Wednesday, January 31, 2018

America's Pension Shithole?

Reuters reports, Illinois pension mega-bond sale idea gets legislative airing:
Illinois lawmakers on Tuesday expressed interest and skepticism in an idea that the U.S. state should sell $107 billion of bonds to address its huge unfunded pension liability.

At a hearing before the Illinois House Personnel and Pensions Committee, Runhuan Feng, an associate professor of mathematics at the University of Illinois, laid out a plan for selling taxable 27-year, fixed-rate bonds to get the state’s five retirement systems to a 90-percent-funded level.

The bond plan, which was offered by a group representing workers and retirees in the Illinois State Universities Retirement System, would result in a $103 billion reduction in the state’s pension costs by 2045, according to Feng.

Committee Chairman Robert Martwick filed a bill for the bond sale, emphasizing that it was in early in the process and promising to bring in bond market and other experts to testify.

In order to become law, the bill would need to pass both Democrat-controlled chambers and be signed into law by the state governor, currently a Republican.

Illinois pension systems’ funded ratio was just under 40 percent in fiscal 2017, while the unfunded liability totaled $129 billion, according to a legislative commission. The state’s annual pension payment is projected to grow from $8.5 billion in fiscal 2019 to $19.6 billion in 2045 under the current funding system.

Some lawmakers questioned what the plan would do to Illinois’ credit ratings, which are already the lowest among the U.S. states, and if the huge borrowing would make future bond sales for capital projects impossible.

“Are we going to be tapped out completely?” asked Democratic State Representative Scott Drury.

Some lawmakers expressed interest if the bond sale came with additional ways to lower costs that would not violate public pension protections in the Illinois Constitution.

The state has already been a prolific issuer of taxable pension bonds, selling $3.7 billion in 2011, $3.5 billion in 2010, and $10 billion in 2003. The 2003 deal included $7.7 billion of bonds that will not mature until 2033 and $1.4 billion maturing in 2023.

The U.S. and Canadian Government Finance Officers Association has advised its state and local government members not to issue pension bonds, citing several risks that could arise from investing bond proceeds and increasing debt burdens.
Opinions vary on this mega-bond sale proposal to shore up Illinois's public pension systems. Paris Schutz, a broadcaster at WTTW Chicago Tonight reports, $107 Billion Borrowing Plan Could Save State Pensions:
It’s being called a “moon shot” proposal to solve the state’s worst-in-the-nation pension crisis.

One state advocacy group is asking lawmakers to borrow massive amounts of money, on top of the debt the state already has. Why do they think it’s the best way to go?

The idea is to go to the bond market, borrow a whopping $107 billion and put it all into the state’s pension funds to get them healthy in one fell swoop. Right now they are short $130 billion of where they need to be, which is helping drive the state’s junk bond rating. The proposal is being pushed by the State University Annuitant’s Association and developed by University of Illinois professor Runhuan Feng, who presented the plan to skeptical lawmakers at a hearing Tuesday in Springfield.

Feng says the state can borrow that money at an interest rate of 5 percent. If historical trends hold up, it can invest that money in the pension funds and get a return of 7 percent, generating a 2-percent profit and saving taxpayers $100 billion over the next 27 years. Feng acknowledges that a lot of chips would have to fall the right way for this plan to work.

“I do realize there’s risk, that’s why we ran a relatively conservative scenario to argue that there is an interest rate arbitrage you can take advantage of,” he said. “And studies show that historically there has been a 2-percent rate based on the tax authorities.”

The testimony was met with a lot of skepticism from lawmakers who wonder what might happen in the case of an economic downturn, and if annual 7-percent returns fail to materialize. Also, would lenders even pony up $100 billion, especially with the state right now not being the most popular of investments? The Civic Federation’s Laurence Msall says no state has even attempted half this amount of borrowing, but because the crisis is so severe, the plan deserves a look.

“No other state in the United States has ever attempted to borrow over $100 billion, no states borrow half that amount, not even California or New York,” Msall said. “And when they borrow that amount, they don’t use it for pensions, they use it to make investments that are going to last longer than the length of the bonds. So, this is an extraordinary idea, it’s one that is only beginning to be vetted, and the burden’s on the promoters to tell us how this could actually be done.”

Gov. Bruce Rauner’s office seemed ho-hum on the idea, through a spokesperson saying: “Pension reform has to save taxpayers money. We ought to start with a constitutional proposal to reform current pensions, like something similar to the so-called ‘consideration model’ first proposed by Senate President Cullerton.”

Other ideas thrown around at Tuesday’s hearing included borrowing this money to pay buyouts to retirees in lieu of receiving yearly pensions. Remember, the Illinois Supreme Court ruled three years ago the state can’t cut or trim benefits.
Indeed, as I have repeated many times, pensions are all about managing assets and liabilities. This means when pensions are chronically underfunded like in the case of Illinois' pension systems (40 percent funded, the worst-funded public pension system of any state), there's not much they can do except raise contributions, cut benefits or both to shore up their plans.

Unfortunately, Illinois' Supreme Court has ruled benefits cannot be cut and public-sector unions and the government don't want to pay more into their public pensions, and taxpayers don't want to pay more in property taxes, so the only politically expedient option seems to be to borrow billions in the bond market to shore up the state‘s woeful pension system.

But while some are sold on the idea of borrowing over $100 billion to shore up Illinois' public pensions in "one fell swoop", others are less enamored by this proposal. Robert Reed of the Chicago Tribune reports, Proposed $107 billion bond isn't the cure for Illinois' public pension crisis:
A big, bold plan to save the state’s debt-strapped public pension funds is being floated this week in Springfield. But don’t get your hopes up.

It’s not the cure to Illinois’ festering financial crisis.

An influential state employee advocacy group, the State Universities Annuitants Association, is urging Illinois to issue $107 billion in bonds to pay off shortfalls in the state’s five leading pension funds.

Yep, that’s a whopping $107 billion — backed by taxpayers who will be on the hook, especially if this deal goes bad. And the odds of that occurring look pretty good.

“It’s a big gamble,” says Howard Cure, director of municipal bond credit research for Evercore Wealth Management in New York.

While full details of this plan are expected to be unveiled Tuesday before a state panel, bond and public finance experts are already highly skeptical. They’re concerned it will add to Illinois’ pension burdens — now estimated at $130 billion in unfunded liabilities and growing — and further hinder the state’s sorry overall financial health.

Let’s start with the bond market.

At $107 billion in 27-year fixed-rate bonds, it would be the largest amount of debt the state ever sought from investors. Bond experts wonder if Illinois — with its record of political dysfunction, inability to pay its bills in a timely way and $25 billion in general obligation debt — will attract enough hungry investors.

One way to lure wary backers is to spice up the bonds and sell them at above-market interest rates. Such a premium would likely attract risk-taking investors, probably from overseas funds, or deep-pocketed individuals hoping to make a killing.

But higher rates are tougher to pay off and investors’ bond payments must be paid on time, says Evercore’s Cure. Missing a debt payment means riling angry bondholders, who could quickly sue the state or take other legal actions to recoup their investments, he adds.

Laurence Msall, president of the Civic Federation — a nonpartisan government research group — says his organization has “serious concerns and reservations” about the proposed bond effort too.

On top of the gargantuan amount, the bond is limited to pensions and not linked to any comprehensive financial plan for improving state finances, Msall asserts. The bond’s size could also impede the state’s ability to seek borrowing or bond financing for infrastructure or other basic needs, he says.

Despite these somber concerns, no one should be beating up on the State Universities Annuitants Association, which represents more than 200,000 current and retired employees, for leading this charge.

The group believes many initial concerns will be addressed when it reveals the details of its plan to the General Assembly committee exploring public pension matters. It will argue that its refinancing proposal will lop $103 billion off state pension costs through 2045 while increasing the pensions’ funding levels to 90 percent.

