Don’t call it a comeback just yet.

As Bloomberg News reported on Tuesday, hedge fund manager Steven A. Cohen is preparing to raise as much as $10 billion from outside investors in 2018 for a new fund. Combined with his personal fortune of $11 billion, the fund could oversee more than $20 billion, which would make it the largest U.S. hedge fund launch in history.

Do It Again

It would also mark an extraordinary turnaround for Cohen. Just four years ago, he made history in all the wrong ways. His hedge fund firm at the time, SAC Capital Advisors LP, was charged with insider trading. The firm pleaded guilty and paid a record $1.8 billion penalty.

In addition, six current or former SAC employees were convicted of various criminal charges related to insider trading. Cohen was never charged with insider trading, but the Securities and Exchange Commission did accuse him of failing to supervise misbehaving employees. In the ensuing settlement, Cohen agreed not to manage outside money until Jan. 1, 2018.

Theories abound about why Cohen would want to get back in the game of managing other peoples’ money, ranging from ego to boredom. And in the end, he may not go through with it.

Cohen clearly doesn’t need the money. Sure, it would be nice to have outside investors help pay for his 1,000-employee family office, Point72 Asset Management LP. But the profits on his personal investments should more than cover those expenses.

Maybe, as Fortune writer Jen Wieczner put it, “Steve Cohen wants people to believe that he never did anything wrong. So how does he prove that? Well, if he can deliver the highest returns -- at least as high as he always has -- while he literally has people from the government, including a government appointed compliance monitor, in his office, then people are going to believe that he really is just that good.”

But trying to recreate the SAC magic with $20 billion would be a huge gamble. If Cohen falls short, it would only reinforce the suspicions he might be trying to dispel. And generating outsize returns with that much money won’t be easy.

Hedge funds generally don’t disclose their performance to the public, but Frontline published a chart in 2014 showing SAC’s annual returns from 1992 to 2012. Using that chart, I estimated the performance of SAC Capital Management LP -- SAC’s fund for U.S. investors -- during that period.

The fund’s performance over the entire period was spectacular. SAC tripled the return of the broad market with comparable risk. The fund returned roughly 26 percent annually over those 21 years with a standard deviation of 22 percent. Over the same time, the S&P 500 returned just 8 percent annually, including dividends, with a standard deviation of 19 percent. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)

There’s a critical detail in the numbers, however. Cohen launched SAC in 1992 with $25 million. Over the next 10 years, the fund returned roughly 43 percent annually, or 30 percentage points annually better than the S&P 500.

Then investors piled in. The firm eventually ballooned to $16 billion, and sustaining those monster returns became ever more difficult along the way. Over the 10 years that ended in 2012, the fund returned roughly 12 percent annually, or 5 percentage points annually better than the S&P 500.

It’s not just SAC. According to Hedge Fund Research Inc., hedge funds managed $100 billion in 1992. Over the next 10 years, the HFRI Fund Weighted Composite Index returned 15 percent annually. By 2012, hedge funds were managing $2.3 trillion, and the returns over the previous 10 years shrunk to 7 percent annually.

Size Kills

As the hedge fund industry has grown, returns have shrunk

It’s a recurring theme in finance: Size kills. There’s a reason why one of the best-performing hedge funds of all time, Renaissance Technologies’ Medallion Fund, obsessively caps its capacity at $10 billion. And yet it’s a lesson that both managers and investors routinely fail to heed.

It's one that Cohen can't ignore as he decides whether he wants to try to reconjure the magic.

Steve Cohen, the billionaire hedge-fund manager briefly banned from the industry after an insider-trading investigation, this week sent investors documents pitching his new fund, Stamford Harbor Capital, a person who has reviewed the deck told Business Insider.

The pitch is the latest move cementing the controversial billionaire's return to managing money.

Investors will have to agree to steep terms to put their money with the famed investor — including a minimum investment of $100 million and an annual management fee of over 2.5% of those assets — this person said, asking not to be identified discussing private information.

Jonathan Gasthalter, a spokesman for Cohen, declined to comment for this story.

Cohen's new fund is arguably one of Wall Street's most anticipated new launches. Bloomberg News reported earlier this month that he could raise between $2 billion and $10 billion. At the high end, it would be the largest hedge-fund launch in history.

'Wink wink, nudge nudge'

Until now, though, investors, advisors, and others in the hedge-fund industry said Cohen's representatives had limited themselves to vague and almost bizarrely hypothetical conversations about the fund along the lines of: If a particular person named Steve Cohen happens to launch a fund, and that fund happens to open next year, what would it take for an investor to sign on?

