Friday, June 30, 2017

CPPIB Bets Big on Houston?

Matt Scuffham of Reuters reports, Canada Pension Plan to buy U.S. REIT Parkway for $1.2 billion:
Canada Pension Plan Investment Board said on Friday it would buy Houston-based real estate investment trust Parkway Inc (PKY) for $1.2 billion, its second significant U.S. investment this week.

Canada's biggest public pension fund, which is one of the world's biggest real estate investors, will pay Parkway stockholders $19.05 per share and a $4 special dividend, the companies said on Friday.

Shares of Parkway were up 12.3 percent at $22.87 in morning trading. That was slightly below the $23.05-per-share deal value, which represented a 14 percent premium to the stock's average price in the past month.

"Parkway fits well with CPPIB's long-term real estate strategy to hold stable, high-quality assets in large U.S. markets," said Hilary Spann, who heads the pension fund's U.S. real estate investment arm.

Parkway, in which private equity firm TPG Capital has a 9.8 percent stake, said it owned 19 Houston properties totaling about 8.7 million square feet.

CPPIB Chief Executive Officer Mark Machin had said in November that he saw U.S. opportunities arising from President Donald Trump's election victory, citing the expectation of increased fiscal stimulus, less regulation and more economic activity.

The CPPIB, which manages Canada's national pension fund and invests on behalf of 20 million Canadians, has been diversifying from its domestic market by acquiring assets such as real estate and infrastructure around the world in addition to buying publicly traded stocks and bonds.

The pension fund is most heavily invested in the United States, which accounts for about 39 percent of its C$317 billion ($245 billion) of assets, according to its 2017 annual report. Asia is a distant second at 18 percent.

On Wednesday, CPPIB agreed to invest up to $1 billion to buy oil and gas assets in the United States in a partnership with Encino Energy Ltd.

HFF Securities LP was Parkway's financial adviser, and Hogan Lovells US LLP was its legal adviser.
Prashant Gopal and Scott Deveau of Bloomberg also report, Canada Pension Plan Agrees to Buy Parkway for $1.2 Billion:
Canada Pension Plan Investment Board agreed to buy Parkway Inc., a real estate investment trust with properties in the Houston area, for $1.2 billion.

The $23.05-a-share cash offer, which consists of $19.05 a share plus a $4 special dividend to be paid prior to the the deal’s completion, is about 13 percent more than Parkway’s closing price on June 29, the companies said in a statement today. TPG Capital and its affiliates, which own about 9.8 percent of the REIT, have agreed to vote in favor of the deal, which is expected to close in the fourth quarter.

The deal helps CPPIB, Canada’s largest pension fund, expand in Houston, where earlier this week it announced a $1.25 billion partnership with Encino Energy LLC that will focus on U.S. oil and gas acquisitions. The area’s office market was hit by the 2014 plunge in oil prices, making it sensible for a company like Parkway to go private, according to Jeffrey Langbaum, an analyst with Bloomberg Intelligence.

The pension fund won’t “have to answer to public shareholders every three months about why the stock price isn’t going up and why the market is blah,” Langbaum said in a phone interview.

Parkway has 19 office properties in the Houston area that were about 88 percent leased as of March 31, according to the statement.

CPPIB probably liked the portfolio because of its “high cap rate and low price-per-pound acquisition cost” relative to real estate in more expensive cities, John W. Guinee, an analyst with Stifel Nicolaus & Co. Inc., said in a phone interview. Cap rates, or net income divided by purchase price, are a measure of yield for property investors.

Houston Spinoff

The Houston assets were a spinoff of the merger in 2016 of Parkway Properties Inc. and Cousins Properties Inc. Shares of the new company had fallen 15 percent through yesterday since they began trading in October. They were up 12 percent to $22.86 at 11:12 a.m. New York time today.

CPPIB has been an active real estate investor for decades. Most recently, it acquired three U.S. student housing portfolios through a joint venture, Scion Student Communities, for $1.6 billion in March. In February, it bought a stake in a group of offices from Parkway in a deal that valued the portfolio at $1.04 billion.
You can read all the latest press releases from CPPIB here. These two deals total US$ 2.2 billion, which is a very significant investment even by CPPIB's standards.

So why did CPPIB make such a significant investments in Houston-based Parkway and Encino Energy?  Do its senior managers see a bottom in oil prices? While this is possible, it's also important to note that like all large pensions, CPPIB is a long-term investor with a long horizon so it doesn't need to pick the bottom in any of its investments.

On Friday, which is the last day of the quarter, oil prices are up and that is boosting energy shares. Some believe this is the beginning of another reflation trade similar to what happened in early 2016.

I'm skeptical on reflation but I do see a potential short-term tradable bottom in oil and energy (click on images):

Still, with central banks around the world increasing their hawkish tone (much to my dismay and horror), it's hard to see the beginning of a sustained rally in oil prices and energy shares.

Again, this is my short-term view and has nothing to do with CPPIB's decision to invest in Parkway and Encino Energy which is a long-term investment decision.

Some might be asking why not invest in Calgary and the answer is CPPIB (rightly) wants to diversify away from its Canadian exposure.

I can't add much more without speaking to Mark Machin or other CPPIB representatives on their view on oil prices and to get more details on these deals.

But one thing I know is Houston is a very popular and diverse city which is growing fast and it's important to note its economy has a diversified away from energy into other sectors like healthcare and manufacturing. In other words, there's a lot more to Houston than oil & gas (see the clips below).

Lastly, as we celebrate Canada 150, I was thinking of a few great Canadians that I admire most and one amazing Canadian always comes at the top of my list. 

I wish all Canadians a Happy Canada Day. We are very lucky to live in this great country. I also wish our southern neighbors a Happy 4th of July. Enjoy the long weekend.

Thursday, June 29, 2017

Caisse Cautious on London Real Estate?

Matt Scuffham of Reuters reports, Canada's Caisse cautious on London amid Brexit fears:
Caisse de depot et placement du Quebec, one of the world's biggest real estate investors, is holding off on major investments in London real estate amid uncertainty over the impact of Britain's planned exit from the European Union.

Canada's second-biggest public pension fund has been an enthusiastic investor in Britain and earlier this year agreed to finance the expansion of London's Heathrow airport in which it is one of the biggest shareholders.

Until recently, London was one of the cities the Caisse was most committed to investing in along with New York and Shanghai.

"That is still certainly true for Shanghai, true for New York," Caisse Chief Executive Michael Sabia told Reuters in an interview on Wednesday.

However, the Caisse has turned more cautious on Britain's capital after Prime Minister Theresa May lost her majority in a parliamentary election in early June, giving her a weaker hand in negotiating Britain's exit from the EU.

"We're pretty cautious right now about making meaningful and significant investments in London real estate," Sabia said.

The Caisse has not seen any impact yet on valuations of its existing real estate portfolio in London which is primarily in high-end office buildings. However, Sabia said valuations of less desirable properties were being affected.

"The question is how far does this go, does it spread? That is why we're being careful until we have a better sense."

Sabia also said Britain's economy, which initially withstood the shock of the Brexit vote, was starting to hurt.

"I think you're going to see slowing in the UK as the reality of Brexit begins to affect decision making more, I think we're already seeing some of that."

The Caisse, which manages public pensions for retirees in Quebec, has a dual mandate both to maximise returns for depositors and support economic growth in the Canadian province.

