar, I remain long and foresee it going higher even if the Fed doesn't raise a third time this year. The US slowdown is already in motion, Europe, Japan and the rest of the world will follow and their currencies are already starting to exhibit weakness.

Hope you enjoyed my comments this week. I want to ask all of you who value my insights on pensions and investments to please take the time to subscribe and/ or donate via PayPal under my picture on the right-hand side. I thank the few who have supported my efforts, it's truly appreciated.

Below, watch the FOMC press conference from a couple of days ago. Listen carefully to Chair Yellen but keep in mind what Neel Kashkari wrote above.

And CNBC's Steve Liesman, provides insight to the Federal Reserve's decision to hike interest rates and what it indicates about the economy and its policies going forward.

The Fed is looking to unwind its balance sheet over the next five years? If my worst fears come true, the Fed's balance sheet will dramatically expand from these levels over the next five years.

Lastly, Jack Ablin, BMO Private Bank's chief investment officer, says if it weren't for liquidity, the stock market rally could be ripping apart. Ablin says investors have been encouraged to take on risk due to the trillions of dollars being pumped into the system by central banks. No kidding, there's a big liquidity party going on in markets, and the music is still playing, for now.