Tuesday, July 31, 2012

Singapore's GIC Raising Cash to Crisis Levels?

Kyunghee Park and Weiyi Lim of Bloomberg report, Singapore’s GIC Boosts Cash to Levels Exceeding 2008 Crisis:
Government of Singapore Investment Corp., managing more than $100 billion, boosted cash to levels exceeding the 2008 global financial crisis as it pared stocks and bonds, reducing its holdings in Europe.

Cash allocation almost quadrupled to 11 percent of its portfolio in the year ended March from 3 percent a year earlier, GIC, as the sovereign wealth fund is known, said in its annual report. Stocks fell to 45 percent from 49 percent as it pared equities in developed markets, while bonds dropped to 17 percent from 22 percent.

GIC is reducing its investments as the MSCI World Index (MXWO) posted its biggest slump since the 2008 global financial crisis and market volatility reached the highest level in more than two years. Trading options have become limited for government funds seeking to preserve capital as policy makers across the world prepare for a deeper impact from Europe’s debt woes.

“There are not many safe havens, so cash is king,” said Ronald Wan, a Hong Kong-based managing director at China Merchants Securities Co., which oversees about $1.5 billion. “It’s logical for everyone to cut investments and take a wait- and-see approach. The economic downturn will last for a while before we can see certainty and a swing-back in investment sentiment.”

GIC’s holdings in Europe fell to 26 percent from 28 percent, with those in the U.K. unchanged at 9 percent, it said. Within Europe, GIC’s assets in Portugal, Ireland, Italy, Greece and Spain made up 1.4 percent of its portfolio, mainly held in real estate and stocks in Italy and Spain, it said.

‘Greater Uncertainties’

Assets in the Americas were unchanged at 42 percent, with 33 percent of the total portfolio in the U.S., it said. It raised its allocation to Asia to 29 percent from 27 percent.

“The market experienced many twists and turns over the last year,” Lim Siong Guan, president of GIC, said in its annual report today. “There will be greater uncertainties in the future.”

Holdings in so-called alternative assets increased to 27 percent from 26 percent, it said, with a gain in private equity and infrastructure investments. Real estate was unchanged at 10 percent of its portfolio, it said.

The so-called 20-year annualized real return was 3.9 percent as of March 2012, unchanged from the previous year, it said. The annualized nominal rate of return in U.S. dollar terms was 3.4 percent over 5 years, 7.6 percent over 10 years and 6.8 percent over 20 years, it said. The fund doesn’t report an annual return or disclose the actual size of its portfolio.

Tracking Performance

The 5 and 10-year returns beat two composite portfolios of stocks and bonds it tracks, while it underperformed over a 20- year period, said GIC, which was set up in 1981.

The International Monetary Fund said yesterday that the euro-area debt crisis has exacerbated global financial instability and an orderly adjustment process is likely to be prolonged and costly.

In Asia, Singapore’s economy unexpectedly contracted last quarter and China and South Korea cut interest rates this month. Europe was plunged into fresh market turmoil as calls for bailout aid sent borrowing costs surging, while Moody’s Investors Service lowered Germany’s rating outlook to negative.

The MSCI World Index dropped 7.6 percent in 2011, the worst annual performance since 2008. The decline narrowed to 1.7 percent for the year ended March.

‘Heightened Uncertainty’

The cost of insuring sovereign bonds from default in Western Europe reached a high this year of 382.5 basis points before falling to 255.24 basis points, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. A similar measure tracking Asia Pacific reached a high of 232.86 on Oct. 4 before declining to 130.05.

“Due to the heightened uncertainty in global markets, we allowed the cash inflow from investment income and fund injection to accumulate during the year in preparation for better investment opportunities,” Ng Kok Song, GIC’s chief investment officer, said in the report. “We reduced the allocation to bonds because bond yields in the developed markets had been pushed down to abnormally low levels by the flight to safe assets and central bank intervention.”

In the year ended March 2009, when its investments were hit by its stake in UBS AG (UBS), GIC raised its cash holdings to 8 percent from 7 percent, and reduced its bond investments to 24 percent from 26 percent, it said at the time.

China’s sovereign wealth fund said last week it will invest with a longer-term focus after it posted a 4.3 percent loss on its overseas holdings last year because of declines in global commodity prices.

CIC’s Returns

Net income at the $482.2 billion fund, with a resources- heavy portfolio, fell to $48.4 billion in the year ended Dec. 31, Beijing-based China Investment Corp. said in its annual report on its website on July 25. The overseas investment performance was the worst since the fund was set up in 2007, and compares with an 11.7 percent return in 2010. CIC was set up to improve returns on foreign-exchange reserves by investing overseas. In China, the fund’s holdings are largely limited to stakes in financial institutions for the government.

Temasek Holdings Pte, Singapore’s state-owned investment company, said it spent the most on new holdings in four years as it added more energy and resources producers to its portfolio. The company said it made S$22 billion ($18 billion) of investments in the year to March 31, boosting assets 2.6 percent to a record S$198 billion.

Temasek’s Profit

The investment firm said profit for the year declined 16 percent as contributions from units fell amid the global slowdown. Net income dropped to S$10.7 billion from S$12.7 billion a year earlier, it said in its annual report. Temasek’s total shareholder return averaged 17 percent since its inception in 1974.

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., held holdings of Treasuries and mortgages steady in June after saying that U.S. securities are still the safest bet. Gross kept the proportion of U.S. government and Treasury debt in his $263 billion Total Return Fund unchanged at 35 percent of assets last month, according to a report on the company’s website. Pimco doesn’t comment directly on monthly changes in its portfolio holdings.

Gross left the Total Return Fund’s net cash-and-equivalent position unchanged at negative 21 percent last month. The fund can have a so-called negative position by using derivatives, futures or by shorting.

“Looking ahead, we assess that the investment environment will be characterized by a global economy struggling to return to sustainable growth,” GIC’s Ng said. “The medium-term investment outlook is therefore challenging.”

You can download Singapore's GIC full annual report here and go to their website for quick overviews.

In particular, go over the CIO's investment report written by Ng Kok Song by downloading it here. Here are the main points:

  • Developed equity markets ended the year broadly unchanged. The rise in the US market made up for the decline in European stocks, but emerging markets suffered negative returns. The flight to safety among investors boosted bond returns particularly of US Treasuries and German Bunds.
  • In the Government’s portfolio, positive returns from bonds and real estate offset the negative returns from emerging markets and natural resource equities.
  • For the 5- and 10-year periods, the Government’s portfolio had higher returns and lower risk than both composite portfolios. For the 20-year period, the Government’s portfolio had a lower return and lower risk. This was because in the first decade of the 20-year
    period, the portfolio was more conservatively invested with more cash and bonds. GIC’s diversification into alternative and private asset classes took place in the last ten years.
  • The allocation to cash rose from 3% to 11%. Due to the heightened uncertainty in global markets, we allowed the cash inflow from investment income and fund injection to accumulate during the year in preparation for better investment opportunities. Consequently, the exposure to public equities fell from 49% to 45%. We reduced the allocation to bonds because bond yields in the developed markets had been pushed down to abnormally low levels by the flight to safe assets and central bank intervention.

And going forward, here is what the CIO states on their outlook:

For a large portfolio to earn returns above inflation over a long investment horizon, it must have significant exposure to equity and equity-like assets. The key risks to the portfolio are thus political and economic developments which impact equity returns.

Looking ahead, we assess that the investment environment will be characterised by a global economy struggling to return to sustainable growth.

The developed economies will continue to be weighed down by an extended period of debt-deleveraging. In Europe, the debt crisis has spread beyond the periphery to the larger Spanish and Italian economies. There is still a risk of disruptive events in the Eurozone, and prolonged weakness in economic growth. In the United States, the fragile economic recovery could be aborted by automatic spending cuts and tax increases if political gridlock continues beyond the 2012 elections with no compromise on a long-term plan for reducing the public deficit.

Growth in the emerging economies, particularly China, is also slowing. A cyclical slowdown in China is necessary for its economy to consolidate to a more sustainable growth trajectory. But this slowdown coincides with the problems in the developed economies. It will thus weaken global business confidence and also impact the commodity-producers.

The medium-term investment outlook is therefore challenging. GIC will continue to invest based on sound fundamentals and where appropriate, take calculated risks in order to reap long-term gains.

Singapore's GIC is one of the best sovereign wealth funds in the world and given their geographical advantage, investors should pay attention to their investment outlook as they provide insights into what's going on in Asia.

Having said this, GIC are disciples of Bridgewater and Ray Dalio's school of thought. I read the outlook above and I'm thinking "Ray Dalio and Bridgewater all the way!". GIC is one of their largest investors and I understand why like so many other institutional investors, they can be overly influenced by Bridgewater's daily comments.

But as I wrote in a recent comment, Dangerous Dynamic or Buying Opportunity?, institutional investors are way too pessimistic and there are plenty of upside surprises in depressed sectors (like US coal shares) that were obliterated over the last year due to euro debt crisis and exaggerated fears of a severe slowdown in China.