A $1.5 billion investment in Bombardier (BA.N), headquartered in Quebec, has been slammed by U.S. rival Boeing (BA.N) as an unfair subsidy but Sabia rejected that characterisation as "absolute nonsense" on Wednesday.


Caisse is embarking this year on the construction of the world's third-biggest public transit system in its home city of Montreal, a groundbreaking project which will see the pension fund take responsibility for both the funding and construction.

The C$6 billion project, which has also received funding from the Quebec government and Canada's federal government, is seen as a test case by other pension funds which normally prefer to invest in 'brownfield' infrastructure that has already been built rather than take on the construction risk through a 'greenfield' project.

But competition for assets such as roads, bridges and tunnels that have already been built has intensified as investors look for alternatives to low-yielding government bonds and volatile equity markets.

Sabia said he believes the Caisse will have an advantage over rivals from developing the skills in-house to manage the construction of new infrastructure and wants to replicate the model in the United States and Europe if it succeeds.

He also argued that much infrastructure development falls between the two, citing Heathrow Airport, where the infrastructure is being expanded, labelling them 'khaki' projects.

"You've got to have the capacity to work across that spectrum, to have a full product offering is something that's going to differentiate yourself in the market."

The Caisse invests money on behalf of workers and retirees in the province of Quebec and Sabia admitted that there would be reputational risk if money was lost on the Montreal transit project.

"Doing things differently and some degree of innovation always comes with some risk. If those reputational issues are so big in your mind then you're condemned to live in the status quo for ever.

"In an investment world that's changing as much as we think it is changing, staying in the status quo means you're toast."
There are two parts to this article. The first deals with the effects of Brexit on the UK economy.

Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson and John Van Reenen of LSE's Centre for Economic Performance published a paper, The consequences of Brexit for UK trade and living standards, which you can read here.

Their main findings are listed below (click on image):

The authors of this paper even quantified the effects of Brexit on UK livings standards under an optimistic and pessimistic scenario (click on image):

As you can see, the effects of Brexit on UK living standards are not good under both scenarios but are particularly terrible under the pessimistic scenario.

Now, these are academic studies and critics will claim they're too gloom and doom. Still, it's clear that Brexit will have an impact on trade and UK living standards, we just don't yet how this will all play out.

As far as London, the financial center of Europe, there are some diverging views among Canada's large pensions. PSP Investments, the other large pension fund in Canada, opened a London office recently which it considers its European growth hub.

However, just like Michael Sabia,  PSP's CEO André Boubonnais, is equally cautious on UK real estate and infrastructure. The latter believes London will continue to be the financial hub of Europe but he too is very cautious when it comes to making big investments in UK's private markets (PSP's main focus is on expanding private debt operations in Europe but it is looking at investments in infrastructure and real estate).

My thoughts on London? It's a global financial center just like New York and to a lesser extent Toronto. In other words, a long bear market or profound shock in the markets aren't too bullish for London, New York or Toronto.

London also houses some very large well-known hedge funds like Brevan Howard which hasn't been performing too well lately. Troubles in Hedge Fund Land don't typically bode well for commercial real estate in large financial centers but the rise of technology juggernauts has helped ease the burden of relying too much on financial firms.

Anyway, the Caisse's real estate subsidiary, Ivanhoé Cambridge, is among the biggest and best real estate investors in the world so I'm confident they know what they're doing when it comes to their decision to be more cautious in terms of London real estate.

As far as the second part of the article, it deals with Michael Sabia's baby, the C$6 billion Réseau électrique métropolitain (REM) project. I recently discussed my thoughts on this project when I went over Ontario Teachers' new infrastructure approach, stating this:
[...] this is one approach. Another approach is what the Caisse is doing now with its massive REM project, which is a purely direct greenfield project. The Caisse got a loan from the Quebec government and will receive money from the federal government too, but what Macky Tall and his team are doing in Montreal is unlike anything any large Canadian pension is doing in infrastructure.

[Note: The Caisse de dépôt et placement du Québec just received confirmation of a $1.283-billion investment, by the Government of Canada and Prime Minister Justin Trudeau, in the Réseau électrique métropolitain (REM) project.]

I just finished covering the International Pension Conference of Montreal and PSP's fiscal 2017 results where I noted that PSP's CEO André Bourbonnais is concerned about investor complacency and rightfully warned institutional investors are underestimating valuation and regulatory risks of infrastructure, mistakenly looking at these investments as a substitute for bonds.

In a private conversation with me at last year's pension conference, Leo de Bever, AIMCo's former CEO, told me he thought some of the infrastructure deals were being priced at "insane levels". I can't tell you which deals he mentioned (will let you guess), but he did add this: "what the Caisse is doing with this greenfield infrastructure project is truly innovative and can pay off in a huge way if they get it right."

I agree. There is no large pension in the world which is doing anything close to what the Caisse is doing in terms of a purely direct major greenfield infrastructure project where it controls everything from A to Z.

In order to do this project, CDPQ Infra went out and recruited people with the requisite skill-sets, people with operational experience developing and managing mammoth greenfield projects (not just MBAs and dealmakers but engineers with MBAs who worked at large construction engineering companies like SNC Lavalin and elsewhere).

This is why I was so disappointed to learn that the new Canadian Infrastructure Bank will be based in Toronto. I respect Jim Leech but in my humble opinion, Montreal, not Toronto, should have been the first and only choice as the headquarter this new federal infrastructure bank and I would have placed someone like Bruno Guilmette, PSP's former head of Infrastructure or someone else I know well as the head of this bank (I'm getting a bad feeling that this new infrastructure bank is going to be staffed by the wrong type of people).
In my opinion, Toronto was chosen as the headquarters of the new federal infrastructure bank because it is the financial epicenter of Canada and all the big pension funds are based there. Still, this decision irks me because Montreal needs a new federal Crown corporation based here (apart from the BDC) and we have plenty of infrastructure expertise that Toronto doesn't have. The Caisse's REM project is a testament to such world class expertise.

Anyway, even if it's headquartered in Toronto, hopefully they will staff this new infrastructure bank with the right people, not just a bunch of cowboy dealmakers.

[Note: A friend of mine reminded me that Toronto has the best infrastructure fund in the world, "it's called Brookfield and they are eons ahead of everyone else." Good point.]

Once again, if you have any thoughts on this comment or want to add anything, feel free to email me your thoughts at and I will be glad to post your comments.

Below, Lindsey Naylor on the macroeconomic impact of Brexit on the domestic economy, and the importance of regulatory matters in sustaining the ability of UK-based firms to face European clients.
Ms Naylor was speaking at the LSE Growth Commission’s Evidence Session on Finance and the City of London held at the Army and Navy Club on 6 December 2016. She is Partner in Oliver Wyman’s Global Corporate & Institutional Banking practice.

And on June 15, 2017, in Montreal, Prime Minister Justin Trudeau, Quebec Premier Philippe Couillard, Montreal Mayor Denis Coderre, and Michael Sabia, President and CEO of the Caisse discussed the federal government’s investment in Montreal’s Réseau électrique metropolitan (REM) light-rail network. Following the announcement, the prime minister, premier, and mayor respond to questions from reporters (in both French and English). You can watch it here.

Lastly, André Bourbonnais, president and CEO of PSP Investments, joins Bloomberg TV Canada’s Lily Jamali to discuss opportunities in the private debt market and his plans to expand globally. Listen carefully to his views on London, this is a great interview.

Wednesday, June 28, 2017

Investing Under Trump?