"It was a lot of wink wink, nudge nudge," said one person, who spoke of meetings before the documents were sent this week. As Bloomberg News reported earlier this month, the official line, meanwhile, was that Cohen was undecided about his plans.

Cohen has been running a family office called Point72, with some $11 billion in assets, since 2014 after he agreed not to manage other people's money and return outside investors' capital. The agreement came after a years-long insider trading investigation at Cohen's SAC Capital that ended with a conviction for one of Cohen's subordinates but not him. His failure, according to the SEC, was to supervise those traders as head of SAC Capital. SAC also pleaded guilty and paid a record fine, $1.2 billion, to settle insider-trading claims.

The ban will be lifted in January 2018.

Now, in anticipation of this, Cohen's marketing is being led by a man named Doug Blagdon at an advisory firm called ShoreBridge Capital who previously led the marketing effort at SAC Capital. Blagdon didn't immediately respond to requests for comment.

Wealthy investors, funds of hedge funds and sovereign wealth funds are the most likely investors in Cohen's new fund, people in the industry say. Public pensions, endowments, and foundations that have become major backers of the hedge fund industry are likely to stay out because they face greater public scrutiny and may find it difficult to explain an investment with a manager who — though he generated huge profits — was tarred by an association with a huge insider trading scandal.

Cohen is also said to have lined up firms to handle the back-end of a hedge fund's operations — the prime brokers who would manage settlement of trades and other basic functions as well as the "cap intro" teams at big banks who serve as gatekeepers to investors. Still, the pitch to investors is not yet widespread, and may never be. Many investors who are usually briefed on hedge fund launches say they have yet to hear anything.

Privately, Cohen has expressed doubts about whether he should come out again, a potential investor who also knows Cohen personally said. Cohen's family office hasn't recently posted the kind of 30% annual returns that he was once famous for.

"I suspect the real question is whether Cohen can still achieve outsized alpha," said Chris Cutler, a consultant, using a hedge-fund term for outperformance. "If even he can't, what is the fate for other long/short-focused managers? I think Cohen will have a willing and ready list of LPs ready to invest with him. He doesn't need to worry about which LPs won't invest with him."

Staffers at Point72, which has been investing Cohen's billions since SAC got shut down, have been largely kept in the dark. They were unsure until recently whether Cohen would open up again. Those who know Cohen personally say the same.

Staffers said they hoped that Cohen would raise outside money – it would show a sense of permanency for their jobs and would make it less likely that Cohen would shut the operation down voluntarily, a person familiar said. Creating a hedge fund would also spread the cost of employees and support staff among other investors — as Point72 is currently managing Cohen's own money and that of some employees.

The hefty demands being made of investors — the minimum investment and fees — are a luxury only afforded to the most superstar investors. Cohen is one, famed for his consistent double-digit returns before he was rocked by the insider-trading investigation.

He has an army of admirers, often those who were made rich by him, either by working for him directly or by investing with him. Many think he has never done anything wrong, and that he's the greatest investor of all time.

Blatant 'no'

But he's also a polarizing figure because of the legal issues.

For at least two investors Blagdon has reached out to, and other potential investors who have yet to hear from him, the answer is a blatant "no."

No matter that the past several years, Cohen has tried to clean up his image. He hired former Department of Justice staffers and McKinsey consultants, and started a training program for young college grads – something Business Insider was invited to tour.

To show how compliant he was, he even put a ban on hiring from Visium, an $8 billion-dollar fund that shut down amid one of the most recent insider-trading scandals, before the public knew that Visium was even under investigation.

Still, it would be "willful ignorance" to think Cohen didn't have some hand in the trading, or at least know about it, one person in the industry said.

Investors who worry about this won't be investing.

At long last, the pretense that Steve Cohen’s return to the hedge fund industry (which is not really a return at all, but whatever) is lifting: Now, in addition to the third-party marketer and fee structure and growing global footprint and ramped-up hiring and shadow-boxing with British regulators and all the rest of it, there’s something tangible and not easily deniable in a “we’re just trying to run the best damned family office we can” sort of way: a marketing deck for Stamford Harbor Capital that’s been seen by real potential investors, albeit not all that many of them.

Until now, though, investors, advisors, and others in the hedge-fund industry said Cohen’s representatives had limited themselves to vague and almost bizarrely hypothetical conversations about the fund along the lines of: If a particular person named Steve Cohen happens to launch a fund, and that fund happens to open next year, what would it take for an investor to sign on?

“It was a lot of wink wink, nudge nudge,” said one person, who spoke of meetings before the documents were sent this week.