Rep. Robert Martwick, the Chicago Democrat who heads the House pension committee, has no position on the bond plan but wants it to become part of a larger pension reform debate. In the coming weeks, the $107 billion initiative will be fully discussed by finance experts, labor and taxpayer advocates, he stresses.

Of course, when it comes to Illinois’ public pension crisis, there’s no shortage of issues to chew over.

Government leaders have been doing that for way too many years with few results, mainly because of state underfunding of pensions, feisty union opposition and a provision in the state constitution that prohibits any structural changes to the funds or benefits.

Those who want to totally dump public pension plans haven’t had any better luck getting around that provision.

It’s a nasty trick bag because, in the meantime, the amount of public pension liabilities keeps stacking up and strapped taxpayers are increasingly responsible for paying more.

It’s a mess.

But this big, bold but flawed bond plan isn’t the solution to the public pension crisis.

We can’t be that desperate.
Unfortunately, after years of state government mismanagement and terrible governance on the part of Illinois' public pensions, the state is desperate to slay its pension dragon once and for all.

My biggest issue with this mega-bond sale is it does nothing to address the structural deficiencies plaguing Illinois' pension systems.

Importantly, even if the state manages to sell these pension bonds, if they don't address lousy governance that has played a big part in the chronic deficit of these public pensions, all they're doing is buying some time without doing anything to cut pension costs and bolster them so they're sustainable over the long run.

But in order to improve governance, the state needs to hire professional pension fund managers who know how to manage money internally to cut costs, and to do this they need a competitive compensation scheme. In other words, no government interference in the oversight of these state pensions. They need to nominate an independent, qualified board to oversee these public pensions (ie., the Canadian pension governance model). They should also almagamate them all into one large state pension plan.

Better governance is only part of the remedy, however. The other missing link is adopting a shared-risk model which explicitly states these plans are jointly sponsored by the unions and the state and they will equally bear the risk of the plans when they are underfunded.

Again, this means when the plans are underfunded, contribution rates need to be raised, benefits cut or both. There is simply no way arround this which is why Illinois' constitution needs to be changed to allow for cuts in benefits if they are needed to shore up these plans.

And I'm not talking drastic cuts, a partial or full removal of cost-of-living adjustments (ie. inflation protection) for a brief period makes perfect sense.

One thing Illinois shouldn't do is lose its pension mind like Kentucky did and switch workers to 401(k)s. This is the dumbest proposal many politicians come up with to gain support from private sector voters but this too will only create a much bigger problem down the road.

Public defined-benefit pensions, when run well and topped out properly by the state, are absolutely worth it and their economic benefits to governments and the economy are often underestimated.

But my claim is based on the assumption that Illinois and other states suffering a similar fate are able to introduce the right governance in these plans.

Don't hold your breath. There are powerful groups in the financial services industry who don't want to change the status quo because many of them are perfectly content with lousy governance as long as they can keep milking the public pension cow.

One last note. I didn't mean to be provocative with my title but the only real difference between Illinois' pension system and the Greek pension system is that Illinois has the capability to borrow billions from the bond market. If Greek politicians were able to do this when the crisis hit, they'd jump on that option faster than you can say "OPA!".

But borrowing billions to shore up public pensions comes at a cost, one that will severely constrain Illinois' already stretched public finances for years or decades to come.

This is why I keep warning you, public pensions matter and the pension crisis is deflationary and will hamper economic growth over the long run.

Lastly, even though Illinois is a big pension shithole, it has a lot of company. There are many other large and small states that aren't too far behind and my biggest fear is when the next crisis hits, many of them will be in a worse position and at that time, they won't be able to borrow at reasonable rates to fund their chronically underfunded public pensions.

You can watch a WTTW Chicago Tonight clip on this mega-bond sale here.

Below, Illinois' lawmakers at odds over pension reform as the state's pension crisis is a problem that can no longer be ignored. Unfortunately, the moonshot pension gamble being proposed doesn't address the underlying structural deficiencies plaguing Illinois' public pension systems which is why I doubt America's pension shithole will be much better off after they borrow billions to shore up these plans.

And in his first State of the Union address, President Trump spoke of shared American values and dreams, while calling for more stringent immigration rules and touting the economy. Judy Woodruff leads analysis of the president’s speech, as well as the Democratic response by Rep. Joe Kennedy.

Noticeably absent in this speech was any discussion on America's ongoing pension crisis. Put simply, you can't make America great again without making public pensions great again!

Update: A wise reader of my blog shared this with me (added emphasis is mine):
US public sector pension plans aren't really pension plans. They are clever ways to unjustly enrich public servants at public expense. To achieve this end, the plans have adopted unsustainable funding and accounting practices made possible by inadequate actuarial and accounting standards. The weakest plans are well past the point of no return. The end game will likely begin in the next recession.

The way the courts interpret the pension promise may be legally sound but it is economically absurd. The states are told that, once they allow employees to participate in a pension plan, they cannot reduce the pensions employees have earned prior to the change (reasonable), nor can they reduce the pensions that employees will earn throughout the remainder of their careers (absurd). This being the case (and I believe that Jerry Brown is challenging this interpretation in California, now that he has decided not to seek reelection), the only way to fix a pension plan that has become too expensive due to low interest rates, increasing life expectancies and/or ill-advised pension negotiations (for example, agreeing to pension "spiking") is to dismiss all of the employees (if the court permits states to fire those it can no longer afford to employ) and start again with a DC plan or a Target Benefit plan.

It comes as no surprise that the proposal to borrow $107 billion to take a flier in the stock market enjoys the support of public sector unions. They bear none of the risk and collect all of the money. As long as they can keep the game going, they win and the public is left holding the bag.
I agreed with him that the pension storm cometh, not on shifting workers to DC or target benefit plans, and asked him his thoughts on a federal bailout, possibly emitting 50-year Treasuries to wipe out public and even private pension deficits. He replied (added emphasis is mine):
I can't predict what the federal government will do. I can't see the argument for bailing out Illinois, or Illinois' public servants. How would one explain this to voters in the states that did not similarly mismanage their public pensions? Why should public servants in Illinois be unjustly enriched at the expense of taxpayers in other states?

At some point, you need to let the plans fail and the courts decide who should pay for it. The courts created the problem, along with dishonest politicians and greedy public sector unions. Let them solve the problems they created, and live with the consequences.

If the reckoning comes during a period of economic distress, the federal government and the Federal Reserve Board can experiment with fiscal and monetary policies and look for remedies that help everyone, not just public servants. They should avoid "trickle down" remedies, like bailing out public service pension plans in the hopes that selfless spending by retired public servants will keep the economy afloat. Government employees understandably favour this kind of approach. No one else does.
I realize his views won't sit well with Illinois' powerful public-sector unions but he does raise many valid points that need careful consideration. I thank him for sharing his thoughts.

Tuesday, January 30, 2018

CPPIB's Big Investment in Chinese Properties?

Rajeshni Naidu-Ghelani of CBC News reports, CPPIB to invest $800M in Chinese real estate developments:
The Canada Pension Plan Investment Board (CPPIB) will invest $800 million in two new property developments in China by developer Longfor Properties, it announced on Monday.

The projects include a 740,000 square metre residential and commercial development in Western Chinese city Chengdu. The city has a population of 16 million.

The other is a 340,000 square metre development in South Minhang, which is a suburb of financial capital Shanghai.

The developments will both include a shopping mall.

"Both cities are well positioned to capitalize on the future economic growth and harness the returns of growing consumption in China," said Jimmy Phua, head of real estate investments Asia, CPPIB.

He added the move was part of the pension board's strategy to grow real estate investments in China, particularly in the fast-growing retail sector.

"The investments will help CPPIB diversify its real estate interests in China, providing attractive risk-adjusted returns over the long term," he said.

