Friday, November 28, 2014

Prepare For a Deflationary Boom?

Jon D. Markman of Yahoo Finance reports, Prepare for the rare “deflationary boom”:
"Deflation" and "boom" are not two words that normally go together. They are almost like "sad happiness," "low-cal donut." But in their very unlikely pairing they appear to do a good job of explaining the unusual economic and market environment that may lie ahead.

It’s a term discussed this week by Cornerstone Macro analyst Francois Trahan to describe a rare condition in which a country’s economic activity rises but inflation falls. He believes that is the right interpretation of the Philadelphia Fed data released on Tuesday that showed output in the region up but prices paid falling, as shown in the chart below.

The improvement of the Philly Fed can be seen in part as a result of the stimulative effect of falling crude oil prices, and their ripple effect on the broad economy. The chart below, created by Cornerstone, shows the Philly Fed Index (green line) charted against the six-month percent change in the price of Brent Oil, advanced four months (gray) and inverted.

The oil price is advanced four months to show the lagged effect that oil has on economic activity. In other words, when oil falls in price it takes about four months for the change to have an effect on end users’ decisions.

You can already start to see the effect of lower oil and interest rate stimulus in the fact that the last four major economic data releases — Empire Manufacturing, NAHB Housing, Philly Fed and Kansas City Fed — have been better than expected, the first time that has happened in quite a while.

What we are starting to see, Trahan argues, is news that demonstrates we are in an “all stimulus, all the time” backdrop, with more boosts to global economic activity coming every day. The latest of course were the monetary policy announcements by the Chinese and Japanese, and the wink to suggest sovereign bond QE in the eurozone. The chart below shows a checklist: The Fed is still stimulating with super-low rates and not trimming its balance sheet of all the bonds bought during three years of QE; oil prices are dropping; long term interest rates are still falling; and the U.S. dollar is rising.

A “deflationary boom” in the United States occurs when the prices of raw materials — ranging from crude oil and precious metals to grains and cotton — fall, stimulating consumers to buy more, lifting demand from factories and service providers.

This is all pretty weird because we are used to seeing a stronger U.S. economy generate higher inflation, particularly as a result of wage growth and greater demand for raw materials. But companies are managing to keep wages relatively low through productivity increases, and commodity prices are sinking because of lower demand from emerging markets and the eurozone.

In short, a deflationary boom is not supposed to be able to happen, but it appears to be a byproduct of globalization.

In this environment, which was last seen in the 1990s, the shares of “early cyclical” companies like airlines, railroads and specialty retailers should go up, while late-stage cyclicals like miners, metal producers and energy producers should go down — pretty much what has been happening in the second half of this year.

Falling inflation boosts consumers’ free cash flow, or disposable income, which leads them to spend more on clothing, travel, cars and the like. For a variety of reasons, Trahan observes, the Phlly Fed tends to be one of the first indexes to respond and rise dramatically, and then activity in other Fed regions — Chicago, Richmond and Dallas — then to follow.

Cornerstone argues that investors who wish to position themselves for these conditions in 2015 should overweight the following “risk-on” industries and sectors: Financials, semiconductors, communications equipment, computer hardware, computer storage, electronic components, machinery, airlines, autos and steel. And they should underweight the “risk off” industries: utilities, food, staples, groceries, health care equipment, consumer services, insurance and software. 

No wonder we’re seeing the odd pairs trade of long Apple, short oil work out so well in the past five months, as shown above.

Summing it up into a single point of view, the Cornerstone team is looking for stronger growth and lower inflation to result in higher P/E multiples next year to go along with higher profit growth. If it’s true that risk-on will surpass risk-off next year, then investors should simply emphasize cyclicals over defensives in their portfolios.

Source: Markman Capital Insight
I'm glad I read this article because it's been a while since I last received research insights from Francois Trahan at Cornerstone Macro. I agree with the thrust of his arguments, the U.S. will experience a "deflationary boom" next year and investors should emphasize cyclicals over defensives in their portfolios.

In fact, as I wrote back in August, the real risk in the stock market is a melt-up, not a meltdown, unlike anything you've ever seen before. This is why I used the big unwind earlier this year and the October selloff to plunge into stocks and add to my biotech positions.

But I've also warned my readers to be very selective, paying attention to what top funds are buying and selling, and steering clear of energy (XLE), materials (XLB) and commodities (GSG) and going overweight small caps (IWM), technology (QQQ or XLK) and especially biotech shares (IBB or XBI). 

In particular, I specifically mentioned to keep an eye on companies like Acadia Pharmaceuticals (ACAD), Avanir Pharmaceuticals (AVNR), Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Seattle Genetics (SGEN), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA) and told you to buy the dip on Twitter (TWTR) which is my favorite social media stock.

However, I warned you to prepare for more volatility in these crazy markets and beware of "high dividend traps," specifically alluding to companies like SeaDrill (SDRL) in my October comment which I knew was going to get slaughtered once it cut its dividend.

And what happened? Earlier this week, SeaDrill cut its dividend and the stock got hammered, now down over 30% in a couple of trading days -- and that's after a sharp selloff over the last few months. The stock keeps making new 52-week lows and I wouldn't touch it or others that are going to suffer the same fate.

In fact, the oil services sector got clobbered this week by the plunge in SeaDrill's stock as everyone is worried about who's next to cut their dividend. As shown below, these oil service stocks are very weak and vulnerable to further weakness (click on image).

OPEC's decision to hold production unchanged just added to the woes of an already weak energy sector and risks pushing Canada's TSX much lower.

So far, most people are focusing on the benefits of lower oil and commodity prices, viewing it as a gift to consumers that will lift aggregate demand. And while lower oil prices will boost consumption, the question is for how long and are these lower prices a harbinger of more pain ahead?

I'm not in the camp that believes we're in a prolonged deflationary boom and the fall in oil and commodity prices is unambiguously good for the world economy.

Importantly, the big danger here is that everyone will focus on the "oil dividend" and the U.S. economy, underestimating the risk of deflation spreading throughout the world and eventually coming to America. Moreover, the surge in the mighty greenback risks reinforcing U.S. deflationary pressures, raising concerns at the Fed.

Sure, the liquidity party will last, we will see P/E multiple expansion taking stocks much higher but if inflation expectations keep dropping, you'll see more central banks panicking, including the Fed and even the Bank of Canada which rightly ignored the OECD's call to hike rates.

That's when a deflationary boom can easily turn into a deflationary bust so don't get carried away thinking the drop in oil and commodity prices is benign and will lead to a huge global economic recovery. It won't, it will lull investors into a false sense of security, ripping them apart when deflation becomes entrenched and serious.

It's worth noting that long-dated U.S. Treasury yields hit their lowest level in over a month for a third straight session and benchmark yields also touched more than one-month lows on Friday, pushed down by signs of disinflation and month-end buying. Is the bond market worried about a major slowdown despite the fall in oil prices? It sure looks that way which is another reason not to sour on debt.

Finally, Jonathan Nitzan sent me the latest research which he co-authored with Shimshon Bichler, Still About Oil?. This is the type of research George Soros would devour and even though it's not an easy and fast read, it's excellent and well worth reading.

