Friday, March 16, 2018

Where To Invest Now?

Jeff Cox of CNBC reports, Investors just pumped the most money ever into stock funds for a single week:
With the market correction barely a month in the rear-view mirror, investors have jumped back into stocks in record numbers.

Stock-focused funds took in $43.3 billion in fresh cash over the past week, a new peak that reverses much of the angst over the past several weeks, according to Bank of America Merrill Lynch.

Resurgent interest in equities came as stock market indexes staged modest gains. The S&P 500 was up about 1.4 percent for the week ended March 14. The Dow industrials were flat during the period.

Investors had pulled $9.4 billion from stock funds the previous week. Bond funds also are looking up, with $2.4 billion of inflows, BofAML reported.

The new money for stock funds amounted to nearly 0.6 percent of total assets, the best since September 2013.

Distribution was widespread, with international funds taking in $53.9 billion and U.S. getting $11.1 billion.

Market sentiment has improved since the major indexes tumbled into correction territory in early February following an inflation scare that generated worries over whether the Federal Reserve would raise interest rates more aggressively than anticipated. A correction is generally defined as a 10 percent or more drop from the most recent high.

Pessimism fell to its lowest level since the first week of 2018, at 21.3 percent a drop of 7.1 percentage points, according to this week's reading from the American Association of Individual Investors Sentiment Survey.

For the year, stock-based ETFs have pulled in $82.7 billion while bond funds have seen $11.7 billion in inflows, according to FactSet.
It was a little over a month ago where I discussed whether it's a correction or something worse. I knew that fears of US wage inflation were overblown and after looking at some weekly charts, I concluded that it looked more like a typical correction that should be bought.

However, hindsight is always a lot easier because I know traders who got scared and sold that correction fearing something worse was ahead, and now they're sitting on losses. Many quantitative hedge funds also took a beating in February.

Most traders don't like buying the big dips (long-term investors like Buffett and pension funds love buying them). Instead, they like buying and trading breakouts, so when markets get hit and volatility spikes, they tend to underperform. That's why a lot of quant funds got clobbered.

So where do we go from here? Sell in April and go away? Tae Kim of CNBC reports that according to Goldman, there's not much upside left for the market here:
With the S&P 500 not far from the firm's 2018 year-end target, Goldman Sachs says there is still an investment strategy that can outperform.

The firm recommended companies with strong prospects for growth at reasonable valuations.

"Secular growth stocks [or] companies with the fastest expected growth offer value relative to history," David Kostin, Goldman's chief U.S. equity strategist, wrote in a report Thursday to clients entitled "Where to Invest Now."

Kostin reiterated his year-end price target of 2,850 for the S&P 500, representing just 3.7 percent upside from Thursday's close.

The strategist screened for companies that grew their sales by 10 percent or more each of the last three years and have strong potential for future growth. He then excluded stocks with high valuation multiples in terms of enterprise value to revenue ratios.

Here are six buy-rated names in the Goldman Sachs "secular growth" stock basket recommended by Kostin.

I would ignore Goldman's secular growth stock basket. Amazon and Google are tech powerhouses but they have been soaring over the last few years. The only Goldman stock recommendation I like  is their upgrade right before the new year on Teva Pharmaceuticals (TEVA) which I bought last quarter after shares plunged.

Teva is one of my core longs (for now) but short sellers have been piling into it ever since Warren Buffett took a position in it last quarter. The stock has sold off recently, part of the "Buffett kiss of death effect" (it happened with IBM, short sellers like shorting Buffett but he's more right than wrong).

But as I explained in my quarterly review of top funds' activity, two other big value investors, David Abrams and Jonathan Jacobson, also owned a huge chunk of Teva shares and they bought before the stock plunged last quarter (Buffett's Berkshire bought the big dip).

I use top funds' activity to gauge where big investors are focusing their attention. For example, looking at the top holdings of David Tepper's Appaloosa, I noticed his fund significantly increased its stake in Micron Technology (MU) last quarter, a bet that paid off hugely this week as shares soared to a new 52-week high:

Now, as I told my followers on my StockTwits account earlier this week, I wouldn't be chasing Micron's stock here, let it fall back to $40 before initiating a new trade. But that's just a potential trade, I'm not bullish on semiconductor shares (SMH) going forward even if they have a beautifully bullish weekly chart (see my reasoning below):

In fact, I wouldn't be surprised if David Tepper's fund sold a big portion of his Micron shares this week and took some profits but we won't know until mid-May when Q1 data on 13-Fs becomes available.

Right now, I'm less concerned with David Tepper and other hedge fund gurus and more concerned about Jonathan Tepper and the inflation disconnect I covered earlier this week.

Importantly, I always worry about macro first and foremost knowing full well that it's the macro environment which can clobber all risk assets very quickly.

Earlier today, I was reading how the yield curve is turning threatening again. Last week at John Mauldin's Strategic Investment Conference 2018, Dr. Lacy Hunt, economist and EVP of Hoisington Investment Management, shared which conditions preceded the last seven recessions and stated the yield curve matters.

At the beginning of the year, Cornerstone Macro's strategist François Trahan shared his thoughts with my readers in my Outlook 2018: Return to Stability, where he explained why the yield curve is the most important indicator to pay attention to (see his upcoming research comment this week once published on Cornerstone Macro's site; if you don't subscribe to Cornerstone Macro’s research, make sure you do so).

My major macro concerns have not changed since writing my outlook comment earlier this year:
  1. I see a US followed by a global slowdown in the second half of the year. This is the primary reason why I've been recommending investors shift to a more defensive stance and overweight healthcare (XLV), consumer staples (XLP), and utilities (XLU) which are basically low vol stocks (SPLV) and underweight cyclicals like energy (XLE), financials (XLF), and industrials (XLI) as we head into year-end. I've also been bullish on US long bonds (TLT) and think they remain the ultimate diversifier to hedge against potential negative shocks.
  2. Now, admittedly, interest-rate sensitive sectors like utilities (XLU), telecoms (VOX) and REITs (IYR) got hit as yields backed up in the first two months of the year but since I see a slowdown ahead and believe it's a bond teddy bear market, I would be buying these sectors and other more stable sectors like healthcare (XLV) and consumer staples (XLP) and hedging my equity exposure with a 50% weighting in US long bonds (TLT).
  3. I remain long the US dollar (UUP) even if I see US bond yields heading back down below 2% by year-end because real rate differentials will widen as the rest of the world slows, and I would be overweight US stocks and bonds over foreign stocks and bonds (don't talk to me about cheap valuations, foreign stocks are cheap relative to US for a reason, when I crisis hits, you want to own stocks in the most liquid market in the world).
Interestingly, one of my faithful blog readers, Drew Wells, sent me a comment earlier today making the case for TLT which I thought was superb.