Market regulation

The announcement comes as policymakers in the world's second largest economy embark on curtailing real estate speculation as home prices continue to surge.

More than 100 cities have imposed measures to crack down on speculative buying with Chinese President Xi Jinping emphasizing that "houses are built to be lived in, not for speculation."

Housing data released last week showed that the measures were starting to take affect with new home prices rising just 5.3 per cent in December from year ago, compared to 12.4 per cent in 2016.

On Monday, the Shanghai government also announced that it would continue to strengthen regulation of the city's property market.

Investments in China

Meanwhile, the deal between CPPIB and Longfor is the third of its kind after a 2014 $234 million deal for a similar project in eastern city Suzhou, followed by a $193 million investment in 2016 for a mall in southwestern city Chongqing.

Zhao Yi, chief financial officer, Longfor Properties said the new projects are ideally located high-quality assets that are expected to offer strong returns.

"Our expertise in real estate development as well as in mall operations and management will help us deliver value to our shareholders and partners," he said.

The services sector in China was one of the big drivers of better-than-expected economic growth last year, according to gross domestic product (GDP) data released last week.

The services industry grew 8.3 per cent in the fourth quarter from a year ago and accounted for almost half of the GDP by value.

Real estate, meanwhile, contributed 6.3 per cent to the economy in the same time frame.
CPPIB put out a press release, Canada Pension Plan Investment Board extends cooperation with Longfor Properties to develop mixed-use sites in Chengdu and Shanghai, China:
Canada Pension Plan Investment Board (CPPIB) and Longfor Properties Co. Ltd (Longfor) announced today they are extending their cooperation to include two new mixed-use real estate development projects in Chengdu and Shanghai in China, for a total CPPIB commitment of approximately RMB 4,200 million (C$800 million).

“We are pleased to extend our existing relationship with Longfor Properties, one of the top real estate developers in China, through these development projects in Chengdu and Shanghai. Both cities are well positioned to capitalize on the future economic growth and harness the returns of growing consumption in China,” said Jimmy Phua, Managing Director, Head of Real Estate Investments Asia, CPPIB. “These projects deliver on CPPIB’s strategy to grow our investments in the Chinese real estate sector, specifically in the fast-growing retail sector. The investments will help CPPIB diversify its real estate interests in China, providing attractive risk-adjusted returns over the long term.”

The mixed-use development project in Chengdu, the capital of Sichuan province with a population of 16 million, is comprised of approximately 740,000 square metres for residential and commercial use. The project is attractively and ideally situated in the East part of Chengdu and contains excellent commercial transportation links, offering great accessibility to the city centre. The site will include a Paradise Walk shopping mall of approximately 140,000 square metres. The large residential component is expected to service the increasing residential demands of Chengdu.

The Shanghai site is approximately 340,000 square metres and is situated in South Minhang, one of the city’s fast-growing suburban areas. The project will comprise retail and commercial components and is ideally located in terms of transport links and its proximity to two universities, as well as the Zizhu technology hub. It, too, will include a Paradise Walk shopping mall.

“We look forward to further extending our cooperation with CPPIB. These investments are another set of landmarks in our work together, following the Suzhou Times Paradise Walk and Chongqing West Paradise Walk projects,” said Zhao Yi, Executive Director and Chief Financial Officer of Longfor Properties. “The mixed-use sites in Chengdu and Shanghai are both ideally located, high-quality assets that are expected to offer strong future returns. Our expertise in real estate development as well as in mall operations and management will help us deliver value to our shareholders and partners.”

Longfor is a well-established residential and retail mall developer and operator in China, and has built a strong brand, experienced retail team and a wide network of local and international tenants in the Paradise Walk malls.

CPPIB and Longfor first collaborated in 2014 with a mixed-use real estate project in Suzhou, which included the development of a Paradise Walk mall.

About Canada Pension Plan Investment Board

Canada Pension Plan Investment Board (CPPIB) is a professional investment management organization that invests the funds not needed by the Canada Pension Plan (CPP) to pay current benefits on behalf of 20 million contributors and beneficiaries. In order to build a diversified portfolio of CPP assets, CPPIB invests in public equities, private equities, real estate, infrastructure and fixed income instruments. Headquartered in Toronto, with offices in Hong Kong, London, Luxembourg, Mumbai, New York City, São Paulo and Sydney, CPPIB is governed and managed independently of the Canada Pension Plan and at arm's length from governments. At September 30, 2017, the CPP Fund totalled C$328.2 billion.For more information about CPPIB, please visit or follow us on LinkedIn or Twitter.

About Longfor Properties Co. Ltd.

Longfor Properties is a premier developer engaged in property development, investment and management in China. With its business spanning 35 cities throughout China, Longfor Properties serves a wide spectrum of customers, including the upper class, middle class and mass markets. The Group’s product offerings range from high-rise apartment buildings, low-rise garden apartments, townhouses, detached villas, as well as shopping malls and other commercial properties.

Being one of the first developers of shopping malls in China, Longfor has been operating commercial properties for over 15 years. To date, it has opened 26 shopping malls with a total area of over 2.6 million sq.m, and working with over 3,800 merchant brands. For more information, please visit
With this investment, CPPIB has invested roughly $1.2 billion of its assets with Longfor, one of the top real estate developers in China.

In fact, for those of you who don't know, Wu Yajun, co-founder and Chairwoman of Longfor Properties, is one of the top ten real estate tycoons and one of the top ten most outstanding businesswomen in China. Here she is posing during a press conference for Longfor Properties in Hong Kong (March, 2014):

If you're going to invest in commercial real estate in China, it helps to have the right partners who know how to navigate the terrain. Longfor is one of the ten best-performing Chinese property companies.

And from the press release:
Being one of the first developers of shopping malls in China, Longfor has been operating commercial properties for over 15 years. To date, it has opened 26 shopping malls with a total area of over 2.6 million sq.m, and working with over 3,800 merchant brands.

It’s clear Longfor has an expertise in developing shopping malls but this deal also includes residential properties.

As far as Chengdhu, China, it's not as popular as Shanghai, but some think it's a beautiful and growing city that should be part of your bucket list. In particular, one of the city’s most famous neighborhoods, the Wide and Narrow Alley is a series of ancient streets and courtyards, which today are home to some of Chengdu’s toniest shops and restaurants.

While this deal is sizable in terms of dollars, it's important to note that emerging market public and private equities represent 5.7% and 1.8% of the total portfolio of $317 billion as of last March and emerging market real estate is less significant in terms of the overall portfolio (especially Chinese real estate).

A full discussion on CPPIB's Real Estate is beyond the scope of this post but you can get some details from pages 64-65 of the Fiscal 2017 Annual Report. The key highlights:
Fiscal 2017 marked another year of steady growth for the Real Estate Equity portfolio, which at the end of the year totalled $40.1 billion, an increase of 9.2% from fiscal 2016. The Equity programs represent 89.3% of the overall real estate portfolio and 54.5% of the Real Assets portfolio. A slowdown in new investment activity and valuation gains coupled with an active dispositions program resulted in moderate growth in the portfolio in fiscal 2017 compared to previous years. Specifically, the value increase in the portfolio was the result of several factors: (i) $4.6 billion in new investment activity, (ii) valuation increases mainly due to improved market conditions and foreign exchange of $1.6 billion, offset by $2.8 billion in return of capital from asset sales.

At year-end, the Real Estate Equity portfolio consisted of 121 investments with 60 operating partners, managed by a team of 75 professionals across six offices globally. The Real Estate Equity portfolio remains well diversified across major markets globally, with 86% in developed markets such as North America, Western Europe and Australia and 14% in the emerging markets including China, India and Brazil.
So, 14% of the $40.1 billion Real Estate Equity portfolio is invested in China, India, and Brazil and most of this is in Brazil and India. Investing in China's commercial real estate is a relatively new venture in terms of CPPIB's Real Estate group but one that will grow significantly over the next decade(s).