There is also the matter of the service providers being lined up, including cap intro folks who’ll get to pitch potentials on the twice-in-a-lifetime opportunity to invest with the great man, now at the low, low price of a 2.5% management fee and $100 million minimum investment, which are the sorts of things that family offices don’t really need but that hedge funds do.

Even still, however, there are those clinging to the belief that Cohen will not, in fact, begin managing outside money again. Including, the rumors and water-cooler talk on Cummings Point Road say, Steve Cohen himself.

Privately, Cohen has expressed doubts about whether he should come out again, a potential investor who also knows Cohen personally said. Cohen’s family office hasn’t recently posted the kind of 30% annual returns that he was once famous for….

Staffers at Point72, which has been investing Cohen’s billions since SAC got shut down, have been largely kept in the dark. They were unsure until recently whether Cohen would open up again. Those who know Cohen personally say the same.

So why, wracked with self-doubt and with his heart not in the project, would Papa Bear be willing to put himself out there? To risk getting hurt again? To deal with slings and arrows like the following?

For at least two investors Blagdon has reached out to, and other potential investors who have yet to hear from him, the answer is a blatant “no….”

It would be “willful ignorance” to think Cohen didn’t have some hand in the trading, or at least know about it, one person in the industry said.

Open your eyes (and hearts), people: Steve Cohen is not doing this for himself! He doesn’t need the money, even if it would come in handy when that tax bill shows up or during his next visit to Christie’s. It’s not even about redeeming his good name. No: Coming back, in the face of the scorn and sniggers, isn’t about raking in a cynical $250 million a year just for sitting on people’s money. It’s about helping people. It’s about not disappointing his fans and his dependents. It’s practically a philanthropic effort for this man focus his time and attention on managing outside capital at these ridiculously low rates.

Staffers said they hoped that Cohen would raise outside money – it would show a sense of permanency for their jobs and would make it less likely that Cohen would shut the operation down voluntarily, a person familiar said….

He has an army of admirers, often those who were made rich by him, either by working for him directly or by investing with him. Many think he has never done anything wrong, and that he’s the greatest investor of all time.

"Steve has asked me to respond to your email, seeking an interview with him for your blog.

We’re going to pass.

Sorry we can’t be more helpful on this."

Public-employee pension funds are big business in Ohio, providing a safety net for 1.75 million people.

There’s a lot riding on them.

Collectively, Ohio’s five public pension funds have $192 billion in assets and last year paid out more than $15 billion in pension benefits and $1.1 billion in health-care benefits. They are not required by law to provide health insurance, but all five do. Whether they will in the future is uncertain.

Although the funds have been mostly reliable and financially sound for decades, recent economic downturns, soaring health-care and prescription-drug costs, and the increased longevity of retirees have taken a toll. Several of the funds are reducing or eliminating cost-of-living adjustments, cutting subsidies and increasing health-care premiums.

The five funds are the Ohio Public Employees Retirement System (public workers); State Teachers Retirement System (teachers); School Employees Retirement System (school-bus drivers, cafeteria workers, janitors, secretaries); Ohio Police & Fire Pension Fund (municipal police officers and firefighters); and the Highway Patrol Retirement System (state troopers). The Ohio General Assembly has oversight of all five through the Ohio Retirement Study Council.

The big question: How long can the pension funds hold out financially in this economic climate? A study released in December by the Mercatus Center at George Mason University painted a gloomy picture.

“Ohio’s four largest public pension plans are severely underfunded based on traditional metrics of pension solvency, and they are only guaranteed to be able to finance their promised obligations for roughly the next decade without additional taxpayer contributions,” economists Erick Elder and David Mitchell wrote.

“However, the funding ratio does not take into consideration the investment risk associated with pension-plan assets; even if Ohio’s pensions were fully funded today, they would still only have a fifty-fifty chance of being able to fulfill their promises in the year 2045.”

The School Employees Retirement System

Members of this pension fund are the lowest-paid of the five, averaging about $24,000 a year, and the fund is under fire from members and the Ohio Association of Public School Employees, a labor union, because of proposed changes in cost-of-living adjustments.

Retirees receive a 3 percent COLA one year after retirement, but fund administrators propose eliminating the COLA from 2018 to 2020 and then capping it at 2.5 percent thereafter. Retirees would get no COLA until their fourth anniversary.

About 200 union members marched last week from the Statehouse to the fund headquarters at 300 E. Broad St. in protest. Some said they are worried that the proposed COLA changes signal bigger problems.

“The fear people have is not having a pension,” said OAPSE President JoAnn Johntony, 76, head custodian in the Girard City Schools in Trumbull County, where she has worked for 50 years. “To try to solve these problems on the backs of school employees is wrong.