You often hear people tell you "bonds are boring" or "you can't make money on bonds" which is just foolish. If a crisis hits and yields go below 2% on the 10-year US Treasury note, you most certainly can make great risk-adjusted returns on US long bonds (TLT) but more importantly, you won't sustain a 30%+ drubbing like when stocks got slammed in 2008.

Now, I don't want to get all bearish on you. No doubt, it's time to be altert. I'm concerned about the second half of the year and think there are legitimate concerns voiced by many investors, including private equity which is bracing for a downturn.

Also, pay attention to credit markets because that's where the first signs of trouble will show up:

But I trade these markets every day and see tons of speculative activity going on, mostly in small cap biotech shares which have been the best performers this year, but also in other sectors which have performed well this year.

For example, on Friday afternoon, a lot of small biotechs on my watch list were up huge (click on image):

Yes, small biotech shares are very volatile, just look at the trading activity this week in Proteostasis Therapeutics (PTI) and Solid Biosciences (SLDB). Or check out activity in small cap agriculture company Arkadia Biosciences (RKDA) which catapulted up over 300% in one day before settling down.

These moves are crazy and no doubt fed by algorithmic trading and big institutions frying small retail investors every chance they get but my point is this, if you really drill down, the market isn't showing me panic, far from it, speculative activity is alive and well!

On this last point, Karl Gauvin of OpenMind Capital told me he looks at the Fed's balance sheet numbers every week (think he said Thursday) from the St-Louis Fed and he sees nothing has changed significantly, only declined as a percentage of GDP (click on image):

As I stated in my recent comment on the Fed's balance of risks, all this talk about the Fed shrinking its balance sheet and its impact on the economy is much ado about nothing.

In fact, if my prediction that the US economy will slow significantly in the second half of the year comes true, I wouldn't be surprised if the Fed pauses its balance sheet reduction or signals a pause.

Karl also notes the following:
The perverse effect of years of quantitative easing is illustrated in the two tables below (click on image). In a nutshell: stocks in the third quartile in terms of Financial Condition Score and first quartile in terms of sales growth (Low Quality Growth Stocks) have outperformed the S&P 500 by 15% in 2017 versus an historical annualized excess returns of -2.25%."

Therefore, if your US Equity manager outpeformed the S&P 500 Index by a lot last years, it may be a red flag!!!!

Institutional and high net worth investors looking for an emerging alpha fund whose managers have years of experience and are very focused on risk-adjusted returns and proper alignment of interests should take a closer look at OpenMind Capital. They're extremely sharp and very good at understanding vol regimes and how to add excess returns in difficult markets.

Anyway, I've covered a lot, hope you all enjoyed this comment. I tend to ramble on but I love stocks and markets so forgive my ranting.

Also, please remember, this blog is free but it takes a considerable amount of time and work to write these daily comments. I'm alone, need to trade to make a living and really appreciate those of you who take the time to support this blog by donating via PayPal on the top right-hand side under my picture (where an image literally says "Keep Calm and Please Donate").

Please take the time to support this blog and help me help you navigate these difficult and challenging markets.

Below, an interesting discussion from earlier today where former Treasury Secretary Jack Lew reflects on the 2008 financial crisis and weighs in on the current political landscape.

Thursday, March 15, 2018

Private Equity Braces For Downturn?

Max Bower of Reuters reports, Private equity firms brace for downturn:
Senior participants are warning that today’s market could be as good as it gets, despite a robust global economic backdrop and buoyant mood in the private equity and leveraged loan markets.

Comparisons to 2007’s pre-crisis conditions are becoming more common and industry figures are debating whether today’s robust conditions constitute a bubble, as purchase prices rise, jumbo buyouts proliferate and deal terms become more aggressive.

“I think we’re now in bubble territory,” said Frode Strand-Nielsen, founder of Nordic private equity firm FSN Capital.

Leveraged buyout purchase price multiples hit a record high of 11.2 times average Ebitda in 2017 and average buyout sizes also hit a new record of US$675m in the third quarter of 2017, up from 10 times in 2016, according to a recent report by Bain & Co.

Increasingly large buyout loans have been announced this year, including Blackstone’s US$20bn buyout of Thomson Reuters’ Financial and Risk division (TRI.TO), and the upcoming €10bn carve-out of Akzo Nobel’s specialty chemicals division.

Blackstone is buying a 55% stake in Thomson Reuters’ Financial and Risk unit, which includes LPC.

Strong debt markets are currently seeing good investor demand, but private equity firms are targeting companies that they can take through a recession, Gregor Bohm, co-head of Carlyle’s European buyout business, said at Berlin’s SuperReturn conference.

“You have to sell all the companies that you don’t want to hold through a recession,” he said.

The next five years could be a difficult environment for private equity and leveraged credits, Strand-Nielsen said, particularly as buyouts that have been financed with cheap debt will get more expensive if interest rates rise.

“There’s a lot of financial engineering, which usually indicates we’re going into a concerning environment,” he said at SuperReturn.

The specter of monetary tightening as the European Central Bank ends its Quantitative Easing program is consistently highlighted as the biggest risk facing the market this year, among many, as global tensions rise.


While private equity firms and bankers are aware that they are at the top of the market, benign borrowing conditions could persist for some time, allowing borrowers to lock in cheap debt.

“Borrowers are enjoying peak funding conditions,” said Ed Eyerman, head of European leveraged finance at Fitch in London.

Comparisons with 2007 overlook the fact that the leveraged loan market has fundamentally changed due to covenant lite lending - which did not exist a decade ago - and a larger and more diverse institutional buyside.

Although the lack of covenants is causing concern, bankers point to Spanish fashion retailer Cortefiel’s 2014 amendment and extension of €1.4bn of debt and 25% covenant headroom increase.

This bought time for the operating business to improve and allowed Cortefiel to return to the debt markets last year, but other companies may not be so lucky.

“Cortefiel was the poster child for cov-lite lending but you can’t assume all will do that well,” a market analyst said.

Co-president Scott Sperling said that Thomas H. Lee Partners is focusing on less cyclical growth businesses which are better positioned to weather a downturn that could have a similar magnitude to the last financial crisis.

“It’s certainly not a brave new world that includes no cycle,” he said. “Our base case incorporates a recession of the size of 2008. The swings can be reasonably violent so you have to recognize how that could affect capital structures.”


The global macroeconomic backdrop is also stronger than 2007 and private equity firms are continuing to benefit from broad-based global economic growth, Sperling and Eyerman said.

Interest rates are rising, but are expected to stay lower for longer than before the financial crisis, which is unlikely to affect companies’ debt-servicing ability in the short term.

Fixed charge cover ratios, which measure how comfortably businesses can meet operating costs, are also higher in leveraged companies than before the crisis.

The type of companies borrowing has also changed with the rise of software and business services with fewer assets and higher free cash flow margins, that require less onerous credit protections, Eyerman said.

“They don’t have the capex and fixed costs of pre-2007 leveraged credits in sectors such as auto supply and building materials,” he said.

Despite lower debt servicing costs, some still think the market’s record nine-year bull run is simply delaying the inevitable correction, which will only make it more painful.