Also, when looking at the overall CPPIB portfolio which is now close to $330 billion, only $1.2 billion is invested in projects with China's Longfor and in terms of the overall portfolio, investments in China's commercial real estate market are small and still insignificant.

This is a good thing because CPPIB is a very long-term investor and will be able to capitalize on the inevitable dislocations that will happen in China's real estate market over the next 50+ years to build a nice portfolio of real estate assets there.

Am I bullish on China and emerging markets right now? Not particularly, I see a significant slowdown ahead but this is irrelevant for a long-term investor like CPPIB which is buying and holding these private market assets for longer than a cycle, in some cases decades.

Let me end by stating once more that the key for Canada's large pensions when it comes to investing in private markets is to find the right partners. This is especially true when investing in China where the right partners play a bigger role in terms of a deal's success.

Below, from Davos last week, Mark Machin, president and chief executive officer of Canada Pension Plan Investment Board, discusses asset-price returns, inflation and emerging markets. He speaks with Bloomberg's Erik Schatzker at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

This is an excellent interview where Mark explains CPPIB's long-term strategy for investing in public and private markets in emerging markets. He also explains CPPIB's massive hedge fund portfolio and how they see things in terms of active versus passive investments and why they will look at Blackstone's new multi-billion infrastructure fund but prefer going direct in this asset class.

Update: Speaking of Blackstone, on Wednesday, CPPIB announced a partnership agreement with Blackstone, GIC and Thomson Reuters (TSX / NYSE: TRI) for Thomson Reuters’ Financial & Risk (F&R) business: 
Under the partnership agreement, the Blackstone-led consortium will own 55 percent of the equity in a new corporation created to hold the F&R business and Thomson Reuters will retain a 45 percent equity stake, at an overall valuation of US$20 billion

Thomson Reuters F&R is a world-leading data and financial technology platform that provides critical information and data analytics, enables financial transactions, and connects communities of trading, investment, financial and corporate professionals. It also provides leading regulatory and risk management solutions to help customers anticipate and manage risk and compliance.

Martin Brand, a Senior Managing Director at Blackstone, said: “We are excited to partner with Thomson Reuters – one of the most trusted companies in financial technology. The F&R division has tremendous assets, including a world-leading data business, essential risk and compliance solutions, OTC trading venues, wealth management software, and a strong desktop business. The partnership with Blackstone provides an opportunity to increase efficiency and accelerate revenue growth through innovation and focus on creating uniquely compelling products for F&R’s customers.”

Joe Baratta, Blackstone's Global Head of Private Equity, said: “We are delighted to partner with Thomson Reuters in continuing to grow the Financial and Risk business. This is a landmark transaction for Blackstone and our investment partners.”

Ryan Selwood, Managing Director & Head of Direct Private Equity, CPPIB, said: “This investment in F&R will broaden our portfolio in the growing financial technology space. We are very pleased to support the evolution of a global market leader.”

Choo Yong Cheen, Chief Investment Officer of Private Equity at GIC, said: “As a long-term value investor, we believe this business transformation will enable F&R to focus on its core customer base and be in a strong position to continue delivering innovative products to the market.”

Reuters News will continue to remain a part of Thomson Reuters and will not be included in the assets being acquired. The new F&R will enter into a 30-year contract for the exclusive rights to distribute Reuters News through all F&R products. Reuters News will continue to have complete editorial independence from F&R and Thomson Reuters, as it does today.
This is another great co-investment for CPPIB and GIC using Blackstone, a trusted partner that has delivered outstanding returns for both funds.

Monday, January 29, 2018

How Scary Is The Bond Market?

Brian Romanchuk of the Bond Economics blog posted a comment over the weekend, Bond Bear Market Scare Stories (added emphasis is mine):
Whenever there is an uptick in bond yields, scare stories about a coming secular bond bear market are not far behind. The problem with most of these stories is that they are not particularly compelling, and different people have been invoking variations of them for decades. Instead, if you want to come up with a much scarier bond bear market scenario, we need to drop some analytical assumptions, and think through the implications.

The Lame Scare Stories

Each commentator comes up with a different spin on why the Treasury market is about to collapse, and what the implications are. I cannot hope to cover them all. However, there are a few basic stories that quite often appear. Unfortunately, if we want to translate them to a (highly dated) pop cultural reference, they are about as scary as Dr. Tongue's Evil House of Pancakes.

Since I am only summarily dismissing these arguments, I will not waste the reader's time by trying to relate them to particular analyses.

The first (and most common) scare story is about rising inflation. (Admittedly, I always throw in a disclaimer about this scenario when discussing long-term prospects.) The problem is that we almost have three decades of stable inflation (since the early 1990s) in the developed countries. This period also included two oil price spikes, which did not translate into higher inflation. (In fact, they preceded recessions that led to lower inflation.) Meanwhile, commentators have been calling for an inflationary accident throughout that entire period. It is clear that we need some form of structural change to help sustain higher inflation.

The second scare story revolves around foreign central banks suddenly dumping Treasurys. These stories fall apart when we realise that even foreign central banks do not want to vapourise their capital. Furthermore, one needs to explain how the flows that lead to this liquidation will be sustained. Selling Treasurys implies a falling U.S. dollar -- making other countries exporters less competitive. Why exactly do these central banks want to sabotage their existing trade policy? Although it is possible to think of scenarios justifying such an outcome, there are a lot of moving parts in the stories that can break down.

The last set of stories are in the "who will buy the bonds?" category. Since monetary flows are circular, these stories never work.

The Scary Bond Bear Market Story

All we need to come up with a good bond bear market scare story is to examine common analytical assumptions. If we amend these assumptions, we have a story that is possibly as scary as the cinematic classic, The Bloodsucking Monkeys of West Mifflin, Pensylvania.

In the financial markets, it would be safe to say that it would be easy to find commentators that will endorse both of the following scenarios:
  1. If the central bank hikes interest rates, it will tend to depress growth, and hence inflation. (The exact transmission mechanism varies based on economic views.)
  2. If government debt gets "too large," bond yields rise, and then there is a fiscal meltdown scenario (leading to hyperinflation if the commentator in question likes invoking hyperinflation).
The interesting part of these two views is that they are contradictory: the first implies that rising bond yields suppresses inflation, whereas the second implies that they raise inflation. This is not a bug, it is a feature. Financial market commentators need to jump back and forth between bulls and bears rapidly, and need to have strong opinions regardless of what side of the market they are on. Embracing contradictory concepts means that they have a story to justify whatever their current view is.

In order to generate a more plausible secular bond bear market story, we need to dig into these contradictory views. One of the advantages of Modern Monetary Theory (MMT) is that the theory has dug into these assumptions, as opposed to conventional economics, where the first view (interest rates reduce inflation) is assumed to be true, and there is no questioning of that assumption.

All we need to do is to question the efficacy of rising interest rates to slow economic growth. (It should be noted that Warren Mosler has pushed the following logic the hardest; it may not represent the consensus of all MMT economists. What I am writing here is a paraphrase of Warren Mosler's statements over the years.)

If the policy rate rises, bond yields will also rise. This will imply a greater interest outlay by the government (on a lagged basis), as a considerable part of government debt is relatively short maturity. Furthermore, it raises the interest costs for the business sector, which is a net borrower. Conversely, the household sector is a net saver, and a lot of household borrowing is in the form of mortgages, which are largely fixed in the United States. (Other countries do not have 30-year fixed mortgages, so the interest cost adjusts more rapidly.)

If the household sector has a relatively stable propensity to consume out of interest income, the net result of rising interest rates is to increase household consumption. Rising consumption raises capacity utilisation, and that will likely be more important than the effect of interest rates on investment decisions. The bottom line is that rising interest rates may end up stimulating the economy, for reasons that are similar to the second story above.