“We have to live and pay bills like everybody else,” Johntony said. ’They’re not seeing the human side of this. They’re not seeing how this affects our daily lives.”

Lois Carson, 57, the union’s vice president and a secretary in the Columbus school district, said she will live on her late husband’s small pension and her pension when she retires.

“I will probably be moving in with my kids to survive,” she said. “I’m very scared about it.”

Facing increases in health-care costs, SERS retirees will be making less in retirement benefits than they did 30 years ago, Carson said.

The fund must get legislative approval for the COLA changes. Bills are pending in both the Ohio House and Senate. Administrators say the changes are needed to stabilize the fund and continue to provide health-care benefits that otherwise probably would run out in less than a decade.

The Ohio Retirement Study Council recommended last week that the legislature approve the COLA adjustment for the school-employees fund.

Ohio Public Employees Retirement System

With 1 million active members and retirees, this is the largest public pension fund in Ohio and the 12th-largest public retirement system in the nation. It affects about 1 in 12 Ohioans and has 3,680 public employers in the system.

Changes began in 2012 when the General Assembly approved cost-cutting measures.

OPERS spokesman Todd Hutchins said the changes keep the health-care package intact “for the foreseeable future.” Hutchins said the fund is 80 percent funded for the future, falling within the 30-year requirement under state law for paying off pension liabilities.

Some of the changes, however, will make it harder for younger retirees and spouses of retirees. New retirees will pay about $219.33 in monthly health premiums, more than six times what retirees paid last year. The fund is also ending both premium payments and reimbursement of some Medicare expenses for the spouses of members.

Ohio Police & Fire Pension Fund

The fund provides pension, disability and optional health-care benefits to full-time police officers and firefighters and their dependents.

“We continue to meet the state requirements as far as our funding level. That’s something we have to look at every year,” spokesman David Graham said. “We must be able to pay off our unfunded liabilities in a 30-year period, and we’re at 29 years.”

But changes are coming for fund members as trustees begin the process of providing stipends to retirees to seek their own health-care coverage rather than providing health insurance for them.

John Gallagher, the fund’s executive director, told The Dispatch, “Our investment returns in 2016 were excellent, with a net 10.9 percent return for the year. Our current challenge is finding a way to sustain a health-care option for our retired population. While it is not a requirement that we provide a health-care plan, we realize it is a vital part of a secure retirement.”

State Teachers Retirement System

Like other public employees, retired teachers face big changes in their benefits. As of July 1, the system will temporarily eliminate all new cost-of-living increases in pensions to “preserve the fiscal integrity of the system.” Spokesman Nick Treneff said the situation will be re-evaluated in five years.

The system previously reduced the annual increase to 2 percent from 3 percent.

Treneff said the decision to eliminate the COLA resulted from three factors: lower-than-expected returns on investments, a larger-than-expected payout in pension benefits, and new mortality statistics showing that retirees are living longer, thus increasing the fund’s financial liability.

“Health care isn’t a requirement, but we know members value it,” Treneff said “To have good coverage is essential to the life of retirees. We don’t divert any money to health care from employee contributions.”

Ohio Highway Patrol Retirement Fund

With 3,200 members, the fund is by far the smallest pension system, and it has had to increase health-care premiums annually to remain in the black.

Like the other funds, the patrol system is struggling to meeting costs, said Mark Atkeson, the executive director. “Health-care costs have skyrocketed. The collapse of 2008-2009 set everything back, and we’re not completely recovered from that.”

Last week, the retirement study council approved removing a provision allowing patrol members to retire at age 48 with unreduced benefits; it also approved some reductions in off-duty disability and survivor benefits. The changes need the approval of the legislature.

Although those adjustments will help, the system’s health-care fund is projected to run out of money in less than a decade, Atkeson said.

The $90.6 billion Ohio Public Employees Retirement System (OPERS) said it is considering limiting the cost-of-living adjustments (COLA) for its retirees.

“Our retirees are living longer, requiring us to pay benefits for many more years than in the past. Further, we are in a decades-long period of low inflation,” said OPERS Executive Director Karen Carraher in a mailer to plan participants. “With this environment in mind, we have begun to gather feedback from members, retirees, and stakeholder groups about potential changes to the cost-of-living adjustment that would affect current retirees.”

OPERS started providing a COLA in 1970, and it has changed several times since then, according to Carraher, who said the purpose of a COLA is to lessen the effects of inflation on participants’ pension benefit, not to fully offset it. OPERS currently has a fixed 3% COLA for its retirees. For those who retired after January 2013, that COLA is scheduled to match the Consumer Price Index (CPI), with a maximum adjustment of 3% starting in 2019.