In this environment dominated by political and economic uncertainty, I understand why GIC is significantly raising cash but I fear they are being way too cautious and risk underperforming when the economic outlook improves in the US and elsewhere. Keep an eye on the ISM report out tomorrow and Friday's jobs report.

Below, Bloomberg's Tom Keene, Scarlet Fu and Mike McKee recap the op-ed pieces and analyst notes providing insight behind today's headlines. They speak on Bloomberg Television's "Bloomberg Surveillance" and focus on policy induced bubbles and ECB cynicism. My message is simple: Don't fight the Fed and global central banks!

Monday, July 30, 2012

Simple Truth #6: Is Consolidation Feasible?

On Friday, I wrote a comment on seven truths about public employee pensions and received excellent feedback from Chis Conradi, a retired pension actuary who spent the last twenty years of his career working on governmental retirement plans, mostly at the statewide level:
In your recent blog posting, you suggest, in your sixth simple truth, the consolidation of local plans. You say:
It's simply mind-boggling to see a bunch of city and county plans that are severely underfunded, bankrupting their communities and jeopardizing vital public services. Both Congress and the Senate need to introduce a bill to consolidate all these plans and have them managed by existing or (preferably) new state public plans.
While consolidation would most probably be a good thing, it is not something that can be forced by the US Congress, due to states’ rights under the Constitution. It will be up to the various state legislatures to accomplish this, and I have a lot of evidence that it will not happen.

Some states already have one or more statewide plans for local government employees, for example: Utah, Missouri, Texas, Colorado, Virginia, North Dakota and Rhode Island. Other states have no such system, for example: Florida, Pennsylvania, Massachusetts. Despite the obvious inefficiencies of not consolidating, these two different approaches have existed side by side almost unchanged for at least thirty years.

Even in states with consolidated statewide systems covering local government pension plans, there are almost always exceptions. For example, Texas has the Texas Municipal Retirement System, larger cities are allowed to maintain their own separate plans, so we have separate plans for Dallas, Houston, Austin, El Paso, etc. Further, firefighters are excluded from this arrangement. Rhode Island, much in the news lately, has a plan for municipalities and police/fire districts, but Providence, Warwick and about 20 smaller communities maintain their own plans. Missouri K12 teachers and other K12 school employees are covered by statewide plans, except that St. Louis and Kansas City maintain their own plans for teachers and school employees. I’m only aware of a couple of isolated instances where there has been any move towards consolidation in the last thirty years: Denver being merged into Colorado PERA and Minneapolis into the Minnesota statewide plan.

I used to see the inefficiency inherent in having hundreds of separate plans, as in Florida and Pennsylvania, but I was never successful in getting this changed anywhere. There are significant issues involving equity for the individual cities, and it’s a far from trivial task. It could be done, probably most effectively by starting a new combined system for all future new hires and waiting for the older systems to age away. However, the political ramifications are significant, and I don’t see it happening.

While there are reasons for believing that a single statewide plan will usually be run better than a multitude of local plans, it isn’t always so. And in my experience, both the local plan and the local government will fight like the clichéd cats and dogs for their autonomy.
I thank Chris for sending me this feedback and he's right, local plans and governments will fight like cats and dogs to preserve their autonomy.

But what is in the best interests of plan sponsors, workers and taxpayers? Here, there is no doubt in my mind that larger, more transparent and more accountable defined-benefit plans are much better than having hundreds of smaller, dispersed plans all over the place, many of which are badly managed and chronically underfunded.

By the way, we have the same problem in Canada, you just don't hear about it because nobody pays attention to all these local plans until a crisis hits and exposes their dire state.

Below, Max Keiser and co-host, Stacy Herbert, discuss feeding frenzy on Wall Street where sharks are taking a bite out of pension funds. Nice clip except Wall Street makes great white sharks look like goldfish.

Sunday, July 29, 2012

A Market-Friendly Debt Buyback?

Dimitris Kontogiannis of ekathimerini reports, A market-friendly debt buyback:

It took just a few months after the completion of the biggest-ever sovereign debt restructuring in history, known as PSI (Private Sector Involvement), for policymakers and others to see what the markets have been saying all along: that the Greek public debt has not become sustainable.

Unfortunately, most decision-makers in the European Union now appear to be leaning toward a writedown of Greek debt in public hands, which is hardly the optimum solution.

PSI turned out to be a big success as far as high investor participation and smooth execution was concerned, but it failed in the most critical test: To provide significant debt relief and convince the markets that the Greek public debt was sustainable, unleashing a series of positive reactions from investors and others that would contribute to the stabilization of the economy.

Debt relief should have amounted to more than 100 billion euros, or 50 percentage points of GDP, after the completion of PSI. This, however, did not happen for specific reasons: Greece is still running a primary budget deficit projected close to 1 percent or 2 billion euros this year. In addition, the so-called snowball effect emanating from the difference between the average nominal interest rate and GDP growth continuous to burden the debt-to-GDP ratio.

The same holds true for tens of billions of euros in official funds/bonds destined for the recapitalization of Greek banks and paying off state arrears. Also, intergovernmental bond holdings held by pension funds and others are not included in the general government debt calculation, making the debt reduction under PSI smaller. Social security funds saw their holdings of more than 24 billion euros cut by more than half in value under PSI.

So, PSI did not provide the kind of debt relief that the markets and others wanted to see in order to believe that Greece could, under some normal assumptions, significantly bring down its debt ratio from the start, and also to benefit from the lower average lending rate and the light redemption schedule in the years ahead due to the extension of maturities.

It is clear that the worse-than-projected performance of the Greek economy in 2012 and its likely underperformance next year necessitates changes to the sustainability analysis of the Greek public debt. The lack of satisfactory progress in the privatization program means the positive impact on the debt from this source may not fully materialize. Also, fiscal slippage cannot be ruled out for sure in 2013 and 2014 if the economy continues to shrink. The situation becomes more nebulous if one assumes a one- or two-year extension of the Greek economic adjustment program wanted by the new coalition government.

So, the goal of pushing the debt-to-GDP ratio down to 120 percent of GDP in 2020 from 165 percent in 2011 envisaged by the IMF is difficult to attain and will require additional debt relief, in order for the Greek debt to be deemed sustainable.

There is already talk that the Greek bonds held by the ECB and other national central banks will have to be restructured to make it possible. Many had criticized the ECB for refusing to take part in PSI but now the issue is coming back since writing down bilateral EU loans to Greece is politically very sensitive. The ECB had refused to take part in PSI, arguing that it would amount to direct state funding, which is prohibited by its charter and runs contrary to the tradition of Bundesbank, the German central bank, after which it is modeled.

Assuming that the ECB’s Greek bond holdings amount to 45-50 billion euros, a 53.5 percent haircut along the lines of PSI, would have provided debt relief of 24-26.75 billion euros. This may be enough to bring the Greek debt ratio down to 120 percent of GDP by 2020 under the new more ominous assumptions about the economy -- privatizations etc. -- but we think it will still not be enough for the markets.

To change the game, policymakers must be willing to do more -- assuming Greece honors most of its commitments under the second financing package. It does not take a genius to see that this can happen without compromising the ECB’s mandate.

As others and we have suggested in the past, the ECB can transfer its Greek bonds to the EFSF or the new permanent mechanism, ESM, at the average price bought by the EU central banks, allegedly between 70 and 80 percent of the nominal value. This way the ECB will not lose money on its Greek bond holdings. Moreover, the EFSF or the ESM can extend a long-term loan to Greece at a reasonable interest rate that will be used to buy the same bonds from them at the same price or lower. This way the country will be able to cut its debt by cancelling the bonds of a higher nominal value.

Since this exercise will not be big enough to provide significant debt relief -- it would save just 10 billion on bonds with a nominal value of 50 billion euros, which undergo a 20 percent haircut -- the same entities could provide Greece with a bigger loan to engage in debt buyback or they could do it themselves and swap the savings to Greece.

This is a market-friendly way to make the Greek debt sustainable in the eyes of the markets. Of course, Greece will also have to do its part by meeting the fiscal targets and modernizing its economy.

All-in-all, a market-friendly debt buyback at the current beaten-down prices of Greek bonds is the best way to cut the public debt significantly and create the conditions for a turnaround in the local economy with positive results for the eurozone. Whether political wrangling and myopia will again stand in the way remains to be seen. However, it looks as if this is the best way to get the ECB out of the difficult position of writing down its holdings, making the Greek debt sustainable and reducing the likelihood of contagion, with a visible improvement on risk bond premiums in the euro periphery.

Ekathimerini reports that Greece’s three coalition leaders are to hold a crucial meeting on Monday that is likely to decide what form the 11.5 billion euros of spending cuts for the next two years are likely to take:

It appears that Prime Minister Antonis Samaras, PASOK leader Evangelos Venizelos and Democratic Left chief Fotis Kouvelis have agreed that the measures should not include a further cut to civil servants’ salaries, thereby ending the 13th and 14th monthly payments, nor the imposition of a 1,500-euro per capita ceiling on healthcare coverage. Instead, it will raise from 5 to 15 euros the cost of a visit to a public hospital for treatment.

One of the areas where the three leaders have yet to agree is on the rise in the retirement age from 65 to 67. This would save about 1 billion euros over the next two years. Venizelos and Kouvelis suggested trying to find alternative measures of equal value.

