Wednesday, June 19, 2013

A Pension Holiday?

I've decided to take a solid break from blogging to spend time with family and friends. Those of you who want to track pension and investment news can do so by following the links below:

1) Google: pension

2) Google: private equity

3) Google: commercial real estate

4) Google: hedge funds

5) Pension Tsunami

6) Benefits in the News

7) Financial Iceberg (blog from my friend, Jean-Pierre Desloges)

In addition, there are many links to other sites on the top right hand side of this blog under the Pension News section.

There are a couple of articles worth noting. The National Post reports that insurance giant Sun Life Financial Inc. has signed a “game-changing” $150-million annuity policy with the Canadian Wheat Board that transfers investment and longevity risk from the wheat board’s pension plan to the insurer.

Pension risk transfers are booming and more deals are on their way. Insurers like Sun Life and Prudential will benefit from this trend. De-risking corporate pension plans makes perfect sense for companies and insurers, less so for plan members because they lose the security of their defined-benefit plan.

Another article, from the Globe and Mail, also caught my attention. It states that Fairfax Financial Holdings Ltd. is investing $244-million to become the largest shareholder of one of Greece’s top real estate companies:
The Toronto-based insurer and investment manager is increasing its position in Eurobank Properties S.A. – a subsidiary of one of Greece’s top lenders, Eurobank Ergasias SA – which is focused on commercial real estate and privatizations in the country and its surrounding region.

Fairfax’s stake in the property company will increase to 42 per cent, from 19 per cent, marking one of the larger foreign investments in a Greek public company since the Great Recession shook the European nation about five years ago.

Fairfax’s investment is a show of confidence from chief executive and noted market bear Prem Watsa, not only for Southern Europe’s commercial real estate market, but also for the ongoing Greek economic recovery.

“We believe that Greece has taken significant steps towards addressing many of the key areas of its economy, thus encouraging foreign investment and creating a positive momentum that will foster increased employment and development in the country,” Mr. Watsa said in a statement following the release early on Wednesday morning.
Mr. Watsa isn't the only one betting on a Greek recovery. Notable hedge funds have been playing this theme too but the nature of this deal is more long-term, as is PSP Investment's new stake in Athens airport. It’s risky but I agree with Mr. Watsa, Greece has taken the right steps to foster foreign investment and growth.

Let me end by thanking all of you who regularly read my blog and those of you who have supported my efforts with your generous contributions and valuable insights. Blogging is demanding and very lonely. Your support and encouragement allowed me to continue through good and difficult times.

Those of you who want to donate can still do so on the top right hand side, under the blog's banner, and click on the ads on this blog. I also welcome annual institutional subscriptions and would appreciate help/ ideas in monetizing my efforts.

Finally, I ask the pension powers in Montreal to please keep me in mind as I would welcome the opportunity to contribute once again to the success of your organizations.

We all confront obstacles in life, some more serious than others. What I’ve learned is that it’s the way we react to serious obstacles that makes all the difference but sometimes these obstacles are truly daunting and we shouldn’t be ashamed to ask for help.

Therefore, as I prepare to take a much needed break, I’m asking for the help and consideration of those who know me best and are willing to help me. If there are any projects I can work on upon my return, please let me know. Thank you.

Below,  the beautiful view from Santorini Caldera. Have a great summer and enjoy your time off.

Tuesday, June 18, 2013

Will Private Equity Spark The Next Crisis?

Dan Primack of Fortune reports, Ben Bernanke threatens private equity:
Some potentially seismic news for the private equity market yesterday, as Yankee Candle canceled a $950 million debt refinancing that would have resulted in a $187 million dividend for owner Madison Dearborn Partners. Not yet reported is that fellow Madison Dearborn portfolio company Asurion Corp. also ended its pursuit of an $850 million term loan to refinance existing debt that comes due in 2017.

To be clear, this isn't a Madison Dearborn issue. It's an industry issue.

Private equity has been propped up over the past few years by artificially low interest rates – an environment that has allowed the industry to often escape negative repercussions for its pre-crisis overspend. But now rates are rising in anticipation of next week's Fed meeting and the dreaded "T" word.

"We've all been expecting this for some time, and now it finally seems to be happening," explains a senior private equity exec. "Low rates were fun while they lasted."

To be sure, it's possible that Big Ben won't actually announce tapering of the Fed's bond buyback program – but the debt markets seem to think he will (if not next week, then soon thereafter).

And if that happens, debt refinancing are about to get much, much harder. So will getting well-priced financing for new deals (got to wonder if this has thrown a wrench into Icahn's Dell financing plans – assuming he still has Dell financing plans).

Private equity execs often blanch at the term "financial engineering," but estimates are that firms have done more refinancings for existing portfolio companies over the past year than they've done new transactions (including bolt-ons).

So if a firm really doesn't rely on financial engineering, it shouldn't have anything to worry about. But for everyone else, here's to hoping you either got your refi done already or actually have an operational roadmap for substantial growth...
Yankee Candle's pulled divididend deal may be a sign that the private equity market is turning. Fears that the Federal Reserve may start to cut down on its bond purchasing program have led to debt deals becoming more expensive in recent weeks — and some of them have been pulled altogether.

But fears of Fed tapering are overblown and this could be a brief respite before dividend recap activity picks up again. Still, there are clear signs that private equity activity is slowing, especially in Europe. As discussed in my last comment on visibility and the clearer trade, there are plenty of reasons to be concerned.

There are also reasons to be concerned about the leverage private equity firms have taken over the last few years. Jenny Cosgrave of Investment Week reports the Bank of England worries that private equity could spark the next wave of the crisis:
The collapse of debt burdened firms that were bought up by private equity companies before the financial crisis could pose the next major risk to the stability of the UK's economy, the Bank of England has warned.

These leveraged buyouts (LBO), which are likely mature next year, pose a systemic threat that needs to be addressed, according to the Bank's quarterly update.

The warning from the Bank comes ahead of a major round of refinancing. Some £32bn of LBO debt has to be refinanced in 2014 and 2015, with a further £41bn of LBO debt maturing over the following three years.

"In the mid-2000s, there was a dramatic increase in acquisitions of UK companies by private equity funds. The leverage on these buyouts, especially the larger ones, was high," the Bank said.

"The resulting increase in indebtedness makes those companies more susceptible to default, exposing their lenders to potential losses.

"This risk is compounded by the need for companies to refinance a cluster of buyout debt maturing over the next few years in an environment of much tighter credit conditions," the Bank added.

As there was a surge in acquisitions in 2007, many of these deals will unwind next year, the Bank said: "The average maturity of UK leveraged buyouts' debt is around seven years. Given that the peak in debt issuance was around 2007, there is a significant 'hump' of maturities from 2014."

The study referenced part-nationalised lender Royal Bank of Scotland, which aggressively expanded its strategy in leveraged finance amid a "search for yield" which drove up demand for leveraged loans.

The Bank said under its new regulatory framework, which is coming into effect next month, it would take on the responsibility to protect and enhance the stability of the UK's financial system in order to prevent "future episodes of exuberance" that took place at the height of the boom before the crisis.
Tim Cross of Forbes reports that private equity sponsors have been busy in the leveraged finance market this year, undertaking some $168 billion of loans through May. That pace would mean a full-year total of roughly $400 billion, easily topping the record $270 billion of LBO loans seen during the height of the pre-Lehman market frenzy, in 2007. But as Cross notes, there’s less here than meets the eye: 
Where high profile (and high fee) LBOs and M&A activity drove the market in 2007, with roughly 75% of all private equity-related loans backing LBOs or acquisitions, thinly priced refinancing loans have dominated in 2013, much to investor chagrin. Indeed, so far this year only 19% of sponsor-backed loans support LBOs/acquisitions, while more than half back refinancing of existing debt, often LBO loans put in place not all that long ago. Much of the remainder back credits funding a dividend to private equity firms (institutional investors care little for those loans, as well).

The reason for the spike in refinancings, of course, is borrowing costs, which earlier in the year hovered at or near record lows, and remain attractive to issuers (though things have tightened up over the past few weeks, with a number of proposed loans pulled due to market gyrations).

LBOs, on the other hand, remain few and far between, largely because sellers and buyers remain far apart regarding price, according to LCD’s Steve Miller. There are few signs of a pickup on the near-term horizon, loan arrangers say, though there’s some speculation – or perhaps hope – that deal flow could shift into a higher gear during the fourth quarter as current screening activity reaches fruition, Miller adds.
Private equity investors have other reasons to be concerned. PE Hub reports that private equity firms are sitting on $116 billion of assets trapped in so-called zombie funds that lie dormant but still rake in fees from investors:
Despite the funds being inactive, general partners — those managing the funds — still collect management fees from investors.