Before joining academia, Jonathan used to be an associate editor of emerging markets at BCA Research. He's an intellectual tour de force and his thinking is way ahead of anything BCA publishes. I asked him about his thoughts on whether we're in the midst of a deflationary boom and he shared this with me:
1. The nineteenth century was characterized by falling prices and rising output (in England, consumer prices are estimated to have fallen by 30%); I doubt that this "deflationary boom" will be repeated any time soon.

2. The future of course is unknowable. But if oil prices and overall inflation continue to drop, that might be symptomatic of dominant capital approaching its asymptotes of power. During the 1980s and 1990s, oil prices and inflation trended downward (Figure 7), but mergers and acquisitions boomed, fueling the differential earnings and capitalization of dominant capital. These days, inflation AND amalgamation are on a downtrend, which makes it difficult for dominant capital to meet the average, let alone beat it.
Again, I will leave it up to you to read their latest research paper on oil to gain a better understanding of his comments above.

Finally, Leo de Bever, CEO & CIO of AIMCo, was interviewed on BNN's "The Close" yesterday (fast forward to minute 15), once again saying lower oil prices are here to stay and Canadian energy firms need to do 20 years of tech development in 5 years to stay competitive.

Last December, I wrote a comment on why it's time to short Canada where Leo predicted oil prices would drop to $70 a barrel "over the next five years." He was laughed at but right on the money even if it happened a lot quicker than he anticipated.

I'm still short Canada and think oil prices will fall below $60 a barrel. This means the TSX and especially the loonie are heading much lower. Canadian banks aren't exposed to the drop in oil in their loan portfolios (only 6% exposure to energy companies) but energy companies generated 30% of underwriting fees in the last few years. The drop in those fees will hurt them.

Below, an interview with Cornerstone Macro’s Investment Strategist, Francois Trahan, who has once again been named the number one ranked strategist on Wall Street by Institutional Investor magazine.

Francois has been a market bull since the fall of 2011 when the markets looked dicey and is still bullish. This interview took place back in October on Consuela Mack's Wealthtrack.

Good interview, take the time to listen to his comments but keep in mind my warning above, a deflationary boom can easily turn into a deflationary bust so enjoy the liquidity party while it lasts because once deflation comes to America, the hangover will last for decades.

Once more, I kindly remind all of you to donate or subscribe to my blog using the PayPal buttons on the top right-hand side and support my efforts. I thank all of you who have donated and subscribed.


Thursday, November 27, 2014

Ontario Teachers and PSP Nearing Telesat Deal?

Alex Sherman of Bloomberg reports, Canada Funds Said Nearing $7 Billion Telesat Deal:
Ontario Teachers' Pension Plan and Public Sector Pension Investment Board are nearing a $7 billion deal for Canadian satellite company Telesat Holdings Inc. after months of delays and discussion breakdowns, people with knowledge of the matter said.

Under the terms being discussed, the funds will acquire Loral Space & Communications Inc. (LORL), a publicly traded shell company that owns 63 percent of Telesat, for about $85 a share, or $2.6 billion, said the people, who asked not to be named discussing private information. While a deal could be announced next month, talks may fall apart again given the parties’ inability to reach an agreement in the past, the people said.

The pension funds are planning to wind up with equal ownership and voting stakes in Telesat, the people said. PSP, which currently holds about 67 percent of the voting rights and 37 percent of the equity in Telesat, would increase its ownership to 50 percent and reduce its voting rights, while Ontario Teachers’ would control the other half of the company.

Telesat has been on and off the block for years. Loral and PSP, which already owns 37 percent of Telesat, called off a sale effort in 2011, after offers from bidders including EchoStar Corp. and Carlyle Group LP fell short of expectations. Talks started again this year before stalling in June because Mark Rachesky, Loral’s largest shareholder, couldn’t agree with PSP on a price to sell the company, failing to bridge an equity gap of about $100 million, people said then.

Three-way talks between Loral, PSP and Ontario Teachers’ restarted last month after Ontario Teachers’ and PSP raised their offer, the people said, leading to renewed negotiations.

Representatives for Loral, Ontario Teachers’ and PSP declined to comment.
Unit Settlement

After climbing 7.2 percent in New York trading yesterday, Loral slipped less than 1 percent to $78.02 as of 10:02 a.m. today, giving it a market value of about $2.4 billion. Telesat had $3.1 billion of long-term debt as of Sept. 30, 2014, according to a company filing.

The exact price will depend on how a September ViaSat Inc. lawsuit settlement is divided between the New York-based company and its former subsidiary, Space Systems/Loral LLC. That unit was sold to MacDonald, Dettwiler and Associates Ltd. in 2012 for about $1 billion.

The division of the settlement, the final hurdle to a sale, may be determined in the coming weeks, the people said.

Loral and PSP acquired Telesat from Canadian telecommunications company BCE Inc., a deal announced in December 2006 valued at about $3 billion including debt.

A sale now would provide Loral with two long-term owners while allowing Loral’s shareholders, including Rachesky’s MHR Fund Management, which owns 38 percent of the company, an attractive premium to their investment. Selling Loral as a whole, rather than the Telesat assets alone, which was previously floated, would save both the company and its shareholders a larger tax bill on the sale.

Telesat owns 14 satellites and manages the operations of satellites for third parties, according to its website. The company was founded in 1969 and launched the world’s first commercial, domestic communications satellite in geostationary orbit in 1972.
The terms of this deal have changed drastically since I last covered it back in April. The media was then reporting that Teachers' was going it alone, bidding on Loral (LORL) Space & Communications Inc.’s Telesat Holdings Inc. for about $7 billion including debt by acquiring Loral straight out and then the rest from PSP Investments.

Now we learn this is another "club deal" between Ontario Teachers' and PSP, with both bidding on Loral, however, as the article states, the deal isn't done just yet and it may fall apart again given the parties' inability to reach an agreement in the past.

But some pretty heavy hitters are betting the deal will go through, including George Soros, Leon Cooperman and Mario Gabelli. Have a look at the Q3 filings on Loral showing the top institutional holders (click on image):

In fact, Soros, Cooperman and other top funds like Ken Griffin's Citadel, are also top holders of Dish Network (DISH), a company which provides pay-television services in the United States through DISH and Wireless segments.

As shown below, shares of Loral and Dish Network have surged over the last month and the latter keeps making new highs (click on images to enlarge):

As you see, there's a very bullish uptrend especially on Dish but I wouldn't touch either share. It's too late, the big money has already been made by the big boys club (wait for a nice pullback before jumping into Dish).

In other related news on PSP Investments, my friends over at Pension360 posted a comment on how it's in talks to buy $1 billion worth of Australian timber assets from Hancock Timber Resource Group. Hope these investments deliver better results for them than they did for CalPERS which is now is one of the largest timber owners in the United States and reviewing their timber allocation after poor performance. Then again, AIMCo scored huge on timberland so it depends on whether these are direct or fund investments, how these deals are structured and whether the assets are bought at a nice discount.

Below, Draper Fisher Jurvetson Partner Steve Jurvetson discusses the benefits of internet satellites, saying they can provide faster, cheaper service. He speaks on “Bloomberg West.” Listen carefully to his comments and you'll understand why Ontario Teachers' and PSP see a bright future for Telesat.

Wednesday, November 26, 2014

New Jersey's Pension GASBing for Air?