The leaders also have to decide where to set the limit on how much retirees who have basic and auxiliary pensions can receive per month. It is likely that the ceiling will be placed between 2,300 and 2,500 euros. There is also a proposal to reduce any pensions above 1,400 euros by 10 percent but Venizelos wants the reduction to be only on the amount that exceeds this level, rather than on the total retirement pay.

Among the measures that look certain to be included in the latest cost-cutting package is a 22.7 percent reduction to the lump sum civil servants receive when they retire. Private sector workers who draw their pensions from state-backed funds could also be in line for a cut. Also, public hospitals will be instructed to increase their use of generic drugs to 66 percent of the total medicines they use by 2014.

The government sees a quick agreement on the fiscal measures as the first step to rebuilding trust with its lenders. “The road ahead is long and demands patience and persistence so we can make up for lost time,” Alternate Finance Minister Christos Staikouras told Sunday’s Kathimerini.

“Greece cannot be saved; that is simple mathematics,” Michael Fuchs, deputy leader of the parliamentary group of Chancellor Angela Merkel’s Christian Democrats told business magazine Wirtschaftswoche. ”The government has neither the will nor the means to implement reforms.”

Germany's patience is wearing thin. The Telegraph reports that Wolfgang Schäuble, the German finance chief, said no further concessions can be made to Greece as he prepared to meet US Treasury Sectretary Timothy Geithner:

At the meeting with Mr Geithner on the German island of Sylt, the two will discuss the US, European and global economies" as growth slows around the world.

The US finance chief will later meet European Central Bank President Mario Draghi, who last week pledged to do all with the his remit to protect the euro after rising fears that Spain will need a full sovereign bail-out.

Both meetings will be closed to the press.

The US economy grew at its slowest pace in a year in the second quarter, weighed down by nervous consumers, the escalating euro-zone debt crisis and worries of slowing growth in China. Figures last week showed the US economy grew at 1.5pc compared with 2pc in the first quarter.

America also faces the threat of a "fiscal cliff" later in the year when Bush-era tax breaks end and $1.2 trillion of spending cuts start.

In the eurozone, Germany is standing firm despite increasing pressure to relax its stance on using the ECB to buy bonds or act as a lender of last resort to help stem the crisis in the single currency, particularly in Spain where borrowing costs are at unsustainable levels.

If Spain, the eurozone's fourth biggest economy and the world's 12th, loses affordable market financing the next domino at risk of falling is Italy - the euro zone's third biggest economy and a member of the G7 group of big wealthy nations.

Many regard September as a "crunch time" for the euro. In that month a top German court rules on the new eurozone rescue fund, the anti-bailout Dutch vote in elections, Greece tries to renegotiate its financial lifeline, and decisions need to be made on whether taxpayers suffer huge losses on state loans to Athens.

Despite denials last week, Reuters reports that a eurozone official said Madrid has now conceded that it might need a full bailout worth €300bn from the EU and IMF if its borrowing costs remain unaffordable.

Greece is compounding the problems as it struggles to implement the necessary reforms to improve its finances and economy. This raises the fear that it may need more time, more money and a debt reduction from eurozone governments.

Mr Schäuble told Germany's Welt am Sonntag newspaper on Sunday that the current bailout plan for Greece was already "very accommodating", adding: "I cannot see that there is any room left for further concessions. The problem did not arise because the programme had faults, but rather because Greece did not implement it fully enough."

He said it was not helpful now to speculate about giving Greece more time or more money.

"It is not a question of generosity. The question is rather, is there plausible way for Greece to manage this."

He also ruled out a further debt writedown for Greece, saying it would "only destroy trust".

Greece is experiencing its Great Depression but the truth is there is no political will whatsoever to introduce meaningful cuts to the bloated public sector, cut red tape to spur foreign investment and put everything on the table, including deep cuts to the defense budget (not part of 'austerity' measures because this benefits German, French and US defense contractors and allows Greek politicians to get rich off bribes from defense contracts).

Everything in Greece is overly-complicated because the political and industrial elite want to maintain their power even as the economy sinks to a new abyss. According to Troika, Greece can't pay its debt:

Greece is not likely to be able to pay its debts, meaning the twice-bailed-out member of the euro zone will have to restructure about $240 billion of sovereign debt, European Union officials told Reuters on Tuesday.

Although the officials, who are part of the so-called Troika that includes the European Central Bank (ECB) and the International Monetary Fund, won't finalize the results of their inspection of Greece's debt-choked economy until next month, their conclusions are already clear.

Prospects of euro zone members or the ECB being willing to bail out Greece yet again appear remote if not nonexistent, especially since the Greek economy is expected to contract by a massive 7 percent this year and Greek officials have not been able to make progress in fixing the 3-year-old crisis.

"Greece is hugely off-track," one of the officials told Reuters. "The situation just goes from bad to worse, and with it the debt ratio."
EU leaders are also to blame as they seem incapable of addressing this 'debt crisis' (really a jobs crisis) once and for all. Mr Schäuble talks a tough game but the reality is German Chancellor Angela Merkel’s export machine is generating far more in revenue than her anti- bailout voters are committing to euro-crisis fighting as the weakening currency adds to the country’s competitive edge:

German exporters are enjoying a 100 billion-euro ($122 billion) annual advantage amid the turmoil, said Nathan Sheets, chief international economist at Citigroup Inc. (C) in New York. That’s more than 10 times the 8.7 billion euros the country is contributing this year to the rescue fund being set up.

The figures underscore the benefits to Europe’s biggest economy of Merkel’s austerity-first strategy, which channels her voters’ doubts about propping up debt-laden countries. Her approach has drawn criticism from policy makers around the world and pleas for easing from southern Europe, where bond spreads have climbed to euro-era records amid concern about whether the 17-nation currency region can hold together.

“Do they care? I don’t think so,” David Buik, a market strategist at Cantor Index in London, said in a July 13 telephone interview, referring to German policy makers. “It’s dog eat dog out there. It is a question of shore up the dams and do what we can for ourselves.”

Of course they don't care! Germans are just as guilty as anyone in this euro mess. In fact, Merkel has knowingly adopted an 'austerity first' strategy precisely because it benefited the German export machine (good in the short-run, longer-term this is a disastrous policy).

Below, former US President Bill Clinton visits Athens with Greek American businessmen to support the new government in the crisis-crippled country, and warns that constant pressure by rescue creditors is counterproductive. Greek PM Samaras says his country is going through its version of the Great Depression.

And European Commission chief Jose Manuel Barroso arrived at the prime ministerial headquarters for talks with the Greek PM Antonis Samaras. Spokesman for the Commission Antoine Colombani told reporters the assessment on Greece's ability to sustain its debt will not be finalized until inspectors from the IMF, the European Central Bank and the European Commission return in September to look into the country's progress.

Saturday, July 28, 2012

The Biology of Boom and Bust?

The Montreal Gazette published an excerpt from John Coates' new book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust:

Derivatives trader turned neuroscientist John Coates looks at the biological roots of economic boom and bust in his new book, The Hour Between Dog and Wolf. Here is an excerpt from Chapter 7, Stress Response on Wall Street.

Shell-shocked traders, under the influence of an overly active amygdala, become prey to rumour and imaginary patterns. In a recent study, two psychologists presented meaningless and random patterns to healthy participants, who appropriately found nothing of significance in them, and then to people exposed to an uncontrollable stressor, who did find patterns in the noise.

Under stress we imagine patterns that do not exist. A striking real-life example of this phenomenon is reported by Paul Fussell in his astonishing book The Great War and Modern Memory. Troops living in the trenches during the First World War, under the most unimaginable conditions of fear and uncertainty, were deprived of reliable information about the war because the official army newspaper contained little but inaccurate propaganda.

In the absence of reliable information, and in desperate need of it, troops fell prey to rumour in a manner not seen since the Middle Ages – rumours of wraithlike spies conversing with frontline troops before disappearing into the mist; of angels in the sky over the Somme; of a factory behind enemy lines called the Destructor where bodies of Allied soldiers were rendered for their fats; of tribes of feral deserters living in no-man’s land, preying on injured soldiers.

Traders during a financial crisis suffer from an equally wretched vulnerability to rumour and suspected conspiracy. Every bank, individually or collectively, at one time or another is going under; hedge funds, huge ones of course, conspiring to push down the markets; the Chinese dumping Treasuries; the UK defaulting on its sovereign debt; broker suicides. Each rumoured catastrophe is now given as much credence, and has as much effect on markets, as hard economic data.

Cortisol’s lethal effects on the brain are compounded by another chemical produced during stress, one produced in the amygdala called CRH (short for corticotropin-releasing hormone). CRH in the brain instils anxiety and what is called ‘anticipatory angst’, a general fear of the world leading to timid behaviour.