On Tuesday, I attended an AIMA luncheon at the St-James Club in Montreal featuring four panelists discussing investing under Trump:
  • Chen Zhao, the now retired former Co-Director of Global Macro Research at Brandywine 
  • Pablo Calderini, the President and Chief Investment Officer of Graham Capital Management
  • Marko Papic, Chief Strategist, Geopolitics at BCA Research
  • Yanick Desnoyers, Deputy Chief Economist of the Caisse de dépôt et placement du Québec 
The event was moderated by Mario Therrien, Senior VP, External Portfolio Management of Public Markets at the Caisse de dépôt et placement du Québec.

Before I begin, let me thank Claude Perron of Crystalline Management for inviting me to this event which he helped organize. For those of you who don't know, Crystalline is run by Marc Amirault and is Quebec's oldest hedge fund and among the first hedge funds established in Canada.

I posted a picture above with Claude, Mario, the panelists (on Mario's left) and the event organizers and sponsors to Claude's right (Stephane Amara, Sophie Palmer and Frederick Chenel).

Anyway, the event began with a presentation from Marko Papic discussing the geopolitical landscape. Marko was kind enough to send me his presentation and he wanted me to stress this point: "Fade Fed dovishness and fade ECB hawkishness."

It was the second time I saw Marko this month. The first time was at the International Pension Conference of Montreal which I covered here.

Marko started off with the way he sees the world over the next 24 months:
  • U.S.: Trumps populist agenda - Tax cuts! - will pass
  • Europe: Euro area collapse is overstated, but Italy is understated
  • China: Beware of Beijing doing the "right thing"
He put up a chart showing Trump which states even though Trump is the least popular president, he retains political capital with GOP voters which will allow to pass his populist agenda (click on image):

According to Marko, passing these reforms is bad news for bonds and bullish for the US dollar.

As far as Europe, he stated that Le Pen never stood a chance and that Germany is turning radically Europhile (click on image):

Interestingly, he said that Europe has experience with populism which is why they implemented the social welfare state a long time ago. He said that populism is more rampant in the US and UK where there are free markets and less rampant in countries where the social welfare system is better (click on image).

Marko is bullish on Europe, stating Macron will be able to introduce major reforms in France and influence Germany to build a better Eurozone.

Equally interesting, he sees inflation pressures picking up in Europe, based on reforms and better growth prospects ahead due to monetary and fiscal policy.

He singled out Italy as a potential problem as the percentage of Italians who think they will be better off out of the Eurozone is climbing, but he didn't sound the alarm on 'Italexit'.

Also interesting, he sees Europe moving more to the right and the US moving more toward the left, stating: "If Trump fails his reforms, watch out in 2020, we might see someone in office who makes Bernie Sanders look like a free market candidate."

As far as China, he sees major structural reforms ahead which will be painful and have ripple effects across the world (click on images):

As I've stated previously, the biggest risk Marko sees ahead is in Asia (not the Middle East) where the Sino-American symbiosis is over and East Asia is the 21st century's powder keg (click on images):

After Marko, Yanick Desnoyers, Deputy Chief Economist of the Caisse de dépôt et placement du Québec, gave an excellent economic overview of the US economy.

Yanick was also kind enough to give me a copy of his presentation. The big picture points are as follows (click on image):

As you can read, Yanick states the current US recovery is slower because of an ageing population and sluggish productivity growth (click on image).

However, he also states the US economy is in excess demand territory and it will be a challenge for the Fed to normalize rates with GDP growth so low (click on images):

But the chart that really caught my eye is the one below on signs of rising wage pressures (click on image):

I've never heard of the Atlanta Fed's Wage Growth Tracker:
The Atlanta Fed's Wage Growth Tracker is a measure of the nominal wage growth of individuals. It is constructed using microdata from the Current Population Survey (CPS), and is the median percent change in the hourly wage of individuals observed 12 months apart. Our measure is based on methodology developed by colleagues at the San Francisco Fed.
Yanick told the audience this is a better measure than average hourly earnings. According to this Bloomberg article:
The Atlanta Fed's wage metric tracks the incomes of individual workers over time, and as such is not prone to the composition effects — like the exit of higher-paid baby boomers from the labor force — that have weighed on the usual measure of average hourly earnings this cycle.

"Average hourly earnings are more susceptible to compositional and demographic changes in the labor force, while the tracker is comparing the wages of the same individuals over time, providing a unique insight into wage growth," said Bespoke Investment Group Macro Strategist George Pearkes. "That growth has been strong and accelerating recently despite very modest inflation and some remaining underemployment."
Moreover, according to Yanick, the Phillips Curve is alive and well (click on image):

Lastly, Yanick warned us that the Fed will have a hard time bringing the economy back to equilibrium (click on image):

Following these two excellent presentations, Mario Therrien moderated a panel discussion. Pablo Calderini discussed the dismal environment for hedge funds noting how a portfolio of stocks and bonds (50/50 or 60/40) had a higher Sharpe ratio than most hedge funds since the crisis because central banks have been backstopping markets.

However, he also warned that the normalization of rates and winding down of balance sheets will present excellent opportunities for top hedge funds, especially top global macro funds (like his).

Chen Zhao was the old Chen I knew from my BCA Research days stating "the consensus view is to be cautious on US stocks, bearish on bonds, bullish on the US dollar and negative on EM and commodities. And we all know the consensus is always wrong."

Non-consensus Chen was kind enough to share his thoughts with me via LinkedIn:
"My view is that while most analysts are trying to figure out where the next recession is, we might have already gone through "nominal recession" in 2015/16 when nominal growth around the world fell to usual recession levels. If so we may be at the start of a new cycle. This would suggest that stocks have further to rise, the USD might have topped out and the Fed would soon stop tightening. Commodities might have already reached the bottom early last year. That being said, I am not bearish on US bonds and 10 year yields could fall further."
I pressed Chen to explain why he's not bearish on US long bonds if he feels we may be at the start of a new cycle:
"Last decade we had booms In American consumption and Chinese investment. This decade, desired investment in China has fallen dramatically and the US consumers spend at less than half of the speed. Nonetheless, China's saving rate has stayed at 50% and the US saving rate is a lot higher than last decade. In absolute terms, we are talking about $10 trillion in net new savings for the US and China alone. How much desired investment there is? Not much. This does not mention that governments are also trying to spend less and saving more (balance the budget). How is it possible for interest rates go up in this environment? I look for zero rates in the US when next recession hits. This is something different from past cycles."
On China, there was divergent viewpoints between Marko and Pablo who were more cautious due to China's dangerous debt levels and Chen who is more bullish. "Nobody can figure China out because they don't really understand the economy," he said.

Chen made a good point that a large population of Chinese were still agrarian and that industrialization will move millions into the cities.

I asked Yanick a question on inflation, noting that inflation expectations are dropping despite the uptick in the Atlanta Fed's Wage Tracker. I covered my thoughts on inflation in my recent comments on Ken Griffin, the Fed making a huge mistake, and on the Bezos and Buffett effect.

Again, I'm in the deflation camp so when I see inflationistas warning of inflation, I tend to dismiss them as does the bond market. But Yanick is a top economist who worked at the National Bank prior to joining the Caisse so I pay attention to his views because he knows what he's talking about.

He told me that any notion that the Phillips Curve is dead is silly and that inflation pressures are building. Again, if this is the case, why are inflation expectations so low and why aren't bond yields surging?

I don't know folks, I'm still a deflationista and have strong doubts there is any significant wage inflation in the US (or elsewhere in the world) to worry about.