U.S. regulator the Securities and Exchange Commission is investigating the use of these essentially inactive funds, which critics say drain money from pension funds and other investors that would otherwise be available to reinvest or return to clients. It is part of a wider SEC probe into the private equity industry as a whole.

Hedge funds, asset managers and other alternative investment vehicles have also recently come under increased scrutiny in both Europe and the U.S. as the public and regulatory backlash since the 2008 financial crisis spreads beyond the banking industry.

The Preqin research — which is based on records of active funds managed between 2001 and 2006 that did not raise a follow-on fund after that time — found that zombie funds were sitting on shares in more than 1,700 companies.

The zombie funds returned less than 40 percent of the capital they paid in, compared with a 99 percent return for all private equity funds raised in 2003, Preqin said.

“No one is a winner when zombie funds are involved and represent a clear misalignment of interests between the fund manager and investor,” said Ignatius Fogarty, head of Private Equity Products at Preqin.

“GPs should be eager to realize investments and return capital to investors so that there is no reputational damage that adversely affects their ability to raise a follow-on fund,” Fogarty added.

Secondary buyouts, a takeover of private-equity assets by another private equity firm, offer a route out of a zombie fund and some fund managers even see buyouts as an investment opportunity.

Last month, Merchant bank Kirchner Group and Crestline Investors Inc., a hedge fund secondary buyer with $7.3 billion under management, teamed up for a joint venture aimed at taking over zombie funds.
Zombie funds aren't the only problem. The WSJ reports that private equity firms have an incentive to make returns look good on paper so they can attract investors into their new funds:
Private-equity firms—which have raised $158.7 billion this year through Monday, according to industry tracker Preqin—are audited and increasingly hire consultants to help them value their holdings. Those third parties perform their own analyses but have to rely somewhat on what the firms tell them.

In the process, some private-equity firms appear to juice the returns intentionally to help raise new funds, according to research released in May by Greg Brown and Oleg Gredil of the University of North Carolina at Chapel Hill and Steven Kaplan of the University of Chicago.

"Some funds may be trying to convince people that they are better than they really are," Mr. Brown says.

The good news: According to the research, most firms that try to manipulate their performance fail to raise a new fund. That suggests potential investors see through the trick.

The research estimates that those firms inflate their asset values by about 20% before trying to find new investors. Afterward, the estimated values typically fall back to earth. The paper finds that top-performing funds actually tend to underreport returns.

Another paper released in February by researchers at the University of Oxford in England also found that some private-equity funds seem to increase the value of their assets shortly before raising money.

In a statement, Bronwyn Bailey, vice president of research at the Private Equity Growth Capital Council, an industry group, said: "The [Brown] paper clearly demonstrates that private-equity returns are, if anything, being reported conservatively and that investors will not invest in firms that deviate from industry-accepted valuation practices," adding that firms that can't raise new funds will go out of business.

So what is an investor to do?

For one, if you are a high-net-worth investor considering a private-equity fund, sign on only with firms whose funds have investments from major institutions, Mr. Brown says. Institutional investors do their own analyses of valuation methods to make sure a firm isn't juicing its returns, which small investors can piggyback on, he says.

University of Oxford finance professor Tim Jenkinson, one of the authors of the February research, says investors might be best served by ignoring interim returns reported in marketing materials altogether. His research found that such returns have little correlation to the funds' final performance relative to other funds.
Finally, while many private equity firms are struggling, the kings of private equity are thriving. This is why shares of Blackstone (BX), KKR (KKR), Apollo (APO) and Carlyle (CG) are all up over the past year,  some significantly outperforming the overall market.

Below, David Rubenstein, Carlyle Group’s co-founder and co-CEO, speaks with The Wall Street Journal’s Financial Editor Francesco Guerrera.

Mr. Rubenstein says that there isn’t a bubble in global equity or debt markets but that easy money does complicate his private equity business. It tempts buyout shops to load up targets with debt and overpay and it is keeping some potential targets from selling, by allowing them to refinance with the same cheap money.

Monday, June 17, 2013

Visibility And The Clearer Trade?

Michael Gayed, chief investment strategist and co-portfolio manager at Pension Partners, wrote a comment over the weekend, Visibility And The Clearer Trade:
The S&P 500 (SPY) fell last week as markets gyrated between gains and losses following unimpressive industrial production, concerns over Japan, the direction of bond yields, and ultimately what the Fed will say next week. On CNBC Thursday, I argued that the big concern is that we are in a period of falling bonds and falling stocks - something which is an infrequent occurrence given the historical inverse relationship between longer duration Treasuries and equities. However, just as everyone is seemingly getting nervous about a rising interest rate environment, it does seem entirely plausible that the exact opposite occurs and we re-enter a period of falling bond yields and recovering cyclicals.

I am not convinced a correction is yet here for stocks. SuperBen and the League of Extraordinary Bankers will not risk their precious wealth effect by attempting to end quantitative easing too early. In fact, I suspect they may talk up the possibility that they will only do more given that global growth is faltering. Recent downgrades of economic activity span across multiple countries, making it hard for any central bank to do anything other than push more money into their respective economies. Schizophrenia over an end to QE will soon be replaced by the very real concerns over deflation given that, as has been the case all year, the reflation story simply is not materializing.
The irony over the last few weeks of the Fed's "confuse and conquer" strategy to tame equity markets is that the threat of QE tapering domestically in the U.S. has most hit emerging markets (EEM), with those currencies (CEW) getting hurt, and equity markets entering correction/bear market territory. Any kind of reversal in rhetoric, then, likely reverses the oversold nature of anything outside U.S. borders. With globalization, the Fed needs to be wary of their words and their actions on not just America, but everything else connected to us and the types of ripple effects and feedback loops that result.
Our ATAC models used for managing our mutual fund and separate accounts rotated, favoring bonds over stocks in the near-term. Historically, such moves have preceded corrective environments, but I'm not so sure if that is the case now. Bonds may simply be a more clear long trade than stocks are either long or short. Much clearly will depend on the tone the Federal Reserve takes, and how that impacts expectations and intermarket trends. I suspect that emerging market currencies will likely bounce rather strongly, alongside sovereign debt. In the U.S., momentum favors shorter-duration Treasuries for now, but perhaps for only a fleeting moment. Any kind of realization that the yield curve steepened too far, too fast likely means the long-duration bond trade (TLT) returns (click inage below).
I agree with Michael and wrote my thoughts last week on why I think fears of Fed tapering are overblown. I mentioned the factors below:
  • Inflation in the US is at a 50-year low, which concerns doves on the FOMC who are worried about deflation. Fiscal austerity and now sequestration are driving inflation expectations lower.
  • Euro zone is flirting with deflation and the ECB is reluctant to crank up its quantitative easing or lower rates. The Fed can't ignore Europe and will step in to fill the void.
  • Emerging markets have experienced a sharp selloff in recent weeks and remain on shaky grounds. Again, the Fed can't ignore what is going on in emerging markets because a crisis there would intensify global deflationary headwinds, which is exactly what the Fed doesn't want.
In recent weeks, hedge funds have been deleveraging and we have seen violent moves in emerging markets and sectors related to them. My lump of coal for Christmas got obliterated last week. Coal exports plunged in April and the sector remains in awful shape (for several reasons, over-supply, demand weakening, competition from nat gas).

And it's not just coal. The broad slump in commodities might be a harbinger of things to come. One thing that strikes me is how dividend stocks have become the new nifty fifty. A year ago, TIME Magazine asked whether dividend stocks are the next bubble and sure enough, they have been rising steadily as investors clamor for yield in an ultra low interest rate environment. 

But  investors dipping their toes back into the market may be in for a rude awakening when the bottom drops out of consumer staples stocks and other high dividend sectors. Chasing yield is risky in this environment. Witness the recent selloff in the mortgage real estate investment trust sector.

The same goes for the high yield bond market (HYG) where history appears to be repeating itself:
At this stage of the game, speculative-grade securities appear to be nearing an extreme. According to economic research firm Bank Credit Analyst, the average price of a bond in the high-yield index is well above par, at $105.92. "It will be difficult for prices to rise much further given that roughly 70% of public market high-yield bonds include some type of call option to the benefit of the issuer," BCA notes. "Thus, total return investors who have become accustomed to equity-like returns from high-yield bonds are liable to be disappointed buying at these prices."

In other words, there are no more seats to be added to the game of musical chairs being played out in the debt markets.

There is a possibility that high-yield securities as a whole have further to run though. Monetary authorities have vowed to maintain an aggressive policy stance in support of economic recovery, which will continue to support corporate cash flows, keep default rates from rising and perpetuate the ongoing credit-agnostic search for income in a yield-starved investment climate.
The extreme valuation in the high yield market is yet another reason for the Fed to keep humming along and not taper any time soon.