Hilary Russ of Reuters reports, New Jersey pension system funding plummets under new rule:
New Jersey's retirement system for public employees is in worse shape than previously reported, thanks to recent accounting changes that are starting to be rolled out across the country.

In a document released on Tuesday after a bond sale, the state revealed that one of its five main pension funds will have insufficient assets to cover projected benefit payments within 10 years.

Under new pension accounting standards, issued by the Government Accounting Standards Board (GASB), the New Jersey system's overall funded level stands at 44 percent for fiscal 2014, compared to the 63 percent previously determined by standard actuarial methods. Eighty percent or more is generally considered healthy.

In the face of a budget crisis in May, Governor Chris Christie, a potential 2016 Republican presidential candidate, slashed two years of state pension contributions by about $2.5 billion altogether, prompting lawsuits by organized labor.

Under Christie's watch, the state has been downgraded eight times by Wall Street credit rating agencies. New Jersey is now the second-lowest rated state behind Illinois, which also has huge pension liabilities.

"Regardless of how the liability is measured, the state's record of underfunding its annual contributions to the pension system is at the root of its deterioration," Standard & Poor's Ratings Services said in statement.

New Jersey Treasury Department spokesman Christopher Santarelli said in a statement that the retirement system had current assets of about $40 billion.

But he added that the new pension reporting system, based on actual contributions, "underscores the urgent need for additional, aggressive reform of a pension and health benefits system that if fully funded would eat up 20 percent of New Jersey's budget."

Christie has called for more pension changes since February without detailing a specific proposal. He appointed a study commission in August, which is expected to present proposals soon.

Only a few pension systems across the country have begun to issue financial reports adhering to the new rules from the GASB.

The GASB rules measure a retirement system's net position as a percentage of total pension liability.

The net position uses market asset values instead of actuarial ones. In the case of more poorly funded systems such as New Jersey's, it also uses lower discount rates that make the liabilities appear much higher.
You can read more on GASB's new rules for pensions here. I note the background for these changes:
On August 2, 2012, the GASB published accounting and financial reporting standards that improve the way state and local governments report their pension liabilities and expenses, resulting in a more faithful representation of the full impact of these obligations.

The guidance contained in these Statements will change how governments calculate and report the costs and obligations associated with pensions in important ways. It is designed to improve the decision-usefulness of reported pension information and to increase the transparency, consistency, and comparability of pension information across state and local governments.

For example, net pension liabilities will be reported on governments’ balance sheet, providing citizens and other users of these financial reports with a clearer picture of the size and nature of the financial obligations to current and former employees for past services rendered.
In particular, Statement 68 requires governments providing defined benefit pensions to recognize their long-term obligation for pension benefits as a liability for the first time, and to more comprehensively and comparably measure the annual costs of pension benefits.

The new GASB rules will impact all state and local pensions, not just New Jersey. This will be another important measure to determine whether U.S. public pensions are indeed on solid footing.

As for New Jersey, back in March, I commented on its pensiongate scandal and didn't mince my words:
The article doesn't capture the real problem at U.S. public pension plans, namely, lack of proper governance. You basically have politicians appointing political bureaucrats in charge of public pensions, paying them peanut salaries and getting monkey results. There are exceptions but this is typically how U.S. public pension funds are mismanaged.

And who benefits most from this? Of course, the Paul Singers, Dan Loebs, Steve Schwarzmans, and all the rest of the who's who managing hedge funds and private equity funds. It's one big alternatives party -- for the big boys. Everyone is making a killing except for these public pension funds, praying for an alternatives miracle that will never happen. These alternatives managers and their sophisticated marketing are milking the public pension cow dry. They basically have a license to steal.

And why not? There are plenty of dumb institutions listening to their useless investment consultants who are more than happy to recommend the latest hot hedge fund or private equity fund to their ignorant clients. It's a frigging joke which is why the Oracle of Omaha is 100% right when he warns us that the worst is yet to come for U.S. public pensions. When the shit really hits the fan, it's going to be a bloodbath!

As far as New Jersey, Gov. Christie has done some good things on pension reform but a lot more needs to be done. Double-dipping pensioners are bleeding New Jersey dry.  Unions can bitch all they want about rich alternatives managers meddling in their state's politics but they must accept shared risk of their plan, which includes raising the retirement age and cuts in benefits as long as the plan is chronically underfunded. The state of New Jersey, however, should make sure it tops up its public pension plan which it neglected to do for years (the major cause of the pension deficit).
The biggest factor explaining the pension deficit in New Jersey and other states is how successive state governments failed to make their pension contributions, using the money to fund other things (no doubt in an effort to buy votes).

But there are plenty of other factors that didn't help, like lack of sensible pension reforms, lousy investment performance and poor governance.

On this last point, Michael B. Marois of Bloomberg reports, California Pension Fund Bonus Payouts Climb 14% From Prior Year:
The $300 billion California Public Employees’ Retirement System, the largest U.S. public pension, paid $9 million in bonuses last fiscal year, up 14 percent from a year earlier as earnings exceeded benchmarks.

The fund, known as Calpers, paid $8.7 million in bonuses to investment staff in the year ended June 30, and almost $300,000 to four non-investment executives, according to data provided by the system. The rewards are based on three-year performance verses a benchmark, as well as the earnings of each asset class and individual portfolios, said spokesman Brad Pacheco.

“These awards are part of the overall compensation we provide to recruit and retain skilled investment professionals needed to ensure success of the fund,” Pacheco said.

Public-pension funds are recouping investment losses suffered during the 18-month recession that ended in June 2009, which wiped out a third of Calpers’ value. Still, the crisis left U.S. pensions short more than an estimated $915 billion needed to cover benefits promised to government workers. Taxpayers have been asked to make up the shortfall.

The biggest bonus earner was Ted Eliopoulos, the chief investment officer who recorded a $305,810 bonus last year in addition to his $412,039 base pay.

Top Job

That bonus was paid when Eliopoulos was acting chief investment officer after his predecessor Joe Dear died in February from cancer. Prior to that, Eliopoulos headed the fund’s real estate portfolio. He now earns $475,000 in base pay after he was tapped for the top investment job in September.

Eliopoulos announced in September that the fund was divesting all $4 billion it had in hedge funds, saying they were too expensive and too complicated and not worth the returns.

The pension fund earned 18.4 percent last fiscal year, 12.5 percent a year earlier and 1 percent in 2012. It estimates it need 7.5 percent annually to meet its long-term obligation to pay benefits promised to state and local government workers.

Calpers is still short $103.6 billion needed to cover those promises based on market value as of June 30, 2012, the latest figure that was available. That shortfall is up 19 percent from a year earlier.

The California fund says it must grant bonuses to help compete with the pay that employees could make if they went to work on Wall Street. Pacheco said spending money on in-house investment management saves about $100 million a year that otherwise would be paid to Wall Street in fees.

Wall Street bonuses, which rose 15 percent on average last year to $164,530 -- the highest since 2007 -- may climb again as a result of payments deferred from previous years, New York Comptroller Thomas DiNapoli said last month.

Four executives outside the Calpers investment office were paid a total of $295,930 in bonuses last year, the fund said. Anne Stausboll, chief executive officer, got $113,679; Chief Actuary Alan Milligan earned $75,748 and Chief Financial Officer Cheryl Eason was paid $89,703, almost double a year earlier.