“The CPI has topped 3% only five times during the past 25 years, so OPERS’ fixed COLA has resulted in a net benefit increase for many retirees,” said Carraher. “Simply put, the COLA we are paying is exceeding the CPI in these low inflationary times.”

Because of this, OPERS has proposed a plan to base the COLA for all retirees, including current retirees, on the CPI capped at 3% starting in 2019. For plan members who retired before 1990, and who have seen inflation reduce their purchasing power, Carraher said OPERS could provide a one-time benefit increase.

“We are also looking at other options,” said Carraher, “including a COLA freeze and a COLA based on the CPI capped at 2.5% or 2%. There are many other scenarios that could be added as we gather feedback.”

Any changes to the COLA require approval by the OPERS Board of Trustees as well as the Ohio Legislature. According to Carraher, OPERS is funded at 80%, and is well within the state-mandated limits for pension fund solvency.

“However, we can’t always count on the future reflecting the past,” she said. “In order to retain our strong financial position, and continue to offer the COLA to current and future retirees, we are considering these steps now. As we go down this path together, it is important to stress we are gathering feedback and will move through a very open and public process to evaluate changes.”

• Immediately cap all pensions to a certain amount, including those of these pension "elites" and let them take you to court if they feel you are reneging on their contract.
• Immediately raise the contribution rate and cut benefits (fully or partially remove cost-of-living adjustments) until the plan gets back to fully-funded status.
• Make pension contribution holidays illegal at UC and everywhere in California and the United States. Period.
• Raise the retirement age of UC's professors to 65. If my 86 year-old father who like most doctors everywhere has no pension can still work as a psychiatrist three times a week, these professors can tough it out in academia till 65 (most work well past that age).
•  Forget shifting new professors to defined-contribution (DC) plans. The brutal truth is they're horrible and will only ensure pension poverty down the road. UC needs to curb pension largess but shifting to DC will only ensure pension poverty and make it harder to attract qualified staff.
• Follow Canada's CAAT Pension Plan when it comes to the gold standard in pensions for university defined-benefit pensions. CAAT Pension Plan is a jointly sponsored plan where sponsors share the risk of the plan if it goes into deficit. You can read all about this plan here and read their 2016 annual report here.

• Introduce a shared-risk model and make sur employees and the plan sponsors share the risk equally. This effectively means when the plan runs into trouble, contributions are raised and benefits are cut (fully or partially remove COLAs) until plans are back at fully-funded status.
• Alamagate all of Ohio's public sector plans into OPERS which is actually well run and has better governance than all the other plans. When it comes to pensions, bigger is better as long as the governance is there.
• Get real on investment assumptions and future returns and prepare for the worst bear market ever. 

Today we’ll continue to size up the bull market in governmental promises. As we do so, keep an old trader’s slogan in mind: “That which cannot go on forever, won’t.” Or we could say it differently: An unsustainable trend must eventually stop.

Lately, I have focused on the trend in US public pension funds, many of which are woefully underfunded and will never be able to pay workers the promised benefits, at least without dumping a huge and unwelcome bill on taxpayers. And since taxpayers are generally voters, it’s not at all clear they will pay that bill.

Readers outside the US might have felt smug and safe reading those stories. There go those Americans again, spending wildly beyond their means. You are correct that generally speaking, we are not exactly the thriftiest people on Earth. However, if you live outside the US, your country may be more like ours than you think. Today we’ll look at some data that will show you what I mean. This week the spotlight will be on Europe.

First, let me suggest that you read my last letter, “Build Your Economic Storm Shelter Now,” if you missed it. It has some important background for today’s discussiion, as well as a special invitation to attend my Strategic Investment Conference next March 6–9 in San Diego. With so much change occurring so quickly now, next year’s conference is an event you shouldn’t miss.

Global Shortfall

I wrote a letter last June titled “Can You Afford to Reach 100?” Your answer may well be “Yes;” but, if so, you are one of the few. The World Economic Forum study I cited in that letter looked at six developed countries (the US, UK, Netherlands, Japan, Australia, and Canada) and two emerging markets (China and India) and found that by 2050 these countries will face a total savings shortfall of $400 trillion. That’s how much more is needed to ensure that future retirees will receive 70% of their working income. This staggering figure doesn’t even include most of Europe.

This problem exists in large part because of the projected enormous increase in median life expectancies. Reaching age 100 is already less remarkable than it used to be. That trend will continue. Better yet, I think we will also be healthier at advanced ages than people are now. Could 80 be the new 50? We’d better hope so, because the math is pretty bleak if we assume people will stop working at age 65–70 and then live another quarter-century or more.