Nevertheless, regardless of what happens at the Fed meeting later this week, there are plenty of reasons to be concerned. The world cannot afford higher interest rates but as the bubble in dividend stocks, high-yield bonds, leveraged loans and structured products keeps growing, so do concerns that the fallout will be much graver when interest rates do start rising again.

Having said this, I'm not worried about a rise in interest rates any time soon. I'm more worried about deflation/ deleveraging which will hit all assets hard (except long bonds). Riskier assets will fall hardest but others will follow if deflation rears its ugly head.

Central banks know this and will keep pumping massive liquidity into the financial system, even if that means sowing the seeds of the next crisis. The question now is how will markets react later this week and in the near-term? Michael Gayed wrote me: "...the question is if stocks will react favorably, or begin to question Fed efficacy aggressively at this point and sell-off. We'll find out soon enough."

We sure will but I don't like the volatility I'm seeing in stocks right now and think that Michael is right that the yield curve steepened too far in recent weeks. If a summer swoon develops, or worse still a crisis, the long duration bond trade (TLT) will return with a vengeance. If you don't like stocks or bonds here, start raising your cash levels and wait for better visibility before taking on more risk. 

Below, discussing how rising interest rates are impacting the economy, with Michael Gayed, Pension Partners; Warren Meyers, DME Securities; Hank Smith, Haverford Investments; and CNBC's Rick Santelli.

Friday, June 14, 2013

When The Pension Crisis Hits Home?

Steve Hawkes of the Telegraph reports, A million over 65s are still in work as pension crisis hits home:
Official job figures on Wednesday showed that nearly one-in-ten “pensioners” were still employed - 615,000 men and 388,000 women.

The total of 1,003,000 is an increase of nearly 100,000 in the past 12 months alone and almost double the levels of a decade ago.

Experts said the marked rise was partly down to changing demographics and the fact that many over 65s - the post war baby boomers - wanted to stay on in the office.

But others said tens of thousands of older workers simply had no choice but to carry on trying to top up their savings given the holes in their pension plans. Annuity rates have tumbled since the Bank of England started its money-printing programme in 2009.

Figures published two months ago showed that men need 29pc more savings to reap the retirement income that they could have gained in 2009. A survey this week said a third of retirees would have worked for longer if they had their chance again.

Chris Ball, chief executive of The Age and Employment Network, said: “The attraction of remaining in active employment is a positive thing that influences people. And more of them now see retirement as a gradual process, not simply a cliff edge that they jump off at a particular point in their lives.

“The other side of the coin is that people are being pushed to work longer in many cases because of their economic circumstances. Quantitative Easing has made a big impact on what people can expect from their annuity when they cash it in.”

Ros Altmann, a former Government policy adviser, added: “Part of this is pure demographics. There are more over 65s than ever before. But for many people’s pensions just haven’t worked out in the way they expected.”

High street stores such as B&Q have made a virtue of their older workforce. The DIY chain scrapped its own retirement age in the mid 1990s after staffing an entire store in Macclesfield, Cheshire with over 50 year-olds and watching as profits rose by almost a fifth.

Engineering companies claim they are turning to older workers as universities are no longer producing enough younger recruits for industry.

The increase in working pensioners has helped the prop up the official employment figures.

Wednesday's numbers from the Office for National Statistics showed that employment in the three months to the end of April was a record of 29.7m, up 24,000.

Unemployment over the same period fell 5,000 to 2.51m - fuelling hopes the recovery is gaining some sort of momentum. Public sector employment has fallen to 5.7m - the lowest figure since 2001. Meanwhile private sector employment has leapt by 740,000 in the past year.

Employment minister Mark Hoban said: "Our priority is getting people back into work and today's figures show we have more people in work than ever before, more women in work than ever before, and more hours worked in the economy than ever before."

Saga said the figures showed the value of the "Silver Pound". Over 50 year-olds now account for almost half of all household expenditure in Britain - £459 billion. The age group accounts for 69.6pc of all spend on "health", but also 52.2pc of the spend on alcohol and tobacco and 52pc of all money splashed out on food and non-alcoholic drink.
Clearly demographics explain the rise in older workers but as the article states, quantitative easing in the UK has sent annuity rates tumbling to their lowest level in decades, forcing millions to work longer to shore up their savings.

An equally disturbing article by Adam Uren of the London Mail states that one in five pension holders think their retirement savings were a waste of money:
Disillusionment with pensions has led to a worrying proportion of savers describing the plans they are making for retirement as 'a waste of money'.

Twelve per cent of pension savers over the age of 45 told insurer MetLife that they wish they hadn't bothered saving for retirement, while another six per cent say they are unhappy with the investment returns on their savings.

The past six years of economic turmoil has shaken the confidence of savers and three-quarters of those with pensions are now less than assured in stock markets to deliver their retirement ambitions.

Nearly half of those surveyed said they were pleased to have saved for retirement, but are concerned about the final level of income, while 22 per cent are confident their savings will deliver their desired return.

But while many will have received employer contributions, not to mention tax relief, they would not have otherwise got if they weren't saving into a pension, some still have regrets about choosing a pension as their retirement vehicle.

Dominic Grinstead, MetLife UK managing director, said: 'Long-term equity investment remains the most effective way to provide an income in retirement but it is also clear that the events of the past five years have hit confidence and undermined faith in pension saving.

'The Government has worked hard to make retirement saving pay with plans for a universal state pension, auto-enrolment into company pensions and changes to the rules on taking retirement income which allow greater flexibility.

'However the retirement income industry has to work harder to rebuild confidence and our research shows that guarantees which are affordable have an important role to play in ensuring that people do not end up feeling they have wasted their money.'

Performance of stock market related investments is only half the story. In most cases retirees need to use their pot to buy an annuity to provide a guaranteed return. Annuity rates have dropped significantly during the financial crisis, and though they have improved since the troughs of last summer, a £100,000 pension pot will at best buy you an income of around £5,800-a-year.

Results of a Money Mail investigation will no doubt add to the frustration of pension savers, as it revealed that insurance firms can pocket as much as £29,000 profit from a £100,000 annuitised pension pot.

Such is the concern among some savers about their pension investment prospects, that almost half of those responding to MetLife said they would consider paying for guarantees on their funds, which would see them protecting their capital in return for giving up some of their gains.

But while incomes may not be as high as they expected, pension holders might be glad for every penny saved come retirement, particularly in light of paying for long-term care.

Matt Phillips from pension investment adviser Broadstone told This is Money this week that a lack of pension saving is the 'biggest threat' to British quality of life and urged people to save early and save quickly for their retirement so they don't become a financial burden on their family in the event they go into care.

The Government has capped lifetime care costs for individuals at £72,000, but many still believe they will be forced to sell their homes to fund care, as their retirement income is insufficient to cover it.
The lack of pension savings is a problem all over the world, not just in the UK. It's particularly hard in Europe where demographic pressures and an ageing population, combined with the poor economic environment and structural unemployment in some EU member states, could render public pension systems unsustainable.

In the United States, fiscal problems are exposing the ruinous promises of underfunded state and municipal pensions. The funding gap for all state schemes is estimated at $4 trillion—25% of GDP. Some states, like California, are on the brink of a full blown pension crisis. Others, like Illinois, are already there, forcing their legislature to meet in special session to address the state's $100 billion unfunded public pension liability.

In Canada, things are better but we still need to address our looming retirement crisis. I recently wrote about the benefits of Canada's 'Top Ten' pension funds, explaining why our governance model works and why I'm a proponent of enhancing the Canada Pension Plan. Critics will claim that we cannot afford it but when you weigh the costs and benefits over the long-run, there is no question that enhancing the CPP is the best way to secure the future for today’s young workers. It's time our federal and provincial finance ministers seize the day on the CPP.

Below, Fox Business reporter Elizabeth MacDonald discusses how growing number of key California cities are a lot worse off than previously thought, thanks to new changes coming in the way state and local governments must account for their pension costs.

The pension changes from Moody’s, and separately the Governmental Accounting Standards Board, scheduled for this month, will impact a number of California cities who might be joining fiscally troubled Stockton and San Bernardino, among others, as severe credit risks.

Thursday, June 13, 2013

Fears of Fed Tapering Overblown?

Marc Jones of Reuters reports, Global shares pummeled, dollar slumps as rout gathers pace:
World stocks were pummeled and the dollar slumped on Thursday as a sell-off on global financial markets in thrall to central bank stimulus accelerated.

European shares fell sharply in morning trading, dropping 1.3 percent after the second biggest fall in Japan's Nikkei in over two years left Asian shares at their lowest level of the year.
Heavy selling hit the dollar, which slumped 2 percent against the yen as investors spooked by the plummeting Japanese stock market unwound hedges. It fell as low as 93.90 yen, its lowest since April 4, giving back almost all the gains made since the Bank of Japan's aggressive monetary easing announced on that day.