Calpers paid a total of $7.9 million in bonuses in the prior fiscal year.
Compensation is part of pension governance and if you ask my expert opinion, CalPERS' compensation is fair and accurately reflects the market, their performance and their ability to attract and retain professionals to manage billions. The only thing I would change is base it on four-year rolling returns, like they do at Canadian public pension funds.

All this hoopla on compensation at U.S. public pension funds is totally misdirected. I happen to think most U.S. public pension fund managers are grossly underpaid, just like I think some Canadian public pension fund managers are grossly overpaid (read my comment on PSP's hefty payouts and the subsequent ones on its tricky balancing act and its FY 2014 results which were likely padded by skirting foreign taxes).

Getting compensation right is critical to the long-term health of any public pension fund but supervisors of these funds should make sure they're paying their senior investment staff properly based on benchmarks that truly reflect the risks they're taking. I believe in paying people for performance, not for taking dumb risks to trounce their silly benchmark (that contributed to Caisse's ABCP disaster which the media is still covering up).

Below, Lisa Ziemer, the Minnesota Teachers Retirement Association's GASB Coordinator, presents an overview of the GASB implementation initiatives on which TRA has been working. Topics covered include GASB 68 history, impact on employer units, and the next steps in the process.

I also embedded a clip where she explains the components that contribute to pension liabilities. These include total pension liability, fiduciary net position, and net pension liability. You can also watch her clip on pension expenses here.

Lastly, I embedded an older clip from a California expert which explains what GASB 68 will force government's to reveal (h/t, Pension Tsunami). If he's right, a lot of U.S. public pension plans which are supposedly on solid footing are going to be GASBing for air.

Tuesday, November 25, 2014

U.S. Public Pensions on Solid Footing?

Business Wire reports, Public Pension Plans Report Solid Returns, Financial Strength, Increasing Confidence:
Confidence continues to rise among public pension plan administrators about the sustainability of their funds and their readiness to address future retirement issues, according to a new survey by the National Conference on Public Employee Retirement Systems (NCPERS).

The 2014 NCPERS Public Retirement Systems Study also shows continuing financial strength for public funds, with healthy long-term investment returns.

“Once again, our annual survey provides convincing evidence that the vast majority of public pension plans are financially sound, well-funded and sustainable for the long term,” said NCPERS Executive Director and Counsel Hank Kim, Esq. “It also demonstrates that defined benefit public pension plans are the least costly way to ensure retirement security for American workers.”

Partnering with Cobalt Community Research, NCPERS surveyed 187 state, local and provincial government pension funds with more than 11.8 million active and retired members and with assets exceeding $1.8 trillion. The majority – 81 percent – were local pension funds, while 19 percent were state pension funds. Of the responding funds, 61 percent are members of NCPERS. The data, collected in September and October 2014, represents the most up-to-date information available.

The major findings of the 2014 NCPERS Public Retirement System Study include:
Confidence continues to grow about readiness to address future retirement trends and issues. Respondents’ overall confidence rating measured 7.9 on a 10-point scale, up from 7.8 in 2013 and 7.4 in 2011.
  • Funds experienced an increase in average funded level – 71.5 percent, up from 70.5 percent in 2013. Two factors contributed to the change: average one-year investment returns of 15 percent and lower amortization periods.
  • Funds continue to experience healthy investment returns: 14.5 percent for one-year investments (compared to 8.8 percent in 2013); 10.3 percent for three-year investments (up from 10.0 percent last year); 9.8 percent for five-year investments (up from 2.7 percent last year); 7.8 percent for 10-year investments (up from 7.0 percent), and 8.1 percent for 20-year investments (virtually unchanged from last year’s 8.2 percent). Funds continue to work toward offsetting sharp losses from the Great Recession in 2008 and 2009 by strengthening investment discipline. Signs point to long-term improvement in public retirement systems’ funded status.
  • Public funds continue to be the most cost effective mechanism for retirement saving. The total average cost of administering funds and paying investment managers was 61 basis points. According to the Investment Company Institute’s 2014 Investment Company Fact Book, the expenses of most equity funds average 74 basis points and hybrid funds average 80 basis points.
“Because they have lower expenses, public retirement funds provide a higher level of benefits to members,” Kim said. “They also produce a higher positive economic impact for the communities those members live in than mutual funds and defined contribution plans like 401(k)s.”
  • Funds continue to tighten benefits, assumptions and governance practices. Examples include a continued trend toward increasing member contribution rates, lowering inflation assumptions, shortening amortization periods, holding actuarial assumed rates of return and lowering the number of retirees receiving health care benefits.
  • Income used to fund public pension programs came from member contributions (8 percent); employer (government) contributions (19 percent) and investment returns (73 percent).
“There is no question that public pension funds are continuing their strong recovery from the historic market downturn of 2008-2009,” Kim said. “The survey shows public pensions are strong and getting stronger, managing their assets efficiently and effectively, making plan design changes to ensure sustainability and are expressing strong and growing confidence about their readiness to address the challenges ahead.”

“The vast majority of public pension plans are thriving, more than adequately funded, inexpensive to operate and sustainable for the long-term. Policymakers, taxpayers and public employees can have confidence that public pension plans will be providing retirement security for covered workers – and thus making positive economic contributions to the communities they live in – well into the future.”


The National Conference on Public Employee Retirement Systems (NCPERS) is the largest trade association for public sector pension funds, representing more than 550 funds throughout the United States and Canada. It is a unique non-profit network of public trustees, administrators, public officials and investment professionals who collectively manage nearly $3 trillion in pension assets. Founded in 1941, NCPERS is the principal trade association working to promote and protect pensions by focusing on advocacy, research and education for the benefit of public sector pension stakeholders.

About Cobalt Community Research

Cobalt Community Research is a nonprofit research coalition created to help governments, schools and other nonprofit organizations measure, benchmark and manage their efforts through high quality and affordable surveys, focus groups and facilitated meetings. Cobalt is headquartered in Lansing, MI.
Let me go over some of my thoughts on this latest survey. First, there is no question that U.S. public pension funds are in much better shape now than right after the 2008 crisis. Public and private markets have rebounded solidly, no thanks to the Fed and other central banks pumping massive liquidity into the global financial system. This is why confidence is so high at U.S. and global funds.

But with bond yields at historic low levels and the threat of deflation looming large, this is most certainly not the time to be complacent because the environment is about to get a lot more challenging over the next decade.

As I recently stated, there is a reason why central banks are panicking, they fear that no matter what they do, they will lose the titanic battle over deflation. And with public pensions pension funds flocking to riskier investments and taking on too much illiquidity risk, if a severe bout of deflation does engulf the global economy, it will come back to haunt them.

This is why I cringe when I read this from the release above: "Signs point to long-term improvement in public retirement systems’ funded status." Unless they see rates coming back to 5-6% over the next ten years and stocks continuing to make record highs, I just don't see the signs of improvement they're talking about.

Moreover, far too many U.S. public pension funds are still holding on to the pension rate-of-return fantasy, believing fairy tales when it comes to discounting their future liabilities using rosy investment assumptions.