“We’re watching a movie where we know what the ending is,” said Guthrie Stewart, global head of private investments at PSP Investments. “Just not how long it is until we get there.”
It's interesting the article ends with a quote from Guthrie Stewart, global head of private investments at PSP.

PSP Investments just announced a deal where it will acquire a significant minority in Learning Care Group:
The Public Sector Pension Investment Board (PSP Investments) has made a significant equity investment in Learning Care Group (US) Inc.

American Securities LLC, which acquired Learning Care Group in May 2014 in partnership with the company’s management team, will remain as controlling shareholder.

Novi, Michigan based Learning Care Group focuses on the care and education of children between the ages of six weeks and 12 years. The company’s national platform of more than 900 schools has the capacity to serve more than 130,000 children in 36 states, the District of Colombia, and internationally. Learning Care Group operates under seven distinct brands: The Children’s Courtyard, Childtime Learning Centers, Creative Kids Learning Centers, Everbrook Academy, La Petite Academy, Montessori Unlimited, and Tutor Time Child Care/Learning Centers.

“Our investment in Learning Care Group is a great example of our strategy to back market-leading businesses with strong long-term fundamentals and world-class management teams,” said Simon Marc, Managing Director, Head of Private Equity, PSP Investments. “With its high-quality services, Learning Care Group is uniquely positioned to further capture growth in the early childhood education market. We are excited to partner with American Securities—with its impressive industry knowledge and a history built on true partnerships—to support Learning Care Group’s management team, which has positioned the company for the next phase of growth.”

“We are pleased to be supported by PSP Investments to continue Learning Care Group’s growth trajectory,” said Kevin Penn, a Managing Director of American Securities. “We look forward to working with them at the board level to further develop the company’s market leadership.”

“We are excited to partner with PSP Investments and believe their international expertise will be invaluable as we further build our business outside of the United States,” said Barbara Beck, Chief Executive Officer, Learning Care Group. “At the same time, this new investment and American Securities’ continued support will enhance our ability to accelerate Learning Care Group’s multiple levers for growth in the United States.”

Arnold & Porter Kaye Scholer LLP acted as legal advisor, and Morgan Stanley and BMO acted as financial advisors to Learning Care Group. PSP Investments’ advisors were Barclays (financial) and Sidley Austin LLP (legal).
You can read the press release PSP put out on this deal here.

Details weren't provided but it's clear PSP is investing in a market-leading business with strong long-term fundamentals and it's a recession-proof industry. In other words, this is a defensive play in private equity.

It was also just announced that a consortium led by BC Partners and including the Public Sector Pension Investment Board (PSP Investments) and Ontario Teachers’ Pension Plan has completed previously announced acquisition of CeramTec Group, a leading international producer of technical ceramics, specializing in the development, production and distribution of components and products made from ceramic materials.

Just by looking at the nature of these private equity investments, it tells me a lot about where PSP and other large Canadian pensions are committing capital in private equity and where their risk appetite lies at this point of the cycle.

And I don't blame them. I recently wrote a lengthy comment on froth in private equity, one you should all take the time to read carefully.

Everything is overvalued right now in public and private markets. Record low rates have driven investors to take bigger and bigger risks to attain their return targets, pumping up valuation to extreme levels.

However, unlike many who see rates rising as inflation creeps into the economy, I see record low rates persisting for a very long period. Too many people still don't understand the inflation disconnect.

In theory, this should bode well for risk assets but I've got some bad news for those of you who think the party in private equity and all risk assets will last a lot longer if rates stay low for a lot longer.

As I keep warning my readers, we are one major deflationary shock away from a significant global downturn, one that will push US long bond rates to a new secular low and clobber risk assets across public and private markets.

This isn't good news for pensions plans as both assets and liabilities will get hit hard and pensions already suffering from chronic deficits will be particularly vulnerable during the next deflationary crisis.

One thing caught my eye from the article above:
Co-president Scott Sperling said that Thomas H. Lee Partners is focusing on less cyclical growth businesses which are better positioned to weather a downturn that could have a similar magnitude to the last financial crisis.

“It’s certainly not a brave new world that includes no cycle,” he said. “Our base case incorporates a recession of the size of 2008. The swings can be reasonably violent so you have to recognize how that could affect capital structures.”  
Imagine, their base case incorporates a recession the size of 2008. What if it's worse next time around and much more protracted? Lots of recent vintage years in private equity are going to record serious losses for their investors.

And it's not just private equity that worries me. Cheap money has fuelled the bubble in venture capital and the recent fraud charges against Theranos founder Elizabeth Holmes are just the tip of the iceberg. There is a lot more nonsense we never hear about with all these unicorn start-ups.

Lastly, a giant retailer of children's toys announced its liquidation today. Below, Perry Mandarino, B. Riley FBR, discusses the troubles for Toys R Us as the toy retailer liquidates its holdings.

Interestingly, this was another victim of private equity's asset-stripping boom but to be fair, this company had so many issues that I don't think ten David Bondermans working full-time to turn it around would have succeeded.

And this morning on CNBC Squawk Box, Richard Bernstein, Richard Bernstein Advisors, and Jason Trennert, Strategas Research Partners, provided insight to what's likely driving market volatility.

Given my views on the inflation disconnect I disagree with Rich Bernstein  and would categorically say large public pensions are much better prepared for inflation than deflation.

Right after this segment, however, they both discussed how private equity is increasingly betting on public companies, taking them private, and how the fate of private equity is inextricably tied to public equity markets and the illusion of low volatility in private equity is just that.

Unfortunately, the clip below stops right before they entered that conversation on private equity.

Wednesday, March 14, 2018

The US Inflation Disconnect?

Pan Kwan Yuk of the Financial Times reports, US inflation rises in line with expectations in February:
A closely-tracked measure of US consumer price inflation rose in line with expectations in February, according to figures released on Tuesday that are likely to reaffirm the Federal Reserve’s case for just three rate hikes this year.

The core consumer price index, which excludes volatile food and energy prices, showed prices were 1.8 per cent higher in February than the same month last year. The rate is unchanged from that reported in January and was as expected by the markets.

The headline index came in at an annual rate of 2.2 per cent growth however, up from the 2.1 per cent reported in January. On a month-on-month basis, headline prices rose just 0.2 per cent, a slowdown from the 0.5 per cent pace recorded in the month prior.

The inflation report comes after the jobs report on Friday showed wage growth remained subdued and prompted some to question whether that could deter policymakers from stepping up the pace of rate increases.

“With markets increasingly on the lookout for signs of positive US inflation surprises, today’s consumer price data is unlikely to make too many waves,” said James Smith, economist at ING.

“The key takeaway is that core inflation remained unchanged at 1.8% YoY, although there is still quite a lot of noise beneath the surface.”

Inflation has remained stubbornly below the Fed’s objective in recent years despite steady economic growth and an unemployment rate that is at a 17-year low.