The U.S. currency dropped to a 3-1/2 month low against the euro before a slight rebound left the common currency buying $1.3350.

The rout has been triggered by noises from the U.S. Federal Reserve, which meets next Tuesday and Wednesday, feeding into feverish uncertainty about the scaling back of its huge asset purchase program.

"The trend is still in principle a sell-off in markets, a sell-off in riskier assets on the expectations that the Fed might signal further readiness to maybe slow down the rate of purchases," said Daiwa Securities economist Tobias Blattner.

"So all eyes are on the FOMC meeting next week. There is very little else that matters at the moment"

In the debt market, German government bonds rose 40 ticks as investors headed for traditional safe-haven paper. The recent selling of euro zone periphery debt also resumed  as Italy also saw its borrowing costs rise at an of an auction of 3-year debt though yields at a parallel 15-year sale were little changed.


U.S. stock futures pointed to Wall Street starting in negative territory again after its recent falls.

Gold saw a second day of minor gains, but there was no sign of any rush to buy bullion, and with oil almost bang in the middle of its recent $100-105 range, commodity markets were largely devoid of the drama going on elsewhere.

Emerging markets were taking another pounding though, a pattern that has taken hold as the uncertainty about central bank stimulus has driven a global dash back to cash and core economies.

Emerging equities fell to 11-month lows and most emerging currencies remained under heavy pressure with the Indian rupee falling to a record low.

The punishing sell-off in Asian markets saw many of them plummet to multi-month lows as investors scrambled to recalibrate positions for a world with potentially reduced liquidity support.

Both the dollar/yen and the Nikkei fell below the Ichimoku cloud bottom for the first time since their rallies began in November, sending a strong bear market signal. The Nikkei also breached its 50 percent retracement from its November rise.

"If you look at it historically, there has never been a period when the Fed has started to take back stimulus that has left the markets untouched," said Hans Peterson, global head of investment strategy at Swedish bank SEB.

"And this time it is a bigger exercise. We have moved markets from 2009 to 2013 on stimulus and now we are trying to take a step into a world which is more driven by natural growth. That transition will not be easy."
This transition is not easy nor is it wise to pull back stimulus at this time which is why Fed officials have been careful to avoid the word 'taper' in their public remarks. In her blog comment, Ann Saphir of Reuters reports, To ‘taper’ or not to ‘taper’? Fading the Fed semantics debate:
Is Federal Reserve Chairman Ben Bernanke avoiding the word “taper” in order to temper expectations that the U.S. central bank will ratchet down its massive bond buying program? This is one view that’s been widely bandied about in recent days.

But then why is it that the Fed officials who are most eager to “taper” have pretty much stopped using the word, too?

The last time Dallas Fed President Richard Fisher used the “T” word in a public speech was in February. But there’s no evidence at all that he’s backing off from his support of the idea. He’s been adamant the Fed should not yank the punch bowl away (or, in his words, go from Wild Turkey to cold turkey) but should gradually reduce stimulus.

Likewise, Philadelphia Fed President Charles Plosser last used the word in a public speech two months ago. Since then he’s leaned more heavily on “dial back” or “gradually unwind” but still means the same thing. Another supporter of tapering QE3, Richmond Fed President Jeffrey Lacker, has similarly changed up his verbiage, but not his views.

In fact, the only top Fed official who regularly uses “tapering” these days is one who pretty much thinks it’s too soon to touch that $85-billion-a-month dial. “I’d like to see some reassurance that this (low inflation) is going to turn around before we start to taper our asset purchase program,” St. Louis Fed President James Bullard said earlier this week.
With inflation at a 53-year low, Bullard is right to be cautious on tapering. He has expressed concern since 2010 that disinflation is indicating a lack of demand that will trigger a cycle of falling prices and spending declines like the one that has afflicted Japan for 15 years.

Matthew O'Brien of the Atlantic wrote an excellent comment, The Biggest Economic Mystery of 2013: What's Up With Inflation?. He looks at money printing vs. austerity and concludes:
-- Is it the austerity, stupid? That giant sucking sound you hear is the government taking demand out of the economy. As you can see on the left axis above, total government spending -- that is, federal plus state and local -- as a percent of potential GDP has been on a steady downward trend since 2010. It's a three-act story of bad policy. First, the stimulus peaked, and then reversed prematurely; then, state and local governments began slashing budgets to balance them as they are required; and now, the federal government is cutting spending in the dumbest way Congress could come up with -- the sequester. Now, QE2 did manage to increase inflation despite some austerity, but there's more of it this time around. The chart above only shows total spending through January 2013; it doesn't include the sequester, or, for that matter, the tax side of austerity. Between the spending cuts and the expiring payroll tax cut, the fiscal contraction the past six months has probably overwhelmed any "money-printing".

But the mystery of our falling inflation rate should make one thing less mysterious: when the Fed will start tapering its bond-buying. The answer is not anytime soon. Yes, 5-year breakevens show that expected inflation is still close to target, but as long as actual inflation is so low, the Fed will not ease off the accelerator. That was Bullard's recent message, and he told me he'd like to see inflation get around its 2 percent target before he'd be comfortable reducing the Fed's monthly bond purchases.

Now the Fed just has to figure out how to increase inflation in an age of (bigger) austerity.
Dealing with austerity isn't just the Fed's problem but it seems to be fighting a lonely battle, especially when you look at the response from Europe's monetary authorities. Desmond Lachman of the American Enterprise Institute notes without bold action from the European Central Bank, it is difficult to see how the European periphery can avoid sinking ever deeper into economic recession in the months ahead:
Despite this downbeat assessment of the European economic outlook, the ECB was not prompted to act at its last policy meeting. Nor was it prompted by the fact that core inflation in Europe is now down to barely 1 percent, around half the ECB’s inflation target of “close to but below 2 percent.” Instead, the ECB decided to keep its policy interest rate unchanged and it eschewed any notion of joining the Federal Reserve and the Bank of Japan in another round of quantitative easing.

More troubling than the ECB’s decision not to reduce interest rates is its seeming indifference to the fact that bank credit continues to be cut in the European periphery and that private sector borrowing costs in the periphery remain much higher than in Europe’s core countries. While the ECB recognizes this problem, it takes the view that the primary cause is a shortage of bank capital in the European periphery, which the ECB considers to be beyond its remit. The ECB also doubts the effectiveness of buying asset-backed loans of small and medium-sized enterprises in the periphery, as is now being recommended by an increasing number of private analysts.

A generous assessment of the ECB’s present passive monetary policy stance in the face of a rising risk of a European deflationary trap is that the ECB might be reluctant to be too bold at this stage in the German political cycle. Germany, which is the ECB’s primary shareholder and has a traditional antipathy to monetary policy activism, is scheduled to hold elections on September 22 and the ECB might not want to insert itself into that election.

Meanwhile, the German constitutional court is presently considering the merits of a petition claiming that the ECB’s Outright Monetary Transactions (OMT) program is inconsistent with the German constitution’s limits on the Bundesbank’s participation in that program. The petition points out that the OMT program envisages that the ECB could buy unlimited amounts of Italian and Spanish government bonds with maturities of up to three years in order to keep government borrowing costs for those two countries at reasonable levels. Perhaps, then, it is understandable that the ECB is taking the view that it might be better to wait for a more propitious moment in the German political cycle before risking a renewed German controversy on any new ECB policy initiative.

While discretion might be the better part of valor for the ECB, it is not without its costs. Absent bold ECB policy action to get bank credit flowing again and to reduce private sector borrowing costs in the European periphery, it is difficult to see how the periphery can avoid sinking ever deeper into economic recession in the months ahead. After all, the European economic periphery is still being required to implement budget austerity, albeit at a more moderate pace than in 2012, within the straitjacket of the euro. And it is being required to do so at the same time that its external economic environment is deteriorating and that the euro is appreciating against the currencies of Europe’s main trade partners.

The ECB’s present passivity in the face of a distinct deflationary risk could complicate the European debt crisis. A prolonged period of deflation would make the European periphery’s efforts to restore order to its public finances all the more difficult since it would increase its real borrowing cost. Given the fact that countries in the European periphery are flirting with deflation if not already experiencing it, the ECB would be ignoring the risk of a deflationary trap for the European periphery at its peril.

A clear lesson from Japan’s two decades of struggling with deflation is that a central bank pays a very high price for falling behind the policy curve. Hopefully, that lesson will not be lost on the ECB and it will become more proactive in its policy decisionmaking once the German elections are out of the way.
The lack of bold ECB policy action is another reason why I don't see the Fed tapering next week or any time soon. In fact, if inflation expectations decline, I wouldn't be surprised to see the Fed step up its asset purchases in the future.

