Pensions' Brave New World?

Chen Zhao, Chief Global Strategist at Alpine Macro sent me their latest weekly comment, Asset Allocation In "A Brave New World":
This week, my colleagues at Alpine Macro and I sat down with a mutual friend who used to manage a large pension fund. We talked about financial markets, portfolio construction and diversification strategies. The big topic was what to do with government bonds. With yields so low, most pension funds are being crunched and are under enormous pressure to increase their risk guidelines.

But in my mind, the key question is what kind of returns can be reasonably expected over the next decade or so from principal asset classes? With interest rates at historical lows and multiples having expanded quickly in the U.S. equity market, returns from traditional assets will likely diminish. As such, asset allocation must be more imaginative and dynamic.
Now, before I begin, Alpine Macro is based here in Montreal and has three BCA Research veterans as its partners: Tony Boeckh, Chen Zhao and David Abramson. My readers can contact Arun Kumar at to get their latest reports, including this one.

Collectively, Chen, Tony, and David have tremendous market experience which is why I call them veterans but in reality, they should be called warriors as they've seen it all.

In fact, my first full-time job after attending McGill University back in 1998 was working at BCA and that is where I learned about global markets by listening to debates between Chen, David, Francis Scotland, Warren Smith, Martin Barnes, Steve Poloz (now Governor of the Bank of Canada), Gerard MacDonell and Mark McClellan (my boss back then).

Tony led BCA from 1968 to 2001 so he rarely debated but sometimes came to listen to those Friday afternoon debates. I loved those debates, sometimes they were boring but other times very lively, especially when the Managing Editors got all riled up and vigorously debated each other.

BCA taught me how to look at the big picture, experience which I subsequently used in my sell-side job working as an economist and buy-side jobs investing in hedge funds, private equity funds and doing research on asset allocation across public and private markets.

In short, I'm a macro guy who loves trading stocks, and this definitely comes out in my comments. I have strong opinions when it comes to where we are heading and I'm not shy to share them (it's not about being right or wrong, it's about having the cojones to express your views and always question them).

Now, getting back to asset allocation in a brave new world. As shown from table 1 below from the report, the projected annualized 10-year returns for equities are highest in Japan, Eurozone, Australia and Emerging Markets and lowest in the US (click on image):

The first thing that struck me was the annual P/E change (P/E expansion) in Japan, which is projected to be 5.6%, well above that of other countries.

The authors note this on Japanese equities:
For Japan, it is multiples expansion that drives the estimated returns for equities. This is consistent with our view that Japan has recently become a value play where equity multiples are significantly lower than where they should be relative to Japan’s current and expected future levels of interest rates. For European equities, dividends and multiples expansion account for about two-thirds of expected returns, while nominal earnings growth explains the remaining third.
As I stated to Chen on LinkedIn, the Bank of Japan owns huge ETF holdings of Japanese equities, a source of concern, and Japanese stock holdings account for over 23 percent of GPIF's assets, another source of concern.

Just how sustainable is this going forward? That all remains to be seen, especially since Japan's long struggle with deflation is far from over.

I can say the same thing about the Eurozone where another false dawn is upon us and many people are overly excited without understanding that structural deflationary headwinds are ensuring anemic growth rates in that region and possibly another euro crisis in the near term.

I'm not going to lie to you, I'm more worried than ever of deflation headed to the US but I still prefer US equities because they tend to outperform global stocks in times of stress (largest, most liquid and most diverse stock market in the world).

Over the long run, I'm long US stocks and bonds and naturally long US dollars which is why I agree with large Canadian pensions that don't hedge F/X risk, over a long period they will come out ahead even if they can get hit in the short run.

This brings me to chart 1 for the Alpine macro report, a summary of return simulations for principal assets (click on image):

As shown above, US stocks (SPY) and high yield bonds (HYG) have the lowest prospective returns among risk assets. I too have concerns with US stocks and junk bonds, but there is so much liquidity in the financial system as central banks go "all in" that it's hard to short these markets.