However Fed officials have repeatedly said they expect the inflation weakness to be mostly transitory and that was one reason why the central bank lifted its benchmark rate three times last year. The Fed has projected another trio of quarter point rate rises for both 2018 and 2019.

Mr Smith at ING said he expects inflation will pick up in the months ahead, with strong consumer demand helping to push prices higher.

“This a key reason why we expect four rate hikes from the Fed this year,” he said.
Strong consumer demand? Well, you'd think so with a booming jobs market but this isn't the case. Lucia Murikani of Reuters reports, U.S. retail sales falter; underlying producer prices rise solidly:
U.S. retail sales fell for a third straight month in February as households cut back on purchases of motor vehicles and other big-ticket items, pointing to a slowdown in economic growth in the first quarter.

Despite signs of cooling in consumer spending, inflation pressures are steadily building, which should allow the Federal Reserve to raise interest rates next week.

Underlying producer prices increasing solidly in February, driven by strong gains in the cost of services such as hotel accommodation, airline fares and hospital inpatient care, other data showed on Wednesday.

The Commerce Department said retail sales slipped 0.1 percent last month. January data was revised to show sales dipping 0.1 percent instead of falling 0.3 percent as previously reported. It was the first time since April 2012 that retail sales have declined for three straight months.

Economists polled by Reuters had forecast retail sales rising 0.3 percent in February. Retail sales in February increased 4.0 percent from a year ago.

Excluding automobiles, gasoline, building materials and food services, retail sales edged up 0.1 percent last month after being unchanged in January. These so-called core retail sales correspond most closely with the consumer spending component of gross domestic product.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, appears to have slowed at the start of the year after accelerating at a 3.8 percent annualized rate in the fourth quarter.

“These retail sales data are weak on the face of it and point to sluggish growth in consumer spending in the first quarter,” said John Ryding, chief economist at RDQ Economics in New York.

In a separate report, the Labor Department said a key measure of underlying producer price pressures that excludes food, energy and trade services rose 0.4 percent last month, matching January’s gain.

That boosted the year-on-year increase in the so-called core PPI to 2.7 percent, the biggest gain since August 2014, from 2.5 percent in January. The increase in underlying wholesale prices supports views that consumer inflation will pick up this year.

U.S. financial markets largely shrugged off the weak retail sales report and investors focused instead on the wholesale inflation data. The dollar was trading higher against a basket of currencies. Prices for U.S. Treasuries were mixed, with the yield on the interest-rate-sensitive two-year note rising.


The Fed has forecast three interest rate increases this year. Many economists expect the U.S. central bank will raise its projection to four rate increases this year because of a robust labor market.

Economists believe that a tightening labor market, weak dollar and fiscal stimulus from a $1.5 trillion income tax cut package and increased government spending will lift inflation toward the Fed’s 2 percent target this year.

The Fed’s preferred inflation measure, the personal consumption expenditures (PCE) price index excluding food and energy, has undershot its target since May 2012.

Slower consumer spending supports expectations of moderate economic growth in the first quarter. GDP growth estimates for the January-March quarter are around a 2 percent annualized rate.

The economy grew at a 2.5 percent pace in the fourth quarter. But revisions to December data on construction spending, factory orders and wholesale inventories have suggested the fourth-quarter growth estimate could be raised to a 3.0 percent pace. The government will publish its third estimate for fourth-quarter GDP growth later this month.

Consumer spending, however, remains underpinned by the jobs market, which is viewed by Fed officials as being near or a little beyond full employment. The economy created 313,000 jobs in February. Consumer spending could also get a lift from the tax cuts.

Auto sales fell 0.9 percent in February after a similar drop in January. Receipts at service stations declined 1.2 percent, reflecting lower gasoline prices.

There were also declines in sales at furniture stores, health and personal care stores and electronics and appliance stores. But there were some pockets of strength. Sales at building material stores increased 1.9 percent last month.

Receipts at clothing stores gained 0.4 percent and sales at online retailers surged 1.0 percent. Consumers also spent more at restaurants and bars and splurged on sporting goods and hobbies.
The key part of this article is this:
Economists believe that a tightening labor market, weak dollar and fiscal stimulus from the tax cuts and increased government spending will lift inflation toward the Fed's 2 percent target this year.
On Tuesday morning, I was listening to Steve Liesman on CNBC stating how he went to a big gathering of institutional investors at the Commonfund featuring Nancy Lazar, a partner who leads the Economic Research team at Cornerstone Macro.

Liesman was saying how bullish Mrs. Lazar is on the US economy citing “tax cuts, wage growth and capital spending”. He said she sees 3 percent growth plus. He also said there was a lot of money in the room and "their number one concern was tariffs".

Anyway, I'm not as bullish on the US economy going forward and think the second half of the year will prove my worries right. Remember, I wrote a comment at the start of the year with Mrs Lazar's partner at Cornerstone, François Trahan, Outlook 2018: Return to Stability, where we explained why it's important to shift to a more defensive stance heading into the year.

The way François explained to me Mrs. Lazar's optimism on the economy is as follows:
She thinks the tax cuts will have a big impact on GDP and the sustainability of the cycle. I don't know. My focus is PE compression so it does not add up to a great equity market no matter how good the economy is.

PEs is often the disconnect between economists and strategists.
Interestingly, the very recent rally in US long bonds (TLT) has helped bolster interest sensitive sectors like utilities (XLU) that got whacked hard in the first two months of the year as rates crept up.

Whether or not this is the beginning of a new, sustainable uptrend in US long bnds and interest rate sensitive sectors remains to be seen but you should all read my recent comments on the risks of a confounding market and the bond teddy bear market.

Importantly, I remain unconvinced that the yield on the 10-year US Treasury bond will exceed 3% this year (or stay above it for long) and given my fears of a second half slowdown in the US and global economy, I'm still forecasting the yield on the 10-year to head below 2% by year-end.

I know, tax cuts, a tight labor market, infrastructure spending are all favorable but there is another disconnect that investors have to contend with which I'm afraid they have yet to grasp and accept.

What is it? All this good news isn't doing squat for US wage growth and unless we get a sustainable rise in wages -- not temporary rises due to weather, hike in minimum wage, etc. -- then you can forget about the Fed reaching its inflation target.

And I have some bad news to report on US wage growth. Despite the "booming" labor market, wages remain uncharacteristically stagnant and they will stay this way for many years to come.

To really understand why, you need to read a recent "Outside the Box" comment by Jonathan Tepper that John Mauldin posted on his website, Why American Workers Aren’t Getting A Raise: An Economic Detective Story:
For the past few months, I’ve been trying to solve an economic puzzle: why are wages growing so slowly despite a growing economy and a booming stock market?

Workers are productive and helping the economy grow, yet unlike previous economic expansions, we are hardly seeing big increases in wages. Instead, companies are sitting on their cash or giving it back to their shareholders through dividends and share buybacks.

