CPPIB Sounds The Alarm?

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Matt Scuffham of Reuters reports, Canada’s CPPIB pension fund concerned over rising protectionism:

The Canada Pension Plan Investment Board, one of the world’s biggest investors, is concerned about the rise of protectionist trade policies, its chief executive told business leaders in Toronto on Friday.

The CPPIB, which manages Canada’s national pension fund and invests on behalf of 20 million Canadians, has become one of the world’s biggest global infrastructure and real estate investors as it seeks to diversify from public equity and fixed income markets.

Chief Executive Mark Machin told the Toronto Region Board of Trade that the pension fund had benefited from globalization and would suffer from policies that make international trade more difficult.

“We worry about it,” Machin said. “Our investment strategy benefits from open markets. Open markets for investment, open markets for trade, open markets for people and impediments to that are not helpful.”

U.S. President Donald Trump is planning to reform a trading agreement between the United States, Mexico and Canada while Britain has voted to leave the European Union and candidates with sceptial views of free trade are running in elections in France and Germany in 2017.

“You can understand some of the concerns that have led to these policies. Not everybody has been a beneficiary of globalization,” said Machin. “Ultimately I hope that pragmatism will reign in the end and we won’t see too profound an impact, whether it’s in Europe or North America, of these policies.”

At the end of 2016, CPPIB had only 13 percent of its assets of over C$300 billion ($226 billion) invested in Canada.

About 44 percent of the investments were in the United States, with about 19 percent in Europe, around 19 percent in the Asia-Pacifc, and about 5 percent in South America and other regions.

Although CPPIB has grown to be one of the world’s biggest infrastructure investors with assets worth C$27.6 billion, it has a relatively modest stake in infrastructure projects in its own country.

Machin said he hoped plans by Canada’s Liberal government to set up an infrastructure bank to facilitate private financing for projects could lead to opportunities to invest in more large-scale projects in Canada.

“We’re hoping that the initiatives the federal government is taking will lead to a better flow of sizeable opportunities,” he said. “We focus on markets where there’s a consistent flow of projects that are investable by institutional money. Canada’s not had too many of those.”

According to Barbara Shecter of the National Post, CPPIB is most interested in airports:

The Canada Pension Plan Investment Board will consider bidding on Canada’s major airports if they’re put on the auction block by the federal government.

“We would look at it — absolutely,” Mark Machin, who took over as CPPIB’s chief executive in June, told the Financial Post on Friday after his first major public address. “We know airports, we like airports, we’d be interested if something happened.”

There has been speculation that the Liberal government is looking to collect billions of dollars by selling off some of the country’s large airports including Pearson International Airport in Toronto.

The Ontario Teachers’ Pension Plan owns stakes in three airports in the UK, including London City Airport, and CPPIB teamed up with a partner in Chile a couple of years ago in an unsuccessful bid for one of the South American country’s large airports.

In the interview with the Post following his speech to a business crowd at the Toronto Region Board of Trade, Machin expressed confidence in Ottawa’s planned Infrastructure Bank, through which the government hopes to combine billions of dollars in public and private money in large-scale projects that will create jobs and stimulate the economy. Ottawa hopes Canadian pensions that invest in infrastructure around the world including toll roads, shipping ports, and airports will be key participants.

“The intent is terrific… I think it’ll come,” Machin said, adding that it will take some time to turn the strategy into a large-scale institution with a systemic approach to infrastructure and a pipeline of deals.

Projects, however, will have to meet certain criteria including scale and an acceptable risk-adjusted return to draw interest from large institutional players such as pensions.

“Canada’s not had a lot of those,” Machin said, though he noted that CPPIB’s largest infrastructure investment is in the 407 highway near Toronto.

Machin said it is a good sign that the government has tapped former Ontario Teachers’ Pension Plan CEO Jim Leech as an adviser for the infrastructure bank, adding that this should ensure its development incorporates the needs of global institutional investors. Smaller projects could be packaged together to reach size requirements, Machin suggested, and there might be ways to structure operations to provide sufficient returns for institutional capital.

“I hope it will get off the ground soon — you can’t create a large institution overnight,” he said.

Machin said CPPIB is continuing to scour the globe for investments, including looking in China, India, and the United Kingdom, where the economy has so far shown little impact as Britain works its way toward an exit from the European Union.

At the conclusion of his speech in Toronto, he told the business crowd he hopes pragmatism prevails over protectionist policies emerging in the United States and Europe.

“CPPIB has been a huge beneficiary of globalization,” he said, adding that while he understands the urge of some countries to protect their citizens and economies, he also recognizes the benefits of open borders and open trade.

What else did Mark Machin discuss? John Gray of BNN reports that he warned investors to expect lower returns:

Canadian investors should lower their expectations for outsized market returns, warns the head of Canada’s largest pension fund.