Inflation is a lagging indicator but given record debt levels and the danger of sliding into a protracted period of debt deflation, the Fed will continue to err on the side of inflation. I believe it's only a matter of time before the ECB joins the Fed and Bank of Japan in fighting the spectre of deflation.

Finally, it's important to note the rolling back of the U.S. Federal Reserve's massive quantitative easing program could be a major issue for all economies, according to former World Bank President Robert Zoellick, who says the move would force countries to look at fundamentals for growth:
"[Fed] tapering is a big issue. I think for all economies - U.S., Europe, China, Southeast Asia - the fundamentals still go back to structural reforms," Robert Zoellick, Distinguished Visiting Fellow at the Peterson Institute for International Economics told CNBC Asia's "Squawk Box" on Tuesday.

He added that "The question will be as the Fed eventually moves away from the monetary easing policies, what will be the effect of the [withdrawal of the wall of money that's moved around the world?"

...Zoellick, who served five years as the president of the World Bank up until 2012, said there's been a big structural shift in emerging market economies, which used to depend on strong U.S. demand for their products.

"In the past when you had a U.S. recovery that boosted some of the exports... [Now] you've got a movement to more domestic demand - it's going be less export led growth, and that's obviously the huge story for China's change under the new leadership," Zoellick said, referring to the Chinese government's push towards consumption led-growth.

In Japan, recent monetary and fiscal policies that have spurred optimism in the economy could just be a "sugar high" unless the government really invests in the "so-called" third arrow of structural reforms, Zoellick said.

"The danger is in the past sometimes Japan just used currency devaluation to help its export sector, and when I worked with the Japanese 20 years ago... Japan never was really willing to open up its services market and other areas that would increase productivity - that's the third arrow," Zoellick said.
The global repercussions of Fed tapering were discussed in the Economist:
Researchers at Barclays Capital have looked at which assets are most sensitive to the Fed’s balance sheet, by dividing the change in the asset prices over periods of QE, by the change in the size of the Fed’s balance sheet. At present, markets are adjusting to the Fed’s balance sheet merely expanding more slowly than expected. At some point they will have to adjust to its outright shrinkage.
Since emerging-market equities and European and American high-yield bonds showed the greatest sensitivity to Fed balance sheet expansion, they could be expected to also fall most when it shrinks. Judged by how an asset deviated from its historical value during QE, Turkish equities and "defensive" stocks (those that do not move with the business cycle, like food) are most vulnerable (click on image).
Any tapering in the Fed’s $85 billion-a-month asset-purchasing program will hurt economies in Europe and Asia, where the focus remains on loose monetary policy, Stephen L. Jen and Joana Freire of London-based hedge fund SLJ Macro Partners LLP wrote in a June 10 report. This decoupling would particularly strike emerging markets, which previously served as magnets for capital as the Fed kept monetary policy looser than their central banks did.

Now think about what will happen if we get a crisis in emerging markets because the Fed starts tapering. It will only reinforce global deflationary headwinds, which is exactly the opposite of what the Fed and other central banks want.

For this and other reasons I've outlined above, I just do not see the Fed tapering any time soon. If they do, they will spark another global financial crisis at a time when the world is still dealing with the effects of the last crisis. Moreover, the spectre of deflation lingers, posing a real threat to the global financial system and to pensions preparing for inflation.

Below, Robert Zoellick, Distinguished Visiting Fellow at the Peterson Institute for International Economics says economies will need to look at fundamentals for future growth as the Fed withdraws its monetary easing.

And Paul Hickey, co-founder at Bespoke Investment Group, talks with Betty Liu about why the market doesn’t need to fear the Federal Reserve tapering QE any time soon. He speaks on Bloomberg Television's "In The Loop."

Finally, Ed Dempsey, CIO of Pension Partners, discusses QE, tapering by the Fed, ATAC, and more with Carrie Lee. Dempsey speaks of how the rise in bond yields has hit emerging markets hard and how disorderly expectations of Fed tapering can lead to more volatility and adverse events.

Wednesday, June 12, 2013

BT Pension Prepares For Inflation?

Mark Cobley of Dow Jones Financial News reports, BT Pension Scheme prepares for inflation rise:
The UK’s biggest pension fund, the £39bn BT Pension Scheme, plans to increase its investments in inflation-proof assets by as much as £4bn over the next few years, paving the way for it to make more infrastructure investments.

The pension fund, like many others in the UK, is exposed to inflation because it must pay out benefits in line with rising prices. This year, the scheme reviewed its investments in negotiation with BT, and has decided to double its target for these assets from 15% of its portfolio to 31%.

The scheme’s 2012 report and accounts, published last week, show that as of December 31 it had an inflation-linked portfolio worth £8.4bn. This is about 22% of its total assets, more than its previous target but well behind the revised one.

Of that figure, £6.7bn is held in “UK public sector” assets, likely UK index-linked government bonds, which are a good match for pension-scheme liabilities. The rest is invested in other countries’ bonds, inflation-linked corporate debt and infrastructure.

Last year, the scheme handed its in-house fund manager Hermes a new mandate to invest in mature infrastructure assets that generate inflation-sensitive income, including renewable energy. This portfolio, managed by Hermes’s GPE division, was worth £730m at year-end.

UK pension funds, especially larger ones, are increasingly keen on acquiring infrastructure assets outright.

Last week, a consortium consisting of the Universities Superannuation Scheme, the UK’s second-biggest fund; Borealis, which is the infrastructure-management arm of the Ontario Municipal Employees Retirement System; and the Kuwait Investment Office, announced an improved bid of £5.3bn for UK water company Severn Trent.

Ten UK schemes, including BT’s, have also agreed to put up £100m each for a new industry-wide Pensions Infrastructure Platform.

A spokeswoman for the BT scheme declined to comment.
Earlier this year, up to 150,000 members of the BT pension scheme were asked if they would give up their guaranteed increases in annual pension payments in return for a rise in their initial income. The company has made a similar offer to other pensioners in the past and companies including ITV and Boots have done the same. But it's not clear whether this is a good deal for BT's members:
Tom McPhail, a pensions expert at Hargreaves Lansdown, the financial adviser, said: "The BT scheme is looking for greater certainty by 'buying out' its unknown future inflation liability in exchange for a fixed price now. In the process it is shifting that uncertainty on to the member, who will then bear the brunt of any significant inflation in the future.

"If you are in poor health and therefore unlikely to benefit from long-term inflation proofing, this could represent a good deal."
It's worth noting UK pension schemes have been preparing for inflation for quite some time. The outlook for  inflation was discussed at a conference held by the National Association of Pension Funds back in March 2011:
The threat of high inflation concerns trustees of UK defined benefit pension funds for a cardinal reason. They are bound by law to increase pensions in payment, and deferred pensions, in line with inflation, although the liability is often capped. So, when inflation jumps, so do pension fund outgoings.

Such fears may prove unfounded in some cases though, advisers say. This is because if rising inflation exceeds the cap that limits the inflation-matching liability of many pension funds, it can help funds reduce their liabilities.

For example, if the inflation rate rose to 7 per cent bond yields would also be likely to rise. If the cap on a pension fund was set at 5 per cent, the current value of its liabilities would fall as they would be discounted at a higher rate.

“The worst thing that could happen to a pension fund is deflation. If inflation is a bit ahead of the consumer price index or the retail price index rate, then pension funds with a cap wouldn't have to increase their pension payments by more than that," says Jeremy Tigue, manager of the Foreign & Colonial Investment Trust.

Nick Sykes, partner with the pensions consultants Mercer, says the relationship between the rise in inflation and the size of liabilities is complicated as the methodology on inflation-capping varies so much from one pension scheme to the next.

Generous schemes are most at risk, meanwhile, as some still offer pensioners protection against the full brunt of inflation rises. The effects of inflation on pension funds’ assets also have to be assessed, Mr Sykes notes. The array of asset classes in which schemes invest has widened since inflation was last a threat in the UK during the early 1990s, but that may not necessarily help.

Commodities are generally viewed as providing inflation protection, for example, but Mr Sykes discourages pension funds from investing in the asset class. “Long term, we’re unconvinced commodities produce an attractive return. They don’t offer an income stream,” he says.

Real estate, however, remains attractive. “We quite like it. Its returns are strong and it offers some inflation protection,” says Colin Robertson, global head of asset allocation at Aon Hewitt, who is just as negative as Mr Sykes on commodities.

If inflation were to soar to stratospheric levels however, Mr Robertson argues that it would hit asset classes such as equities and be a “net negative” for pension funds. Funds with inflation-linked liabilities also face problems as they tend to underhedge exposure to inflation. Having said that, one must also consider the possibility that inflation may peter out.