The answer of why wages are not growing mattered a lot to me. A few years ago, some friends and I started Variant Perception a company that predicts the ups and downs of the economy using leading indicators. Before growth or inflation turn up and down, there are generally clues that tell you what is coming. For example, building permits provide a good warning sign that growth will turn up or down. When the US stopped building as many houses in 2005-06, it predicted the recession of 2007-08.

Our leading indicator for wages normally provides a 15 month advanced warning of changes in wages. It is pretty good and all the ingredients are the same ones that have accurately worked for decades, yet the relationship has broken down. It was annoying me: why are wages not following growth? I should know the answer to why this is happening. I should have all the tools, yet something appeared broken in the economy.

All the signs that should lead to higher wages are present. Today, employers are saying that it is hard to find workers and many small businesses say they expect to raise wages, initial unemployment claims are extremely low. This should be an economy that is good for workers to get higher wages, yet wages stink.

After a lot of research, I think the answers are clear. Let’s look at the problem.

Companies are keeping more of the economic pie

The flipside of low wages is that companies have taken a record part of the economic pie. Corporate profits as percentage of Gross Domestic Profit (GDP) are near record highs and labor’s share of GDP is near record lows. You can see from the following chart that the chart looks like a giant alligator jaws. The divergence started in the early 1980s when the regular rise and fall of corporate profits and workers’ compensation broke down.

The trend in corporate profits is a mystery to economists and investment strategists. Jeremy Grantham, a well-known investor, has pointed out, “Profits are the most mean reverting series in finance. If margins don’t revert something has gone wrong with capitalism.”

The flipside of low wages is that companies have taken a record part of the economic pie. Corporate profits as percentage of Gross Domestic Profit (GDP) are near record highs and labor’s share of GDP is near record lows. You can see from the following chart that the chart looks like a giant alligator jaws. The divergence started in the early 1980s when the regular rise and fall of corporate profits and workers’ compensation broke down.

The trend in corporate profits is a mystery to economists and investment strategists. Jeremy Grantham, a well-known investor, has pointed out, “Profits are the most mean reverting series in finance. If margins don’t revert something has gone wrong with capitalism.”

Employee compensation as a percentage of GDP has been falling for years
(Source: Economic Cycle Research Institute)

 Something has indeed gone very wrong with capitalism. In a competitive market, if a company is making a lot of money, other companies will get excited by the prospects of high profits and will enter the industry and compete. Eventually margins decline as more competitors fight each other. That is how dynamic, capitalist economies should be. Something is profoundly broken with capitalism if corporate profit margins do not revert to the historical mean.

Rising industrial concentration is a powerful reason why profits don’t mean revert and a powerful explanation for the imbalance between corporations and workers. Workers in many industries have fewer choices of employer, and when industries are monopolists or oligopolists, they have significant market power versus their employees.

The role of high industrial concentration on inequality is now becoming clear from dozens recent academic studies. Work by The Economist found that over the fifteen-year period from 1997 to 2012 two-thirds of American industries were more concentrated in the hands of a few firms.(i) In 2015, Jonathan Baker and Steven Salop found that “market power contributes to the development and perpetuation of inequality.”(ii)

One of the most comprehensive overviews available of increasing industrial concentration shows that we have seen a collapse in the number of publicly listed companies and a shift in power towards big companies. Gustavo Grullon, Yelena Larkin, and Roni Michaely have documented how despite a much larger economy, we have seen the number of listed firms fall by half, and many industries now have only a few big players. There is a strong and direct correlation between how few players there are in an industry and how high corporate profits are.(iii)

Workers are productive but are not getting paid for it

Given the gaping disparity in pay between the average worker and CEOs, you might imagine managers were superstars and the average worker was bad at his job. But that is hardly the case. While many executives go on the front cover of Fortune or Forbes and get all the credit for their company stock, worker productivity has been steadily rising for decades. Unfortunately, earnings have not kept up with productivity increases. Workers are producing more goods with less labor, and companies are making higher profits, but the benefits are not being shared with workers. Notice that productivity growth has been rising in a straight line since the 1950s, but starting in 1980 hourly compensation has not risen much. The money from that gap doesn’t vanish into thin air, and it has to show up somewhere.

Disconnect between productivity and typical worker’s compensation
(Source: Economic Policy Institute)

 Some economists have argued that the gap between wages and productivity is an illusion. They argue that much of the gap can be explained by year-end bonuses, which are not included in hourly pay, by healthcare costs, which doesn’t show up in a paycheck but the worker benefits from, and by stock options, which also doesn’t show up in a paycheck. However, we can discount these explanations. Healthcare, bonuses and options are a real expense to companies, and if companies were getting hit with these costs instead of wages, it would show up in corporate profit margins. Today, corporate profit margins would not be at record highs. If the divergence between wages and productivity is real, the difference should clearly shows up in corporate profits, and it does.

Companies have more market power

The economists Jan De Loecker of Princteon University and Jan Eeckhout of the University College London found that average markups, have surged since the early1980s. The average markup was 18% in 1980, but by 2014 it was nearly 70%. Higher markups suggest an increase in what economists refer to as “market power,” which is the result of more highly concentrated industries.

A markup may sound like a very technical term, but you see it in everyday life. The best example is in luxury goods, where the right logo on a handbag will make the leather sell for a lot more than it costs to make. Part of what you’re paying for is status and association.

De Loecker and Eechkhout noted that The rise in markups explains lower wages almost perfectly. They also found that “the rise in markups naturally gives rise to a decrease in the labor share, a decrease in the capital share, a decrease in low skilled wages, a decrease in labor market participation, and decrease in job flows.”(iv)

The Evolution of Average Markups (1960-2014)
 (Source: Jan De Loecker, Jan Eeckhout)

Market power has been rising in many industries. Americans have the illusion of choice, but in industry after industry, a few players dominate the entire market:
  • Two corporations control 90% of the beer Americans drink.
  • When it comes to high-speed internet access, almost all markets are local monopolies; over 75 percent of households have no choice with only one provider.
  • Four airlines completely dominate airline traffic, often enjoying local monopolies or duopolies in their regional hubs. Five banks control about half of the nation’s banking assets.
  • Many states have health insurance markets where the top two insurers have 80-90% market share. For example, in Alabama one company has 84% market share and in Hawaii one has 65% market share.
  • Four players control the entire US beef market.
  • After two mergers this year, three companies will control 70 percent of the world’s pesticide market and 80 percent of the US corn-seed market.
The list of industries with dominant players is endless.

After a wave of mergers, there is simply less competition.

Merger Manias 1890-2015: Merger Waves Are More Frequent and Bigger
(Source: Pine Capital)

Over half of all public firms have disappeared over the last twenty years. We’ve seen a collapse of publicly listed companies. Astonishingly, according to a study by Credit Suisse, “between 1996 and 2016, the number of publicly-listed stocks in the U.S. fell by roughly 50% — from more than 7,300 to fewer than 3,600 — while rising by about 50% in other developed nations.”(i) It is not lower growth or the global Financial Crisis that caused fewer IPOs. This is distinctly an American phenomenon.