Second, it's important to remember there is a huge dispersion when it comes to the health of U.S. public pension plans. Last week, Bloomberg reported that Illinois will have to find a new way to fix the worst pension shortfall in the U.S. after a judge struck down a 2013 law that included raising the retirement age:
Yesterday’s ruling that the pension changes would have violated the state’s constitution undoes a signature achievement of outgoing Democratic Governor Pat Quinn and hands responsibility for tackling the state’s $111 billion pension deficit to Republican businessman Bruce Rauner, who defeated him in the Nov. 4 election.

State constitutions have been invoked elsewhere to try to prevent cuts to public pensions. In Rhode Island, unions settled with the state over pension cuts before their constitutional challenge could be put to the test. In municipal bankruptcy cases in Detroit and California, judges ruled that federal law overrode state bans on cutting pensions.

Illinois Attorney General Lisa Madigan, a Democrat, said she’ll appeal the ruling by Judge John Belz in Springfield and ask the state Supreme Court to fast-track the review.
And it's not just Illinois. At Kentucky, a  state panel will likely call on the General Assembly to find more money for Kentucky's struggling pension system, although it's unclear where the funding might come from:
The Public Pension Oversight Board advanced more than a dozen recommendations Monday to revamp polices at Kentucky Retirement Systems and help address concerns over the system's long-term financial health.

Key among the recommendations are:
  • The General Assembly should secure additional money to stave off any insolvency problems in KERS non-hazardous — the largest pension plan for state workers, which has only 21 percent of the money it needs to cover benefits.
  • The Kentucky Teachers' Retirement System, along with pension plans for lawmakers and judges, should be reviewed by the oversight board as part of its official duties.
  • KRS should better publicize its board meetings, particularly to employee, retiree and interest groups.
  • The General Assembly should enact legislation to regulate how agencies withdraw from the pension system — a concern that has emerged amid the bankruptcy of Seven Counties Services, the community mental health center for the Louisville area.
Other recommendations would modify how KRS handles its financial studies and how public employers pay for "spiking" — a situation in which employees use overtime and other strategies to boost their pension.

Lawmakers and state officials have spent the past year developing the recommendations, and officials plan to compile them into a report for final approval next month.
Third, and most critically, the governance at U.S. public pension plans needs to be drastically improved. Dan Fitzpatrick and Juliet Chung of the Wall Street Journal report, Strategy spurs rethink on San Diego pension’s oversight:
A large California pension fund is searching for a new investment chief amid concerns about an outside firm’s investment strategy, the latest clash between public retirement systems and external advisers.

The board of San Diego County Employees Retirement Association authorized the move in an 8-1 vote that requires the $10.5 billion fund to install an internal investment chief instead of relying on Houston-based Salient Partners LP for that role.

Directors stopped short of ending a contract with Salient, which suggested an investing strategy that uses derivatives to boost performance. Salient is paid $8 million annually to act as the system’s chief investment officer and manage retirement assets for county employees.

The strategy involves buying futures contracts tied to the performance of stocks, bonds and commodities. Salient recommended the approach, which would allow the pension fund potentially to receive bigger gains, and possibly suffer larger losses, than it would by owning the assets themselves.

Salient, which was first hired in 2009, said in a statement that a team led by Salient Chief Investment Officer Lee Partridge generated a 10.2% annualized return for the retirement system over the past five years, and it would continue to perform its duties “over the duration of whatever transition period the board establishes.”

“We are proud of our work,” the firm added.

Scrutiny of the relationships between pension funds and the outside firms that manage their money or provide investment advice is intensifying as public retirement systems wrestle with how to fulfill obligations to retirees. For external advisers, fees that can reach into the millions of dollars are at stake.

Outside firms are hired by cities, states, corporations and others to provide guidance to retirement plans. A number of those firms also offer to help manage pension assets, an assignment that typically means higher fees. More than 75% of pension-consulting firms registered with the Securities and Exchange Commission act as both investment managers and outside consultants for clients, according to reports filed on the SEC website.

A top Labor Department official recently said in a private letter that consultants recommending themselves as money managers for pensions could be violating federal law, according to a document reviewed by The Wall Street Journal. The letter came in response to a request from a senior Democratic congressman that the department examine potential conflicts of interest within the industry.

Salient said it isn’t a consultant to the San Diego County pension. The county has a separate outside consultant that offers advice to the system, while Salient as the external CIO makes decisions on strategy and investments.

In some parts of the U.S., disputes between outside firms and their pension-fund clients are spilling into court. Providence, R.I., sued an actuarial firm over estimates of how much the city would save by making a change to its pension system. In Houston, the city is wrangling with an outside consultant over a series of calculations in 2000 that the city views as “the root cause of the pension funding crisis now facing the city of Houston,” according to a lawsuit filed in August.

Even consultants that have a long-standing relationship with a pension fund are encountering questions about their conduct. Last month, the chairman of the San Francisco Employees’ Retirement System delayed a vote on whether to invest in hedge funds for the first time because he said he wasn’t aware the system’s adviser operated its own fund. Angeles Investment Advisors has provided advice to the system for the past two decades.

During the meeting, Angeles principal Leslie Kautz said the existence of the fund, which invests in other hedge funds, had been communicated in a 2010 letter to the system and that her firm wouldn’t recommend it as an investment for San Francisco. Angeles principal Michael Rosen said in an interview Monday that Angeles doesn’t charge clients a fee to participate in the fund.

“We believe disclosure has been made and there is no conflict with regard to our advice,” Ms. Kautz said in October.

In San Diego County, several retirement-system board members have argued for Salient’s ouster amid a debate over the company’s new investment strategy.

The board approved the plan at an April meeting, and one estimate floated at the time was the bet could involve an amount equal to as much as 95% of the fund’s $10.5 billion in assets. Salient eventually increased the fund’s market exposure to $16 billion, according to the firm.

But some board members said they were surprised total exposure had become that large and set a limit of $12 billion.

“It was a surprise, and board members should never be surprised,” said Dianne Jacob, one of the board members, in an interview. In October, a proposal to terminate the consultant’s contract failed in a 5-4 vote.

The decision on Friday to restore an in-house chief investment officer and have that person report to the chief executive doesn’t mean the board decided to end Salient’s contract, a spokesman for the retirement system said.
I've long argued that there should be more transparency on useless investment consultants and advisers, scrutinizing the fees and services they charge. The same goes with all the fees being doled out to brokers, vendors peddling risk, front and back office software, and alternative investment managers charging 2 & 20 for lousy performance.

In fact, never mind buyout bullies, we need a lot more transparency on all costs at the operational level. This can be done in a way that does not jeopardize the best interests of the plan's stakeholders.

My final thoughts on this survey is that it clearly demonstrates the cost effectiveness of public defined-benefit plans. Go back to read my comment on the brutal truth on DC plans. As stated above, most of the income used at U.S. public pension programs (73%) comes from investment gains and the rest from employee (8%) and employer contributions (19%). The 73% seems high but is consistent with the typical investment gains DB plans report (66%).

I happen to think that employees and employers need to share the risk equally at public pension plans but there is no doubt that these plans are cost effective and a potential solution to America's looming retirement crisis. Moreover, as more plans follow Wisconsin and CalSTRS and start managing assets internally, the cost of these plans will fall further.

Below, Charlie Bilello, director of research at Pension Partners, and Bloomberg’s Mia Saini examine whether or not Federal Reserve policy is creating a market bubble. They speak in "On The Markets" on "In The Loop.”