My macro thoughts remain the same:
  • Long US stocks, especially biotech (XBI) and technology (XLK), but be ready for a major pullback in Q4 or Q1 of next year (hedge your portfolio with US long bonds).
  • Long the USD (UUP). The US economy leads the global economy by six to nine months so get ready to see weakness in Europe and Japan in the last quarter and early next year (short the euro and yen relative to the USD)
  • Long US long bonds (TLT). Stimulus or no stimulus, the US economy is slowing, inflation expectations are dropping, and long bonds will rally, especially if we get another crisis (flight to safety will support bonds and the greenback).
  • Short Emerging Markets (EEM), commodities, energy, commodity currencies and commodity-weighted stock indices (Australia and Canada).
If you have anything to add concerning this event or attended and want me to add something, please feel free to contact me at

As always, please remember to contribute to this blog and support my efforts in bringing you some unique insights on pensions and investments. I thank all of you who take the time to contribute, it's greatly appreciated.

Below, a couple of clips where Marko Papic, Chief Geopolitical Strategist at BCA Research talks to Money Talk's Kim Parlee about how markets are understating risks in 2018 and why Italy is Europe's biggest threat (see the entire interview here where it is easier to watch).

Tuesday, June 27, 2017

Are ETFs Driving The Market Higher?

Evelyn Cheng of CNBC reports, Goldman says there's one major force behind the market's gains this year: ETFs:
Passive investing is taking a bigger share of the stock market, helping to drive gains.

Exchange-traded funds, or ETFs, owned nearly 6 percent of the U.S. stock market as of the end of the first quarter, their greatest share on record, according to analysis by Goldman Sachs.

Known as passive investments, ETFs are baskets of stocks tracking various market indexes and have grown in popularity for their relatively low fees. In contrast, mutual funds that involve higher-cost active stock picking have declined in popularity, and their ownership of the U.S. stock market has fallen to 24 percent, the lowest since 2004.

ETFs purchased $98 billion worth of stocks in the first quarter, putting them on pace to buy $390 billion of stock this year, more than the last two years' combined total of $362 billion, according to the Friday note by a group of analysts led by Goldman's chief U.S. equity strategist, David Kostin. Goldman based its analysis on the Federal Reserve Board's June 8 report on first-quarter U.S. financial accounts.

ETF ownership of equities is at the highest level on record, as of the first quarter (click on image):

Source: Federal Reserve Board and Goldman Sachs Global Investment Research.

Analysts said the growth of ETFs can help explain why stocks have gained this year despite delays in passing the Trump administration's pro-growth proposals and increased geopolitical worries.

"I agree that ETFs have been a big driver," Ilya Feygin, managing director and senior strategist at WallachBeth Capital, told CNBC in an email. "The market has often made strong gains in weeks of strong inflows even in the face of bearish macro news. It has paused when there is not much inflow or the inflow went to international ETFs instead of U.S."

In a sixth straight quarter of gains, the S&P 500 climbed 5.5 percent in the first quarter to record highs. The index is tracking for gains of more than 3.5 percent this quarter.

Corporate buybacks and foreign investors also have driven demand for U.S. stocks.

Share buybacks were still the largest source of demand for stocks in the first quarter at $136 billion, or 46.6 percent of purchases, the Goldman report said, while the first quarter marked the second time in the last eight quarters that foreigners bought more U.S. stocks than they sold.

Momentum behind U.S. stocks could fade

That said, Kostin doesn't expect the strong demand for U.S. stocks in the first quarter to hold.

Goldman's year-end target for the S&P 500 is 2,300, about 5.7 percent below Friday's close of 2,438. U.S. stocks were slightly higher Monday, with the S&P near its record high hit June 19.

Expectations for a slight decline in U.S. stocks should lead to "a modest deceleration in ETF purchases" in the second half of the year, the report said, while a switch to passive management will add to mutual fund withdrawals.

Since 2007, $3.1 trillion has flowed into passive bond and stock funds, while $1.3 trillion has flowed out of actively managed bond and stock funds, according to a Bank of America Merrill Lynch report Thursday.

Cumulative active vs. passive flows to bond & equity funds ($ trillions)

Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global

Stock buybacks are also on the decline and should weigh on market returns. Kostin cut his forecast for corporate buyback growth this year to 2 percent from 11 percent.

"Our new estimate excludes any boost from tax reform in 2017 and also accounts for weaker activity in 1Q," Kostin said in the report. He previously expected tax reform this year to result in firms bringing back cash from overseas and using those funds to buy back shares.

Over the 12 months ended in March 2017, buybacks for S&P 500 companies declined 13.8 percent from a record high in the same period a year ago, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

Second-half fund flows should support overseas markets

On the other hand, improved growth in Europe and the rest of the world should benefit stocks outside the U.S.

Goldman expects the Europe STOXX 600 to gain 6 percent over the next six months in local currency terms, Japan's Topix to climb 2 percent and the MSCI Asia-Pacific ex-Japan Index to rise 1 percent.

"Higher return potential in major non-US equity markets vs. the US and a political stalemate in Washington D.C. suggest foreign investors will be net sellers of US stocks in 2H," Kostin said in the report.

Kostin also expects better returns overseas to attract U.S. buyers, who already bought $83 billion in foreign equities in the first quarter, reversing a trend in five of the last six quarters of selling more foreign stocks than buying.
When Goldman talks, investors listen. Alright, let me begin by stating there is a giant passive 'beta' bubble going on driven by the increasing popularity of exchange-traded funds (ETFs) and digital (aka robo) advisors. I've written all about it in my comment on the $3 (now $4) trillion dollar shift in investing,

Jack Bogle has revolutionalized the investment world for the better but in the process of doing so he may have created a monster that will sow the seeds of the next major financial crisis. This may be the Mother of all beta bubbles but it's very hard for people to realize it until the crisis hits and the dust settles.

And if history is any guide, these bubbles last a lot longer than investors can fathom. Martin Lalonde, manager of Rivemont, sent me a nice comment by the Collaborative Fund, The Reasonable Formation of Unreasonable Things, which you can read here (this is an excellent read).

Nevertheless, one thing is for sure, even if the stock market is on a tear, the US economy is slowing as I discussed here and here. At one point, the liquidity party will dry up, credit spreads will widen, and companies won't be able to borrow as much to buy back shares which will pretty much spell the end of the bull market (share buybacks have been the biggest factor driving shares higher).

Having said this, it's very hard calling a top when there is still plenty of liquidity driving risk assets higher. Sure, stocks are not cheap based on the CAPE ratio or "Shiller PE" but as Charlie Bilello of Pension Partners notes in his comment, Is This 1929 or 1997?, relying on this indicator to predict future returns isn't particularly wise.

As I end this brief comment, markets are selling off. I was busy earlier today attending a CFA luncheon where I enjoyed listening to macro views from some astute market observers. I will share some thoughts from this luncheon in a follow-up comment.

As far as what's driving the market higher, I would say central banks, share buybacks, ETFs and animal spirits. Is passive investing going to continue growing? Of course, but this growth will present opportunities to active managers especially when markets tank again.

One final note on ETFs and the VIX (or fear) index. As mentioned in this article, the rise of ETFs is impacting the volatility index through hedging activities:
Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.

With the S&P 500 stock index .SPX near a record high, demand for these is quite strong.

For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX.P), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating steady demand for VIX futures that the hedge funds are only too happy to supply.

"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.

Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.