Together with cortisol, it also suppresses the production of testosterone, the invigorating hormone that powered so much of (Wall Street banker) Scott’s confidence, exploratory behaviour and risk-taking during the bull market. He now scares easily. He develops a selective attention to sad and depressing facts; news comes freighted with ill portent; and he seems to find danger everywhere, even where it does not exist. This paranoia colours his every experience; and when riding home in the taxi at night Scott finds that even his beloved New York City, once sparkling with opportunity and excitement, has lately taken on a menacing silhouette. As a result of chronic stress he, like most of his colleagues, becomes irrationally risk-averse.

By mid-December (2008), the financial industry has endured a month and a half of endless volatility and non-stop losses. The run-up to Christmas is normally one of the most optimistic and playful times of the year, with the holidays and skiing vacations to look forward to, followed by bonus payments in the New Year.

But such gaiety as had survived the crash has now been crushed by layoffs, brutally announced just before Christmas, involving almost 15 per cent of the sales and trading staff. Few people will get any bonus at all; and the lucky ones, like Martin and Gwen, who do get a small one, harbour a deep resentment because this year they have made record profits and helped to keep the bank afloat, while traders like Stefan, paid over $25 million last year, have helped blow up the bank and with it their, Martin and Gwen’s, bonuses. Scott will get nothing at all, and does not know how long he will be kept on. Layoffs have been similarly announced all along Wall Street and in the City of London. Many firms, facing bankruptcy, have closed their doors. One by one, the lights are going out all across the financial world.

With their jobs on the line, traders like Scott desperately need to make money, but find themselves oddly unable to initiate a trade, even one that looks attractive, being held back from the phones as if by a force field. They have become, as they say in the business, ‘gun shy’.

A reduced risk-taking among traders would be a welcome change under normal conditions, but during a crash it poses a threat to the stability of the financial system. Economists assume economic agents act rationally, and thus respond to price signals such as interest rates, the price of money. In the event of a market crash, so the thinking goes, central banks need only lower interest rates to stimulate the buying of risky assets, which now offer relatively more attractive returns compared to the low interest rates on Treasury bonds.

But central banks have met with very limited success in arresting the downward momentum of a collapsing market. One possible reason for this failure could be that the chronically high levels of cortisol among the banking community have powerful cognitive effects. Steroids at levels commonly seen among highly stressed individuals may make traders irrationally risk-averse and even price insensitive. Compared to the Gothic fears now vexing traders to nightmare, lowering interest rates by 1 or 2 per cent has a trivial impact. Central bankers and policy-makers, when considering their response to a financial crisis, have to understand that during a severe bear market the banking and investment community may rapidly develop into a clinical population.

Of the conditions affecting traders, a particularly unfortunate one is known as ‘learned helplessness’, a state in which a person loses all faith in his or her ability to control their own fate. It has been found that animals exposed repeatedly to uncontrollable stressors may pathetically fail to leave the cage in which this experiment was conducted if the door was left open.

Traders, after weeks and months of losses and volatility, may similarly give up, slumping in their chairs and failing to respond to profit opportunities they would only recently have leapt on. In fact there is some evidence suggesting that people like traders might be especially prone to this sort of collapse. Banks and hedge funds commonly select traders for their tough, risk-taking, optimistic attitude. Optimism is generally a valuable trait in a person, especially a trader, for it leads them to welcome risk, and to thrive on it.

But not always. Not if they are exposed to longlasting and unpredictable stressors. Research has suggested that optimistic people, those who are used to things working out, may not handle recurrent failure very well, and may end up with an impaired immune system and increased illness. Bankers, so well suited to the bull market, may be constitutionally ill prepared to handle bear markets.

A telling sign of the onset of learned helplessness is the subsiding of anger on the trading floor, anger being in fact a healthy sign that someone fully expects to be in control. During a crisis, when swearing dies down, fewer phones are smashed, and anger is replaced by resignation, withdrawal and depression, chances are traders have succumbed to learned helplessness. Once stress in the financial world has reached this pathological state, governments must step in, as they did in 2008-09, and do the job that traders can no longer perform – buy risky assets, reduce credit risk, lead the traders, now reduced to a shellshocked state, out of the slough of despond.

Stress-related disease in the financial industry

Prolonged and severe stress endangers more than the financial system: it poses a serious threat to the personal health of people working in the financial industry, and indeed in all the industries affected by troubles in the banking sector. In the workplace the difference between acute and chronic effects is most worryingly apparent. A prolonged stress response, by shutting down so many long-term functions of the body, impairs its ability to maintain itself. Blood has been shunted away from the digestive tract, so people become more susceptible to gastric ulcers.

The immune system, thrown into overdrive during the early stages of the stress response, has after chronic exposure to cortisol been suppressed (possibly because it draws too much energy), so people find themselves constantly battling upper respiratory diseases, like colds and ’flus, and other recurrent viruses, like herpes. Growth hormone and its effects have been suppressed, as have the reproductive tract and the production of testosterone.

This last effect, in addition to tensed muscles which prevent blood flow into what are called the cavernous cylinders (corpora cavernosa) of the penis, causes bankers like Scott, sexually insatiable during the bull market, to have difficulty maintaining an erection, even mustering any interest in sex, testosterone being the chemical inducement for erotic thoughts. Chronic stress, largely through cortisol’s interaction with the dopamine system, can also make people more susceptible to drug addiction.

And all these effects are magnified by the fact that elevated cortisol levels reduce sleep time, especially REM sleep, thereby depriving people of the downtime needed for mental and physical health. Steroids may orchestrate a symphony of physiological effects, but as time passes the music turns into a cacophony.

Perhaps the most harmful effect of prolonged stress is the chronically raised heart rate and blood pressure, a condition known as hypertension. The unceasing pressure on arteries that comes with hypertension can cause small tears in arterial walls, tears which then attract healing agents called macrophages or, more commonly, white blood cells. Mounds of these sticky clotting agents grow over the arterial injuries, and subsequently trap passing molecules, like fats and cholesterol.

Larger and larger plaques form, which can become calcified, a condition known as atherosclerosis, or hardening of the arteries. As the plaques grow and block arteries, they decrease blood flow to the heart itself, causing myocardial ischemia, or angina, a recurring pain in the chest. If the plaques become large enough they may break off, producing a thrombus, or clot, which then travels downstream to smaller and smaller arteries, and ends up blocking an artery to the heart, causing a heart attack, or an artery to the brain, causing a stroke.

As the economic crisis deepens, cortisol’s catabolic effects add to the problems created by high blood pressure. Insulin, which normally withdraws glucose from our blood for storage in cells, has been inhibited for months now, so high levels of glucose and low-density lipoproteins, the so-called bad cholesterol, course through traders’ arteries. Muscles as well get broken down for their nutrients, and the resulting amino acids and glucose circulate needlessly in the blood, looking for an outlet in demanding physical struggle.

Our stress response is designed to fuel a muscular effort, yet the stress most of us now face is largely psychological and social, and we endure it sitting in a chair. The unused glucose ends up being deposited around the waist as fat, the type of fat deposit posing the greatest risk for heart disease. At the extreme, stressed individuals, with elevated glucose and inhibited insulin, can become susceptible to abdominal obesity and type 2 diabetes. Patients suffering from Cushing’s syndrome epitomise the change in body shape, having atrophied arm and leg muscles and fat build-up on the torso, neck and face, making them appear much like an apple on toothpicks. A year into the financial crisis, the testosterone-ripped iron men of the bull market start to look decidedly puffy.

In the myriad ways described here, the stress response, as it builds and ramifies over the course of weeks and months, worsens the credit crisis. The bodily response initiated to handle the stress feeds back on the brain, causing anxiety, fear and a tendency to see danger everywhere. By so doing, this steroid feedback loop, in which market losses and volatility lead to risk-aversion and to a further sell-off in the market, can exaggerate a bear market and turn it into a crash.

Body-brain interactions may thus shift risk preferences systematically across the business cycle, destabilising it. Economists and central bankers, such as Alan Greenspan, refer to an irrational pessimism upsetting the markets, just as John Maynard Keynes once spoke of the dimming of animal spirits. With the development of modern neuroscience and endocrinology we can begin to provide a scientific explanation for these colourful phrases: cortisol is the molecule of irrational pessimism.

This is a fascinating excerpt, one that I can relate to as an individual trading in this wolf market dominated by big banks, big hedge funds and high frequency trading platforms.

My stresses are amplified because I suffer from Multiple Sclerosis. But in an odd way, my 15-year battle with MS has helped me deal with unimaginable stress that would make even the most seasoned Wall Street trader crack under pressure.

I remember meeting with Jean Turmel, president of Perseus Capital Inc., and former president of Financial Markets, Treasury and Investment Bank for the National Bank of Canada. He told me trading will make my MS worse and advised me against such a vocation.

He was wrong. MS has made me a better trader precisely because it helps me deal with stress and puts perspective in my life. Sure, hate when I experience a huge loss (love taking huge risk), but the way I deal with those losses is key: just like with MS, if I stumble and fall, I pick myself up, dust myself off and forge ahead. I have MS; MS doesn't have me. No matter what obstacles I face in life, I persevere.

My health is the most important thing in my life. Without your health, you're finished, which is why I tell people to put themselves first. Makes perfect sense but I am shocked to see how people fret over trivial things like a house, a car, their social or even professional status and pay little to no attention to their mental and physical health.

