Friday, March 14, 2014

Soros Warns Japan to Crank Up the Risk?

The Economist reports the world’s largest pension fund is changing the way it invests, with big consequences for the market:
When George Soros, a billionaire investor, met Shinzo Abe, the prime minister of Japan, at Davos in January, he hectored him about asset management. Japan’s massive public pension fund needed to take more risk, he reportedly told Mr Abe. With ¥128.6 trillion ($1.25 trillion) of assets, the Government Pension Investment Fund (GPIF) is the world’s biggest public-sector investor, outgunning both foreign rivals and Arab sovereign-wealth funds. Yet its mountain of money is run by risk-averse bureaucrats using an investment strategy not much more adventurous than stuffing bundles of yen under a futon. It keeps around two-thirds of assets in bonds, mostly of the local variety. Like an investing novice, it mostly follows indices passively, and hardly ventures abroad.

The government would dearly love to oblige Mr Soros. Mr Abe is now taking steps to overhaul the fund. In November last year an official panel laid out a plan of far-reaching reform, some of which could take effect as soon as this year. To boost returns to future pensioners, it concluded, the GPIF should reduce its reliance on bonds, head into stocks and also invest in different asset classes including infrastructure and venture capital.

Most radically, the government wants to break the ties that bind the GPIF to the Ministry of Health, Labour and Welfare. It is the ministry’s cautious bureaucrats that keep the fund so averse to risk-taking. Even with a low return, of an annualised 1.54% over the past 12 years, the GPIF has met its own targets cheaply. The ministry is frugal to the point of meanness. The fund’s 80-strong staff are often unable to buy the market data they need. It is one thing to keep costs low, quite another to forgo receptionists, as the GPIF does at its non-descript office in Tokyo.

For Mr Abe, geeing up the fund is part of his plan to revive Japan’s economy, alongside a radical monetary easing which the Bank of Japan began in earnest in April 2013. As well as defeating deflation, Mr Abe seeks to boost risk-taking in the economy. The planned changes to the fund also include demanding better corporate governance from Japan’s large companies.

Already, the markets are anticipating the effect of the slow shift in direction. GPIF’s influence is amplified by other public pension investors following its lead. The fund lowered the weight of Japanese government bonds (JGBs) from 62% in its portfolio in March 2013 to 55% at the close of the year, putting most of the money—roughly ¥8 trillion—into local and foreign shares instead (see chart). The GPIF’s shift may have contributed to the giddy rise of Japan’s stockmarket, which was one of the best-performing rich-country bourses in 2013. For investors, the likelihood that the GPIF will continue shifting towards equities is a convincing reason to buy Japanese shares. That in turn reinforces Mr Abe’s will to enact the reform. So far this year the Nikkei’s rise, an important contributor to the government’s broad popularity, has stalled.

But for every equity punter cheering on the reform, there is a JGB holder fretful about the eventual impact on prices if the asset class’s biggest backer continues to sell off. Investors have long predicted a meltdown in the Japanese bond market, given that its public debt stands at nearly 240% of GDP. One explanation of why the cost of borrowing for the government has remained low is that JGBs are chiefly held by loyal local banks and by public pension funds, rather than by foreigners who would demand a higher risk premium. Yet the landscape is changing as retirees draw down their savings, meaning that institutional holders will become still more important. Ominously, Japan’s current account has moved into deficit.

For the time being, the monetary easing undertaken by the Bank of Japan will more than offset the effect of any bond sales by the GPIF. So now is exactly the right moment for the fund to sell with no fear of triggering a broader sell-off, argues Takatoshi Ito, the chairman of the government-backed panel on the GPIF.

Yet though the fund may at last escape its duty of holding oodles of government debt, the shift could exacerbate problems once the central bank starts eventually to withdraw from its “quantitative easing”. The partial withdrawal of the GPIF from the market, says Naka Matsuzawa, chief strategist at Nomura Securities in Tokyo, may contribute to a crisis later on. When in December Mr Ito called for a radical cut in the GPIF’s bond portfolio from 55% down to 35%, yields on JGBs temporarily rose.

The basic arguments for overhauling the fund are persuasive. With an ageing population, meaning the fund is already paying out more in benefits than it receives in contributions, it can ill afford to settle for a low-risk, low-returns approach. Its strategy stands in contrast to pension pots in Canada and Australia, for example, which are given leeway to be more daring. They also regularly badger managers of the firms whose shares they own. Obliging the GPIF to insist on more active oversight of firms would be the most useful way to improve Japan’s corporate governance, says Hans-Christoph Hirt of Hermes, a British fund manager.