Neil Williams, chief economist for Hermes, which looks after BT’s pension scheme, thinks that unless demand returns, the pick-up in UK inflation – which is being driven by rising oil and food prices – may fizzle out in a few months. “For past inflation to guarantee future inflation you need to have strength in the labour market,” he says. “The tension in North Africa and the Middle East and the disaster in Japan have added more threats to the outlook for economic growth.”

Regardless of the consequences, it stands to reason that the volatility whipping through markets in the wake of the situation in Japan and the political upheaval in North Africa, is only encouraging pension funds to rachet up their efforts to hedge portfolios against inflation risks. “There's been a surge in demand for inflation-linked bonds and this suggests to me that the world has in mind an inflationary future,” says Mr Williams of Hermes.

Mr Robertson of Aon Hewitt, and Mike Smedley, a partner in KPMG’s pension practice, agree. “A large number of clients are in the process of putting on de-risking strategies or taking out the inflation or duration risks arising from their liabilities,” says Mr Robertson.

Mr Smedley adds: “We’ve seen a steady growth in the number of clients who are interested in buying inflation protection. But a lot of clients don’t want to pay for it at current prices.”

Historically, index-linked gilts and swaps are the conventional ways to hedge against inflation. Of the two, swaps, a type of derivative by which a scheme pays a fixed rate (over the length of the swap) and receives the retail price index yield from the counterparty bank, remain more popular as they allow managers to deploy, say, just 20 per cent of their capital to gain 100 per cent protection on their portfolios.

However, Robert Gardner, founder of Redington, a UK pensions consultancy, says both investments are now a “quite expensive risk lever” for pension funds to pull.

Desperate times require creative measures. In the past year, Mr Gardner notes that more pension funds have begun to invest in municipal libraries or supermarkets with long-dated leases that are linked to either the retail price index or the consumer price index. “The point to note is that people are looking at property investments via a fixed income lens,” he says.

Mr Smedley says some clients have bought into RPI-linked bonds issued by National Rail. Yet he remains cautious on more unusual methods of inflation proofing. “Schemes out there are trying to do quirky things. But it can be hard to demonstrate that the quirky things are a good match to protect against inflation,” he says.
The article above was written over two years ago and offers a good discussion on why UK pensions are worried about inflation and what options are available to hedge against rising inflation.

Direct infrastructure investments represent another way of hedging against inflation. These are long-dated assets -- much longer than real estate -- that provide strong, stable cash flows with built-in inflation hedges (although academics have challenged the widespread belief that infrastructure offers a good inflation hedge).

Earlier this week, I discussed the fallout of GPIF's new asset allocation and explained why it's critically important to get the inflation/ deflation debate right. Japan is trying to ignite inflation by lowering the yen to increase import prices, but if successful this policy will hit their bond and equity makets hard and export deflation to the rest of the world.

That's why many prominent economists still worry about a deflationary slump, like Japan. Deflationary fears are the main reason why commodities and commodity stocks have been hammered this past year. This is why it's hard to conclude the bond selloff is for real. Yields have risen because global growth is improving but absent real inflation pressures, there is no imminent threat to bonds (Read Bill Gross's latest, Wounded Heart).

All this to say that pensions can prepare for inflation but they also need to prepare for deflation and how it will hit their public and private assets. If a protracted deflationary slump occurs, all assets except bonds will get roiled. This will be disastrous for pension funds and the financial system, which is why central banks will fight deflation with everything they've got.

Below, author and well known bear, Harry Dent, discusses inflation vs. deflation in an interview with FutureMoneyTrends. Scary interview but listen carefully to his comments as he raises many excellent points.

Tuesday, June 11, 2013

AIMCo, OMERS Going To The Movies?

Gary Lamphier of the Edmonton Journal reports, European movie theatres just the ticket for Alberta pension fund AIMCo:
Alberta Investment Management Corporation is taking a bold step into the movie business.

The province’s $70 billion pension fund manager and an Ontario-based partner have agreed to acquire one of Europe’s top movie theatre chains for 935 million British pounds, about $1.48 billion Cdn.

AIMCo’s joint purchase of Vue Entertainment with OMERS Private Equity — the investment arm of the $61 billion Ontario Municipal Employees Retirement System — is expected to close in July.

Vue Entertainment, currently owned by London-based Doughty Hanson & Co., one of Europe’s largest independent private equity firms, operates 1,321 movie screens in 146 cinemas across Europe and beyond.

“This took a little longer to close than we thought,” AIMCo chief Leo de Bever told the Journal on Monday, after returning to Edmonton from Europe on Sunday evening. “There are always last-minute (snags) and we’d actually expected it to close on Friday, but these things happen.”

Although the purchase of a cinema chain in recession-racked Europe may strike some as an odd move for AIMCo, which is more typically involved in major infrastructure, resource or real estate investments, de Bever says the deal makes sense on several levels.

“It’s a relatively low-risk transaction. The revenue streams are not cyclically sensitive, so they’re reasonably recession-proof, and the returns will ultimately come from really managing this thing from an efficiency point of view,” he says.

“Europe is a little behind us in terms of having very highly optimized networks for movies, and in Eastern Europe there is still a fair bit of growth potential. They’ve never had these kinds of (modern) facilities, particularly in Poland and parts of Germany.”

Vue Entertainment, described by Bloomberg as the second-largest cinema chain outside of North America, also operates in Britain, Ireland, Denmark, Portugal, Latvia, Lithuania and Taiwan.

Since Doughty Hanson acquired Vue for 450 million British pounds ($713 billion Cdn) in late 2010, the chain has expanded rapidly through a series of acquisitions, roughly doubling the number of locations and theatre screens in its network.

Although the eurozone’s economy has shrunk for six straight quarters, and jobless rates — especially among the young — remain at nosebleed levels, de Bever says theatre box office revenues have remained strong.

The Hollywood Reporter, a respected U.S.-based film industry trade publication, recently reported that European theatre revenues hit a new record high of nearly 6.5 billion British pounds ($10.3 billion Cdn) in 2012, with strong markets in Britain, Germany, Finland and Romania offsetting declines in Italy, Greece, Portugal and Spain.

“I think we got it for a bargain. But it was well priced in the sense that, given all the (issues) about the European economy, but also the incomplete optimization of this particular industry, this represented a medium risk, good return combination,” says de Bever.

Although pay-per-view movies also pose a competitive threat to traditional cinemas, he says the latter option is still preferred by many movie patrons who are seeking an affordable night out on the town.

“When we looked at the market, (going to the movies) competes with a number of other things you could do, and it remains relatively inexpensive,” he says.

OMERS and AIMCo were both familiar with Vue Entertainment, since they had taken a look at the company when it was last on the market in 2010.

“There was some history there and we were familiar with it. So when it became available (again) we quickly got into a private negotiation,” says de Bever.

“Often with these kinds of deals, there is more to it than price. People often have strong views on who they want to end up with this kind of an asset, and that often counts for as much as delivering a big cheque.”

Doughty Hanson opted to put Vue Entertainment back on the market after one of its two co-founders died earlier this year. Tim Richards, the theatre chain’s founder and CEO, will remain with the business, Doughty Hanson says.

“As the company moves forward I am confident that we do so from a position of real strength,” Richards said in a release. “We will continue to build on this success by innovating, enhancing and growing the Vue business through our continuing plan for organic growth supplemented by strategic acquisitions.”
Kristen Schweizer of Bloomberg also reports, Vue Sold to Omers, Alberta Investment for $1.5 Billion:
Vue Entertainment Ltd. was bought by two Canadian pension-fund managers looking to continue the expansion of one of Europe’s largest cinema operators for 935 million pounds ($1.45 billion).

Ontario Municipal Employees Retirement System and Alberta Investment Management Corp. are buying Vue from private-equity firm Doughty Hanson & Co. and the London-based cinema operator’s management, according to a statement today by the three companies.

Vue, which operates in countries including the U.K., Germany and Portugal, has doubled the number of cinemas it owns in the past three years. Chief Executive Officer Tim Richards will retain an equity stake and remain in charge, according to the statement. Vue, which in recent months bought rivals in Poland and Germany, will continue making “strategic acquisitions” where appropriate, Richards said today.

“This is the most active time in Europe for cinema in probably the past 10 years because the banks are back in business and supporting companies and assets” are for sale, he said in an interview.

The deal should close at the end of July, according to the statement. The Ontario pension fund, known as Omers, and Alberta Investment plan to use their own funds to finance the buyout before finalizing debt financing by early August, according to a person familiar with the deal who asked not to be named as the details are private.

James Devas, a spokesman in London for Omers, declined to comment on the debt financing.
‘Patient Capital’

Vue is the second-largest cinema operator outside North America and has more than 1,300 screens at 146 cinemas across Europe, according to the statement.