It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
Below, Bloomberg Intelligence's Eric Balchunas and Bloomberg's Julie Hyman look at claims that ETFs are inflating stock prices and creating a market bubble. They speak on "Bloomberg Markets" (March 24, 2017). Good discussion, listen carefully to his comments but keep in mind the trend that Goldman notes above.

Monday, June 26, 2017

Will Public Pensions Sink Illinois?

The Associated Press reports, Illinois debt is about to be rated 'junk.' What that means:
Illinois is on track to become the first U.S. state to have its credit rating downgraded to "junk" status, which would deepen its multibillion-dollar deficit and cost taxpayers more for years to come.

S&P Global Ratings has warned the agency will likely lower Illinois' creditworthiness to below investment grade if feuding lawmakers fail to agree on a state budget for a third straight year, increasing the amount the state will have to pay to borrow money for things such as building roads or refinancing existing debt.

The outlook for a deal wasn't good Saturday, as lawmakers meeting in Springfield for a special legislative session remained deadlocked with the July 1 start of the new fiscal year approaching.

That should alarm everyone, not just those at the Capitol, said Brian Battle, director at Performance Trust Capital Partners, a Chicago-based investment firm.

"It isn't a political show," he said. "Everyone in Illinois has a stake in what's happening here. One day everybody will wake up and say 'What happened? Why are my taxes going up so much?'"

Here's a look at what's happening and what a junk rating could mean:

Why now?

Ratings agencies have been downgrading Illinois' credit rating for years, though they've accelerated the process as the stalemate has dragged on between Republican Gov. Bruce Rauner and the Democrats who control the General Assembly.

The agencies are concerned about Illinois' massive pension debt, as well as a $15 billion backlog of unpaid bills and the drop in revenue that occurred when lawmakers in 2015 allowed a temporary income tax increase to expire.

"In our view, the unrelenting political brinkmanship now poses a threat to the timely payment of the state's core priority payments," S&P stated when it dropped Illinois' rating to one level above junk, which was just after lawmakers adjourned their regular session on May 31 without a deal.

Moody's did the same, stating: "As the regular legislative session elapsed, political barriers to progress appeared to harden, indicating both the severity of the state's challenges and the political difficulty of advocating their solutions."

What is a 'junk' rating?

Think of it as a credit score, but for a state (or city or county) instead of a person.

When Illinois wants to borrow money, it issues bonds. Investors base their decision on whether to buy Illinois bonds on what level of risk they're willing to take, informed greatly by the rating that agencies like Moody's assign.

A junk rating means the state is at a higher risk of repaying its debt. At that point, many mutual funds and individual investors — who make up more than half the buyers in the bond market — won't buy. Those willing to take a chance, such as distressed debt investors, will only do so if they are getting a higher interest rate.

While no other state has been placed at junk, counties, and cities such as Chicago, Atlantic City and Detroit have. Detroit saw its rating increased back to investment grade in 2015 as it emerged from bankruptcy — an option that by law, states don't have.

What will it cost?

Battle says the cost to taxpayers in additional interest the next time Illinois sells bonds, which it inevitably will need to do in the long-term, could be in the "tens of millions" of dollars or more.

The more money the state has to pay on interest, the less that's available for things such as schools, state parks, social services and fixing roads."

For the taxpayer, it will cost more to get a lower level of service," Battle said. Comptroller Susana Mendoza, who controls the state checkbook, agreed.

"It's going to cost people more every day," she said. "Our reputation really can't get much worse, but our state finances can."

Other impacts?

Because the state has historically been a significant funding source to other entities, such as local government and universities, many of them are feeling the impact of Illinois' worsening creditworthiness already.

S&P already moved bonds held by the Metropolitan Pier & Exposition Authority and the Illinois Sports Facilities Authority — the entities that run Navy Pier, McCormick Place, and U.S. Cellular Field — to junk. Five universities also have the rating: Eastern Illinois University, Governors State University, Northeastern Illinois University, Northern Illinois University and Southern Illinois University.
Cole Lauterbach of the Illinois News Agency also reports, Lawmakers spend Sunday talking pensions; still no budget:
Illinois House lawmakers used one of their final days of the special session discussing the merits of different pension reform proposals. No votes were taken on it or a budget.

After quickly going through the motions to enter and exit the special session mandated by Republican Gov. Bruce Rauner and passing a couple non-budgetary items, panel discussions continued.

The state's official estimate of unfunded pension liabilities is $130 billion, but Moody's places the state's shortfall at closer to $250 billion. Both numbers are higher than nearly any other state. Illinois' annual pension obligation is around 25 percent of its annual budget. That's set to increase based on the changes to reforms made by lawmakers and former Gov. Jim Edgar.

Lawmakers on both sides of the aisle have filed reform proposals for pensions. They make a number of changes ranging from limiting cost-of-living increases in exchange for other benefits, to creating a new classification for teachers with a different structure of benefits.

Virtually all of the panelists that testified Sunday had union connections, and they were cool to any proposal that made pensions more affordable to taxpayers. They said the proposed reforms would diminish pensions, deemed unconstitutional by the Illinois Supreme Court.

"Pensions are good public policy," said Daniel Montgomery, president of the Illinois Federation of Teachers, who opposed changes to the current systems beyond those that would lead to better funding. "We've had a long history of not funding them properly."

Others said the changes did nothing to solve the massive fiscal crisis.

"Taxpayers have put in $20 billion more than the 'Edgar ramp' originally called for and yet, despite those billions more, pensions are going bankrupt," said Ted Dabrowski, vice president of Policy for the Illinois Policy Institute. "We may soon have the first junk bond rating of any state. Pensions are a driver of that. Illinois needs the boldest reforms. The two bills in question would only perpetuate the crisis and make things worse."

Dabrowski advocated eliminating defined benefit pensions for new state hires, which he said are unaffordable to taxpayers and going bankrupt. Instead, new state employees should be enrolled in a defined contribution plan similar to 401(k)'s that most private businesses have converted to. This would give the employees control of their retirement funds and prevent politicians from under-funding them.

While the thought of having a lifetime guaranteed paycheck from a pension sounds appealing, there are setbacks. Should a teacher spend a decade in a classroom, decide to change course and pursue another career, their pension would not be portable. That decade of contributions would be lost. Members of some pensions are also ineligible for Social Security benefits, making their defined-income plans their only offered source of income in retirement beyond a separate plan. And some, such as Dabrowski, fear Illinois' pension systems are so underfunded that they face bankruptcy, which would lead to reduced benefits.
What a mess. I've been watching the slow motion train wreck of Illinois's public pensions for years, especially the Teachers' Retirement System (TRS).

The Illinois House and Senate recently passed legislation to reform teacher pension funding but the situation is so grave that Illinois Governor Bruce Rauner, a former private equity executive before his 2014 election to the governor's office, has made several new appointments to the board of the $46 billion pension plan and named Marc Levine chair of the Illinois State Investment Board (ISIB) and to the teachers' retirement board.

As far as reforms, I don't agree with Dabrowski who advocates eliminating defined-benefit pensions for new state hires. Illinois's teachers and public sector employees know all too well about the brutal truth on defined-contribution plans.

Importantly, shifting public or private sector workers out of DB into DC plans just doesn't make sense. It's dumb public policy because it will exacerbate pension poverty over the long run and detract from Illinois's economic activity over the long run.

But the unions can't have their cake and eat it too. Illinois teachers need to accept some form of risk-sharing in their plan just like Ontario's teachers did, which is why their plan is fully funded while Illinois's TRS is still on death watch, chronically underfunded and in need of major reforms.