However, the key is that this effect is relatively weak. The business cycle is not greatly affected by interest rates (absent the key possibility where a real estate bubble is crushed by higher interest rates).

If policy rates are not particularly potent tool, their precise level is an arbitrary decision of the central bank. This is completely unlike mainstream theory, where the economy spirals to hyper-inflation or hyper-deflation if interest rates are not automatically adjusted to achieve price stability.

In other words, the natural real rate of interest is a chimera. If the central bank thinks the real natural rate of interest is 2%, observed real rates should average 2% across the cycle. If it thinks the natural rate is 3%, the average will be higher -- with no observable difference in outcomes.

If we accept these premises, generating a self-reinforcing bond bear market is straightforward. A change in personnel at the central bank can result in a change to the central bank's reaction function; it could effectively target a higher natural rate of interest. Rising interest rates raise interest income, raising nominal demand. The resulting higher inflation will cause the more-hawkish central bank to keep hiking interest rates.

The only thing that stops this "doom loop" is the tendency of financial markets to blow themselves up. So long as the central bank does not get too aggressive, there is little reason for rate hikes to derail growth. Demand is rising, and although there are pockets of nuttiness in risk markets, private borrowing has been tepid so far this cycle.

In summary, all we need for a secular bond bear market is for Fed policymakers to stop panicking at the first whiff of a slowdown, and to resume rate hikes more rapidly after a recession. Once the pattern of cutting more in a downturn than during the expansion is broken, interest rates will be able to once again take an upward trend.

Is This Plausible?

Although this scare story is more plausible than others, there are still weak links.

Firstly, private sector balance sheets are heavily encumbered with debt. Unless wage growth is quite strong, debt service concerns will limit how far rates can rise. That said, a secular bond bear market would take place over at least a decade (by definition), and so there will be time to adjust.

Secondly, the tendency for the Bank of Japan to keep rates near zero acts an attractor for developed country interest rates. Hiking rates back to 5% again (for example) would create a huge carry differential, and risk pushing the yen to deeply undervalued status.

Concluding Remarks

I am certainly not calling for a secular bond bear market. That said, a change in the Fed's reaction function as a result of changing personnel poses an obvious risk to be monitored.
I enjoy reading Brian's comment because unlike others, it offers some much-needed balance and places these scary bond market stories in the right context.

For example, if you read this article on why it's time to exit Treasuries you'd think there's a run on the US dollar and Treasuries are cooked. This falls under what Brian calls Dr. Tongue's Evil House of Pancakes.

Every day US long bond yields rise, people get very nervous, following the action tick by tick:

Of course, the bond market matters. It's a lot bigger than the stock market and when rates start rising, investors get very nervous because a backup in yields, if significant, can clobber all risk assets.

Put another way, every asset class with risk is priced relative to the risk-free bond rate so when yields rise, it tends to make these assets less attractive relative to bonds.

Brian makes a good point that a change to the central bank's reaction function could effectively target a higher natural rate of interest but it's unclear that such a change will occur and more importantly, that any change in the reaction function targetting higher rates can be sustained.

Let's say the new Fed Chair, Jerome Powell, decides to raise rates by more than what the market is anticipating at a time when global PMIs are weakening. What will happen? The yield curve will invert and long-term deflationary headwinds will intensify.

There's simply too much debt, especially consumer debt, for the economy to withstand a pronounced and prolonged rise in rates.

What about Ray Dalio's story of "beautiful deleveraging"? I don't see it. US credit card debt just hit a record high as the average American has a credit card balance of $6,375, up nearly 3 percent from last year.

In fact, total credit card debt has reached its highest point ever, surpassing $1 trillion in 2017, according to a separate report by the Federal Reserve.

This is why I find a lot of holes in Dalio's assertion that a bear market in bonds is upon us. For someone who understands the bottom 60% is hurting, he makes these claims that just don't hold up.

My other issue is he doesn't understand his pension clients. If he did, he'd realize they're jumping on US long bonds to immunize their portfolios as long bond yields rise. Pensions have long-dated liabilities, as stocks soar and rates rise, they will rebalance and buy more long bonds to match their long-dated liabilities.

This was a point that Pimco's Ed Devlin made on BNN's Weekly with Andrew McCreath. You can watch Part 1 of this interview here and Part 2 here. I don't agree with everything Devlin states but he gets pensions. (You can also watch BNN Weekly here).

Anyway, you know my thoughts on the 2018 Treasury bear market, I think it's silly to forecast a sustained rise in US long bond yields. It just can't happen, the US and world economy aren't capable of withstanding such increases in US long bond yields.

This is why I keep telling you to use the recent backup in yields/ decline in prices to buy more US long bonds (TLT) here and hedge against downside risks of stocks:

Can the yield on the 10-year Treasury note hit 3% and prices fall further? Sure it can but the more people anticipate the magical 3% number, the less confident I am that we will see it.

Either way, the backup in long bond yields is starting to hit stocks and we are getting close to a point where equities can see a meaningful pullback if they keep rising:

Nonetheless, it's too early to tell whether the big pullback in stocks is upon us. The danger of irrational complacency still reigns supreme so don't get overly nervous if US long bond yields keep rising and stocks sell off after posting solid monthly gains.

The critical point I want to make is to take all these scary bond market stories with a shaker of salt. There is no bear market in bonds, none whatsoever, and any suggestion that there is and things will get worse simply isn't based in reality.

With global PMIs slowing and starting to decline, you will see a lot of bids for US Treasuries and the US dollar in the months ahead (yes, the two can rally concurently). The thing to watch for is whether the reversal will be slow and orderly or abrupt and harsh, like when markets crash.

I'm not worried about any crash but I am worried about irrational complacency and overly euphoric investors extrapolating recent gains in stocks well into the future.

I leave you with some final thoughts on bonds. An astute investor shared this tweet from Alex Gurevich, CIO of HonTe Investments with me:

This investor shared his thoughts with me:
Alex Gurevich recently posed the following question on Twitter: “Is it possible that corporate tax cut may prove disinflationary, as it will allow for more price competition and investment in productivity?”

It’s a fascinating question to me, because the disinflationary effect of zombie companies should be the same regardless of how they are kept alive, be it ultra-low interest rates, fiscal injections like TARP or slashing taxes?

If a competition to slash corporate tax rates spreads globally, as some have suggested it will, perhaps you’ll be adding corporate tax cuts to your list of deflationary forces.
Another sharp hedge fund manager shared this with me earlier today:

US 10yr Nominal Yield + 10yr Term Premium = 2.189% (as of JAN 25 close)

It will be time to own USTreasury duration shortly; upper channel within ~50bps.

With the 10-year yield now trading at 2.72%, the 10-year term premium is negative, which leads this hedge fund manager to state the following:
2.189 projection is where I would look to position long, for a trade.

Yes, term premium is negative which is lunacy.

So, if term premium does not adjust north, 10yr ~3.20% is where we look to position.
So, he expects the 10-year yield to marginally overshoot 3% but as I stated above, it's not a given that we will see 3%+ in the 10-year yield.

Also, since everyone likes drawing historical charts of the US 10-year bond yield, a nice tweet from Cullen Roche:

Lastly, take the time to read a comment from Cam Hui of Pennock Idea Hub, The Pain Trade Signals From the Bond Market, where he explains why they feel the bond market is poised for a rally.

I particularly like the two charts below from Cam's comment (click on images):

Below, Wells Fargo's head of interest rate strategy, Michael Schumacher, warns a fire sale by the Treasury could send shock waves through the bond market. More scary bond market stories I would ignore.