Also, Dan Morris, global investment strategist for TIAA-CREF, which holds $840 billion in assets under management, discusses why even though the S&P 500 and the Dow Jones industrial average both at all-time highs, it's all about to get rocky for stocks when interest rates start rising (see the clip here).

As I stated in my last comment on the Caisse souring on debt, I'm not concerned about rising rates. Moreover, the Fed will never raise rates as long as global deflationary pressures remain intense. As Sober Look rightly notes, the Fed is concerned about importing disinflation.

So enjoy the liquidity party while it lasts but choose your stocks and sectors carefully because when deflation eventually hits America, the hangover will last for decades.

Monday, November 24, 2014

Caisse Sours on Debt?

Caisse Sours on Debt With Yields at Record Lows:
Caisse de Depot et Placement du Quebec, Canada’s second-largest pension fund manager, is losing its enthusiasm for bonds with yields close to record lows.

“Fixed income isn’t what it used to be,” Chief Executive Officer Michael Sabia, said yesterday in an interview at Bloomberg headquarters in New York. The manager of about C$215 billion ($190 billion) in assets anticipates reducing its holdings in bonds to around 30 percent over the next two years from about 35 percent, he said.

Bonds worldwide have returned 6.3 percent this year, the most since 2002, according to the $46 trillion of debt securities included in the Bank of America Merrill Lynch Global Broad Market Index. The rally, prompted by central banks in the U.S., Europe and Japan keeping borrowing costs close to record lows to spur growth, pushed average yields globally to a record-low 1.51 percent last month.

Sabia said he may reallocate sovereign debt that included C$15.7 billion of federal government bonds, C$14 billion of Quebec government debt, C$712 million of U.S. government debt and C$2 billion of other types of sovereign bonds at the end of last year. As Quebec’s largest institutional investor, Montreal-based Caisse has traditionally been the main buyer of bonds issued by the provincial government -- a situation that’s unlikely to change.
Lower Exposure

Canada Pension Plan Investment Board is the country’s biggest public pension manager, with net assets of C$234.4 billion as of Sept. 30.

“There are a lot of sovereigns in our portfolio,” Sabia said. “The balance between sovereigns and some other forms of debt, private debt, corporate debt, some real estate debt -- we may want to increase some of that and lower the sovereign exposure. That’s a way of leaving the fixed income in place, but doing a little better from a returns perspective.”

Sabia didn’t specify which sovereign bonds the Caisse would look to sell. At the end of last year, the Caisse held about C$19.7 billion of corporate bonds, including C$13.2 billion of Canadian company debt.

Lowering exposure to government bonds is part of a Caisse strategy to reduce the volatility associated with public markets. Sabia said last year the Caisse was planning to add as much as C$12 billion in “less liquid” assets such as infrastructure and real estate over two years.

Capital markets and central banks have developed an increased sensitivity toward each other since the global financial crisis of 2008, he said. That “co-dependency” may persist in 2015 and 2016, until the relationship between central banks and the capital markets normalizes, according to the 61-year-old CEO.
‘Market Turbulence’

Federal Reserve Chair Janet Yellen has said “she was going to look through the market turbulence -- if the market had a tantrum, she was going to look through the tantrum,” Sabia said. “I think they are trying to find this goldilocks solution where they can move interest rates slowly and keep everybody kind of OK. I’m not sure that’s doable, because I don’t think the markets have taken on board how fragile the situation is. That’s why I think 2015 and 2016 are going to be rock ’n’ roll.

More than half of economists surveyed by Bloomberg from Nov. 12-14 said improvements in the labor market would prompt the Fed to raise rates in mid-2015. The Bank of Canada is forecast to keep rates at 1 percent until the last three months of 2015. The U.S. central bank ended unprecedented economic stimulus known as quantitative easing in October with the world’s largest economy gathering momentum.
Liability Matching

Economic recovery in the U.S. “is not strong by postwar standards, but it’s not bad,” Sabia said. “The U.S economy is actually doing pretty well. If you were just looking at that, you would say that the Fed is going to have to worry about how close the economy is getting to full employment, and what kind of ramp-up on interest rates is going to be required to moderate that, so that they don’t get too far behind the curve in terms of managing inflationary pressures.”

The Caisse held C$69.2 billion of bonds, real estate debt and other short-term securities in 2013 -- a collection of assets that generated an investment loss of C$41 million. Bond markets worldwide fell 0.3 percent last year, Bank of America data show. Overall, the Caisse had investment income of C$22.8 billion last year.

“If you were just making a pure returns-based decision, you would take that 35 percent down pretty sharply,” Sabia said, referring to the Caisse’s bond holdings. “Fixed income has other attributes. In terms of matching liabilities with the people whose assets we manage, that’s a reason not to take it down as sharply.”

For Related News and Information: Fed Debate Shifts to Tightening Pace After First Rate Increase Blackstone Said to Sell NYC Tower to Ivanhoe for $2.25 Billion Quebec’s Caisse Targets Regular Debt Sales to Help Cut Costs Crumbling U.S. Fix Seen in Trillions of Dollars of Global Money.
I discussed this latest news item with Brian Romanchuk, a former quantitative analyst at the Caisse's fixed income group who now consults and writes an excellent blog, Bond Economics. Brian shared this with me:
The premise of the article seems misleading. The issue is that they believe that other asset classes, especially illiquid stuff, can do better. Given the low interest rates on government bonds, that is not a high hurdle rate. In other words, if we avoid a risk asset apocalypse, those assets will outperform government bonds. I find it hard to argue against that.

Bonds are vulnerable versus cash in a rate hike cycle, but the potential losses are a fraction of the uncertainty in the valuation of things like real estate. But editors love stories that are bearish on government bonds. Even though we have been in a bond bull market for 30 years, I would be hard placed to remember an article with the headline "Expert says government bonds to outperform cash next year".
I also asked him: "What if deflation settles in Europe and comes to America, do you still think bonds will underperform illiquid asset classes?". He replied:
A mild deflation should not be that bad for risk assets; bonds would give positive returns. It would just mean that the current environment continues longer.

The real risk is a recession; it should not be as traumatic as 2008, but it would probably result in a reversal for risk assets.
Brian is one of the smartest and nicest people I ever worked with (worked with him at BCA Research and the Caisse). He reads incessantly and reviews many books. For a PhD in electrical engineering, he has a firm grasp of economic history and theory and is well read on Keynes, the monetarists and Hyman Minsky. I don't plug his blog as often as I should but always read his comments and think extremely highly of him (the financial industry needs more Brian Romanchucks and less weasels).

And he is right, all these experts bearish on bonds have been dead wrong for years. More worrisome, far too many investors are underestimating the risk of deflation spreading throughout the world and what this means for risk assets going forward. In my opinion, there is a reason why central banks are panicking, they fear that no matter what they do, they will lose the titanic battle over deflation.

And if they do lose this titanic battle, the only thing that will save your portfolio from huge losses is good old government bonds, which is why I wouldn't be surprised if U.S. bonds keep rallying despite historic low yields.

Interestingly, my contacts in the hedge fund community tell me a lot of macro funds got their calls on stocks and currencies right -- going long the S&P and shorting the yen and euro -- but got killed on their bearish view on bonds which is why many of them are underperforming in 2014.