The other thing that the Ontario Teachers' Pension Plan has is first-rate governance, separating government out of investment decisions and paying its pension managers properly to attract and retain talent to bring assets internally.

It looks like Marc Levine is trying to reform the way Illinois public pensions are doing business but the situation is so grave that they absolutely need concessions from unions to share the risk of their plan. I've discussed all these issues in my comment on the pension prescription where I also discussed the big squeeze fees have on these pensions.

As far as the issue of pension portability, I don't understand why teachers who leave their work after a certain number of years cannot leave their pension money in a DB fund and get reduced benefits in the future. If they want to receive a lump-sum payment to put it into their 401(k) plan, sure, but my advice would certainly be against this.

Honestly, what Illinois and other states that suffer from similar pension woes need is to amalgamate all these public pensions at the state level, introduce better governance, adopt a shared-risk model, and get real on investment  returns even if this means higher contributions from employees and the state government (these plans need be jointly sponsored).

But none of these reforms are being discussed. Instead, lawmakers want quick fixes which will make things worse for everyone, including Illinois taxpayers.

In the meantime, rating agencies are taking notice, targeting chronically underfunded US state plans,  much to the dismay of state governments and taxpayers. Not that the rating agencies have much of a choice but to take notice. The pension storm cometh and it will crush many chronically underfunded mature state pension plans.

In fact, ValueWalk recently did an analysis stating that US pensions funds have a $4 trillion hole and even a 5% decline could be catastrophic. But it's even worse than that because this analysis only focuses on assets, not liabilities. If rates plunge to record low levels and stay there, the catastrophe will be much worse than anything we can imagine (remember a decline in rates impacts pension deficits a lot more than a decline in assets because the duration of liabilities is a lot bigger than the duration of assets).

The situation really scares me because it will impact millions of workers and beneficiaries of these state plans as contributions rise and benefits decline. It's not just GE that botched it pension math, it's pretty much the majority of US public plans, and when it hits the fan, it will be devastating.

Maybe I'm too cynical, perhaps I'm not seeing a silver lining in this grim situation, but I doubt it. I've been looking at this from all angles and it's just ugly and getting worse. But if you see some hope in this US public pension catastrophe, feel free to email me your thoughts at

Below, Marc Levine, chairman of Illinois State Board of Investment, talks about the hedge fund wrecks and which ones he actually trusts. The “Fast Money” traders weigh in.

Over the weekend, I listed Penta's top 100 hedge funds on LinkedIn but didn't notice any of the three hedge funds mentioned in the clip below, which isn't necessarily a bad thing. In fact, I quickly looked at the portfolio and AUM of HR Vora Capital Management which was among the three mentioned below and liked what I saw (take all these top hedge funds lists with a shaker of salt!!).

But like I said when I went over GE's botched pension math, more hedge funds and private equity funds aren't the solution to America's public pension crisis. So, no matter what Mr. Levine and his team do on that front, it won't make a big difference when it comes to public pensions sinking Illinois.

Friday, June 23, 2017

The Bezos and Buffett Effect?

Matthew Boesler of Bloomberg reports, Amazon Has at Least One Fed Official Rethinking Inflation:
News that rocked the retail world last week is coming at just the wrong time for U.S. central bankers already puzzling over why inflation is conspicuously absent.

When online retail giant Inc. announced last Friday that it would purchase Whole Foods Market Inc., a plunge in retail and grocery stocks reinforced the disinflationary tone set by three straight months of disappointing data on consumer prices. It’s an example of the technological forces that are increasing competition and further limiting companies’ ability to pass on higher wage costs to customers.

“That normally indicates that somebody thinks that they are not going to be earning as much as they were,” Federal Reserve Bank of Chicago President Charles Evans said of the market reaction to the deal while speaking with reporters Monday evening after a speech in New York.

“For me, it just seems like technology keeps moving, it’s disruptive, and it’s showing up in places where -- probably nobody thought too much three years ago about Amazon merging with Whole Foods,” he said.

Evans, a voter on the Federal Open Market Committee this year who supported its decision to raise interest rates last week, says he is less confident than most of his colleagues that inflation will soon rise to their 2 percent target.

A big reason for his ambivalence: Deflationary competitive pressures could have become more important for the overall trend in prices than the so-called Phillips Curve relationship, which links inflation to the state of the labor market. That model, coined almost 60 years ago, is the basis for the Fed’s outlook for continued gradual rate increases.

In order for it to work, though, businesses need to be able to raise prices to offset increases in labor costs as unemployment falls and available workers become more scarce. But a stumble in corporate profit margins suggests companies are struggling to raise prices.

“That’s one of the things that makes me nervous, that I think there’s something possibly going on, some secular trend, that isn’t just a U.S. story,” Evans said.

“We know that technology is disruptive. It’s changing a number of business models that used to be very successful, and you have to wonder if certain economic actors can continue to maintain their price margins, or if they are under threat from additional competition,” he said. “And that could be an undercurrent for holding back inflation.”

Every indication from FOMC leadership is that continued tightening in the labor market will lead to higher inflation, despite the recent wobbles in the inflation data, which Fed Chair Janet Yellen called “noisy” in a press conference following last week’s meeting.

“We think if the labor market continues to tighten, wages will gradually pick up, and with that, we’ll see inflation get back to 2 percent,” William Dudley, who as New York Fed president is also vice chairman of the FOMC, said Monday in Plattsburgh, New York.

Such remarks reinforce expectations that policy makers will hike again before the end of the year, as signaled by their latest forecasts for interest rates.

Evans isn’t ready to abandon that logic yet, either, but he does sound more skeptical.

“I can’t say that the Phillips Curve isn’t going to lead to higher inflation, but I worry that it’s very flat and it’s not going to,” he told reporters Monday. “It’s still very early in this process.”

The Chicago Fed chief is not alone in thinking about the impact of disruptive technologies on prices. Dallas Fed President Robert Kaplan -- another FOMC voter this year -- describes such forces, and the uncertainty they generate, as currently the most intense he’s ever seen.

Ultimately, if the unemployment rate continues to fall and inflation doesn’t respond, the Phillips Curve may fall further out of favor as a guide to inflation dynamics, and by extension, interest-rate policy, as Evans hinted at Tuesday in a follow-up interview on CNBC.

“If that’s the case -- and I think that’s just speculative at this point -- then it means we need even more accommodation to get inflation up,” he said.
You can read Federal Reserve Bank of Chicago President Charles Evans's speech here. Take the time to read through this speech, it's excellent.

Last Friday, I discussed whether the Fed is making a huge mistake tightening as the US economy slows. I went over a comment written Minneapolis Fed President Neel Kashkari explaining why he dissented again.

In that comment, I stated the following:
I've been warning of the risks of debt deflation for a very long time, long before I began writing this blog in 2008 right before the financial crisis hit full force.

In a recent comment of mine where I discussed why Citadel's Ken Griffin is warning of inflation, I went over yet again six structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  • The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  • Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  • The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  • Excessive private and public debt: Rising government debt levels and consumer debt levels are constraining public finances and consumer spending.
  • Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality, is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  • Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics,  and other technological shifts that lower prices and destroy more jobs than they create.
Now, we can argue about the importance of each structural factor but there is no arguing that an aging population, a less-than-spectacular labor market, the global pension crisis, excessive public and private debt, rising inequality and technological shifts are all deflationary.

