Monday, August 13, 2018

CPPIB Worried About Inflation?

Jesse Snyder of the National Post reports, CPPIB head says U.S. inflation a potential risk, but threat of overheated economy anything but imminent:
The chief executive of the Canada Pension Plan Investment Board on Friday said U.S. inflation continues to pose a risk to the fund, but added those concerns are tempered by strong economic underpinnings south of the border.

“Am I worried about a market where 40 per cent of our money is invested? Absolutely, it’s our biggest market,” Mark Machin said.

Still, he said that risks to the U.S. economy, which would include a spillover into Canada, are likely not imminent.

“The U.S. has been well supported by economic growth,” Machin said. “It has driven earnings growth. The fundamentals in the U.S. are still incredibly strong, and the question now is: how long can that go on?”

In a written message along with CPPIB’s quarterly earnings that were released Friday, Machin said that “solid performance today cushions the fund for an inevitable future market downturn.”

The U.S. is by far CPPIB’s largest market, with $131 billion invested as of March 31, 2018. Canada is next with $54 billion, or 15 per cent of its portfolio, followed by Europe at $47 billion (13 per cent).

Some economists worry that inflationary pressures in the U.S. threaten to spur a market correction, hastened by President Donald Trump’s hefty stimulus plans and a recent tax reform aimed at encouraging business investment. Higher oil prices have also helped fuel inflation.

Rising wage growth in Canada, which observers say could push inflation higher, compounds those worries at home. A recent Bank of Canada survey found 34 per cent of businesses expected to face a labour shortage in the second half of 2018.

In a recent research note, Desjardins Group analysts said the BoC “will have to monitor this situation closely” as wage growth continues to rise while productivity loses ground, threatening to nudge inflationary pressure upward.

The U.S. Federal Reserve hiked its main interest rate in June for the second time this year, up to two per cent. The Bank of Canada in July raised its benchmark rate to 1.5 per cent.

Some market watchers, however, say the risks of the U.S. overheating are exaggerated, driven mainly by stock market volatility and rapid wage growth in a few select sectors such as oil and gas.

The CPPIB on Friday reported net assets of $366.6 billion for the quarter ended June 30, compared with $356.1 billion at the end of March. It reported net investment returns of 1.8 per cent, largely tied to its private-asset holdings.

In May, CPPIB reported an 11.6-per-cent return on investments during the last fiscal year, but warned that such double-digit growth was not sustainable as competition for assets intensifies.

That competition has been particularly visible for renewable energy assets as private equity floods into the market while previous asset holders shed their positions. That has pushed valuations sharply higher as various governments introduce stringent climate policies and offer incentives to would-be developers.

“It’s been fairly expensive for the last few years around the world, there’s a lot of capital chasing renewables,” Machin said. “We’ve found it difficult to find assets that we wanted.”

Over the quarter, the fund purchased a stake in various onshore renewable assets in North America and offshore wind projects in Germany from Enbridge Inc. for $2.25 billion. CPPIB also purchased 396 megawatts of renewable capacity from its subsidiary, Cordelio Power, for $740 million.

Large investment funds have flocked to renewables as they become increasingly competitive and offer stable returns for investors.

“We’re not going after them because they’re renewables, we’re not filling a bucket of renewables,” Machin said. “We have a view that the energy transition is underway.”
The energy transition is on its way but as I stated in my comment on whether it's time to divest from fossil fuels, this transition will take decades and Mark Machin is right, you still need to be careful investing in renewables because they're the "hot commodity" right now and valuations are being bid up as investors flock to them.

CPPIB recently issued green bonds to expand its growing portfolio of wind farms and other renewable energy, focus on sustainable water and wastewater management, and invest in LEED platinum certified commercial real estate all over the world.

As far as US inflation pressures, I'm not worried. On Friday, I wrote a comment looking at whether stocks will plunge in 2019 and stated the following:
Who cares about Turkey and emerging markets? As long as FANG stocks keep rising, everything is fine. Right?

Well, it's not that simple. A crisis in emerging markets heightens the risk of a global deflationary shock, one that will clobber global risk assets, send the US dollar higher and boost US long bonds (TLT) which haven't done anything all year but seem to be breaking out here (click on image):


And remember, a stronger US dollar means lower oil and commodity prices and lower import prices going forward, so even if you have some cyclical inflation pressures now, it won't be sustained.

This is why when people tell me the bond bear market is just beginning, I ignore them. Sure, President Trump might announce a trillion dollar infrastructure program next year but that will be too little too late. By then, the damage will be done and the global and US economy will be in a recession.

The wildcard here is the Fed because if it ignores developments outside the US and continues raising rates, the yield curve will invert and it will exacerbate the global deflationary crisis.

All this to say, it's very hard to know whether the stock market is entering a destructive phase, I personally think it's premature to conclude this. However, it is time to get defensive and position your portfolio for an eventual slowdown.
Please repeat after me: Inflation is a lagging economic indicator. Period.

When people talk to me about inflation pressures as part of their economic forecasts, I ask them whether they drive their car looking in the rear view miror.

What about the Fed? Doesn't it look at core inflation pressures? Yes, it does and there too there is a danger that the Fed overreacts to cyclical inflation pressures despite the fact that some economists erroneously believe the Fed is "ridiculously behind the curve":



Be careful when you read the Fed is behind the curve, the jobs conundrum continues and unless I see sustainable wage inflation, I certainly don't think the Fed is ridiculously behind the curve.

Also, one big crisis in emerging markets and you will see another global deflationary shock and the Fed will respond by cutting rates back to zero.

Anyway, all this to say I wouldn't read too much into cyclical inflation pressures and unless I see sustainable wage inflation, there are no real inflation risks to worry about.

As far as CPPIB's quarterly release, you can read the details on the press release here.

I note the following from the press release:
The Investment Portfolio achieved 10-year and five-year annualized net nominal returns of 8.0% and 12.3%, respectively, and 1.8% for the quarter. These returns are net of all CPPIB costs (click on image).



“While performance was solid across our investment departments, our private assets did particularly well. Global equity markets maintained positive performance this quarter, contributing to Fund growth,” says Mark Machin, President & Chief Executive Officer, Canada Pension Plan Investment Board (CPPIB). “While we focus on strong average returns stretching well beyond five and 10 years, solid performance today cushions the Fund for an inevitable future market downturn. We are confident that our investment strategy will continue to serve the Fund through multiple economic cycles.”


CPPIB continues to build a portfolio designed to achieve a maximum rate of return at an appropriate risk level, having regard to our exceptionally long investment horizon. Accordingly, long-term results are a more appropriate measure of CPPIB’s investment performance than returns in any given quarter or single fiscal year.
Given its size and long investment horizon, I don't typically cover CPPIB's quaterly results, only the fiscal year (see my coverage of CPPIB's fiscal 2018 results here).

Mark Machin is preparing everyone for the eventual downturn, one that may be around the corner.

This is why CPPIB's diversification across public and private markets is so crucial, it allows the fund to outperform its public market reference portfolio during periods of market dislocations.

Below, Mark Machin, president and CEO of the Canada Pension Plan Investment Board, joins BNN Bloomberg to talk about the Crown corporation's latest quarter. He also weighs in on trade tensions, rising rates, the Canada-Saudi dispute and the Turkey crisis.

Second, Barbara Shecter speaks with Mark on how the CPPIB selects long-term investments and their decision to substantially invest in renewable energy (June 2018).

Lastly, Larry Fink, Chairman & CEO of BlackRock, sits down with Mark Machin to offer his insight on long-term value and differentiated data (June 2018).



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