For now the GPIF and the ministry are together resisting Mr Abe’s initiative. The GPIF’s purpose is not to lift the stockmarket but to invest the people’s money in a safe and efficient way, complained its president, Takahiro Mitani, in February. The GPIF will probably seek to reduce its bond portfolio by as little as it can. The labour ministry’s bureaucrats are understandably loth to forgo the prestige of managing the planet’s single-largest pot of money. Yet the government is determined to overcome opposition, say insiders. Mr Soros, who reportedly made a cool $1 billion by shorting the yen in 2013, may soon be called in to offer further lessons.
There is a lot to ponder in this article. First, why is George Soros , the undisputed king of hedge funds, lecturing Shinzo Abe on why the GPIF needs to take more risk? It doesn't surprise me that Soros made a cool $1 billion by shorting the yen in 2013. In fact, anyone who read my November 2012 comment on Japan's seismic shift would have made a killing shorting the yen (hopefully Soros, who periodically reads my blog, also shorted the hell out of the Canadian dollar following my December 2013 comment on why it's time to short Canada. Keep shorting the loonie, it's cooked!).

But why is Soros urging Japan's giant pension fund, the GPIF, to crank up the risk? Because Soros is part of the real power elite and he's privy to information you and I are not privy to. He understands the global economy better than any other investor in the world, including the great Warren Buffett who recently sounded the alarm on U.S. public pensions.

What is Soros worried about? The same thing I'm worried about, global deflation. In fact, Soros recently told Bloomberg's Francine Lacqua that Europe faces 25 years of Japanese-style stagnation unless politicians pursue further integration of the currency bloc and change policies that have discouraged banks from lending:
Europe “may not survive 25 years of stagnation,” Soros said in the interview with Francine Lacqua. “You have to go further with the integration. You have to solve the banking problem, because Europe is lagging behind the rest of the world in sorting out its banks.”

Soros, whose hedge-fund firm gained about 20 percent a year on average from 1969 to 2011, has been a constant critic of how the European currency bloc was designed and of budget cuts imposed on indebted nations such as Greece and Spain at the height of the crisis. He said more “radical” policies are required to avoid a “long period” of stagnation.
Soros is right on the money on Europe. It's still a mess and if you think the crisis is over, you're wrong. Politicians and the ECB have bought time but the worst is yet to come in Italy, France and the mighty Germany. Europe is a slow motion train wreck and until they sort out their banks and reshape policies, it won't be the driver of global growth (As I wrote back in 2008, I don't buy the decoupling theory, the U.S. economy remains the tail that wags the global economy).

But if deflation is the ultimate end game, why the hell should Japan's giant pension fund crank up the risk at this time? I've written many comments on Japan's GPIF. In my last comment, I discussed why the GPIF is not ready for Abenomics, stating the following:
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.
Brian Romanchuk, author of the Bond Economics blog, recently discussed Japan's dismal economic data, noting the following:
Japanese data released yesterday were dismal, with fourth quarter GDP below expectations, and the current account deficit hitting a record.

To put it bluntly, there's not a whole lot of momentum behind Abenomics at this point, and we have not yet seen the impact of the consumer tax hike. The external sector is not helping out growth, although the figures are unusually bad as a result of the nuclear reactor shutdown.

Although the chart of the current account deficit above looks horrible, the number has to be kept in perspective. The seasonally adjusted deficit in January was about one-half trillion yen, or around $5 billion US. (The non-seasonally adjusted figure was bigger, at about 1.5 trillion yen.) However, the Japanese held 661 trillion yen of foreign assets at the end of 2012 (Ministry of Finance International Investment data link). The flow that is the current account deficit is completely dwarfed by the impulses generated by the portfolio preferences of Japanese investors.

However, it is interesting that Moody's is attempting to hop on the bandwagon about worrying about the Japanese external position, as was noted in this Bloomberg article:
Prolonged deterioration in Japan’s current-account balance would erode the nation’s position as a net creditor, one of its main credit strengths, Moody’s Investors Service said last month in a report.
I guess since that whole debt-to-GDP ratio thing didn't work out, they have to come up with some other reason to worry about JGB's. But it does not look like the JGB market is particularly concerned (click on image below):

Data have been dismal as well outside of Japan. Although people may dismiss the latest number as the result of the weather, rising auto inventories could be the Achilles Heel of the United States economy. I do not know enough about the Chinese economy to draw any confident conclusions, but the chatter around the copper market and their shadow banking system bears watching. Even if China itself can avoid a hit to its domestic economy by taking countermeasures, commodity producers could be collateral damage if there is some rebalancing in that economy.
Brian is one of the smartest analysts I ever worked with. We worked together at BCA Research and more recently at the Caisse.

Anyways, back to the subject at hand. Should GPIF heed Soros's warning and crank up the risk? I'm very skeptical and think they should proceed cautiously in this environment. Why? Because as I wrote in my outlook 2014, once the mother of all liquidity rallies dissipates, we will have the mother of all liquidity hangovers, but we won't have to worry about that until 2015 or 2016. I discussed why bonds aren't dead and why illiquid alternatives are frothy and vulnerable to a shock.

Finally, as Russian troops build up on the border of Ukraine, there is something else worth noting. As geopolitical tensions mount, where do you think global investors run to? Good old U.S. Treasuries and JGBs, that's where. All these idiots shorting bonds in this environment are going to get slaughtered and rightfully so, they don't get the macro environment.

Below, George Soros talks about the outlook for Europe's economy, the situation in Ukraine and global financial markets. Soros speaks with Bloomberg Television's Francine Lacqua in London.