Given my worries of global deflation, I’m short Chinese (FXI) and emerging market equities (EEM) and bonds (EMB). Because of deflation, I'm also short oil (USO), energy (XLE), metals and mining (XME), industrials (XLI) and financials (XLF) and commodity currencies like the CAD, Kiwi and Aussie and remain long and strong good old boring US bonds (TLT), the ultimate diversifier in these insane markets.

In short, I don't buy the global reflation nonsense which is why I am holding my nose and trading these markets, focusing on some stock specific stories (see December surprise for examples) but feeling just fine recommending US long bonds (TLT) on a risk-adjusted basis to investors looking to sleep well at night.

Interestingly, the Alpine Macro report did discuss return scenarios under the deflation and inflation surprises, which you can see in table 2 below (click on image):

Quite shockingly, the authors conclude higher inflation would result in a worse outcome:
This is primarily because the P/E ratio would be compressed significantly, and the ERP would rise, both undercutting expected returns for stocks. For example, if we assume that steady-state inflation in the U.S. were to rise to 3.5%, with 2.5% steady-state real growth, equilibrium bond yields would be 6%. With the ERP at 200 basis points, the expected total return for U.S. stocks would be 3.2%. After inflation, the real return will be -0.3%.
I say shockingly because for pensions managing assets and liabilities, there is no question that unexpected inflation (which leads to higher rates) is a much better outcome than unexpected deflation.

I guess it all depends on what deflation scenario we're talking about because a prolonged debt deflation scenario I'm worried about will roil assets and make liabilities soar as the yield on the 10-year US Treasury note hits a new secular low. Mild disinflation is fine, prolonged debt deflation is a nightmare.

In any case, I highly recommend you contact Arun Kumar at to get their latest reports:
  • December 1, 2017- Weekly Report: Asset Allocation In A Brave New World
  • November 24, 2017- Weekly Report: A Pause Coming Soon?
  • November 17, 2017- Macro Monthly: Macro Monthly
  • November 10, 2017- Weekly Report: Debt Creation: What is the limit?
  • November 3, 2017– Weekly Report: It's Not Too Late To Go International
  • October 27, 2017– Inaugural Report: Echoes of the 1990s…
Just because I don't agree 100% with their views, doesn't mean I don't learn a lot by reading their thoughts (hell, I question my own views all the time, so don't expect me to agree with anyone a hundred percent of the time).

Again, Tony, Chen, and David are warriors, they've been around a very long time and have seen it all. I wish them a lot of success at Alpine Macro and most of all, hope they're having fun.

Lastly, this weekend I picked up a copy of Satyajit Das's new book, The Age of Stagnation, and highly recommend you all read it. It's an easy read and superb even if I don't agree with all his observations and conclusions.

One thing I can tell you is to prepare for much lower returns ahead. The silence of the bears and VIX will come to an abrupt end which is why from a risk perspective, I keep telling people to increase their exposure to US long bonds (TLT), especially if stocks keep running up as momentum algorithms and central banks keep squeezing shorts higher.

I say this because I worry about a lot of retail investors looking to retire in the next three to five years who are chasing momentum stocks higher and higher without any consideration of the rising macro risks. Markets can stay irrational longer than people think on the upside and downside. Don't risk your retirement future; be cognizant that as markets rise ever higher, so do downside risks.

As for all you millenial young bucks with a long investment horizon, go read William Bernstein's The Intelligent Asset Allocator and The Four Pillars of Investing, but also be cognizant of the rising risks which can negatively impact these markets.

Below, the latest installment of Real Vision's interview series featuring Jim Grant, longtime publisher of Grant's Interest-Rate Observer. The newsletter publisher sits down with Alan Fournier, the billionaire founder of Pennant Capital, who claims "pension funds are so desperate for yield, they're systematically selling vol" (h/t, Zero Hedge).

As a pension expert, I can tell you that Alan Fournier's claim that pension funds are "systemically selling vol" is pure rubbish. The real culprits behind the collapse of vol are central banks looking to remove vol from markets (to kill short sellers and reflate risk assets) and large speculators (ie. big banks) who are selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility (see my comment on the silence of the VIX).