I should be a poster child for people suffering with chronic diseases. After undergoing my liberation treatment, decided to join a gym and get active. I didn't stop there. Have seen numerous physios, a few chiropractors who tortured me (lol), and took the advice of my dad and brother to talk to a psychologist about dealing with MS.

My psychologist is cool. We basically go over communication skills and talk about how to best cope with MS and negative situations. With her help, I realized that I am an imposing and direct individual (also a great guy who got royally screwed and discriminated against!). That's my style but she made me understand that it can be perceived as a negative trait in the workplace or personal relationships. "You are who you are but it's how others perceive you that also matters."

There other things she keeps telling me is "don't focus your energy on negative people" and "acceptance is freedom from hell." Must admit, still can't accept how some prospective employers continuously discriminate against me based on the fact that I have MS or because I write a "controversial" blog (meaning I talk straight and piss off powerful people).

But when I am trading, blogging, analyzing markets, I put all those negative thoughts aside and focus on making links in the big picture to become a better trader and investment analyst. I love looking at trends in the hedge fund, private equity and real estate industry to see where I should be focusing my attention. I love learning through trial and error and have made my share of trading blunders. In trading, your learn the most when losing money. Period.

Making money in markets isn't a science. It's a life-long process where you continuously learn and adapt or else you will get killed. Traders will give you great advice like "cut your losses " but they rarely know when to "average down" or when to go "bottom-fishing" in depressed sectors.

Great traders do know how to take risk but in these schizoid markets which continuously shift like the wind, this isn't always easy and the psychological stress of losing big money on any given day can be overwhelming and put huge stress on one's mental and physical well-being.

That's why I will end off by giving you some wise advice. I take no medication for my MS. Partly by choice, partly because even though my disease has progressed very slowly, I'm considered "secondary progressive" (not relapsing-remitting) and there are no breakthrough therapies for this cohort yet (there will be).

What I do is simple. First, I eat well. Wake up and have a bowl of Nature's Path non-gluten Mesa Sunrise cereal with unsweetened almond milk (avoid dairy) and tons of blueberries. Go the gym three times a week in the morning or in the summer, swim every day. Try to follow a Mediterranean diet which means lots of salads, greens (steam asparagus, broccoli, spinach, or kale), skinless chicken and fish. Portion my meals and eat fruits, veggies and almonds as snacks in between meals (important to lose weight, you must snack in between meals).

Sure, I cheat once in a while and stuff myself with a pizza or a tasty souvlaki gyro, but almost never eat chips, processed foods and junk. I avoid sugar and artificial sweeteners, limit my gluten intake, and drink plenty of water to keep hydrated. And I never smoke cigarettes (the worst possible habit/ addiction!).

As far as supplements, I take large doses of vitamin D drops (cut it to 10,000 IUs a day) and liquid calcium magnesium right after dinner (make sure you have 2:1 ratio of magnesium to calcium or else you will be constipated and have a shitty day!) . Vitamin D and magnesium deficiency are extremely prevalent out there and yet most people are completely unaware they suffer from these deficiencies.

Magnesium helps calm your central nervous system and I guarantee it will give you more energy, maintain regularity and help you sleep like a baby (take a large dose with your vitamin D right after dinner). Adequate sleep and moderate exercise will also help reduce cortisol levels and reduce stress, allowing you to make better decisions.

Don't know why I am sharing all this health information with you but my point is simple: don't take your mental or physical health for granted! Companies also have to do their part to make sure their employees are healthy, especially in the financial sector where nowadays it seems everyone is treated like shit.

It's sad but I have come to accept that the financial industry is a hopelessly shallow and immoral industry full of lying, insecure scumbags that protect their turf at all cost (there are good people too but not enough). Every week I learn about something at some organization but nothing shocks me anymore.

Office politics and the culture at banks, pensions and money management firms is the worst it has ever been which is why many traders want to leave and start their own fund (not easy in this environment). The thinking is if you're going to be fired so easily mind as well go off on your own and enjoy the upside of your blood, sweat and tears.

Below, Stephanie Ruhle reports on Jefferies Group's Sean George. Banker by day, boxer by night, George talks straight on the dismal state of Wall Street where perennial whiners suffering from severe entitlement issues aren't grateful for what they have.

Friday, July 27, 2012

Seven Truths About Public Employee Pensions?

Kil Huh, Director of Research, Pew Center on the States, wrote an article for Huffington Post, Five Truths About Public Employee Pensions:

The debate over public pensions and retiree health benefits is vital, so we were heartened to see it in The Huffington Post. However, Harold Schaitberger's recent piece misrepresents our work and the realities facing state and local governments. Here are five truths about state and local pensions.

1) Public pension funds face real funding challenges in a majority of states.

In fiscal year 2010, public pension funds as a whole were only 75 percent funded and had a shortfall of $757 billion between what they should have set aside to pay for the benefits promised to workers and retirees and what they had on hand. While some states, like New York, North Carolina, and Wisconsin, have well-funded and well-managed plans, the majority of states face significant challenges. Thirty-four states were less than 80 percent funded -- a threshold many experts recommend for health pension systems.

This problem is the result of a decade of states taking pension holidays and raising benefits without paying for them, not the Great Recession. Investment gains of 20 and 13 percent in 2009 and 2010, respectively, were not nearly enough to overcome losses from the financial crisis, and pension funding levels continued to drop. The weak returns of less than 1 percent at the end of 2011 also show how hard it will be for states to invest their way out of this crisis. Initial projections suggest that funding levels will be stagnant in fiscal year 2011, and in some states will continue to drop.

2) The funding gaps have real impacts on taxpayers and states' budgets.

The pressure on state budgets springs from policy makers' failure to keep up with their pension fund contributions. States don't have to close the $757 billion gap in one year or even five. Like a home mortgage, they can spread the costs over 30 years. But they have to make their full payments as recommended by their actuaries, and each year they underfund their pensions, their costs will grow.

New York and New Jersey both had fully funded pension systems in 2000. In the following decade, New York consistently made its full contributions into its pension plans, while New Jersey failed to do so. Now New Jersey has an unfunded liability of $36 billion. To catch up, it will have to contribute $2 billion per year more than New York, even though New York has a much bigger pension system. That's $2 billion that New Jersey could be using to build roads, improve schools, and offer raises to police officers and teachers.

3) Policy makers must be responsible stewards of their pension plans.

It is easy to blame unions or Wall Street for states' pension problems. But policy makers are the ones who made promises they couldn't afford, didn't pay for, and now can't keep. Recent investment losses have hurt pension plans, but the decline in pension funding started before then -- largely because some policy makers shortchanged their retirement systems for years and relied heavily on investment gains that never materialized. Now, these same states can't count on investing their way out of this funding crisis.

In states with well-managed pension systems, such as North Carolina and New York, the Great Recession did not wreak havoc on pension plans, and these states haven't had to make drastic changes in their plans to meet their obligations.

4) There are no simple fixes.

States with large funding gaps can't simply cut benefits for new employees or put them in a 401(k)-style plan. Either they will have to funnel more taxpayer dollars into the system, or they will have to ask workers to contribute more or accept less in benefits. States that have gotten into trouble by failing to keep up with required contributions, promising more than they can afford or taking investment risks will have to adjust their plans. Pension reform needs to be fair, comprehensive, and sustainable. Real reform will require hard choices, good information, and thoughtful analysis.

5) States need to make sure retirement benefits are there for retirees and affordable for taxpayers.

Some states with well-managed pension plans can continue providing benefits as long as they are disciplined about paying the annual required contributions and don't promise additional benefits they can't afford. However, many states can't continue with the status quo. These states do not face challenges because public employees and taxpayers did anything wrong -- public employees helped pay for their retirement with every pay stub. Rather, policy makers in many states did not responsibly hold up their end of the bargain. Now they need to reduce their growing pension costs while still crafting retirement plans that will help them attract and retain talented workers. Fortunately for the states that need reform, they have a range of options that can help achieve both.

Excellent article, one that exposes some hard truths and explains the real cause of massive pension deficits in the United States.

Importantly, the main reason behind these massive pension deficits is that states failed to top up their pension plans and over-relied on investment gains based on rosy assumptions to get them back to a fully funded status.

Now that pension myths are confronting reality, hard choices lie ahead. I agree with Huh: "Real reform will require hard choices, good information, and thoughtful analysis."

But you will notice through my title that I added a couple of truths that Huh failed to mention in his article. Will go over them below.

6) US states need to consolidate public pensions and introduce major governance reform to bolster public pension plans.

It's simply mind-boggling to see a bunch of city and county plans that are severely underfunded, bankrupting their communities and jeopardizing vital public services. Both Congress and the Senate need to introduce a bill to consolidate all these plans and have them managed by existing or (preferably) new state public plans.

However, that is not enough. While 'pension holidays' are the main reason the pathetic state of state plans, the truth is US public pension funds have a lot of work in terms of nuking their current governance model, replacing it with those adopted by Canadian or Dutch and Danish plans.

Finally, the Alliance for Retirement Income Security (ARIA) recently did a profile on me, stating I'm an "ardent defender" of the DB model. No question about it, which leads me to my seventh and final truth below.