The decline in listed companies has been so spectacular that the number lower is than it was in the early 1970s, when the real GDP in the US was just one third of what it is today.(ii) America’s economy grows ever year, but the number of listed companies shrinks. On this trend, by 2070 we will only have one company per industry.

Many workers are dealing with a monopsonist

In a monopoly, there is only one seller, while in a monopsony, there is only one buyer. The extreme example of a monopsony is a coal town in West Virginia, where the only buyer of labor is the coal company

Large parts of America are dominated by monopsonies. In a comprehensive study, Marshall Steinbaum, Ioana Marinescu, and Jose Azar looked across all industries and commuting zones in the US to measure how concentrated employers were. They found that most labor markets are very concentrated and that it has a strong negative impact on posted wages for job openings.(v) They showed that going from a very competitive to a highly concentrated job market is associated with a 15-25% decline in wages.

The study shows that labor monopsony is not only pervasive across the US, but is especially so in non-metropolitan areas. This makes intuitive sense – smaller towns mean fewer employment options.

Areas with fewer employers have lower wages
(Source: Roosevelt Institute)

In a monopsony, workers have little choice in where they work and have little negotiating power for wages with employers. In a healthy economy, many firms would be competing equally for workers and would be incentivized to entice new hires with higher wages, better benefit packages, and few restrictions on their next career moves. But monopsonies make it easier for firms to depress worker wages. The classic example of this is a coal-mining town, where the coal plant is the only employer and only purchaser of labor. Today, in many smaller towns, WalMart is the new coal plant – and is the only retail company hiring.

Many firms are able to suppress the bargaining power of labor by making labor markets less competitive. Economists Jason Furman and Alan Krueger argue that firms in concentrated industries are able to suppress wages through collusion and non-compete agreements that cover 20% of American workers.(vi)
Many workers live in a rural area with less choice of jobs

Today, the story of America is largely the story of two economies – rural and urban. It was not always this way. The antitrust movement of the 1940s not only targeted giant firms, but was also an attempt to weaken regional centers that had amassed too much power. This largely worked and, by the mid 1970’s, there was a fairly uniform American standard of living – being middle class in the Mideast was pretty much the same as middle class in New England. However, in the 1980s, many of the policies that helped ensure this balance between regions was neglected or reversed.

A great divide formed between rural and metropolitan areas in the US. In 1980, if you lived in Washington D.C., your per-capita income was 29 percent above the average American; in 2013 you would be 68 percent above. In New York City, the income was 80 percent above the national average in 1980 and skyrocketed to 172 percent above by 2013.(vii) Power and money began concentrating in urban centers across the country as a rural ‘brain drain’ occurred.

Major cities attract diverse talent and many corporations, which must bid competitively for workers. Workers living in these cities make significantly more money than workers elsewhere. There is power in numbers, and nurses who have 5 metropolitan hospitals to choose from will make more money than those who work in a town with only one hospital.

Rural Areas Are Lagging
(Source: Bloomberg, Shift: The Commission on Work, Workers, and Technology)

CEOs are getting paid a lot more than workers

In the US CEO pay has exploded. From 1978 to 2013, CEO compensation adjusted for inflation increased 937%. By contrast, the average worker’s income grew by a pathetic 10% over the same period. To put the change in perspective, the CEO-to-worker pay ratio was 33-to-1 in 1978 and grew to 276-to-1 in 2015.(viii) The US is a big outlier in terms of how vastly overpaid the top corporate officers are vs the average worker. For CEOs in the UK, the ratio is 22; in France, it’s 15; and in Germany it’s 12.(ix) US CEOs are vastly overpaid no matter how you look at it.

Rising CEO-to-Worker Compensation Ratio
(Source: Economic Policy Institute)

There is no countervailing force to high CEO and low worker pay

Unions maintained an important part in American working life for decades, but then declined again. In 1983, about 1 in 5 Americans were part of a union; today, only 6.4% of private sector workers in America are unionized and less than 11% of total workers.(x) This represents a considerable decline in the ability of workers to organize. Unions, though controversial, provided a needed forum for workers to band together and advocate for their collective rights.

Falling Union Membership and Lower Middle Class Share of Income
(Source: The Atlantic)

Inequality is inversely related to union membership. If you plot the percentage of national income going to the top 10%, as you can see it is almost the perfect mirror image. When union membership is low, a higher percentage of income goes to the top 10%. This may help, in part, to explain recent trends in income inequality.

Union Membership vs Income Distribution to Top 10%
(Source: The Atlantic, Emin M. Dinlersoz and Jeremy Greenwood) (xi)

Managers collectively represent thousands if not millions of shareholders. Union leaders may likewise represent thousands if not millions of workers. The strength of unions, however, does not come merely from concentrating forces but from the real threat of strikes. There is an extremely high correlation historically between the index of the number of strikes in the US with the wage growth of workers. Today, strikes are extremely rare, and this in part explains why wages are so low.

Wage growth closely associated with strikes
(Source: Taylor Mann, Pine Advisors)

 I’m writing a book on monopolies, monopsonies and how they are affecting startups, workers’ pay and economic growth. This is just a small part of some of the ideas in the book.

If you liked this post, let me know and I’ll keep you posted on further charts, blog posts and let you know when my book is coming out.


(ii) Baker, Jonathan and Salop, Steven, “Antitrust, Competition Policy, and Inequality” (2015). Working Papers.

(iii) Grullon, Gustavo and Larkin, Yelena and Michaely, Roni, Are U.S. Industries Becoming More Concentrated? (August 31, 2017). Available at SSRN:

(iv) Jan De Loecker, Jan Eeckhout, “The Rise of Market Power and the Macroeconomic Implications”, (August 2017) NBER Working Paper No. 23687

(i) Credit Suisse, The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer U.S. Equities

(ii) Grullon, Gustavo and Larkin, Yelena and Michaely, Roni, Are U.S. Industries Becoming More Concentrated? (August 31, 2017). Available at SSRN:

(v) and Azar, José and Marinescu, Ioana Elena and Steinbaum, Marshall, Labor Market Concentration (December 15, 2017). Available at SSRN:

(vi) Why Aren’t Americans Getting Raises? Blame the Monopsony, Jason Furman and Alan B. Krueger Wall Street Journal

(vii) Longman, Phil. “Why the Economic Fates of America’s Cities Diverged.” Nov 28, 2015.



(x) Bureau of Labor Statistics. “Union Members Summary.” January 26, 2017.

(xi) Ebersole, Phil. June 12, 2012.
Whether or not you agree with Jonathan Tepper (no relation to hedge fund billionaire David Tepper), I'd like you to keep in mind the structural factors he discusses above because I happen to agree with him, over the long run, capitalists have managed to shrink wages as a percentage of the economic pie and this long-term trend will continue.