Stocks, real estate and other global assets are fully valued and are will likely see more modest returns for the time being, Mark Machin, CEO of the Canada Pension Plan Investment Board (CPPIB) told BNN in an interview.

“Most asset prices are quite rich around the world so we are going to be careful and cautious about where we invest,” he said. “It also means that expectations about returns from relatively full value are going to be lower for a period of time.”

CPPIB manages more than $298 billion in assets on behalf of the Canadian Pension Plan. The fund reported a net investment return of about 6.9 per cent in December.

The fund is looking to increase its investment return by looking for more alternative investments, he said. “We find opportunities by looking at other asset classes, other strategies, other geographies, and not following the crowd into really crowded trades,” he said.

Machin’s comments come just two days after the Ontario Teachers’ Pension Plan (OTPP) reported a rate of return of 4.2 per cent, down from 13 per cent in the same period in 2015. The fund cited unfavorable currency movements as one of the primary sources of weakness.

CPPIB’s long investment horizon makes hedging Canadian currency risk impractical, says Machin. The CPPIB also has a diversified portfolio of global investments that also act as a natural currency hedge, he says.

Last week, I went over Ontario Teachers’ 2016 results and discussed the impact of currency swings on the Fund’s overall results.

I had a chance to talk to OTPP’s President and CEO, Ron Mock, yesterday and we went over the 2016 results. I asked him plenty of questions and he was kind enough to answer them all and cover a lot of material.

I began with the most obvious, the impact of currency swings which is front and center in the news articles and in the Annual Report (click on image):

By now, everyone in the world knows Brexit hit Teachers’ results last year and if their investment staff didn’t partially (50%) hedge the Fund’s exposure to the Pound Sterling prior to the Brexit vote, the results would have been even worse.

As stated in the press release, Teachers has investments in 37 global currencies and in more than 50 countries. In those local currencies, the return on our investments was 7.2%. Converting the return on those investments back into Canadian dollars, the currency in which pensions are paid, had a -2.8% impact on the Plan’s total-fund rate of return. By contrast, currency gains added 8.3% in 2015.

Ron told me that in terms of asset returns, 2016 was actually better than the previous year, but when you factored in currency swings, it really detracted from the performance.

Like CPPIB, Ontario Teachers’ typically doesn’t hedge currencies. This means in years where the euro, yen, pound, and US dollar are up relative to the Canadian dollar, they enjoy currency gains but in years where the CAD is doing relatively better, they take a hit on currencies.

What else did I discuss? The new federal infrastructure bank:

[…] on the newly created $35-billion Canada Infrastructure Bank, Bill Curry of the Globe and Mail reports that Ottawa just hired Metrolinx CEO, Bruce McCuaig, to advise it. Mr. McCuaig will be joining Jim Leech, the former CEO of Ontario Teachers’, who was tapped last month to get this new federal infrastructure bank up and running.

I don’t know but Ron Mock is right, considerable work needs to be done to get better alignment of interests and the bigger, more ambitious infrastructure projects take years to set up and complete.

In the meantime, I agree with those who think Ottawa’s plan to sell airports needs to take off right now — while the market is still hot. This is something that I’m sure Ontario Teachers’ and other large Canadian pensions would invest in and help transform our airports into world class airports.

In fact, just yesterday Ron Mock told BNN that Canadians will be slow to adapt to the concept of privately-owned airports, but will eventually understand their benefit.

I briefly discussed this new federal infrastructure bank with someone over the weekend who told me “it looks like they’re going to set it up in Toronto by the looks of the people that are working on it.”

I told him that would a shame because Montreal has great infrastructure expertise and the city desperately needs a new federal organization like this one.

He told me “regardless of where its headquarters will be, they need to get the governance and compensation right or else it’s going nowhere.”

Jim Leech knows all this which is why I know he’s working hard to set it up right. Canada’s large pensions are counting on him to lay the proper foundations for this organization.

I also had a chance to relay this CNBC clip on how some new infrastructure projects can be privately financed, using REITs as a model to Andrew Claerhout who leads Ontario Teachers’ Infrastructure & Natural Resources Group. Andrew shared these thoughts with me:

Raising funds from retail investors through a REIT or REIT-like structure is an interesting thought, but it fails to deal with the fundamental issue which is a lack of investable opportunities (and not a lack of capital).

During the interview, Scott failed to directly answer the question of where the funding would come from: government or tolls.

If from government through an availability payment, then there’s already a large investor universe focused on traditional PPPs and, as we have discussed before, these types of deals cater much more to lenders and construction companies than equity investors, as the equity cheques involved are typically very, very small relative to the total cost of the project.

If from tolls, then these are the exactly the types of assets large institutional investors such as Teachers’ focus on and want to see more of.

In both cases, no more capital is needed and so although the idea is interesting, I doubt it would result in any further infrastructure being built.