Also, Erik Townsend welcomes Artemis Capital's Chris Cole to MacroVoices to discuss volatility and the alchemy of risk. The interview begins at roughly 12:30. Erik and Chris discuss:
  • Risks in share buybacks
  • Defining the short volatility trade
  • Explicit vs implicit short vol positions
  • Risk parity, VAR control, Risk Premia and CTAs
  • Considerations on the unwind of the short VIX trade
  • History of correlations on stocks and bonds
  • The scenario where we can have another 1987 market drop again
  • Consideration on the growing trend to passive investing
  • Potential catalysis for market triggers
The supporting slides to this discussion are found here and there is more background material here.

Cole states: "Leading up to the 1987 crash, 2% of the market comprised of portfolio insurance. Today, anywhere between 6% to 10% of the market comprises of these implicit and explicit short volatility strategies, and this should be concerning."

Listening to Mr. Cole, he's obviously a smart fellow talking up his book and likely doesn't see any value in hedging your portfolio using US long bonds. Unfortunately, he must be underperforming in this environment of irrational complacency eagerly waiting for something to crack.

Still, if you want to worry about something, worry about the proliferation of implicit and explicit short vol strategies over the last decade and how things can unravel very quickly if something goes wrong (Note: His thesis assumes central banks will not or cannot save the day, a very big assumption!).

And if things unravel fast, there's no doubt Chris Cole and other hedge funds designed to hedge against disaster will perform well but bonds will help save your portfolio from catastrophic losses (without hedge fund fees). Hedge accordingly and ignore scary bond market stories.

Friday, January 26, 2018

The Danger of Irrational Complacency?

Jeff Cox of CNBC reports, An indicator with a perfect track record just sent a 'powerful' sell signal:
The relentless gush of cash into the stock market is sending a powerful "sell" signal, according to a Bank of America Merrill Lynch gauge that has been a reliable indicator in the past.

Investors poured $33.2 billion into stock-based funds through the week ended Wednesday, BofAML said in a report. That's a record both for total flows and as well as for active funds, which alone pulled in $12.2 billion.

By comparison, equity funds across all classes took in a net $278 billion for all of 2017, according to Morningstar, meaning that last week alone equated to 12 percent of flows for the entire previous year.

The week continued a trend that has seen money rush into stocks as major averages climb to new records. The Dow Jones industrial average is up 7 percent year to date.

While the inflows have helped push the market higher, they also can be seen as a contrary indicator when they flash signs of excess. BofAML uses a proprietary "Bull & Bear" indicator that gauges when inflows or outflows point to investors moving too far to either side.

The current reading on the indicator of 7.9 is the most bullish since a reading above 8 in March 2013 — a sell signal. Michael Hartnett, BofAML's chief investment strategist, said the Bull & Bear indicator has shown 11 previous sell signals since the firm started tracking it in 2002 and has been correct each time.

In the near term, around February and March, that suggests a technical pullback for the S&P 500 to 2,686, which would represent a drop of close to 6 percent, Hartnett said.

The enthusiasm has not been unique to the U.S., whose equity markets brought in $7 billion of fresh cash.

Emerging markets attracted $8.1 billion in new flows, Europe brought in $4.6 billion and Japan saw $3.4 billion. That comes as 98 percent of global markets are trading above their 50- and 200-day moving averages, both classic signs of overbought markets.

Stock-based funds overall have brought in just shy of $77 billion in 2018, with the lion's share of $59.2 billion going to passively focused exchange-traded funds.

However, investors continue to hedge, giving about $32 billion to bonds, while last week's $1.5 billion flow into gold funds was the highest in 50 weeks.
Zero Hedge provides charts from this Bank of America report here. Below, you can view the main ones (click on images):

So what should we conclude from this report? Honestly, not much, it just confirms what I warned of back in November, namely, euphoria is creeping into markets (no thanks to central banks actively buying equities) which is why the masses are chasing stocks higher and higher, plowing money into active equity funds and passive ETFs as stocks keep making record highs.

Go back to carefully read my last comment on Ray Dalio's macro outlook where I went over important macro concepts before stating the following:
The conspiracy theorist in me says the US Treasury Secretary is doing his part in talking down the US dollar to raise inflation expectations and prevent global deflation from reaching the US. [Update: Mnuchin clarified his comments on Friday, stating a strong dollar is in the best interests of the US.]

Will it work? In the short run, yes, but longer term it might create an even bigger problem. Why? Quite simply, the depreciation in the US dollar means the appreciation of the euro and yen, and exacerbates deflationary pressures in these regions. If deflation rears its ugly head back in Europe, Japan and elsewhere, it then heightens the risks that deflation will be exported to the US.

Right now, nobody sees this. "Global synchronized growth" rules the day, everyone is excited about the great market melt-up of 2008, and companies like Caterpillar (CAT) and Boeing (BA) leveraged to global growth are seeing their shares rise to record levels, lifting the Dow to record levels.

Good times!! Just buy more stocks! Nothing can stop this bull market! Even Ray Dalio says there's a market surge ahead and "if you're holding cash, you're going to feel pretty stupid.”

He might be right on stocks, after all, just look at this 5-year weekly chart below of the S&P 500 (SPY) and tell me who in their right mind wouldn’t want to buy more stocks (click on image):

As you can see, the S&P 500 broke out in the fall of 2017 on the weekly chart and hasn't fallen below its 10-week moving average. If this isn't momentum trading at its finest, I don't know what is.

And here we are talking about an index of 500 large companies, not a high-flier stock like Intuitive Surgical (ISRG) which keeps making new highs (click on image):

I'm astounded at people who come on television and keep repeating the mantra, buy stocks, sell bonds, stocks are overbought but they will melt up to the moon!!

I'm not saying this melt-up can't continue, it most certainly can, but as stocks keep making record highs, downside risks are rising even faster.

Earlier this week, Yves Martin, a former colleague of mine from the Caisse who ran his own commodity fund, gave me this update on the market melt-up (he was quoting someone):
"The largest melt-up occurred in 1929 when the Dow rallied 29.9% in 94 days. The current rally - which I believe is in a melt-up - has lasted 95 days and is up 21%."
Of course, history doesn't repeat itself, it's possible that this QE/ central bank engineered melt-up lasts longer, but people tend to get way ahead of themselves when they see stocks making record highs and many extrapolate recent good performance well into the future.

On the flip side, bonds are bad! Who in their right mind would want to buy US long bonds (TLT) when the Dow (DIA), S&P 500 (SPY) and Nasdaq (QQQ) keep making record highs?

Even Ray Dalio appeared on Bloomberg yesterday stating bonds face their biggest bear market in 40 years, echoing what Jeffrey Gundlach and Bill Gross have been warning of.

As you are well aware by reading my comments, I don't buy this nonsense on the 2018 Treasury bond bear market and neither should you.

I've had market disagreements with Ray Dalio privately when we met back in 2004. I don't care if he manages the world's largest, most successful hedge fund, I'm firmly in the camp that believes there is no bond bear market, only a temporary backup in yields due to a temporary rise in US inflation.

Importantly, I can't tell you whether the yield on the 10-year Treasury note will hit 3% in the next three months but if my Outlook 2018 is right, the yield will be below 2% by yearend, which is why I've been telling investors to buy US long bonds (TLT) as yields back up and prices fall (click on image):

Remember, bonds aren't going to make you rich but they're going to save your portfolio from a serious drawdown when risk assets get clobbered.
I still fundamentally believe that in this environment, US long bonds remain the ultimate diversifier and investors chasing stocks would be wise to hedge for increasing downside risks.

I understand, every day you open your screen, the Dow is up another 100+ points, making fresh record highs, and the same goes for the S&P 500 and the Nasdaq, they too are on fire, soaring to record highs. Why bother with bonds when momentum is clearly in stocks?

There is no easy answer to this question except nobody can predict the future and if something goes wrong, you don't want to be caught like the proverbial deer staring at headlights.

I personally would like to see the S&P 500 pull back to its 50-week moving average. Guess what? The market doesn't care about what I'd like to see or what Ray Dalio, George Soros or anyone else wants or thinks.

