Wednesday, October 9, 2013

GPIF Not Ready For Abenomics?

Shigeki Nozawa of Bloomberg reports, Biggest Pension Fund at Risk Holding 60% in Japanese Debt:
Japan's Government Pension Investment Fund, the world’s largest manager of retirement savings, isn’t ready for Abenomics, according to the head of an expert panel advising on public investments.

The set of policies from Prime Minister Shinzo Abe aims to defeat 15 years of deflation and spur growth by using the “three arrows” of fiscal stimulus, monetary easing and business deregulation. GPIF needs to reduce the risk of losses on its bond holdings should interest rates start to rise as the economy improves, said Takatoshi Ito.

“The majority of the panel thinks the GPIF is exposed to too much interest-rate risk,” Ito said in an Oct. 4 interview. “If they’re really aware of interest-rate risk, why are 60 percent of the assets in domestic bonds?”

An interim report from the panel on Sept. 26 showed some members wanted the 121 trillion yen ($1.25 trillion) GPIF to add new assets such as real-estate trusts, infrastructure and private-equity investments and commodities. The group will meet two to four more times before issuing its final report next month, Ito said.

The Bank of Japan unveiled an unprecedented monetary stimulus program in April, saying it would double monthly bond purchases to more than 7 trillion yen in pursuit of a 2 percent inflation target in two years. The easing has kept a lid on bond yields as it helped Japan’s exporters by sending the yen to a 4 1/2-year low of 103.74 per dollar in May.
‘Plausible’ Target

The central bank’s inflation goal “is plausible” and the government pension fund “should be using this as their main scenario,” according to Ito, who is the dean of the Graduate School of Public Policy at the University of Tokyo.

“GPIF should be thinking of risk and returns on the basis of future economic forecasts,” he said.

The pension fund announced in June a cut to its target holding for domestic bonds, to 60 percent from 67 percent, while the proportion of foreign and local shares was changed to 12 percent each, from 9 percent and 11 percent respectively. Allocations will remain at the revised levels until at least March 2015, GPIF President Takahiro Mitani has said.

Mitani in June expressed doubt that the BOJ can achieve its inflation goal, saying in an interview that the transmission of policy pledges to changes in consumer price expectations “isn’t that smooth.”

GPIF posted its smallest gain in three quarters in the period ended in June because of record domestic bond losses. The advisory panel hasn’t discussed how much of the portfolio should move from bonds into other assets, Ito said, adding that those decisions are a “governance issue.”
‘Baby Fund’

The pension fund last week announced it was hiring staff for its investment management and research units. That followed recommendations in the panel’s interim report that more “front-line” experts are required to diversify investments and adopt more sophisticated risk-management measures.

“As an individual, I agree with the idea of breaking off some of the assets and putting them in a so-called baby fund,” said Ito, who has held roles at Japan’s Ministry of Finance and the International Monetary Fund. In June, he was named to the newly formed panel, which also includes Masaaki Kanno, the chief Japan economist at JPMorgan Chase & Co., and Mitsumaru Kumagai, the chief economist at Daiwa Institute of Research Ltd.
Stimulus Package

Abe last week unveiled a 5 trillion yen stimulus package to cushion the economy from a sales-tax increase due in April, the first since 1997. Data in the past couple weeks have shown that confidence among Japan’s large manufacturers climbed to a more than five-year high while core consumer prices rose the most since November 2008.

“If interest rate expectations rise, it’s possible wages will go up too,” said Ito. “The inflation target isn’t a transient 2 percent, it’s for inflation to settle around that level over the medium term.”

The Nikkei newspaper reported on Oct. 5 that GPIF plans to boost investment in growth-related shares. The fund will move some of its domestic stock holdings, 80 percent of which track the Topix index, to a new gauge focused on returns on equity, governance and trading volume, Nikkei said without citing anyone.