Now, getting back to the article above, Michael Sabia isn't exactly writing bonds off. Far from it. He worries about how the Fed will raise rates slowly to maintain the Goldilocks economy but he rightly notes that from an asset-liability point of view, bonds play a significant role.

Given my views on deflation, I'm not as worried as Michael about bonds and how well they will continue to perform going forward. He's right, things will be "rock 'n roll" in the next two years but not because the Fed will be hiking up rates and bonds will crumble. It will be because inflation expectations will sink further as more and more investors come to grips with deflation coming to America and fear sets in as they perceive the Fed has fallen behind the deflation, not inflation, curve.

This is why I openly worry about pension funds flocking to riskier investments at this point and time. If a severe bout of deflation does engulf the global economy, taking on too much illiquidity risk can come back to haunt them.

Below, the Caisse's CEO Michael Sabia discusses the markets and his investment ideas on Bloomberg's ”Market Makers.” This is an excellent interview so take the time to listen to his comments on why markets are too focused on the short-term, why the Caisse is moving more into illiquid investments and why despite having 1% invested in hedge funds, there are advantages to investing with the best alpha managers around the world (basically knowledge leverage).

As a background to this interview, read Brian Romanchuk's recent comment, Abenomics - Mission Accomplished?, and my comment on life after benchmarks. I also urge you to read my last comment on the Caisse's warning on Canada's energy policy and why their focus on pipelines and investments in Mexico has significant risks.

I also embedded a CNBC clip discussing whether we're in the midst of a credit boom and how much further equities can run, with Jeffrey Saut, Raymond James, and Brian Reynolds, Rosenblatt Securities.

As I've warned, the real risk in the stock market is a melt-up, not a meltdown, but choose your stocks and sectors right before taking the plunge and use the information I provide you on top funds' quarterly activity wisely, keeping in mind that in these crazy markets, even the best of the best get it wrong.

Lastly, I embedded a CBS 60 Minutes report on America's neglected infrastructure. There is no question in my mind that U.S. politicians need to increase the gas tax and invest more in their crumbling infrastructure. Watch this report, it's a real eye-opener.

Friday, November 21, 2014

Are Central Banks Panicking?

Koh Gui Qing and Jason Subler of Reuters report, China surprises with interest rate cut to spur growth:
China cut interest rates unexpectedly on Friday, stepping up efforts to support the world's second-biggest economy as it heads towards its slowest expansion in nearly a quarter of a century.

The cut, the first in over two years, came as factory growth has stalled and the property market, long a pillar of growth, has remained weak, dragging on broader activity and curbing demand for everything from furniture to cement and steel.

"It's comes right after China's disappointing PMI figures showing that manufacturing activity is getting dangerously close to contraction," said Alexandre Baradez, chief market analyst at IG in Paris, referring to a private factory survey this week which added to worries about slowing global growth.

"China's central bank is now following the path of the Fed, the ECB and the BoJ. Central banks are really driving markets," he said.

Just a few weeks ago, Chinese President Xi Jinping had assured global business leaders that the risks faced by China's economy were "not so scary" and the government was confident it could head off the dangers.

In a speech to chief executives at the Asia Pacific Economic Cooperation (APEC) CEO Summit, Xi said even if China's economy were to grow 7 percent, that would still rank it at the forefront of the world's economies.

The People's Bank of China said it was cutting one-year benchmark lending rates by 40 basis points to 5.6 percent. It lowered one-year benchmark deposit rates by less - just 25 basis points. The changes take effect from Saturday.

"The problem of difficult financing, costly financing remains glaring in the real economy," the PBOC said.


The central bank also took a step to free up deposit rates, allowing banks to pay depositors 1.2 times the benchmark level, up from 1.1 times previously.

"They are cutting rates and liberalising rates at the same time so that the stimulus won't be so damaging," said Li Huiyong, an economist at Shenyin and Wanguo Securities.

Recent data showed bank lending tumbled in October and money supply growth cooled, raising fears of a sharper economic slowdown and prompting calls for more stimulus measures, including cutting interest rates.

But many analysts had expected the central bank to hold off on cutting interest rates for now, as authorities have opted instead for measures like more fiscal spending, as they also try to balance the need to reform the economy.

Chinese leaders have also repeatedly stressed they would tolerate somewhat slower growth as long as the jobs market remained resilient.

More recently, the central bank injected cash into the system in the form of short-term loans to banks in an attempt to keep down borrowing costs and encourage more lending even as bad loans increase.

But a growing number of economists said those moves were not translating into either lower financing costs or more credit for cash-starved Chinese companies.

Analysts expressed doubts over whether the impact of the rate cut would find its way into the real economy, either, as the cooling economy makes lenders more risk-averse. Some predicted multiple cuts would be needed well into next year.

Hurt by the cooling property sector, erratic export demand and slackening domestic investment growth, China's economy is seen posting its weakest annual growth in 24 years this year at 7.4 percent.

China's rate move comes after the Bank of Japan sprang a surprise on Oct. 31 by dramatically increasing the pace of its money creation, while European Central Bank President Mario Draghi shifted gear on Friday and threw the door wide open to quantitative easing in the euro zone.

"There is definitely more concern around about the state of the global economy than there was a few months ago, you see that not just when you talk about Europe," British finance minister George Osborne told an audience of business leaders in London on Friday.
Reuters also reports world shares surged on Friday as China surprised markets with its first interest rate cut in more than two years and the European Central Bank's Mario Draghi threw the door wide open to full scale money printing:
European shares and other growth sensitive commodities all leapt as China's move to cut rates to 5.6 percent gave markets a welcome lift after a week where data has shown its giant economy heading for its worst year in almost quarter of a century.

It came as ECB head Draghi spoke in Frankfurt of his determination to use more aggressive measures such as large scale asset purchases -longhand for money printing- to ensure the euro zone did not slump into a new crisis.

"We will continue to meet our responsibility - we will do what we must to raise inflation and inflation expectations as fast as possible," Draghi said in a heavyweight speech.

"If on its current trajectory our policy is not effective enough to achieve this ... we would step up the pressure and broaden even more the channels through which we intervene."

Both the euro zone and China have been lagging the momentum of the United States, stimulus-driven Japan and faster-growing Britain over the last month, but a ramping up of the ECB's rhetoric and Beijing's actions will stoke hopes of a turnaround.

Germany's DAX, France's CAC and pan-regional Euro STOXX 50 were all up between 0.8 and 1 percent by 1230 GMT, leaving them on course for weekly gains of 4.5 percent, 2 percent and 2.4 percent respectively.

"The two together, (China cut, Draghi speech) suggest to me there is still a lot of hard policy work to be done next year," said Neil Williams, chief economist at fund manager Hermes in London.

Beijing's move also carried a hint of an escalating currency tussle in Asia.

A sharp fall in the yen this year as Tokyo has introduced wave after wave of stimulus, has been putting the squeeze on China's exporters due to a loss of cost advantage.

Japanese Finance Minister Taro Aso said on Friday that the yen's fall over the past week had been "too rapid". It was one of the strongest warnings against a weak yen since the aggressive stimulus efforts began two years ago and saw the currency leap off a 7-year low to 117.98.


Currency markets everywhere were shaken into life by China's move and the signals coming out of Frankfurt.