Are markets overbought and over-extended? Yes but we're not living in normal times. Importantly, unlike 1929, global central banks are actively backstopping equities which makes all historical comparisons useless.

But it also creates an atmosphere of irrational complacency which is why Alberto Gallo, portfolio manager and partner at the London-based asset manager Algebris Investments, doubts that central banks can normalize their policy without causing a correction:
Mr. Gallo, the world economy is expanding synchronously and volatility is at record lows. Are financial markets poised for another strong year?
Investors are very complacent, but I think it’s an irrational complacency. The market is pricing in that earnings will keep rising, volatility will stay low and central banks continue to support growth without generating inflation. The party can go on for while, but there are more and more reasons to be cautious.

What are the main reasons to be cautious, and what has changed in the last months?
Central banks are moving closer to the point where they will have to normalize interest rates. And rates might rise faster than the market is pricing in. This and next year some of the ECB board member will leave. And the new board will definitely not be as dovish as the current one.

Inflation is still very low. Doesn’t this mean that monetary policy can remain accommodative?
Inflation has been elusive 2017 but could actually re-appear this year. There are several forces that could push inflation higher. Fiscal policy in the US and in Europe is loosening with Trump’s tax programme and a probable great coalition in Germany which could result in higher government spending. And China, the big engine of global disinflation from 2012 to 2016, is now exporting inflation as prices continue to increase and the renminbi is strengthening. Last but not least, there is inflationary pressure coming from rising commodity prices.

But why should we worry? The Fed has raised rates five times and nothing happened.
This kind of complacency is actually another reason to be cautious. There is the belief that central banks will manage the transition without bumps. Over the last two years, stocks went up and credit spreads shrunk when interest rates and government bond yields rose. But this correlation is not stable. The risk is that central banks lose control over the markets. Think of the taper tantrum back in 2013 when the Fed mentioned a possible reduction of its QE-pogramme and markets were freaking out.

Haven’t the central banks learned from that experience?
There is this widespread belief that they have and that they are a lot more cautious in communicating today. It’s a dangerous assumption and it’s a reason why there has been more risk taking in the market.

Where is this risk-taking most visible?
People are selling volatility and basically betting that tomorrow will be as calm as today. We estimate that there are over $2 trillion in these kinds of short volatility strategies.

Why is this problematic?
We have to put this number into context. At the bottom, you have $20 trillion in central bank balance sheets. Then you have $8 trillion worth of negative yielding bonds and $5 to $6 trillion non-investment grade bonds that trade at a yield of close to 2%. And then you have the $2 trillion in short volatility strategies. These strategies are just the top of the pyramid.

Is this the likely source of the next financial crisis?
I am not forecasting a financial crisis but the risks are increasing. The risks have shifted from the banks to the capital markets and the nature of leverage has changed. Back in 2007 investors were highly leveraged in credit products. Now they are leveraged to short volatility.

What about investor sentiment?
Investors are very bullish and become even more bullish with every day. For example, a year ago, there was still a lot of skepticism about the recovery in the eurozone, but now more people are positive, even on weaker economies such as Italy and Greece. That’s positive for these markets, but overall it’s another reason to be more cautious.

When everybody is positive and the market is going up in a straight line you do not even need a catalyst to cause a correction.

A market correction is one thing to be prepared for. But what about the risk of an economic downturn or a recession?
In the near term, I am worried about the high valuations and the belief that central banks will manage to gradually scale back without bumps. This makes a major correction very likely. A recession, however, is not in the cards over the next 12 months.

What are the medium and long-term risks?
The recent policies, such as Trump’s tax programme, increase the degree of inequality and that can cause the political system to polarize further – and populism to rise. The Brexit vote and the election of Donald Trump were just the beginning. With rising inequality there will be more anti-capitalist, protectionist and anti-free market policies.

Is the situation in the US and the UK worse than in continental Europe?

In the US and in the UK, the polarization has already intensified not least because inequality has risen faster. The UK is probably the most divided country where we are invested in. In the eurozone, the populists are not yet very strong and we have relative stability. But we are worried that in the next downturn the political landscape will get more polarized and populism will be on the rise if reforms are not implemented.

Italy is going to have general elections this year. What outcome do you expect?
For the financial markets, the Italian election is a non-event, luckily, but unluckily for the Italian people. Because the most probable outcome is a fragmented government and that would mean a lack of reforms on a three-year-horizon and no solution to the problem of low productivity growth.

What does all this mean for the positioning in your portfolios?
We are more cautious than a year ago. We hold more cash and have reduced our overall credit risk. We see more upside in equities than in credit, but overall we have reduced risks in our portfolios.

How painful are rising rates for the bond market?
The normalization of the central bank policies is going to hurt most fixed income assets except subordinated bank debt, Greece and Italy, which need higher inflation to pay their debt. That’s why we see more upside in equities.

Which equity markets do you prefer?
Within equities, we like emerging markets as we expect a weaker dollar. The most interesting sectors are energy and financials.

Where do you see opportunities in fixed income?

The overall market offers less value than a year ago. We like Europe but are underweight the US. American high yield bonds for example will particularly suffer when the tide of central bank liquidity turns. In Europe, we are two years behind in the credit cycle compared to the US and now the balance sheets of corporates are becoming healthier. We also see value in some sovereign bond issuers that are still perceived as too risky, like for example Greece.
Greek bonds?!? Believe it or not, Greek bond yields hit record lows this week:
Short-dated Greek bond yields hit record lows in Tuesday’s trading.

Two and five-year bonds yields in Greece, which received its first ratings upgrade from Standard & Poor’s in two years on Friday, hit record lows at 1.21 percent and 2.73 percent respectively.

“Concerns about Italy have died down, we’ve had the Spain upgrade, good news on Greece as well as a quite good economic environment, which is something that benefits the periphery,” said DZ Bank strategist Daniel Lenz.

Eurozone finance ministers welcomed Greek progress in delivering reforms but said on Monday they would only disburse the next tranche of loans once all agreed actions are complete.
All this good news out of the eurozone has driven the euro to a three-year high versus the US dollar:

Now, if I told you a year ago to go long the euro following the Brexit vote knowing all the political and economic problems in the periphery, you'd think I'm nuts.

What's even more impressive? Despite the significant appreciation in the euro, European shares have been on fire since bottoming in November 2016. Have a look at the 5-year weekly chart of the Vanguard FTSE Europe ETF (VGK):

So, getting back to irrational complacency and Mr. Gallo's comments, I find it hard for him to say on one hand he's worried about central banks normalizing rates quickly, especially if the ECB elects a more hawkish board, and then recommending emerging market (EEM) and European (VGK) shares.

In fact, the appreciation of emerging market currencies and the euro relative to the US dollar tell me there's trouble ahead for risk assets in these regions, so it's best to maintain a US bias in equities.