That said, I think we’ll see a great deal of national variation in these trends. The $400 trillion gap is the shortfall in government, employer, and individual savings. The proportions among the three vary a great deal. Some countries have robust government-provided retirement plans; others depend more on employer and individual contributions. In the aggregate, though, the money just isn’t there. Nor will it magically appear just when it’s needed.

WEF reaches the same conclusion I did long ago: The idea that we’ll enjoy decades of leisure before our final decline simply can’t work. Our attempt to live out long and leisurely retirements is quickly reaching its limits. Most of us will work well past 65 whether we want to or not, and many of us will not have our promised retirement benefits to help us through our final decades.

What about the millions who are already retired or close to retirement? That’s a big problem, particularly for the US public-sector workers I wrote about in my last two letters. We should also note that we’re all public-sector workers in a way, since we must pay into Social Security and can only hope Washington gives us something back someday.

Let’s look at a few other countries that are not much better off.

UK Time Bomb

The WEF study shows that the United Kingdom presently has a $4 trillion retirement savings shortfall, which is projected to rise 4% a year and reach $33 trillion by 2050. This in a country whose total GDP is $3 trillion. That means the shortfall is already bigger than the entire economy, and even if inflation is modest, the situation is going to get worse. Further, these figures are based mostly on calculations made before the UK decided to leave the European Union. Brexit is a major economic realignment that could certainly change the retirement outlook. Whether it would change it for better or worse, we don’t yet know.

A 2015 OECD study (mentioned here) found that across the developed world, workers could, on average, expect governmental programs to replace 63% of their working-age incomes. Not so bad. But in the UK that figure is only 38%, the lowest in all OECD countries. This means UK workers must either build larger personal savings or severely tighten their belts when they retire. Working past retirement age is another choice, but it has broader economic effects – freezing younger workers out of the job market, for instance.

UK employer-based savings plans aren’t on particularly sound footing, either. According to the government’s Pension Protection Fund, some 72.2% of the country’s private-sector defined-benefit plans are in deficit, and the shortfalls total £257.9 billion. Government liabilities for pensions went from being well-funded in 2007 to having a shortfall 10 years later of £384 billion (~$500 billion). Of course, that figure is now out of date because, just a few months later, it’s now £408 billion – that’s how fast these unfunded liabilities are growing. Again, that’s a rather tidy sum for a $3 trillion economy to handle.

UK retirees have had a kind of safety valve: the ability to retire in EU countries with lower living costs. Depending how Brexit negotiations go, that option could disappear.

Turning next to the Green Isle, 80% of the Irish who have pensions don’t think they will have sufficient income in retirement, and 47% don’t even have pensions. I think you would find similar statistics throughout much of Europe.

A report this summer from the International Longevity Centre suggested that younger workers in the UK need to save 18% of their annual earnings in order to have an “adequate” retirement income – which it defines as less than today’s retirees enjoy. But no such thing will happen, so the UK is heading toward a retirement implosion that could be at least as damaging as the US’s.

Swiss Cheese Retirement

Americans often have romanticized views of Switzerland. They think it’s the land of fiscal discipline, among other things. To some extent that’s true, but Switzerland has its share of problems, too. The national pension plan there has been running deficits as the population grows older.

Earlier this month, Swiss voters rejected a pension reform plan that would have strengthened the system by raising women’s retirement age from 64 to 65 and raising taxes and required worker contributions. From what I can see, these were fairly minor changes, but the plan still went down in flames as 52.7% of voters said no.

Voters around the globe generally want to have their cake and eat it, too. We demand generous benefits but don’t like the price tags that come with them. The Swiss, despite their fiscally prudent reputation, appear to be not so different from the rest of us. Consider this from the Financial Times:

Alain Berset, interior minister, said the No vote was “not easy to interpret” but was “not so far from a majority” and work would begin soon on revised reform proposals.

Bern had sought to spread the burden of changes to the pension system, said Daniel Kalt, chief economist for UBS in Switzerland. “But it’s difficult to find a compromise to which everyone can say Yes.” The pressure for reform was “not yet high enough,” he argued. “Awareness that something has to be done will now increase.”

That description captures the attitude of the entire developed world. Compromise is always difficult. Both politicians and voters ignore the long-term problems they know are coming and think no further ahead than the next election. The remark that “Awareness that something has to be done will now increase” may be true, but there’s a big gap between awareness and motivation – in Switzerland and everywhere else.

Switzerland and the UK have mandatory retirement pre-funding with private management and modest public safety nets, as do Denmark, the Netherlands, Sweden, Poland, and Hungary. Not that all of these countries don’t have problems, but even with their problems, these European nations are far better off than some others.