Another friend of mine who is an infrastructure expert at the Caisse shared Andrew’s sentiments and said that the problem isn’t lack of capital, it’s lack of investable opportunities and investors can already invest in infrastructure in public markets, “it’s called Brookfield.”

Back to Mark Machin’s comments above. CPPIB isn’t the only big pension fund worried about protectionism. On Friday, I discussed why the Caisse invested in insurance and water, buying USI Insurance with its private equity partner, KKR, for $4.3 billion:

The deal is the latest in a string of mergers in the insurance market, which has not grown quickly enough to support smaller brokerages.

“It’s a sector we like,” Caisse Chief Investment Officer Roland Lescure said in an interview. “It’s quite defensive, it has high cash-flow generation, and it’s a growing sector where there is consolidation taking place.”

The Caisse, Canada’s second-largest public pension plan, is buying businesses to help it diversify from public equity and fixed income markets.

The pension fund, which has net assets of more than C$270 billion ($202 billion), wants to have 30 percent to 35 percent of its investments in areas such as private equity, infrastructure and real estate in the next four to five years, compared with 28 percent currently.

“At a time when there are lots of fears and questions on the potential protectionism and border adjustment tax,” Lescure said, “being exposed to small and medium companies is a safer way of exposing yourself to the U.S. economy.”

Now, I highly doubt the Trump Administration will go ahead with nonsensical protectionist policies but you never know exactly what this administration will do in terms of trade.

I think it’s fair to assume powerful CEOs of multinational corporations are warning the administration not to pursue such disastrous trade policies and Trump being a businessman, will listen to their concerns.

As far as expecting lower returns ahead, I’ve been warning of this for a long time. Ron Mock also warned of this as have Michael Sabia and André Bourbonnais.

Interestingly, over the weekend, Bryce Cowen of Knowledge Leaders Capital put out a nice comment, Stock/Bond Ratio Back at 2007 Peak:

As 1Q17 finishes with a gain in the books, the stock to bond performance ratio has also broken to a new cycle high, elevating to levels not seen since mid-2007. Our measure of the stock to bond ratio measures the total return of the S&P 500 relative to that of the JPM 10 year treasury total return index. When the blue line rises, stocks are outperforming bonds, and vice versa (click on image).

While a rising stock to bond ratio isn’t all that surprising, especially in a bull market, the recent acceleration is not commonplace. Over the last two quarters stocks have outperformed bonds by 31%, which is highest level since 2011. Only in 1999 did stocks outperform bonds by a wider wide margin over a two quarter period (click on image).

So what does this simple chart tell us? Over short periods of time, the relative performance of stocks and bonds fluctuates around around a mean of about zero. When stocks outperform bonds by a large amount over a short period, that period of outperformance reverts back towards zero, either through time or performance. While we can’t possibly predict the performance of either stocks or bonds, what we can fairly confidently deduce is that further stock strength relative to bonds is unlikely over the coming months.

Now, I always warn my readers that “markets can stay irrational longer than you can stay solvent,” which is a quote often attributed to Keynes but it comes from Gary Shilling.

In my opinion, there is still a lot of juice in the system to drive risk assets higher but I have warned my readers that the Trump rally won’t go on forever, regardless of the proposed tax cuts and plans to revamp US infrastructure.

This is why I’ve been telling people to ignore the reflation chimera and bond bears that are getting slaughtered and keep buying the dips on US long bonds (TLT) to sleep well at night because if we get any negative surprises in the second half of the year, long bonds will rally a lot further (click on image):

It’s also worth remembering that CPPIB is a large pension fund with a great liquidity profile, so in a bear market, it typically outperforms because its fund managers are able to capitalize on public and private market dislocations across the world. The same goes for all of Canada’s large pensions, but CPPIB and PSP have the added advantage of great liquidity that others don’t have.

Let me end by plugging the market research at Cornerstone Macro. François Trahan and Michael Kantrowitz sent out a great report this morning, Addressing Most Popular Questions While On The Road, which I highly recommend my institutional readers all read.

In fact, if you’re not subscribed to the market research at Cornerstone Macro, I highly recommend you do so. François Trahan and Michael Kantrowitz regularly put out great reports covering market trends in detail (I covered François’s CFA luncheon in Montreal here).

Again, given my views on the reflation chimera and a potential US dollar crisis despite the recent selloff, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE) and Financial (XLF) shares.

The only sector I like and trade now, and it’s very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now. As I stated above, if you want to sleep well, buy US long bonds (TLT) and thank me later this year.

I foresee very choppy markets in Q2 but the risks of a reversal are high, so be prepared for a downturn. Of course, if we have a melt-up like 1999-2000, stocks are heading higher, but the risks of a bigger downturn down the road will be magnified (who knows, we shall see).

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