“People have suggested that” an acquisition of Odeon and UCI Cinemas Group Ltd. “may be the next step in a consolidation,” Aimco CEO Leo De Bever said in a phone interview from Edmonton, Alberta. “But we’re not in any discussions on that one.”

Omers approached London-based Odeon in 2011 with BC Partners Ltd. to purchase the chain, two people familiar with the plan said at the time. The pension funds may run into regulatory issues if they seek to acquire Odeon because of the large market share it would command, De Bever said.

“Presumably, if you had that kind of concentration, you might get a bit more push back from the regulators,” De Bever said. “That’s not on the table right now.” He doesn’t expect there to be any regulatory issues in the Vue deal.
Canada Pensions

Omers is one of Canada’s largest pension funds with more than C$61 billion ($60 billion) in assets. Alberta Investment has more than C$70 billion under management, according to the statement.

“Our combined ownership gives Vue the distinct advantage of patient capital and deep pockets for organic and acquisitive growth,” Mark Redman, the head of Europe at Omers Private Equity, said in the statement.

Doughty Hanson bought Vue in November 2010. The disposal is the second from its Doughty Hanson V fund after the sale of Norit, a maker of water-purification systems, the company said. The firm is in the process of raising about 2 billion euros ($2.6 billion) for its sixth buyout fund, Doughty Hanson VI. It will be the firm’s first fundraising since the death of co-founder Nigel Doughty in February 2012.
And Elizabeth Pfeuti of aiCIO reports, AIMCo, OMERS Take Cinema Chain on Second Attempt:
A pair of giant Canadian investors has bought a UK-based cinema group some two and a half years after their initial bid for the company.

The Alberta Investment Management Corporation (AIMCo) and the Ontario Municipal Employees' Retirement System (OMERS) and have agreed terms with private equity leader Doughty Hanson, the company which beat them to buy Vue Entertainment in November 2010.

The deal will see the Canadian duo commit £935 million to the acquisition, more than double the £450 million paid by Doughty Hanson, the company announced today.

To warrant this increased price tag, Vue Entertainment has more than doubled in size since the pension consortium missed out initially.

The entertainment firm has been expanded from owning and running 68 cinemas, offering 678 screens and sitting in third place in the UK sector in 2010, to operating 146 establishments with 1,321 screens.

In the period between the two deals, the entertainment company bought similar businesses in Poland and Germany, and shored up its prominence in the UK with the take-over of Apollo Cinemas last year, making it one of the largest in the world.

"I'm constantly building relationships globally because I believe in the power of trust-based relationships. A network of reliable, global partners will help AIMCo get the local knowledge of foreign markets it needs to succeed," the fund's Deputy CIO, Jagdeep Bachher, told aiCIO last year. He added that AIMCo should "become the first stop for companies and international institutional investors seeking a partner to help them become world class organizations."

Last week, OMERS was part of a consortium making its second bid on UK utility company Severn Trent. The firm rejected the approach, saying it undervalued its worth and today the consortium has appeared to give up its chasing of the firm.
I think this is a great deal for AIMCo and OMERS. Leo de Bever is right, the deal is well priced and it's a relatively low risk transaction as the revenue streams are not cyclically sensitive and reasonably recession-proof. Also, in Europe, people love going to the movies as it's a relatively inexpensive way to enjoy an outing.

And as Leo de Bever states, the incomplete optimization of this industry is another reason why the deal represents a medium risk, good return combination. Moreover, Chief Executive Officer Tim Richards will retain an equity stake and remain in charge, which means he will keep growing the business.

Also worth noting box office revenue in Europe hit a new high of $8.5 billion (€6.47 billion) last year, even as admissions slipped slightly and several territories experienced a major recession-led drop in sales:
Overall, EU theater goers bought 313 million tickets for European movies last year, a 12 percent jump on 2011, and European titles accounted for more than a third (33.6 percent) of overall admissions, a 5.6 percent increase.

That positive news, however, masks the major drops in EU countries suffering from the Euro crisis, particularly in the recession-wracked south. Admissions were down 10 percent in Italy, 6.7 percent in Greece and 12 percent in Portugal. In Spain, admissions fell 5 percent and would have been much worse without The Impossible, which earned more than $54 million locally, the best-ever performance by a Spanish title. Even France, home to Europe's largest theatrical audience, saw a substantial drop in ticket sales, with admissions falling 6.3 percent year-on-year, to 203.4 million.

On the plus side were Germany (4.3 percent increase), Finland (up 19.7 percent) and Romania (up 15.4 percent), with the U.K. holding steady as Skyfall made up for the lack of a Harry Potter title in release last year.
If peripheral economies finally turn the corner and start growing again, this deal will provide growing revenue streams to its new owners. AIMCo and OMERS might also opt to sell this asset down the road at a much higher multiple.

Leo de Bever always talks about "investing between the cracks," finding deals that make sense which others are not looking at. This was definitely another such deal and even though it took a little longer to close, it was well worth it.

Below, Vue Cinemas 4K on-screen promo created for Vue Entertainment. And Steve Knibbs, Chief Operating Officer at Vue Cinemas, talks about his responsibilities and how he worked his way up from "sweeping floors and handing out popcorn" to a senior management position.

Monday, June 10, 2013

Fallout From GPIF's New Asset Allocation?

Yoshiaki Nohara, Toshiro Hasegawa and Satoshi Kawano of Bloomberg report, Japan’s Pension Fund Cutting Local Bonds to Buy Equities:
Japan's public pension fund, the world’s biggest manager of retirement savings, said it will reduce its holdings of local bonds and buy more shares.

The proportion of assets held in Japanese bonds will be cut to 60 percent from 67 percent, the health ministry said yesterday in Tokyo at a briefing to announce changes to the mid-term plan of the Government Pension Investment Fund. The weighting of local shares will be increased to 12 percent from 11 percent currently. The Health and Welfare Ministry, which oversees pensions, didn’t give a time frame for the changes.

“It was a negative factor as far as bond supply and demand is concerned,” said Makoto Suzuki, a bond strategist at Okasan Securities Co. in Tokyo, one of the 24 primary dealers obliged to bid at government debt sales.

GPIF’s shift toward higher-yielding assets comes as it prepares to fund retirements in the world’s most elderly population and Prime Minister Shinzo Abe tries to revive the economy through fiscal and monetary stimulus. Domestic shares have slid since Abe said on June 6 that a legislative campaign to loosen rules on businesses, the “third arrow” of his economic plan, won’t begin for months.

Changes to GPIF’s asset allocation are effective from yesterday, fund official Masahiro Ooe told reporters. He declined to elaborate on the timing for completion of the portfolio changes.
Investing Abroad

Allocations to foreign bonds will rise to 11 percent from 8 percent, while overseas shares will increase to 12 percent from 9 percent, according to a document on GPIF’s website.

Nikkei 225 Stock Average futures in Chicago rose the most in two months last night, with the June contract gaining 4.1 percent to 13,240. The Nikkei 225 fell 0.2 percent in Tokyo yesterday to 12,877.53, while the broader Topix index slid 1.3 percent and is down about 17 percent from its May high.

GPIF, created in 2006, managed 112 trillion yen ($1.16 trillion) as of Dec. 31. It didn’t alter the structure of its holdings during the worst global financial crisis in 80 years or in response to Japan’s 2011 earthquake and nuclear disaster.

In an interview in February, GPIF President Takahiro Mitani the fund may have to reduce its bond holdings and buy alternative assets to cope with a higher interest-rate environment under Abe. After a review in April-to-May, any portfolio changes would begin in early 2014, he said at the time.
Yields Rise

Yields on 10-year Japanese government bonds increased 2 1/2 basis points to 0.86 percent in Tokyo, according to Japan Bond Trading Co. Futures on the notes recovered from a drop in the afternoon to close at 143.11 on the Tokyo Stock Exchange, the highest since May 10.

“The reaction we have seen in the futures market has been muted,” said Teruyoshi Sotome, a Tokyo-based senior bond strategist at Mizuho Securities Co., one of the 24 primary dealers obliged to bid at government auctions. “We shouldn’t forget the change in GPIF’s portfolio is going to take place over the long term. The announcement is not a declaration that they are going to increase foreign investments by large amounts going forward.”

Japanese households had 1,547 trillion yen in financial assets as of the end of December, according to Bank of Japan data. That compares with 32 trillion yen of debt securities and 106 trillion yen in equities and investments, the data show.
BOJ Buys

Even as GPIF reduces its allocation to JGBs, the Bank of Japan has stepped up purchases. The BOJ said in April it would double monthly buying of JGBs to more than 7 trillion yen, and in May said it would increase the frequency of the operations.