7) Well governed defined-benefit plans are infinitely better than any defined-contribution plan.

There is a war being raged on defined-benefit plans, but if you ask real pension experts like John Crocker, the former president and CEO of HOOPP, and Jim Leech, the current President and CEO of Ontario Teachers', there is a case for boosting DB pensions and we must not allow "pension envy" to define the debate.

Importantly, the solution to America's retirement crisis is not to switch workers over to defined-contribution plans. The disaster in 401(k)s only underscores this last point. Left fending for themselves in this wolf market dominated by the banking mafia and their elite hedge fund clients, workers will have the dubious distinction of retiring in poverty.

Pensions are under attack in America and elsewhere. The solution the retirement crisis, however, is not to demonize public sector workers and introduce shortsighted measures that will exacerbate pension poverty. The solution is to focus on job creation and adopt new thinking on the retirement crisis, one that is in the best interests of workers, governments and corporations.

Below, PBS NewsHour's Jeffrey Brown discusses how pension shortfalls are forcing states to consider benefit cuts with the Pew Center's Kil Huh and Northwestern University's Joshua Rauh.

Also embedded highlights of the LCP Global Pensions in 2012 conference, held at The May Fair Hotel, London in mid May.

Thursday, July 26, 2012

Can Japan's GPIF Solve its Funding Problems?

Institutional Investor reports, Can Japan's Government Pension Solve its Funding Problems?:

THE AIR INSIDE THE GOVERNMENT PENSION FUND'S Tokyo headquarters was as warm and dry as a spaceship’s. As president Takahiro Mitani and his colleagues filed silently into an austere meeting room, I was sweating slightly, struggling to compose my question with the correct level of Japanese politesse: “How did the world’s largest pension fund decide on such a conservative level of risk and return for its portfolio?”

It was far from an idle question. The GPIF has ¥108 trillion ($1.36 trillion) in assets under management. That’s nearly six times as much as the California Public Employees’ Retirement System, the biggest U.S. pension fund, and nearly four times as much as Europe’s largest pension plan, Stichting Pensioenfonds ABP of the Netherlands. Even more striking than the fund’s gargantuan size is its composition: Fully three quarters of the GPIF is invested in bonds, including ¥58.4 trillion of domestic bonds and ¥14.4 trillion of government agency debt.

Many large Western pension funds, led by pioneers like Cal­PERS and ABP, have chosen to reach for yield, a choice they know exposes them to big market swings. For some of these funds, the portfolio losses of 2008–’09 were near-death experiences (CalPERS’s assets plunged 38 percent), pushing their funding ratios down into the red zone. Yet most of these funds are trying to grow their way out by continuing to bet heavily on equities and making ever-larger allocations to private equity, hedge funds, real estate, infrastructure and other illiquid assets.

But not the GPIF. At the end of 2011, the Japanese fund had 67.4 percent of its portfolio invested in Japanese bonds, 11.1 percent in Japanese stocks, 8.4 percent in foreign bonds, 10.1 percent in foreign stocks and 3 percent in short-term assets. No exotic long-dated assets anywhere. And fully 80 percent of the portfolio is invested passively.

The GPIF’s financial conservatism is all the more striking considering its demographic challenge: Japan is starting to slide down the reverse slope of an inexorable demographic curve. Forecasts by the country’s National Institute of Population and Social Security Research estimate that the number of people between 15 and 64 years old will nearly halve in the next 50 years, to 44.2 million in 2060 from 81.7 million in 2010, even as the number of retirees swells.

Japan’s public pension system was basically a pay-as-you-go defined benefit plan until the past decade, when Tokyo created the GPIF and began a series of incremental reforms designed to put the country’s pension system on a more sustainable basis, such as increasing contribution rates and reducing benefits. Those measures fall well short of what’s needed to ensure that the GPIF will be able to redeem the promises made to today’s workers, though. Already, the fund is paying out more in pension benefits than it receives in contributions, an inflection point it passed in 2009.

The twin problems of government deficits and demographic decline have seized center stage in Japan’s policy debate. All eyes are on the GPIF and its massive pot of money, to see whether the fund can generate adequate returns on its portfolio. This debate highlights several policy trade-offs of deep interest to pension funds, money managers and Treasury and Finance Ministry officials in North America and Europe, where countries face the same dilemma of demographic pressures and underfunded pension schemes. How Japan resolves its debate is bound to shape global financial markets in a profound way.

Hence my trek to see Mitani-san. Why did the GPIF make its conservative portfolio strategy choice? What political factors got it there, and what governance structures keep it there? Who makes money from the GPIF’s strategy, and who might profit — or lose — from a shift in the fund’s risk-reward profile? These were just a few of the questions I hoped to get answers to.

Those of you who want to read the rest of the article can do so by clicking here. It's clear that Japan's giant pensions will face the same funding pressures putting pressure on global pensions to hunt for yield.

Monami Yui and Yumi Ikeda of Bloomberg report, World’s Biggest Pension Fund Sells JGBs to Cover Payouts:
Japan's public pension fund, the world’s largest, said it has been selling domestic government bonds as the number of people eligible for retirement payments increases.

“Payouts are getting bigger than insurance revenue, so we need to sell Japanese government bonds to raise cash,” said Takahiro Mitani, president of the Government Pension Investment Fund, which oversees 113.6 trillion yen ($1.45 trillion). “To boost returns, we may have to consider investing in new assets beyond conventional ones,” he said in an interview in Tokyo yesterday.

“Payouts are getting bigger than insurance revenue, so we need to sell Japanese government bonds to raise cash,” said Takahiro Mitani, president of the Government Pension Investment Fund, which oversees 113.6 trillion yen ($1.45 trillion). “To boost returns, we may have to consider investing in new assets beyond conventional ones,” he said in an interview in Tokyo yesterday.

Japan’s population is aging, and baby boomers born in the wake of World War II are beginning to reach 65 and become eligible for pensions. That’s putting GPIF under pressure to sell JGBs to cover the increase in payouts. The fund needs to raise about 8.87 trillion yen this fiscal year, Mitani said in an interview in April. As part of its effort to diversify assets and generate higher returns, GPIF recently started investing in emerging market stocks.

GPIF is historically one of the biggest buyers of Japanese debt and held 71.9 trillion yen, or 63 percent of its assets, in domestic bonds as of March, according to the fund’s financial statement for the 2011 fiscal year. That compares with 13 percent in domestic stocks, 8.7 percent in foreign bonds and 11 percent in overseas equities.

Emerging Stocks

The fund named six institutions including Nomura Asset Management Co. and Mizuho Asset Management Co. to manage its emerging market stocks portfolio, according to a statement on its website earlier this month. The investments will be focused on countries in the MSCI Emerging Markets Index (MXEF), which tracks 21 nations including Brazil, Russia, India, China, South Korea, Taiwan and South Africa.

“We started with a small amount very recently,” Mitani said yesterday, without elaborating.

Mitani also declined to say whether the fund’s performance since April is matching last year’s total return of 2.32 percent. “Our performance is not that good so far this year due to the yen’s strength and losses in domestic and overseas stocks,” he said.

The market environment may remain “favorable” for Japan’s debt over the next couple of years on prospects that the Bank of Japan will keep easing monetary policy to meet its 1 percent inflation goal, according to Mitani.

GPIF is the biggest pension fund in the world by assets under management, according to the Towers Watson Global 300 survey in September, followed by Norway’s government pension fund.

Bond Yields

The yield on 10-year Japanese government notes climbed one basis point, or 0.01 percentage point, to 0.73 percent as of 10:30 a.m. in Tokyo. The rate closed at 0.72 percent yesterday, matching the lowest level since June 2003, when it fell to a record 0.43 percent. Bonds with a maturity of up to three years all yield about 0.1 percent as the central bank buys these securities through its asset-purchase program.

The prolonged debt crisis in Europe has added to demand for yen-denominated assets, sending the currency to 77.94 per dollar this week, the strongest since June 1. Against the euro the yen reached 94.12, a level unseen since November 2000.

“There isn’t much value in short-term notes as the BOJ’s massive asset purchases have made their yields extremely low,” said Mitani. “I would say the current 0.7 percent level for 10- year yields is a bit too low, because we have to take into account that there are flight-to-quality bids in JGBs because of the European crisis.”

Recently, Japan's Government Pension Investment Fund dipped its toe in emerging markets, selecting six asset managers to make its first investments in that region as it tries to boost returns in the face of rising payout obligations.

Fox Business reports that the giant pension fund is facing increased scrutiny at home:

The Labor and Welfare Ministry has begun an organizational review of Japan's biggest public pension fund, seeking to weaken the chief executive's authority and increase national oversight, The Nikkei reported early Wednesday.

The Government Pension Investment Fund had 113 trillion yen in assets under management at the end of March. It is run by a president and an executive managing director, who are watched over by two auditors. An in-house investment committee offers advice, but the president has the final word on investment and operating decisions. Critics say this structure impedes external oversight.

A Labor Ministry panel took up the issue Tuesday and intends to report on its review by year-end. Legislative changes would follow next year.