(Sidebar: low or negative rates in those countries make it almost impossible for their private pension funds to come anywhere close to meeting their mandates. And many of the funds are by law are required to invest in government bonds, which pay either negligible or negative returns.)

Pay-As-You-Go Woes

The European nations noted above have nowhere near the crisis potential that the next group does: France, Belgium, Germany, Austria, and Spain are all pay-as-you-go countries (PAYG). That means they have nothing saved in the public coffers for future pension obligations, and the money has to come out of the general budget each year. The crisis for these countries is quite predictable, because the number of retirees is growing even as the number of workers paying into the national coffers is falling. There is a sad shortfall of babies being born in these countries, making the demographic reality even more difficult. Let’s look at some details.

Spain was hit hard in the financial crisis but has bounced back more vigorously than some of its Mediterranean peers did, such as Greece. That’s also true of its national pension plan, which actually had a surplus until recently. Unfortunately, the government chose to “borrow” some of that surplus for other purposes, and it will soon turn into a sizable deficit.

Just as in the US, Spain’s program is called Social Security, but in fact it is neither social nor secure. Both the US and Spanish governments have raided supposedly sacrosanct retirement schemes, and both allow their governments to use those savings for whatever the political winds favor.

The Spanish reserve fund at one time had €66 billion and is now estimated to be completely depleted by the end of this year or early in 2018. The cause? There are 1.1 million more pensioners than there were just 10 years ago. And as the Baby Boom generation retires, there will be even more pensioners and fewer workers to support them. A 25% unemployment rate among younger workers doesn’t help contributions to the system, either.

A similar dynamic may actually work for the US, because we control our own currency and can debase it as necessary to keep the government afloat. Social Security checks will always clear, but they may not buy as much. Spain’s version of Social Security doesn’t have that advantage as long as the country stays tied to the euro. That’s one reason we must recognize the potential for the Eurozone to eventually spin apart. (More on that below.)

On the whole, public pension plans in the pay-as-you-go countries would now replace about 60% of retirees’ salaries. Further, several of these countries let people retire at less than 60 years old. In most countries, fewer than 25% of workers contribute to pension plans. That rate would have to double in the next 30 years to make programs sustainable. Sell that to younger workers.

The Wall Street Journal recently did a rather bleak report on public pension funds in Europe. Quoting:

Europe’s population of pensioners, already the largest in the world, continues to grow. Looking at Europeans 65 or older who aren’t working, there are 42 for every 100 workers, and this will rise to 65 per 100 by 2060, the European Union’s data agency says. By comparison, the U.S. has 24 nonworking people 65 or over per 100 workers, says the Bureau of Labor Statistics, which doesn’t have a projection for 2060. (WSJ)
While the WSJ story focuses on Poland and the difficulties facing retirees there, the graphs and data in the story make clear the increasingly tenuous situation across much of Europe. And unlike most European financial problems, this isn’t a north-south issue. Austria and Slovenia face the most difficult demographic challenges, right along with Greece. Greece, like Poland, has seen a lot of its young people leave for other parts of the world. This next chart compares the share of Europe’s population that 65 years and older to the rest of the regions of the world and then to the share of population of workers between 20 and 64. These are ugly numbers.

Source: WSJ

The WSJ continues:

Across Europe, the birthrate has fallen 40% since the 1960s to around 1.5 children per woman, according to the United Nations. In that time, life expectancies have risen to roughly 80 from 69.

In Poland birthrates are even lower, and here the demographic disconnect is compounded by emigration. Taking advantage of the EU’s freedom of movement, many Polish youth of working age flock to the West, especially London, in search of higher pay. A paper published by the country’s central bank forecasts that by 2030, a quarter of Polish women and a fifth of Polish men will be 70 or older.

Source: WSJ

Next week we will look at the unfunded liabilities of the US government. It will not surprise anyone to learn that the situation is ugly, and there is no way – zero chance, zippo – that the US government will be able to fund those liabilities without massive debt and monetization.

Now, what I am telling you is that every bit of analysis about the pay-as-you-go countries in Europe suggests that they are in a far worse position than the United States is. Plus, the economies of those countries are more or less stagnant, and they are already taxing their citizens at close to 50% of GDP.

The chart below shows the percentage of GDP needed to cover government pension payments in 2015 and 2050. But consider that the percentage of tax revenues required will be much higher. For instance, in Belgium the percentage of GDP going to pensions will be 18% in about 30 years, but that’s 40–50% of total tax revenues. That hunk doesn’t leave much for other budgetary items. Greece, Italy, Spain? Not far behind.