The euro fell sharply, slicing its way back down through $1.25 to $1.2430, while 10-year Italian government bond yields, which have been one of the biggest beneficiaries since Draghi took charge of the ECB in 2011, hit a new all-time low.

Hopes that China's growth will now quicken provided a shot in the arm for the Australian dollar, often used as a more liquid proxy for Chinese investments, and likewise lifted other key commodity currencies.

The rate cut also added to a positive mood among oil traders, many of whom expect the Organization of the Petroleum Exporting Countries to trim production, at what looks to be a landmark meeting in Vienna on Nov. 27.

Oil jumped 2 percent, or $1.75 to $81.07 a barrel as it surged towards its first weekly rise since mid-September in its biggest daily rise in a month.


Global investor sentiment was also underpinned by record finishes by the Dow Jones industrial average and S&P 500 on Thursday after a spate of upbeat U.S. data that offset the recent signs of spreading weakness in China and Europe.

Wall Street was expected to add a further 0.6 percent when trading resumes with the day's upbeat sentiment expected to more than make up for a lack major data.

In emerging markets, Russia's rouble, which is closely tied to the fortunes of oil, was heading for its first weekly rise since early September as the pressure it has been under eased.

Copper and gold also got a lift, with the red metal up 1 percent and spot gold climbing to $1,197 an ounce as traders cheered the prospect of more global stimulus.

"Commodity prices have risen across the board," said Carsten Fritsch, senior oil and commodities analyst at Commerzbank. There is hope that this step (lower Chinese interest rates) will lift commodities demand."
So what's going on here? China's surprise interest rate cut comes a few weeks after the BoJ's Halloween surprise. Global stock and commodity markets are rejoicing after this latest central bank "surprise" but I'd be very careful here because after the initial knee-jerk reaction, reality will settle in.

And the reality is that apart from the United States, the world economy is very weak, with many big economies teetering on recession. Nowhere is this more alarming than in Europe where shrinking incomes are wreaking havoc on periphery and core economies:
Seven years after the financial crisis first struck in 2007, Europe continues to teeter on the brink of a recession. Many economies in the region are yet to regain the levels of per capita income they saw in 2007. For some, incomes are much lower than what they were seven years ago. The accompanying chart shows those European economies that continue to see a fall in per capita incomes, computed in their national currencies at constant prices, compared with 2007. The data have been taken from the International Monetary Fund’s World Economic Outlook database, updated in October.

Greece has been the worst affected, but it is not only southern Europe that has been hit. Incomes in Finland, Denmark, Luxembourg and Norway are still considerably below where they were in 2007. While there’s much talk of a recovery in the UK, per capita incomes there are still below their 2007 level (click on image below).

The weakness in Europe will have several consequences. The obvious one is exports to the region will suffer. The frailty of the euro zone will ensure that monetary policy at the European Central Bank will remain easy for a long time and the ultra-low interest rates there will be a source of liquidity for global markets. Further, with incomes not rising, fresh investments in Europe are likely to be delayed. As a result, funds are likely to move out of Europe to greener pastures, to markets such as India.

The long stagnation in Europe is already having social repercussions, with mainstream parties losing ground to populists of the right and the left. But the stark question that confronts Europe today is: in an era of globalization and footloose capital, is it possible for its welfare states to survive? Or, is the welfare state a hoary relic of a bygone Keynesian age?
Indeed, I visited the epicenter of the euro crisis in September and saw deflation in the form of much lower wages and pensions. I also witnessed how the bloated public sector keeps thriving, weighing Greece down. And this isn't just a Greek problem.

Importantly, as long as Europeans keep putting off major structural reforms, their deflation crisis will just deepen and potentially spread throughout the world, including the United States. Everyone is underestimating the risk of deflation coming to America but I think global central banks are terrified of this prospect and will do anything they can to fight deflationary headwinds spreading throughout the world.

The big question remains will the titanic battle over deflation sink bonds? I don't see it and apparently neither does George Soros who just handed Bill Gross at Janus $500 million of his money to manage.
And if deflation does eventually come to America, all those global pension funds flocking to riskier investments are going to get clobbered, wishing they were more invested in good old bonds.

But for now, markets are rejoicing, hoping for the best. You're seeing a major relief rally going on in energy (XLE) and materials (XLB). Beaten down sectors like coal (KOL), gold (GLD) and oil services (OIH) and especially stocks like Freeport-McMoRan (FCX), Cliffs Natural Resources (CLF), Teck Resources (TCK), Petrobras (PBR) and Vale (VALE) are all rallying hard off their 52-week lows on Friday as investors think the latest central bank moves are all positive for the global recovery.

I haven't changed my outlook at all. I think short-sellers are licking their chops and using this latest relief rally to add to their short positions in these sectors and stocks. Be very careful here, don't get carried away and don't read more into China's surprise interest rate cut than the fact that they're very worried. Moreover, we can be on the precipice of a major currency war which will propel the mighty greenback higher and commodity and oil prices lower.

Deflation will be the final nail in the coffin. I had an interesting exchange earlier this week with an astute private equity investor who shared these comments with me on Yves Smith's latest rant against private equity and Blackstone:
Some truths mixed in with rants which could apply to any and all facets of the investment industry. If you don't like Blackstone, don't put money with them. PE even in its golden age did less well across the board then generally perceived, but has played its role reasonably well in dealing with the unpleasant reality of mature companies in mature economies. The bigger picture involves risks around deflation, China, quiet changes to the ISDA contracts that govern counterparties, etc. these things matter more.
I want you all to keep this in mind as global markets rejoice after the latest "surprise" move by a central bank.  

Having said this, the deflation scenario I have in mind is still a few years off. This is why I told my readers to plunge into stocks in mid October but to choose their stocks and sectors very carefully:
I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come. 

Keep an eye on companies like Acadia Pharmaceuticals (ACAD), Avanir Pharmaceuticals (AVNR), Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Seattle Genetics (SGEN), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.

Are there other stocks I like at these levels? Yes but I'm waiting to see what top funds bought and sold in Q3 before delving into more stock specific ideas. All I can say is tread carefully here and know when to buy the dips and more importantly, when to sell the rips.
This is still very much a stock picker's market which is why I track top funds' quarterly activity very closely.  I've added quite a few new funds to Q3 activity, including  John Lykouretzos' Hoplite Capital Management and David Gallo's Valinor Management, and will keep adding more to this list.

Please use this information carefully and remember to donate and subscribe to my blog via the PayPal buttons at the top right-hand side. Too many institutions that regularly read my comments have yet to subscribe but others have recognized the value and work that goes into writing these comments. I thank all of you who have subscribed and donated and continue to support my efforts.

Below, Bob Stokes of Elliot Wave International discusses why central bankers fear deflation. Also, Richard Bernstein, Richard Bernstein Advisors, discusses the ECB's decision to expand its balance sheet and why he is "confused" by Mario Draghi's statements.

If you ask me, it's too late, the ECB has pretty much lost all credibility and is well behind the deflation curve and central banks in Asia are right to fear the worst.

Lastly, in the second of three interviews (part 1 here), the manager of the global macro fund Eclectica, Hugh Hendry, tells MoneyWeek's Merryn Somerset Webb why central banks will go even further than anyone expects to keep the global economy afloat (h/t, Zero Hedge).

Indeed, all aboard the QE Express! Stay tuned, the macro environment is about to get a lot more interesting going into 2015.