I found Gallo's comments interesting but confusing and lacking coherence:
  • He rightly notes there is a lot of complacency in the markets as witnessed by the ongoing silence of the VIX and silence of the bears
  • He then notes inflation might rear its ugly head in 2018, failing to explain this is cyclical (short-term) inflation due to the weaker US dollar pushing up commodity prices, not structural (long-term) inflation due to sustainable wage gains. He alludes to rising commodity prices, Trump's tax cuts and adds: "China, the big engine of global disinflation from 2012 to 2016, is now exporting inflation as prices continue to increase and the renminbi is strengthening." Really? This is news to me. How can the renmibi have appreciated if it's pegged to the US dollar which is declining? Also, I agree with those who say China is not booming, pointing to the slowdown in fixed asset investment. The mere thought of China "exporting inflation" is preposterous, I worry that this time next year, China's deflation demons will come back to haunt the global economy. Then again, Chen Zhao and the folks at Alpine Global are bullish on China, commodities and commodity currencies, stating the 2018 consensus is wrong (read their latest weekly comment on "What Would Charles Kindleberger Say?").
  • As far as the Fed and central banks normalizing too fast, and the market not pricing this in, this is the same argument Ray Dalio made this week. Admittedly, it is a fear of mine too as central banks might erroneously overreact to cyclical inflation pressures (due to a declining US dollar) but I had an interesting discussion with a currency trader earlier today who told me the Fed and other central banks have become a lot more forward-looking in the last few years, telegraphing their every move as to not catch markets off-guard. According to him, the risk of the Fed or other central banks hiking rates by a lot more than what is priced in is way overdone. Also, he told me: "Central banks won't backstop currencies but they are actively backstopping equities and will react swiftly if stocks start plunging."
  • Gallo does strike a cautious tone, in line with my Outlook 2018: Return to Stability, but he repeats the mistakes of bond bears who believe the Treasury bond bear market is just beginning and recommends energy (XLE), financials (XLF), emerging market (EEM) and European (VGK) shares. I would take profits and underweight all these sectors as global PMIs turn south in the first half of the year.
Interestingly, in my discussion with the currency trader earlier today, he told me that repatriation of US foreign profits (which will get a boost now from the weak US dollar) "will lead to more share buybacks and fixed investment and once the Trump administration announces the trillion dollar (or more) infrastructure program, it will boost the economy for another couple of years". He added: "US workers are going to receive an extra $1000 on average from tax cuts but they're going to blow it or pay down their debt."

He doesn't see rates going up too high (another 100 basis points max on the Fed funds and the 10-year Treasury yield between 3-3.5%) but worries that after the 2020 US elections, "we're going to be in for a long tough slug ahead because there will be a lot more debt and a lot less stimulus."

As far as stocks, he only holds ETFs like the S&P 500 (SPY) and the S&P/ TSX 60 (XIU.TO) as he's Canadian and he personally doesn't like picking stocks. However, he agreed with me that Starbucks (SBUX) is a great company and one stock he might buy and own for the long run given its recent weakness (click on image):

[Note: I'm not recommending individual stocks but you can follow me on Stocktwits. Importantly, do your own due diligence and most of you should be buying stock and bond ETFs and sleeping well at night without the stress of picking the right stock. If you're looking for a low-volatility ETF with low fees, do some research on the Vanguard Global Minimum Volatility ETF (VVO.TO). It's not very liquid but it's worth looking into.]

I'll leave you with some more food for thought. First, a tweet from David Rosenberg that caught my attention earlier today:

Also, as far as the US tax cuts, I agree with the folks at the Economic Cycle Research Institute (ECRI), Trump's Tax Cuts Won't Offset the Impending Slowdown:
Market-oriented economies such as the U.S. are inherently cyclical, and there are warnings of a cyclical slowdown in 2018. Yet this view is at odds with the increasingly optimistic consensus that economic momentum, turbocharged by President Donald Trump's tax cuts, will sustain the upswing throughout the year.

The notion that momentum propels economic expansion -- and is therefore a good way to forecast growth -- is often valid away from cycle turning points. This is why extrapolating recent trends is a popular basis for forecasting growth. The exception, by definition, is at cyclical turning points, when momentum reverses. This is when gross domestic product consensus forecasts systematically exhibit their largest errors.

Good leading indexes are designed to signal when the risk of a turning point is high, or when some of the biggest GDP forecast errors are likely. Lately, growth in the Economic Cycle Research Institute's U.S. Short Leading Index, which we recently highlighted, has been "pointing to a U.S. growth rate cycle downturn." Prospects for a slowdown have not changed despite an even more upbeat consensus. In turn, this optimism has supported a record-breaking rise in stock prices to start the year.

The cheerful sentiment is driven by expectations the tax cuts will provide a lift not only to profits, but also to economic growth. But business investment growth in the year after tax cuts has actually been shrinking since the 1960s; President George W. Bush’s tax cut was followed by less growth than occurred after President Ronald Reagan's tax cut, and even less than after those signed into law by President Lyndon Johnson. In any case, most estimates of the boost to overall growth from the Trump tax cuts in 2018 are in the range of some fraction of 1 percent of GDP.

Nevertheless, virtually everyone, including ECRI, agrees that the tax cuts will provide at least some economic boost, following the cyclical upturn during which year-over-year GDP growth probably doubled by the end of 2017 from the three-year low of 1.25 percent in mid-2016. The question is if tax cuts can offset the cyclical slowdown that is likely to follow.

Since the last recession, the U.S. has had three cyclical slowdowns, in 2010-11, 2012-13, and 2015-16. As the chart shows, those downturns typically reduced year-over-year GDP growth by a couple of percentage points.

The point is that such slowdowns tend to cut GDP growth by quite a bit more than the expected gain from the tax cut.

Looking elsewhere, could the synchronized upturn in global growth help sustain U.S. growth momentum? In theory, yes, but ECRI's international leading indicators also point to slowing growth ahead.

In fact, the growth rate of ECRI's international long leading index -- which, a year ago, correctly proclaimed the "brightest global growth outlook since 2010" -- has turned down, delivering a clear message. Cyclical forces are in no position to sustain the synchronized global growth upturn that has gone on for more than a year.

Not that global growth has been providing a major tailwind for U.S. growth. Even with synchronized global growth in full swing in 2017, U.S. net imports of non-petroleum goods over the past 12 months were larger than ever.

Despite hopes that economic growth momentum from 2017 can be sustained through 2018, a slowdown is likely to take hold this year. Perhaps this is part of the message from bond market yield spreads. And even as tax cuts support growth, they will, at best, mitigate that slowdown -- a far cry from current expectations.
Now, I like the folks at ECRI but a lot of the material posted above I've already read a few months ago by reading François Trahan's comments at Cornerstone Macro. In fact, I'm pretty sure I saw that first chart in his research or something very similar.

Regardless, the point is the same. US tax cuts won't stop the impending slowdown and those of you who want to position your portfolio accordingly should take the time to read my Outlook 2018: Return to Stability to understand why Risk Off markets will dominate the second half of the year, the shift will be from growth to profitability, and you're better off underweighting cyclical sectors like energy (XLE), financials (XLF), and industrials (XLI) and overweight less cyclical sectors like healthcare (XLV), consumer staples (XLP) and utilities (XLU).

More importantly, the downturn in global PMIs augurs well for US long bonds (TLT) and the US dollar (UUP) so take advantage of the recent backup in US long bond yields (decline in prices) to add more Treasuries to your asset mix.

Hope you enjoyed reading this comment. As always, please remember to kindly donate or subscribe to this blog on the top right-hand side, under my picture and show your support for the work that goes into these comments. My job is to make you think and always ask questions. I thank all of you who value my efforts and support my blog through a monetary contribution.

Below, Davide Serra, chief executive officer and founder at Algebris Investments (where Mr. Gallo works), discusses various markets and his thoughts on investing. He joins Bloomberg's Erik Schatzker on "Bloomberg Markets" at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

Second, Mark Machin, president and chief executive officer of Canada Pension Plan Investment Board, discusses asset-price returns, inflation and emerging markets. He speaks with Bloomberg's Erik Schatzker at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

Third, Michael Sabia, chief executive officer of Caisse de Depot et Placement du Quebec, discusses the outlook for markets, the impact of politics and importance of trade. He joins Bloomberg's Erik Schatzker on "Bloomberg Markets" at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

Lastly, André Bourbonnais, president and CEO of PSP Investments, was in Davos this week. Below, he discusses why "it's very hard to find value" in any of the asset classes. I wish they posted the extended version online but this gives you a sense at what the big institutions are worried about. Watch the interview here if it doesn't load below.

These are all great interviews. As you can see, the CEOs of Canada's largest pension funds aren't suffering from irrational complacency and they're already thinking ahead to the next downturn and how they will weather the storm given that they are investors with a long investment horizon that are continuously invested across public and private markets all over the world.