All this to say that I agree with Neel Kashkari, I think it's silly for the Fed to raise rates in a deflationary environment, especially now that the US economy is slowing. Not surprisingly, institutional investors are "increasingly uncomfortable" with the Fed tightening during a slowdown.
I don't just think it's silly for the Fed to raise in a deflationary environment, I'm equally perplexed when I read comments on why the Bank of Canada is all of sudden in a hurry to raise rates. On LinkedIn, I posted this comment regarding this article:
"I think it is highly unlikely the Bank of Canada will hike in July if oil prices keep dropping from now till the meeting. If the BoC hikes, it will only exacerbate deflationary pressures. The only rational argument I've heard for hiking is to cool speculative activity in the housing market, but the market is already taking care of that. Having worked with Steve Poloz at BCA Research a long time ago, he might like to suprise people once in a while, but he's no cowboy and is well aware of the deflationary risks I'm talking about."
Speaking of BCA Research, I agree with Anastasios Avgeriou, BCA's Chief Equity Strategist, no matter what Pimco's Ivascyn says, this time isn't different, the inverted yield curve is signalling a US recession ahead:

I warned my blog readers in April that the next economic shoe is dropping and more recently to prepare for a US slowdown

The US slowdown is already underway and next will follow Europe, Japan, China and the rest of the world. This is why I remain long US long bonds (TLT), the US dollar (UUP) and select US equity sectors like biotech (XBI) and technology (XLK) and I'm underweight/ short energy (XLE), materials (XME), industrials (XLI), financials (XLF) and emerging markets (EEM).

In fact, had you loaded up on biotech (XBI) prior to the US presidential election back in November when I wrote about America's Brexit or biotech moment and loaded up on US long bonds (TLT) at the start of the year when I explained why it's not the beginning of the end for bonds, you would have made great returns and thrown me a bone via a donation or subscription to this blog (I remain long biotech but took some profits and added to my US long bonds).

Anyway, I'm talking up my book and getting off track. Back to the Bezos or Amazon effect. I was talking to a buddy of mine earlier this week about Amazon's impact on inflation. He mentioned to me "it's like the Wal Mart effect that happened in the 90s but on a much bigger scale and much more pervasive."

I agree, Amazon has forever changed the retail landscape which is why many retail stocks (XRT) have gotten killed over the last year (click on image) :

Now, before you go buying the dip on retail stocks, let me show you a scarier chart that goes back over ten years (click on image):

I'm not saying we are going to revisit the 2008 financial crisis levels but I would be very cautious on retail stocks. In fact, if you want retail exposure, you're probably better off sticking with Amazon (AMZN), the online retail goliath that has been growing by leaps and bounds over the last ten years, succeeding in online shopping and its cloud business (click on image):

Still, I think it's best to temper your enthusiasm on any retail stock, including red-hot Amazon as we head into a US and global recession.

Also, following Amazon's Whole Foods deal, I saw some grocery stocks like Kroger (KR) get killed as if it's a done deal (it's not) and as if grocery stores will never be able to compete against Amazon (click on image):

Kroger's stock is way oversold (resting on its 400-week moving average) and although I'm not particularly bullish on it, I think this is a gross overreaction and if a recession hits, you want to have defensive stocks like grocers in your portfolio.

Anyway, there is little doubt Amazon has an impact on inflation just like Uber, Nexflix (NFLX) and Tesla (TSLA) do. In fact, my buddy shared this me earlier this week:
"The biggest influence on inflation is oil. Tesla is changing the automobile market and as demand for electric cars picks up, it will impact oil prices over the long run. Why do you think the Saudis are selling Aramco? They see the writing on the wall and need to diversify their economy. Netflix is also impacting inflation. As people stop going ot the movies, they stop going out and spending on restaurants and order more as they stay home."
I told him that explains why shares of Domino's Pizza (DPZ) have been on a tear over the last five years while other restaurant stocks haven't been sinking (click on image):

Now, this comment is called the Bezos and Buffett but so far, I've only focused on Amazon.

Matt Scuffham of Reuters reports, Shares in Canada's Home Capital surge as Buffett rides to rescue:
Warren Buffett's Berkshire Hathaway Inc (BRK) is providing a C$2 billion loan to Home Capital Group Inc (HCG.TO) and taking a 38 percent stake in the mortgage lender, a move which is pressuring short sellers who targeted the stock as Canada's housing market has turned riskier.

Shares in Home Capital closed up 27 percent on Thursday.

Shares in other Canadian alternative lenders also rose on Thursday. Equitable Group Inc (EQB.TO) closed up 12.5 percent. Street Capital Group (SCB.TO) closed up 8.3 percent. Shares in mortgage insurer Genworth MI Canada Inc (MIC.TO) were up 11.5 percent.

The deal may bring to a close a two-month effort by Home Capital's board, and advisers RBC Capital Markets and BMO Capital Markets, to replace a costly credit facility with the Healthcare of Ontario Pension Plan (HOOPP) and shore up the lender's balance sheet.

The credit facility was arranged earlier to provide funding for Canada's largest non-bank lender which had suffered from the withdrawal of 95 percent of its high interest deposits in the past two months.

Alan Hibben, a former Royal Bank of Canada executive who was recruited to the Home Capital board last month, said over 70 parties had expressed interest in investing in the lender. In an interview, Hibben said Home Capital was drawn to Berkshire Hathaway because of Buffet's credibility with both investors and depositors.

"The board decided it would be nice for a sponsor to give us a view where somebody could say 'wow, if that smart person thinks the Home Capital business model and portfolios are good, I'm going to think that'," he said.

Hibben said Buffett had become involved "later in the process" with Home Capital approaching Berkshire Hathaway rather than the other way round.

Home Capital has played an important role in Canada's mortgage market, lending to new immigrants and self-employed workers who may not be able to get loans from the country's biggest banks.

But home prices in Toronto and Vancouver have fallen after the government introduced measures to cool overheating prices with household debt in Canada has reaching record levels.

Investors are wondering whether the deal will be as successful as Buffett's decidedly bigger deal to buy Goldman Sachs preferred shares during the global financial crisis in 2008.

“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” said Berkshire's chairman Warren Buffett, in a statement on the deal released by Home Capital on Thursday.


Short sellers are continuing to take positions in Home Capital though, aiming to profit by selling borrowed shares on the hope of buying them back later at a lower price.

Combined short interest in the company's Canadian and U.S.-listed shares stands at about $183 million, up $62 million this month, according to data from financial analytics firm S3 Partners.

Marc Cohodes, a short seller who has been betting against Home Capital for two years, said on Thursday he continued to do so.

"If it wasn't Warren Buffett's name, the stock would be way, way way, down today," he said in an interview.

Home Capital was forced to raise new capital after depositors rushed to withdraw funds from its high-interest savings accounts. They pulled 95 percent of funds from Home Capital's high-interest savings accounts since March 27, when the company terminated the employment of former Chief Executive Officer Martin Reid.

The withdrawals accelerated after April 19, when Canada's biggest securities regulator, the Ontario Securities Commission, accused Home Capital of making misleading statements to investors about its mortgage underwriting business.

Home Capital reached a settlement with the commission last week and accepted responsibility for misleading investors about mortgage underwriting problems.

"The 'endorsement' from Warren Buffet may prove to rehabilitate depositor confidence, thus turning deposit flow positive," said National Bank of Canada analyst Jaeme Gloyn.