JGBs have lost about 1.64 percent so far this quarter, the most since the period ended September 2003, according to a Bank of America Merrill Lynch index.

Domestic bonds made up about 60 percent of GPIF’s assets at the end of December, according to a document on its website. The fund is amending its targets to bring them into line with the changing value of its holdings, said Hideo Shimomura, who helps oversee the equivalent of $62 billion in Tokyo as chief fund investor at Mitsubishi UFJ Asset Management Co., a unit of Japan’s largest publicly traded bank.

“They don’t have to touch their assets,” Shimomura said. “I don’t think this news could affect markets.”
Chikafumi Hodo of Reuters also reports, Japan's $1 trillion public pension cuts government bond weighting, lifts stocks:
Japan's public pension fund, the world's largest with a pool of $1.1 trillion, announced on Friday the most significant shift in its asset allocation since 2006 so it can take on greater risk by shifting into stocks and away from Japanese government bonds.

The steps by the Government Pension Investment Fund (GPIF) come after a draft strategy document this week showed Prime Minister Shinzo Abe was considering a push for public funds to increase returns as part of measures to revive the economy's fortunes. The events confirm reports by Reuters this week.

GPIF said it is increasing its Japanese stocks allocation to 12 percent of its portfolio from 11 percent, while lowering its JGB weighting to 60 percent from 67 percent. However, the change largely reflects adjustments already made in the portfolio, suggesting limited impact on markets.

The fund's latest publicly available allocations show that as of December 60.1 percent of the 111.9 trillion yen ($1.1 trillion) under management was already in JGBs. It had already allocated 12.9 percent to domestic stocks.

"GPIF is ratifying the current situation taking into account the moves in the market. GPIF would avoid readjusting its portfolio by doing this," said Eiji Dohke, director and chief JGB strategist at Citigroup Global Markets Japan.

GPIF said it would increase its weighting in foreign stocks to 12 percent from 9 percent and lift its allocation of foreign bonds to 11 percent from 8 percent.

The new allocations were released after the close of Tokyo share trading but expectations of the announcement had pushed stocks up from the day's low. The stock benchmark Nikkei average closed down 0.2 percent on the day.


Masahiro Ooe, a councilor at GPIF, told a news conference that a review of the fund's long-term risk and return profile had concluded the pension could take more risk.

The fund said it will not comment on whether it will trade actively in the market.

Dohke said the changes could still depress JGBs as hopes for GPIF inflows into JGBs could now have receded. Some in the market had thought the fund would have to sell domestic shares and foreign assets to maintain its investment limits and they had speculated some of the cash proceeds would then go into JGBS.

"But this is not likely to happen after today's change, Dohke said.

Government bonds will remain the fund's staple investment however, unlike some other large public funds globally which adopt a much greater weighting in stocks.

Canada's Pension Plan Investment Board, with $183 billion in assets, and Norway's $686 billion pool of government savings from petroleum revenue, known as the Government Pension Fund Global, both allocate most of their money to equities.

GPIF hit its own internal return targets in recent years, or a total return averaging 2.4 percent a year. By comparison, Norway's Government Pension Fund Global, returned almost 6 percent a year over the past decade.


A growth strategy outlined this week by Abe marked the first time he had sought to mobilize public savings to support an aggressive growth agenda aimed at defeating years of deflation and sluggish economic growth. GPIF and other Japanese public funds have a collective pool of $2 trillion in assets.

Abe has already pushed through $100 billion in government spending and shaken up monetary policy by prodding the Bank of Japan into a $1.4 trillion stimulus effort to achieve 2 percent inflation within two years.

He won a December election as leader of the Liberal Democratic Party and promised "bold" economic policies, which been dubbed 'Abenomics' by the media.

The Nikkei is up 24 percent this year off the back of Abe's policies, although a bout of profit taking has pulled the average back from its highs of the year.

"Recent weakness in the market represents a little bit of a disappointment for Abenomics," said Kenji Shiomura, an analyst at Daiwa Securities.

"But it would be too extreme to say that hopes for Abenomics have faded completely because the biggest impact Abenomics gave the market was monetary easing, and it is still continuing," he said.

The changes by the GPIF were prompted by a report from Japan's Board of Audit, which had been requested by Japan's upper house. The board called last year for the fund to review its targets and allocations.
GPIF's new asset allocation may not affect markets now but it created quite a stir when the story broke out early last week that GPIF is mulling a shift into equities. This was followed by news that the government of Japan is now targeting Japanese pension funds as part of its growth strategy.

What are the key takeaways for global asset allocators? First, global liquidity flows should continue to support risk assets and alternative investments. Second, Japan is exporting deflation and this will eventually force other central banks to respond to a weakening yen. Third, the Bank of Japan will have to step up its purchases of JGBs following the pension fund news.

The most important question is whether or not central bank policies will eventually lead to inflation or deflation down the road. The irony is that Japan's quest to conquer deflation is exporting deflation elsewhere at the worst possible time, endangering the global economic recovery.

Last week, I discussed whether the recent sell-off in bonds is for real, pointing out that while inflation expectations remain muted, global growth is driving bond yields higher. But if yields back up too much, too fast, it will wreak havoc on markets and Asia is particularly vulnerable to any abrupt shift in global bond yields.

One prominent Wall Street strategist who used to make bold calls at Merrill Lynch, Richard Bernstein, is now betting the U.S. will beat emerging markets, stating the following to Barron's:
People continue to overestimate the risks in the U.S. I would argue that they grossly -- and I'm not using that word lightly -- underestimate the risks in the emerging markets. A lot of the problems that people think are inevitably going to crop up here, including inflation and out-of-control money growth, are actually happening in the emerging markets. We aren't seeing those risks here. But the thinking is that it is inevitable and it has to happen here. A lot of people have talked about how the great rotation will be a shift from bonds to stocks. But that's not right. The great rotation -- and the biggest decision you have to make for your portfolio -- is that for five to seven years, it is not going to be bonds to stocks, but rather non-U.S. assets to U.S assets. We are maybe in the fourth inning of a secular period of outperformance for U.S. assets. Think about this: The Standard & Poor's 500 has outperformed emerging markets now for five years. Nobody cares, and it pains people to admit that the U.S. market has been outperforming.
...the hyperbolic credit creation in China has gotten worse, for example, and the money supply problems in India have gotten worse, as have the corporate fundamentals in China. The Chinese corporate sector is now one of the most levered in the world, and its marginal return on investment is going down. So the efficiency of that economy's credit is getting lower and lower. That's not healthy; that's not a growth story. Expectations are too high. In 2012's fourth quarter, just under 60% of emerging-market companies reported negative earnings surprises, compared with 28% in the U.S. And the corporate fundamentals in emerging markets continue to erode.
Bernstein is warning investors to shy away from large-cap multinationals relying on emerging markets and focus on the "American industrial renaissance," where they see small- and mid-cap industrial-manufacturing companies in the U.S. gaining market share. This is why he particularly likes smaller U.S.banks.

Bernstein is underweight energy and commodities for two reasons: cyclical, the other secular. Starting with the cyclical: Energy and commodities are traditional late-cycle plays. Why? Because inflation is a late-cycle play. You need bottlenecks in the economy, and you need demand to outstrip supply. I don't care about all these guys who say inflation is imminent because the Fed is printing money. Demand must outstrip supply to get inflation. But we aren't late in the cycle. The Fed isn't tightening. The secular reason is that if you agree with us that emerging markets have been overstimulated by the global credit bubble, that explains the demand for commodities on a secular basis. Again, commodities are very credit-sensitive. I find it quite amazing that people will generally agree that the global credit bubble is deflating. But then they want to play credit-sensitive investments like energy and commodities and gold. That doesn't make a lot of sense.
Interestingly, Goldman Sachs and Citigroup Inc. predict the end of the decade-long bull market in commodities even as the global economy expands. And hedge funds' bullish bets on commodities are at a six week low, which tells you where sentiment lies. Still, if global growth heats up, commodities could bounce back strongly. Also worth noting that China's imports of major commodities all rose in May, even as overall imports weakened.

One thing is for sure, the slide in commodity prices has been a boon for resource-hungry firms' shares, keeping inflation expectations muted even as bond yields creep up. This supports continued strength in industrial, financial and technology shares going forward.

I started this comment discussing GPIF's new asset allocation and ended up talking about global asset alocation. There are many things happening all at the same time but the key thing to remember is the titanic battle over deflation has gone global and pension funds need to assess their asset allocation accordingly in this new environment, looking at how it will impact their public and private market portfolios around the world.

Below, John Mauldin, president of Millennium Wave Advisors, talks about the Japanese government's economic policies and outlook for the Japanese yen. Mauldin speaks with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance." Dan Clifton of Strategas Research Partners also speaks.