Ministry officials say the president has too much discretion over the GPIF's vast pool of assets. The ministry wants to reorganize the fund's management to create multiple angles for oversight. Among the ideas to be considered is a corporate-boardroom-style governance model, where multiple directors make decisions in concert.

The review won't address the fund's investment strategy, which has a major impact on the long-term stability of the pension system. Not everyone on the panel agrees with that decision.

"Unless it's clear whether the fund aims for high-return investment or reduced-risk investment, it will be difficult to discuss organizational changes," said Shigeru Kojima, a researcher with the Rengo labor union confederation's Research Institute for Advancement of Living Standards.

I find it interesting that so much power is concentrated in such few hands at the world's largest pension fund but they seem to be doing just fine. Investing in JGBs shielded them from serious market downturns.

But now there are increasing calls to start looking outside to realize the target return they require, and investing in JGBs won't cut it. Keep an eye on this giant pension as it may slowly morph into another global pension powerhouse that invests in traditional and alternative assets.

Below, European Central Bank President Mario Draghi signaled that officials are prepared to do whatever is needed to preserve the euro and act on surging bond yields that are tearing at the seams of the 17-nation currency bloc.

Wednesday, July 25, 2012

Dangerous Dynamic Or Big Buying Opportunity?

Nathaniel Baker of Bloombeg reports, Bridgewater Sees ‘Dangerous Dynamic’ as Largest Economies Slow:

Bridgewater Associates LP, the hedge fund founded by Ray Dalio that manages about $120 billion in assets, said the global economy is facing the threat of a self- reinforcing decline after the world’s largest economies slowed in recent months.

Global growth has slowed to about 1.9 percent “in the past few months” from around 3.3 percent as Europe deleverages and China’s economic is cooling, the Westport, Connecticut-based firm estimated in its second-quarter report, a copy of which was obtained by Bloomberg News. Bridgewater also said the European debt crisis has been poorly managed, bringing Europe closer to a “debt implosion” or a currency collapse.

“The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce,” Bridgewater said in the report.

Bridgewater, which had three of the industry’s 12 best- performing funds last year, said Europe is in the “most critical” stage of a global deleveraging process, as deteriorating finances in France and differences with Germany make it less likely that the region’s strongest economies will pick up the tab to solve the region’s debt crisis.

The International Monetary Fund last week cut its 2013 global growth forecast to 3.9 percent from the 4.1 percent estimate in April, as Europe’s debt crisis prolongs Spain’s recession and slows expansions in emerging markets from China to India.

Moody’s Rating

Euro-area bonds fell today after Moody’s lowered the outlook to negative for the Aaa credit ratings of Germany, the Netherlands and Luxembourg. Moody’s cited “rising uncertainty” over Europe’s debt crisis. It left Finland as the only country in the 17-nation euro region with a stable outlook for its top ranking.

“We think that the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with money to make all of these debts good should not be taken for granted,” Bridgewater said. “We think there are good reasons to doubt that the European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way.”

Financial markets have begun to discount weaker economic growth, as evidenced by the rise in credit spreads, fall in bond yields and lower future earnings expectations, Bridgewater said.

Earnings Miss

United Parcel Service Inc., the world’s largest package- delivery company, today cut its full-year forecast after a drop in international package sales dragged quarterly profit below analysts’ estimates. Yesterday, McDonald’s Corp. reported second-quarter profit that trailed analysts’ estimates amid slowing U.S. same-store sales and said the restaurant chain may miss its full-year operating income growth target.

The Standard & Poor’s 500 Index has declined 4.1 percent since the end of the first quarter, and global stocks are down 8.2 percent.

A “meaningful deleveraging for an extended period of time” is now priced into the market, Bridgewater said. With this pricing at a “midpoint of discounted expectations,” individual markets have an equal probability of outperforming or underperforming.

Bridgewater, which uses a macro strategy as it seeks to profit from economic trends, placed diversified bets in 2011 after predicting a flight to safer assets such as U.S. Treasuries and German bonds. Dalio’s Pure Alpha hedge fund made $13.8 billion for clients last year helping the manager beat rivals such as John Paulson, who posted a record loss of 51 percent in 2011 in one of his biggest funds. Bridgewater money for institutional investors such as pension funds, endowments and foreign governments, according to its website.

According to Bloomberg, John Paulson told clients he sees a 50 percent chance the euro will unravel:

An event causing a breakup may happen in three months to two years, Paulson said on a conference call today reviewing second-quarter performance, according to the investor, who asked not to be named because the call was private. Paulson, who runs Paulson & Co., said he expects sovereign yield spreads to widen.

Paulson, who posted a 16 percent loss from one of his largest funds in the first half of the year, told clients in February that Greece may default by the end of this March, and said the European currency is “structurally flawed and will likely eventually unravel.”

Armel Leslie, a spokesman for the $22 billion firm in New York, declined to comment.

Paulson is seeking to recoup losses after his Advantage Plus Fund fell a record 51 percent last year following failed bets on a U.S. economic recovery.

Paulson said on today’s call that his firm has reduced risk at some of its funds, according to the client. So-called net exposure in its Advantage funds, which seek to profit from corporate events such as takeovers and bankruptcies, is now 11 percent; at the Credit funds it’s minus 9 percent; and at the Recovery funds, which bet on assets Paulson believes will benefit from a long-term economic advance, it’s 31 percent, the investor said.

Paulson is desperately trying to recoup losses, trying to bounce back. But as he shifts from using an event-driven approach to more of a global macro approach, it remains to be seen whether he'll be successful. I remain extremely skeptical and wrote all about the rise and fall of hedge fund titans.

Other hedge funds are optimistic that Europe will work through this mess. Nelson Schwartz of the New York Times reports, Hedge Fund Places Faith in Euro Zone:

Marc Lasry has never been afraid to go his own way.

While other Wall Streeters who supported President Obama in 2008 are rushing to distance themselves from the White House, Mr. Lasry remains one of the president’s most loyal backers.

He loaded up on Ford Motor bonds in late 2008 and early 2009 when it seemed that the company might join Chrysler and General Motors in bankruptcy, and made a bundle when it did not.

And after markets rallied in 2009 and 2010, instead of holding out for more gains, he took money off the table and returned $9 billion to investors in his hedge fund.

Now, even as Europe’s economic problems worsen and the markets punish giants like Spain and Italy, Mr. Lasry is betting on a long-term comeback for the Continent. This month, his hedge fund, Avenue Capital, finished raising nearly $3 billion for a fund that will invest in the debt of troubled European companies.

He has committed roughly $75 million of his own money to the new fund. That’s still a small part of his estimated $1.3 billion fortune, but Mr. Lasry is among a coterie of hedge fund and private equity managers who are gambling that the euro zone will stay intact and revive over the long run.

Besides Avenue, Blackstone and Kohlberg Kravis Roberts plan to buy assets in Europe and in some cases already have done so, as have other well-known money managers like Leon Black of Apollo Global Management.

Not that Mr. Lasry is expecting a quick turnaround for Europe. “It’s not a three-month bet or a six-month bet,” he said. “It’s a three- to five-year bet.”

Last week, renewed worries about Spain’s ability to keep borrowing sent stocks in Europe tumbling and sparked about a 1 percent decline Friday on Wall Street, though the major United States indexes were up slightly for the week. Mr. Lasry and Richard P. Furst, a senior portfolio manager at Avenue who directs the European strategy, say they expect worries about the Continent to keep rattling the markets, creating buying opportunities for the new fund.

So far, Mr. Lasry and Mr. Furst have put 25 percent to 30 percent of the fund to work, deploying an additional 5 percent or so each month.

“We could invest the whole fund today but you want to average in,” said Mr. Furst. “There will be relief rallies, but when the fear comes back in, we buy.”

The two money managers are using the broader fears about Europe to load up on troubled debt of companies in healthier countries in the region. The biggest chunk of the new fund’s assets have been invested in Britain, followed by France, with purchases in Sweden and other northern European nations, as well.

They are avoiding Greece, the country where the euro zone crisis began, and the home of one of their more notable mistakes, a losing bet in 2010 on the debt of a Greek casino operator in an earlier European fund. That position has steadily lost value as Greece’s outlook has deteriorated. Mr. Lasry and Mr. Furst are also steering clear of troubled giants like Spain and Italy.

Instead, they see opportunity as banks in Europe come under pressure from regulators to shrink their balance sheets and unload debt at deep discounts. Financial institutions also are focusing on home markets, prompting Italian and Spanish banks, for example, to sell off debt from other countries.

In Britain, Avenue’s bets include the debt of Punch Taverns as well as Travelodge, a hotel operator burdened by heavy borrowing from an unsuccessful 2006 $1.2 billion buyout by Dubai’s sovereign wealth fund.

“Travelodge is a good business but they’re having trouble in the current economic environment,” Mr. Lasry said. Another sizable investment is in Preem, the largest oil refiner in Sweden.

In Preem’s case, Avenue bought bonds from holders based in the United States, while Punch’s debt was purchased from British insurance companies. Travelodge’s debt was acquired from banks in Britain, Italy and Ireland.

In all three cases, Avenue’s traders benefited because investors were itching to get out of anything European, even though Sweden and Britain aren’t being directly buffeted by the problems in the euro zone and have their own currencies.