This is why I ignore hedge fund gurus like Paul Tudor Jones, Ken Griffin, Paul Singer, and others warning of inflation because there are no structural factors supporting their concerns.

I also ignore bond gurus who think the 10-year Treasury yield is going above 3%:

Sure, there is a bit of cyclical inflation mostly owing to the weakening US dollar last year (raises import prices transiently) but there is no structural inflation going on and if we get another downturn, we will once again be talking about structural deflation next year, something I'm very concerned about, especially if it hits the US.

Lastly, I know inflation is a lagging indicator, every economist knows that, but I want all you people collectively managing trillions to really think carefully about the US and global inflation disconnect because I fear a lot of you are buying the optimistic global growth story and aren't well positioned for the deflationary tsunami headed our way.

I have stated this plenty of times, global asset managers should be obsessing over global inflation versus deflation, this is THE MOST important trend going on in the background and if you're not thinking or worried about it, you will get your head handed to you.

By the way, keep an eye on the US dollar (UUP) because it seems to have stabilized and slightly rebounded but remains weak on the weekly chart:

If the US dollar continues gaining strength throughout the remainder of the year and next year -- another one of my forecasts -- then expect import prices to start falling 12 to 18 months from now, adding to any other global deflationary headwinds headed toward the US economy. Just something to keep in mind.

Also, if there is a full out global trade war, something I'm not worried about even though the media plays it up and investors are on edge, then expect the US dollar to gain even more strongly throughout the coming year. A stronger greenback will reinforce US disinflation and hit commodity prices hard.

Below, Danielle DiMartino Booth, Money Strong President, talks about strong employment numbers and possible wage inflation with CNBC and on RT's Boom Bust.

I like and respect Danielle a lot, think she is a first-rate economist, but I have to disagree with her here. I simply don't see wage inflation picking up steam and being sustained in this economy.

Tuesday, March 13, 2018

OPTrust Delivers 9.5% in 2017

Martha Porado of Benefits Canada reports, Equities boost OPTrust return to 9.5% in 2017:
The OPSEU Pension Trust posted a 9.5 per cent return for 2017, an increase on its six per cent return in 2016 and its eight per cent return in 2015.

“We were strong across all the asset classes,” says Hugh O’Reilly, president and chief executive officer of OPTrust, noting the fund saw a 22.9 per cent return in public equities and a 21.6 per cent return in private equities. Alternatives also performed strongly, he says, with real estate returning 14.7 per cent and infrastructure returning 11 per cent. The fund’s fixed-income investments gained a 4.6 per cent return.

The one problematic area for the year was currencies, says O’Reilly. “We had a slight drag on our portfolio from foreign currency, U.S. dollar exposure.”

O’Reilly notes that good investment returns are increasingly difficult to achieve in the current market environment. “We believe in taking risk efficiently and purposefully,” he says. “We think that overall returns going forward are going to be more and more difficult to achieve.”

O’Reilly notes, however, that OPTrust “will not be taking more risk in order to gain greater returns.”

One area of concern is climate change, he adds. “Climate risk is a significant risk to us as investors and we want to make sure that the entities that we invest in disclose their climate risks, so that will allow us to engage with them, so we better understand the risks being taken. We can make better investment decisions and as appropriate, we can get them to change direction.”

But the pension fund isn’t divesting from certain sectors where climate change is concerned. “We believe in improving practices in the oil and gas industries,” says O’Reilly. “We’ve also done an accounting of what our exposure is in renewables and we’re better beginning to understand our real estate portfolio in terms of its green effects.”

Another challenge OPTrust will continue to address is the likelihood of an ongoing increase in its members’ life expectancy, which will further add to the plan’s obligations. “We have to make sure that our assumptions reflect those improvements,” says O’Reilly says. The plan’s discount rate was lowered to 3.3 per cent in 2017, from 3.4 per cent in 2016, reflecting increased actuarial margins.

All in all, the fund now holds new assets of $20 billion. Its funding status increased slightly, to 111 per cent compared to 110 per cent in 2016.
OPTrust put out a press release, OPTrust Takes Measures to Reduce Risks for Members:
OPTrust today released its 2017 Funded Status Report, which details the Plan’s ninth consecutive fully funded position and financial results. OPTrust achieved an investment return of 9.5% for the total fund, net of external management fees. The organization also received high scores, with members and retirees rating their service satisfaction as 9 out of 10. In addition, OPTrust is one of the first plans to report in accordance with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

"Last year, we started a conversation within our industry about what we believe matters most to our members,” said Hugh O'Reilly, President and CEO of OPTrust. “Our answer hasn’t changed: it’s the Plan’s funded status. That’s why this year, we are continuing the conversation.”

“The funded status is the foundation on which secure, sustainable retirement futures rest, and for us, it is the measure that matters," O’Reilly added. “We are working in an environment where investment returns are increasingly difficult to achieve without taking excess risk, and we are dealing with the effects of the ongoing maturation of the Plan. These challenges require constant innovation on our part. We also share our ideas and successes with others, which is an important part of being good pension citizens.”

The Plan remained fully funded in 2017 on a regulatory filing basis, while the organization continued to strengthen its actuarial assumptions to enhance long-term funding health. The Plan’s real discount rate was lowered to 3.30%, net of inflation, from 3.40% in 2016, reflecting increased actuarial margins and reducing the risk of future losses due to investment returns falling short of the expected cost of members’ future pensions.

With an update of assumptions regarding member longevity, the Plan has addressed the likelihood that members’ life expectancy will continue to increase, thereby increasing the Plan’s pension obligations. The funding valuation confirmed deferred investment gains of $885 million at the end of 2017, which should further improve funded status in the years to come.

OPTrust introduced its member-driven investing (MDI) strategy in 2015 with a singular focus to increase the likelihood of plan certainty by balancing the objectives of sustainability and security to better align the Plan’s outcomes with members' needs. Superior risk management has helped the Plan to improve its funded status, maintaining stability and helping to ensure the Plan can weather a severe market downturn, like the one experienced by the global economy in 2008. The Plan's net assets increased to over $20 billion at 2017 year-end, up from $19 billion as at December 31, 2016.

More detailed information about OPTrust's 2017 strategy and results is available in its Funded Status Report at

About OPTrust

With net assets of over $20 billion, OPTrust invests and manages one of Canada's largest pension funds and administers the OPSEU Pension Plan, a defined benefit plan with over 92,000 members and retirees. OPTrust was established to give plan members and the Government of Ontario an equal voice in the administration of the Plan and the investment of its assets through joint trusteeship. OPTrust is governed by a 10-member Board of Trustees, five of whom are appointed by OPSEU and five by the Government of Ontario.
Take the time to carefully read through OPTrust's 2017 Funded Status Report which is available here. This is their version of their Annual Report but the title reflects where their priorities lie.

Below, I provide you with an image which goes over the main highlights of this report (click on image):

As you can see, OPTrust had another solid year and is delivering outstanding services to its members. Moreover, the focus remains squarely on the funded status and the Plan is taking the lead on many initiatives.