The Berkshire credit agreement comes with an interest rate of 9.0 percent, with a standby fee on funds not drawn down of 1.0 percent, compared with 2.5 percent previously.
Katia Dmitrieva and David Scanlan of Bloomberg also report, The real reason Warren Buffett is rescuing Home Capital:
Warren Buffett has become the lender of last resort for Home Capital Group Inc. The billionaire investor agreed to buy shares at a deep discount and provide a fresh credit line for the Canadian mortgage company, tapping a formula he used to prop up lenders from Goldman Sachs Group Inc. to Bank of America Corp.

Buffett’s Berkshire Hathaway Inc. will buy a 38 per cent stake for about $400 million and provide a $2 billion credit line with an interest rate of 9 per cent to backstop the embattled Toronto-based lender, Home Capital said late Wednesday in a statement. The interest on the one-year loan would net Berkshire at least $180 million if it’s fully tapped.

“While the terms of the new credit line with Berkshire Hathaway remain harsh, we believe the purpose of this loan is to motivate Home Capital’s management to bolster their own funding sources,” said Hugo Chan, chief investment officer at Kingsferry Capital in Shanghai, which owns shares in Home Capital. “This again shows Mr. Buffett’s masterful capital allocation skills,” said Chan, citing his investment motto: “be greedy when others are fearful.”

Home Capital shares surge as Warren Buffett rides to the rescue

The financial backing from the billionaire investor is poised to send the stock higher Wednesday, though it comes at a cost, in keeping with his past bailouts of financial firms. Buffett has buoyed some of the biggest U.S. corporations in times of trouble, including a combined $8 billion injection to prop up Goldman Sachs and General Electric Co. when credit markets froze during the 2008 financial crisis.

Berkshire’s purchase of $5 billion of Goldman Sachs preferred stock paid Buffett’s company an annual dividend of 10 per cent, and the billionaire also got warrants he later used to get more than $2 billion of the bank’s shares in a cashless transaction.

Deal Discount

In the Home Capital deal, Buffett’s firm agreed to pay an average price of $10 a share, a 33 per cent discount to yesterday’s closing price of $14.94. Berkshire would become the largest shareholder in Home Capital, which has a market value of $959 million.

“If you have the Warren Buffett seal of approval, people will take you more seriously than if you don’t,” said Meyer Shields, an analyst with Keefe, Bruyette and Woods. “So you sort of look beyond the settlement and say, ‘OK, what matters most now is that Warren Buffett trusts this company. And that in turn, allows Warren Buffett to get much better returns on capital than maybe some other lender would have been able to.”

The $2 billion credit line is only marginally cheaper than the emergency credit provided by the Healthcare of Ontario Pension Plan, which company directors have termed as “costly.”

Under the new credit agreement, the interest rate on outstanding balances will fall to 9.5 per cent, from 10 per cent under the existing HOOPP line. The rate will drop to 9 per cent after the initial investment is completed. The standby fee on undrawn funds will dip to 1.75 per cent from the current 2.5 per cent, then fall further to 1 per cent. The credit line is for one year. Home Capital has drawn about $1.65 billion from the HOOPP loan.

The investment “is a strong vote of confidence,” in the long-term value of the business, Brenda Eprile, Home Capital’s chairwoman, said in the statement.

New Terms

The move is the latest sign of a turnaround in the 30-year-old lender after a regulator in April accused it of misleading shareholders on mortgage fraud, which sent its shares tumbling, sparked deposit withdrawals and threatened to disrupt Canada’s real estate sector. Earlier this week, Home Capital agreed to sell a portfolio of commercial mortgages to affiliates of KingSett Capital Inc. for $1.16 billion in cash.

“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” Buffett said in the statement.

The share purchase will be done in two parts: an initial investment of $153 million for about a 20 per cent equity stake, then an additional investment of $247 million taking the stake to about 38 per cent. The second phase requires extra approvals.

Berkshire will not be granted any rights to nominate directors and has agreed to only vote shares representing 25 per cent of the company’s stock, Home Capital said.

Home Capital shares have almost tripled since bottoming in May when its troubles began to accelerate, though remain about 73 per cent down from their peak in 2014. The company last week took full responsibility over allegations the lender misled shareholders about mortgage fraud and agreed with three former executives to pay more than $30 million to reach settlements with regulators and investors.

Buffett’s Berkshire Hathaway is wading into a tense Canadian housing market, with Toronto house prices cooling after being hit with a 15 per cent tax on foreign buyers and tighter mortgage regulations, and confidence shaken by the Home Capital drama. Meanwhile, prices are surging in Vancouver again after being sideswiped by similar policy moves.
There's no doubt the "Buffett effect" boosted shares of Home Capital Group this week but I would seriously take any profits if you risked capital and bought shares at the bottom (click on image):

I didn't buy shares of Home Capital when they tanked because I don't have Buffett's deep pockets and because I don't like the sector from a macro perspective. I can also guarantee you Buffett won't make anywhere near the killing he made when he bought Goldman Sachs's preferred shares during the crisis.

But I had a feeling something was going to happen after I wrote my comment on Canada's pensions to the rescue where I noted that pension heavyweights Claude Lamoureux, Ontario Teacher's former CEO, and Paul Haggis, the former CEO of OMERS are joining Home Capital's Board.

Home Capital approached Warren Buffett but don't kid yourselves, Claude Lamoureux, Paul Haggis and even former Board member, HOOPP CEO Jim Keohane certainly had something to do with facilitating this deal.

[Note: I send my blog comments to Warren Buffett's Executive Assistant, Debbie Bosanek, but I doubt he reads them. The Globe and Mail reports that Buffet's interest in rescuing Home Capital Group was piqued by an email from 82-year-old Don Johnson, a Canadian banker who sends his thoughts to the investment guru now and then.]

I asked Jim Keohane how this deal will impact HOOPP's investment earlier today and he replied: "Buffet will provide a line of credit at a slightly better rate and Home will pay ours off.  Our loan was always intended to be a short-term liquidity fix and we expected that we would get paid back in a relatively short time frame."

Jim is at an offsite for the Board of Queen's University so I appreciate him taking the time to answer me.

Anyway, I wish all of you a great weekend and all Quebecers a Happy St-Jean Baptiste Day! Please remember to support my blog by donating or subscribing via PayPal at the top right-hand side under my picture.

Below, Federal Reserve of Chicago President Charles Evans speaks to CNBC's Steve Liesman about the Fed's inflation target, the outlook for rate hikes and the state of the US economy.

And Alan Hibben, Board member at Home Capital, explains how the company secured a $1.5 billion lifeline from the Oracle of Omaha. Again, there was a process, and whle the provincial government didn't have anything to do with this deal, I'm sure Claude Lamoureux, Paul Haggis and Jim Keohane did facilitate this deal. They all have solid reputations that helped ease Buffett's concerns.

And Berkshire Hathaway's Warren Buffett discusses Jeff Bezos' extraordinary success with Amazon, calling him 'the most remakable business person of our age'. No doubt, Bezos is changing the world in ways we can't imagine, but my fear is the world isn't ready for such disruptive change and we need to address this and rising inequality in order to sustain a vibrant and healthy democracy.

Remember what Buffett once said:"The marginal utility of an extra billion to me is not as much as it can be to millions of others in desperate need."

Interestingly, Jeff Bezos hasn't signed the Giving Pledge that Buffett, Gates and other billionaires have signed but he is now looking to donate billions to philanthropy and is looking for help (see clip below).

There are many great philphilanthropic causes but I would urge Bezos and the world's billionaires to figure out ways to help the poor and disabled to earn a living and stop being marginalized by society.