Domestic bonds are “vastly overweighted” at GPIF compared to other major public pension funds, which allocate about 30 percent at the most, according to UBS AG economist Daiju Aoki. While recommendations from Ito’s panel will go to the health ministry, which oversees public pensions, for approval, there is the chance for “major alterations” from the November report.
Default Danger

The ministry is likely aligned with Abe who “is keen to reallocate resources both to contribute to the sustainability of social welfare and to support market and corporate sentiment,” Aoki wrote in an Oct. 7 report.

The Topix has surged 33 percent this year. The nation’s sovereign bonds handed investors a 2.2 percent return in the same period, according to an index compiled by Bloomberg. Japan’s 10-year bond rose one basis point to 0.65 percent as of 1:05 p.m. in Tokyo after reaching 0.625 percent Oct. 4, a level not seen since May 10.

The yen touched an eight-week high of 96.57 per dollar today as investors sought haven assets amid speculation that a budget impasse in the U.S. will prevent lawmakers from raising the nation’s debt limit by an Oct. 17 deadline. Officials from China and Japan, the biggest foreign holders of Treasuries, have expressed concern about the potential for a U.S. default.

“I doubt we’ll see the U.S. fall into default on the 17th, but if it happened it would be worse than the Lehman shock,” Ito said, referring to the collapse of Lehman Brothers Holdings Inc. in 2008. “I can’t imagine Japan and China would just sit there quietly taking losses on their foreign reserves.”
I don't share Ito's thoughts on a U.S. debt default. Think the politicos in Washington will bungle this up, triggering a technical default before they finally get down to business and hammer out a debt deal. The world won't come to an end but there will be a hit to the U.S. economy and multiples will come down in stock markets around the world (already happening).

Leaving the debt drama aside, let's focus on whether GPIF is ready for Abenomics. When you look at their portfolio, you'd think they're crazy holding so much Japanese debt at a time when the Bank of Japan is ramping up its quantitative easing, targeting higher inflation.

In fact, some market commentators are now warning of Japan's coming inflation:
There’s a widespread view that deflation is at the heart of Japan’s economic woes. If only it could generate inflation, the country would manage to pull out of its two lost decades.

That’s a mistake which could ultimately lead to disaster–and probably a salient one for some of Europe’s economies.

Anybody who knows anything about Japan’s economy, knows two facts. One is that the economy has stagnated since Japan’s equity and housing markets started to collapse in the early 1990s. And two, that over the same period, the country has struggled to shake off deflation.

It’s not a big leap from there to say deflation has caused Japan’s lost decades.

But that’d be wrong. Japan’s lost decades aren’t quite what they seem. Yes, overall gross domestic product has stagnated for much of the time. But this has been down to demographics, an ageing and now shrinking population. Japanese GDP per capita has broadly grown in line with that of other developed countries for the past couple of decades.

Indeed, deflation itself might be a function of demographics. Older populations become increasingly resistant to having their savings inflated away.

Meanwhile, Japan’s shrinking population limits how much the economy overall can grow.

Which means that the government’s current targets of 2% GDP growth and 2% inflation are very likely to be incompatible.

Andrew Smithers, an independent London-based economic consultant, summarizes the problem in a recent research note.

Japanese trend growth is probably around 1% and, at the same time, there’s not much spare capacity in the economy, Mr. Smithers argued. So if the official target is 2% growth, inflation is likely to start rising faster than the 2% being aimed at.

For a while, this inflationary trend is likely to be clouded by the yen’s depreciation as well as a projected consumption tax rise next spring. The headline numbers will be firm, but the overshoot will in all likelihood be put down to special factors, Mr. Smithers wrote. By the time people realize what’s happening, high inflation will become entrenched.

That’s where Mr. Smithers’ note ends. But with inflation, Japan’s real economic crisis only begins.

As part of an effort to stimulate its way to growth, Japan is running some of the biggest government budget deficits in the world--much as it has done since the early 1990s. At current projections Japan’s gross debt won’t be far short of 250% of GDP in a year or two.

Interest expenses already make up around 30% of Japan’s tax revenues, while debt service accounts for around 60%. And that’s at 10-year bond yields of just 0.65%. Once those yields start rising, Japan’s ability to service that massive pile of outstanding debt will rapidly diminish. And as inflation goes up, so too will those yields.