I had a brief conversation with OPTrust's President & CEO Hugh O'Reilly yesterday going over the results and some of the initiatives the Plan is taking a lead on.

Before I get to our conversation, I note the following from his Message on pages 12 and 13 of the 2017 Funded Status report on enhancing their investment capabilities:
Our Member-Driven Investing (MDI) strategy has a simple idea at its heart: the primary goal of a pension plan must be to maintain its funded status. Above all, members want pension certainty, stability and sustainability. Our job is to balance those goals by achieving sufficient investment returns to support plan sustainability without taking on excess risk that could undermine the stability of contribution and benefit levels. We view risk as a scarce resource that must be carefully allocated.

The effectiveness of this approach continues to be validated as we have once again successfully maintained a fully funded plan for our members. In 2017, we internalized a significant portion of our public markets assets and activities as part of our overall MDI strategy. Our new internal capabilities in these asset classes complement our long-standing internal capabilities and sophistication in private equity, infrastructure and real estate.

By the end of the year our new trading desk had completed over 2,850 trades. Internalization has enhanced our ability to dynamically manage risk in our portfolios.
And this on promoting new ideas in the pension industry:
At OPTrust, acting in the best interests of our members and being good pension citizens are one and the same. One of the best ways to create long-term sustainability is to foster new thinking and industry dialogue that can strengthen all aspects of the defined benefit model. In 2017, we undertook innovative research on climate change in partnership with Mercer, and in so doing, furthered our industry’s understanding of the need for investors to better measure, model and mitigate the risks that climate change presents.

We also continued our work to promote and defend defined benefit pensions globally, as we discussed retirement innovation with the Washington D.C.-based Brookings Institution and participated in a World Bank report on the Canadian pension model. Closer to home, we launched a new advocacy and education program, People for Pensions, which has engaged our members in an ongoing conversation about the advantages and importance of the defined benefit pension model.
Those of you who read my blog regularly know I'm a big defender of  well-governned defined-benefit plans and believe that any country which is serious on tackling the ongoing retirement crisis should be bolstering DB plans, not weakening them.

Anyway, back to my conversation with Hugh O'Reilly. Hugh noted that the funded status is what counts most to them because it allows them to maintain the current benefits and contribution rate.

It’s worth noting the Plan’s real discount rate was lowered to 3.30%, net of inflation, from 3.40% in 2016, reflecting increased actuarial margins and reducing the risk of future losses due to investment returns falling short of the expected cost of members’ future pensions.

Hugh noted they use one of the lowest discount rates among large public pensions and are prudent which is why they lowered it to increase the cushion in case another crisis hits the Plan's assets and liabilities.

In terms of overall results, he told me the 9.5% return had contributions from all asset classes but there was a small drag from currency exposure as unlike HOOPP, they don't fully hedge their foreign exchange risk and are exposed to depreciating foreign currencies, in particular the US dollar (click on image):

Hugh told me they do some hedging on the foreign exchange but are mostly unhedged on safe haven currencies which leaves them exposed for years where the Canadian dollar outperforms them.

Interestingly, after reading my last comment on HOOPP's 2017 results, HOOPP's President and CEO Jim Keohane shared this with me on HOOPP's currency hedging policy: "There is no right answer when it comes to FX. We do pursue some active strategies in FX derivatives but we do hedge our translation risk. It is just not where we want to use our risk budget."

Hugh told me the same thing, "we don't get compensated for taking F/X risk", but they prefer taking the opposite side of the hedging spectrum like AIMCo, OTPP, CPPIB, and PSP, ie. they prefer to mostly stay unhedged, especially on safe haven currencies.

All I can say is that at least they're honest about the foreign exchange drag and every single pension plan should include a similar chart to the one above showing how F/X swings impacted their overall return, whether it's good or bad (reporters never ask this question, drives me crazy!).

Now, the big contributors to overall returns were Public Equity (22.9%), Real Estate (14.7%), and Private Equity (21.6%). Hugh told me that the value-added over the benchmark portfolio was 2.6% (260 basis points) which is excellent.

In private equity, they are almost exclusively focusing on co-investments, a form of direct investments, to lower overall fees paid to funds. They have a similar structure in real estate but in infrastructure, over 90% is purely direct investments.

Below, I embedded pages 28-30 of the Funded Status report going over the returns of the main asset classes (click on each image):

In terms of weighting, Hugh told me Public Equity represents 15-18% and the rally in emerging market equities last year helped lift that portfolio. Fixed income represents 30%, Private Equity 8%, Real estate and Infrastructure each 12-13%.

Unlike HOOPP, OPTrust does allocate to external absolute return funds and tries to leverage off these relationships as much as possible to bolster and enhance their internal absolute return activities.

Interestingly, Hugh told me they fully hedge their interest rate risk and like HOOPP, are in a good position if rates start to rise (liabilities will fall if rates rise). He told me if rates rise, they too will buy more long bonds to fully hedge interest rate risk which represents the biggest risk to the Plan.

Like Jim Keohane, Hugh is very cautious on markets and has publicly voiced his concerns on skyrocketing valuations:

In many ways, HOOPP and OPTrust are very similar which is why their presidents focus on funded status as the real measure of a pension plan's success, but they have quirks and differences too. Hugh told me: "We worship the same god but practice different religions."

Two things stand out to me:
  1. OPTrust has a greater concentration in alternatives and they are more open to allocating to external managers across public markets and leverage off these relationships. They have opened up offices in London and Sydney to develop relationships with partners in public and private markets.
  2. Like OMERS, OPTrust has guaranteed indexation which means their active members bear most of the risk of the plan. HOOPP and OTPP have ad hoc or partial indexation which allows them to spread the risk of the plan across active and retired members (this makes most logical sense to me).
 We ended our conversation by talking about some intitiatives OPTrust is taking the lead on:
  1. Hedging for longevity risk: Hugh told me demographics are changing and OPTrust is taking the lead to reflect the new report from the Canadian Institute of Actuaries which shows Canadians are living longer.
  2. Taking climate change seriously: If you read pages 16-17 of the Funded Status Report, you will understand how OPTrust is taking the lead on responsible investing in terms of taking climate change seriously. Hugh emphasized that unlike tobacco where they are butting out for good, they don't want to divest from energy companies but want to work with them to focus on better ways to address global climate change.
Lastly, I note executive compensation of OPTrust's senior officers below (click on image):

A full discussion on compensation is available in the Funded Status Report. All I can say is that Hugh O'Reilly and James Davis are doing a great job and are being compensated in line with their peers (even below them).

Below, Hugh O'Reilly sits down with members of the Plan to discuss why OPTrust’s mission is paying pensions today, preserving pensions for tomorrow.

This was another excellent year for OPTrust and just like HOOPP, their members are very lucky to have a solid team of professionals making sure their pension plan is sustainable over the long run.