“Bad things happen in Spain and Greece, and people want to sell bonds in a refiner that’s doing well,” added Mr. Furst. “The perceived risk is greater than the actual risk.”

After founding Avenue in 1995, Mr. Lasry initially concentrated on distressed debt of American companies. He invested in Asia after the financial crisis there in the late 1990s, earning big profits when it roared back. He started an earlier European fund in 2004.

The companies Avenue aims for in Europe tend to be midsize, with valuations of $250 million to $1 billion. The first European fund has five-year returns with percentages in the high teens annually, according to Avenue.

The strategy requires investor patience — and an iron stomach when volatile markets produce roller-coaster returns for Avenue. In 2008, Avenue’s total portfolio dropped about 25 percent as investors fled all kinds of assets amid the collapse of Lehman Brothers and the overall market downturn.

When markets recovered in 2009 and big holdings like the Ford bonds soared in value, Avenue’s returns jumped by 66 percent, followed by a 20 percent gain in 2010. Returns dropped 10 percent last year, while Avenue is up 10 percent this year, according to the fund. In all, Avenue has $13 billion under management.

Over all, Mr. Lasry’s family and colleagues at the firm have more than $800 million in Avenue funds.

“Marc is definitely adventurous,” said David Bonderman, a fellow billionaire who helped found the buyout firm TPG Capital. Mr. Bonderman was Mr. Lasry’s boss when they managed money in the late 1980s for Robert M. Bass, whose family originally made its money in oil before diversifying. “He’s willing to take contrarian risks and he’s willing to act promptly. Avenue doesn’t have a big bureaucracy.”

“It’s still somewhat early, but if you have a feeling that Europe and the euro aren’t going to collapse, it’s appealing,” Mr. Bonderman said.

“He looks at every dollar he has under management like it’s his own dollar, and that gives him a certain credibility in terms of raising money from investors and keeping them satisfied over the long term,” said Blair W. Effron, a co-founder of Centerview Partners, a boutique investment bank.

Mr. Effron, who is also Mr. Lasry’s brother-in-law, adds that he is a competitive athlete, especially in basketball and tennis.

Mr. Lasry, 52, was born in Morocco and came to the United States as a child. He trained as a lawyer before turning to distressed investing. About once a month, he travels to London, where Avenue has a staff of about 20 that focuses on opportunities in Europe. Over all, the firm employs 275.

From 2006 to 2008, one of those employees included Chelsea Clinton, and Mr. Lasry remains close to the Clinton family as well as President Obama. One of Mr. Lasry’s five children recently worked for the White House.

While other prominent Wall Streeters like Jamie Dimon, the chief executive of JPMorgan Chase, have backed away from the president, and others complain that the White House has used bankers as a piñata, Mr. Lasry is more like the last man standing.

Last month, he held a $40,000 a plate fund-raiser for President Obama at Mr. Lasry’s Fifth Avenue home, and later this month he plans to hold another fund-raiser for the president at Nomad, a Manhattan restaurant.

Unlike his fellow Masters of the Universe, you won’t find Mr. Lasry spending summers on Raiders Row or other luxurious Hamptons hangouts. He prefers lower-key Westport, Conn.

“I’m a value guy,” he joked. “I can’t afford the Hamptons.”

As for Europe, he seems happy to wait out the waves of fear, like last week’s anxiety about Spain.

“Europe isn’t going away, and the companies aren’t going away,” Mr. Lasry said. “You can never time a bottom. What you can do is a time a cycle and five years from now, people will say, ‘Why didn’t I buy?’ ”

Marc Lasry is right, Europe isn't going away but in our hyper-sensitive world dominated by social media, every tweet on Spain, Greece or China sends investors running for cover.

Speaking of China, the IMF said China's slowing economy faces significant downside risks and relies too much on investment, urging leaders to boost consumption and channel citizens' savings away from housing. Indeed, CNBC reports, Think Libor's Bad? Fake China GDP Is Worse:

A fake Libor rate, the scandal involving global benchmark interest rates that has raised the level of distrust in major banks and markets, is nothing compared to the damage that could be done if China's true economic growth figures were revealed, according to Larry McDonald's newsletter.

"Is Chinese GDP the new Libor?" asked McDonald, author of "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers," in a much talked about note to clients last week. "More and more investors are starting to question the Chinese math on GDP."

Annual gross domestic product came in at 7.6 percent in the second quarter, according to China's government on July 13th. The report was better than investors expected, easing concern of a dramatic slowdown for the world's second-biggest economy and sparking a bid in risk assets like stocks that has lasted for two weeks.

But slowing imports and industrial production, as well as harder-to-fudge electricity usage data, points to much slower growth, according to McDonald and other investors. Barclays believes the number should have been more like 7.15 percent.

What worries McDonald, a former vice president at Lehman, is that lying by governments and banks - be it Libor rates or GDP statistics - raises the systemic risk to the markets, which is much worse than just economic risk.

"As difficult as economically driven market sell offs are, they do not compare to 2011, 2008, 1929 and 1907," wrote McDonald. "A look through history shows traditional economically driven sell offs range from 5-15%, or one standard deviation. Systemic risk sell offs, 2008 and 2011 are 25-50%, or two standard deviations."

Governments not being forthright is happening right now in Europe, with the Bank of Spain the latest to update its number of actual bad loans.

"One of the primary reasons for Japan's lost decade was their government's cover up of bank losses," said McDonald. "The faster pain is taken, the faster the return to healthy markets."

Have news for McDonald et al., all governments and all major banks continuously lie about the true state of the economy and the health of their balance sheets. Barring a social revolution, the banking mafia will never be broken.

Not everyone is buying the China crash story. Famous hedge fund manager Jim Rogers has dismissed fears of a hard landing in China, saying slowing growth is simply proof the authorities are managing the economy as they intended:

Rogers’ bullish views on China’s long-term economic prospects place him at odds with well-known China bears Hugh Hendry of Eclectica and SocGen’s Albert Edwards.

“Hugh has been dead wrong about China for three years now and China has not collapsed as he predicted, loudly, verbally and widely,” said Rogers.

“Albert has been bearish on everything for a long time. So if you are telling me he is bearish on China and bullish on everything else that would be different. But no, he is bearish on everything, including you, me and Mother Teresa.”

Hendry, who runs the CF Eclectica Absolute Macro fund, has refuted claims China will act as the main driver for global economic growth and is extremely bearish on Asia as a whole, while SocGen’s Edwards expects China to suffer an extreme hard landing which will prompt stocks to collapse.

China’s benchmark index hit its lowest level in three and a half years last week, and the region’s slowing growth continues to fuel investor concern. The Shanghai Composite index closed at 2,147 on Monday – its lowest level since March 2009 and 40% down on August 2009 highs of 3,471.

In March, Rogers told Investment Week he was banking on a sharp sell-off of Chinese shares as an opportunity to buy back in, and last week’s price falls have caught his attention.

“The lower they go, the more interested I become,” he said. A full blown share price collapse could be triggered by any kind of shock event, according to Rogers, from a bankruptcy in Spain, Italy or the UK, to rocketing inflation or a natural disaster.

“We have many problems facing the world and are set for some very serious problems in 2013 and 2014,” he said. China reported GDP growth of 7.6% in 2012, its slowest growth rate since 2009, and last week Premier Wen Jiabao issued a warning on the country’s stability and economic prospects.

But Rogers said these developments are just evidence the Chinese government is sticking to its long-term plan for the economy. “For three years China has announced publicly, loudly and clearly it is trying to slow its economy down. They wanted to pop their real estate bubble and do something about inflation so they have slowed things down. What is the surprise here? What is the news?”

China is bound to face challenges along its journey to success, just as the US did in the nineteenth century, added Rogers. “China will have problems as it rises. In the nineteenth century, the US had 15 depressions. It was a huge mess, but out of that came a successful country in the twentieth century. That is my view of China.”

Although he is pessimistic about the global outlook, Rogers expects China will be better placed to withstand any upcoming shocks due to its substantial foreign exchange reserves, he added.

I am in partial agreement with Rogers. I'm actually very bullish on America. In fact, as China costs rise, technology lures US factories home. Moreover, the global game changer will spark a US manufacturing renaissance. And for once I agree with Goldman, the US will experience a strong housing recovery as employment growth picks up pace and excess inventories are shed.

Strong housing is bullish for banks. In my opinion, US financials are cheap. And so are energy and basic material shares trading at ridiculous levels. Oil, nat gas, and coal shares in particular have all been decimated by Europe's ongoing debt crisis and exaggerated fears of a significant Chinese slowdown.

For all you pension funds with a 'long-term investment horizon', stop paying hedgies 2 & 20 for beta, and start scaling in and buying up financial, energy, basic material and technology shares at these levels. I don't see another repeat of last summer and think this selloff is yet another big buying opportunity.

Below, Ryan Detrick, Senior Technical Strategist at Schaeffer's Investment Research, who says the ''extreme worry" out there makes for the "ultimate contrarian play." Simply put, he says too many people are positioned for higher volatility as measured by record open interest in the VIX (^VIX). I agree, time to buy the fear!