Should underlying inflation start to overshoot the Bank of Japan’s 2% target, it wouldn’t be long before bond investors started to panic. Like any other market, bonds have a habit of overshooting too.

The result would very likely trigger a run on the yen, faster inflation and further bond market panic.

Yes, this potential scenario has been around for a long while. And no, it hasn’t come to pass. And yes, there’s a whole subgroup of Chicken Littles who’ve developed sore necks from staring up at Japan’s debt burden.

But Japan’s economics are ultimately unsustainable. So they won’t be sustained. And once the market starts to react, it’ll look out for other potential Japans–countries with big debt burdens and poor demographics. Like Italy.

Which means Japan’s problem will be Europe’s problem. And that means it’ll be a global problem.
Interestingly, Japan's inflation-linked bonds drew in strong demand on Tuesday, with a total auction of about ¥300 billion in 10-year inflation-linked bonds with a 0.1 percent coupon drawing bids totaling ¥1.12 trillion.

Are global investors starting to worry about inflation in Japan? It sure looks that way but I share Mitani's doubts on the BOJ achieving its inflation goal and dismiss any analysis which claims a spectacular Japanese bond market blowup is coming. Legions of hedge funds have attempted shorting JGBs in the last 20 years and  most of them got clobbered every time they bet against Japan's bond market. This time won't be different.

But as far as the GPIF is concerned, it needs to start diversifying its massive portfolio but the approach is crucial and it's not ready to undertake any big shift in its asset allocation, even if the government is pushing it to do so:
The GPIF’s current mandate in investing the huge fund, according to its current chairman Takahiro Mitani, is to keep the costs down, and not do anything risky with the fund. And Mitano says that the GPIF – along with its 80 employees – have performed the task according to the mandate given to them. But now that the Abe administration is aggressively looking to take Japan’s economy out of chronic deflation, the government is looking to mobilize the huge GPIF fund to help drive Japan out of sluggish economic growth. A more aggressive investment approach could bolster economic sentiment in Japan, eventually weakening the yen more, and ultimately helping the country’s export-driven industries. On Monday, a panel that reports to the prime minister met for the first time to consider wide reforms that could push the GPIF to use funds more aggressively, taking in more risk and shifting more money into stocks, foreign assets, as well as emerge as a more independent fund with deeper expertise.

Mitani thinks this is all well and good, but he says that he will need more fund managers and a better manpower pool if this is to happen. The fund employs so few people – 80 at this time – because of government rules that limit operating costs. “If we have to diversify and move into new areas and take on more risk, we need a workforce with the skills to manage those risks,” he said. “We don’t have such resources now,” Mitani observed. Currently unable to lure the more talented fund managers with higher salaries because of government-imposed controls on pay, GPIF has leaned heavily on outside fund managers. In comparison, Canada’s pension fund – the CPPIB – manages a fund just 15% the size of Japan’s fund, but it employs a staff almost 7 times larger than the GPIF. With more talent, the CPPIB’s portfolio has outperformed the GPIF over the past 10 years.

But Abe understands the GPIF’s potential to boost Japanese economy. “It’s one of the few levers Abe has,” said Itay Tuchman, head of foreign exchange at Citigroup in Tokyo. Takatoshi Ito, an economist from the University of Tokyo who has been involved with the fund before, will head the review panel which focuses on the fund’s investment policy and operating procedures. “All we can do right now is calmly wait for the outcome of the panel,” Mitani said in an interview last month. “We’ll obey the government’s decision if it decides to change the law or the framework for us to be more aggressive.”
The panel has spoken and it says that GPIF isn't ready for Abenomics. It will be interesting to see what happens next but I think Japan should consider various governance models from countries like Canada, the Netherlands, Sweden, Denmark and Norway. There is a lot of money on the line and if they don't get the governance right, it will lead to huge problems down the road.

Below, Alvine Capital Management Strategist Stephen Isaacs discusses Japan’s efforts to fight deflation with Anna Edwards and Mark Barton on Bloomberg Television’s “Countdown.”