And there is other research that makes the above numbers seem optimistic by comparison. The problem that the European economies have is that for the most part they are already massively in debt and have high tax rates. And they can’t print their own currencies.

Many of Europe’s private pension companies and corporations are also in seriously deep kimchee. Low and negative interest rates have devastated the ability of pension funds to grow their assets. Combined with public pension liabilities, the total cost of meeting the income and healthcare needs of retirees is going to increase dramatically all across Europe.

Macron, the new French president, really is trying to shake up the old order, to his credit; and this week he came out and began to lay the foundation for the mutualization of all European debt, which I assume would end up on the balance sheet of the ECB. However, that plan still doesn’t deal with the unfunded liabilities. Do countries just run up more debt? It seems like the plan is to kick the can down the road just a little further, something Europe is becoming really good at.

In this next chart, note the line running through each of the countries, showing their debt as a percentage of GDP. Italy’s is already over 150%. And this is a chart based mostly on 2006 and earlier data. A newer chart would be much uglier.

I could go on reviewing the retirement problems in other countries, but I hope you begin to see the big picture. This crisis isn’t purely a result of faulty politics – though that’s a big contributor – it’s a problem that is far bigger than even the most disciplined, future-focused governments and businesses can easily handle.

Look what we’re trying to do. We think people can spend 35–40 years working and saving, then stop working and go on for another 20–30–40 years at the same comfort level – but with a growing percentage of retirees and a shrinking number of workers paying into the system. I’m sorry, but that’s magical thinking. And it’s not what the original retirement schemes envisioned at all. Their goal was to provide for a relatively small number of elderly people who were unable to work. Life expectancies were such that most workers would not reach that point, or would at least live just a few years beyond retirement.

As I have pointed out in past letters, when Franklin Roosevelt created Social Security for people over 65 years old, US life expectancy was about 56 years. If the retirement age had kept up with the increase in life expectancy, the retirement age in the US would now be 82. Try and sell that to voters.

Worse, generations of politicians have convinced the public that not only is a magical outcome possible, it is guaranteed. Many politicians actually believe it themselves. They aren’t lying so much as just ignoring reality. They’ve made promises they aren’t able to keep and are letting others arrange their lives based on the assumption that the impossible will happen. It won’t.

How do we get out of this jam? We’re all going to make big adjustments. If the longevity breakthroughs I expect to happen soon (as in the next 10–15 years), we may be able to adjust with minimal pain. We’ll work longer years, and retirement will be shorter, but it will be better because we’ll be healthier.

That’s the best-case outcome, and I think we have a fair chance of seeing it, but not without a lot of social and political travail. How we get through that process may be the most important question we face.

The Federal Reserve’s own actions, not transitory factors, are responsible for weak inflation, a Fed policymaker argued on Monday, and the U.S. central bank should wait to raise rates again until inflation hits its 2-percent goal.

“The FOMC’s policy to remove monetary accommodation over the past few years is likely an important factor driving inflation expectations lower,” Minneapolis Fed President Neel Kashkari wrote in an essay on the bank’s website, referring to the central bank’s Federal Open Market Committee, which sets U.S. interest rates. “My preference would be not to raise rates again until we actually hit 2 percent core PCE inflation on a 12-month basis, unless we have seen a large drop in the headline unemployment rate signaling that we have used up remaining labor market slack, or a surprise increase in inflation expectations.”

Kashkari’s comments stake out a dovish view of policy at odds with that of the Fed’s core, who expect inflation to strengthen as the labor market tightens. Most Fed policymakers, including Fed Chair Janet Yellen, expect they will need to raise rates in December, and three more times next year, to keep the economy from overheating.

Kashkari, who dissented twice this year against Fed rate hikes, argued Monday that the Fed’s decision to end bond-buying in 2014, its hawkish guidance on rate hikes since then, and the four rate hikes it has actually completed have pushed inflation expectations down and kept job and wage growth slower than they would have been otherwise.

Allowing inflation expectations to slip gives the Fed less leeway to fight future downturns with rate cuts, he said.

“There is no reason to raise rates until we start to see wages and inflation climb back to target,” Kashkari wrote. “The only explanation that would potentially call for further policy tightening is the transitory factor explanation. But the longer low inflation persists (here and around the world), the more tenuous that story becomes.”

The Fed should therefore “proceed with caution” on raising rates further, he said.

The FOMC began actually raising the FFR in December 2015 and followed up with three more hikes through June 2017, despite muted wage and inflationary pressures. The signal from this activity suggests a strong desire to raise rates, even with an absence of inflationary pressures.

We know that monetary policy operates with a lag. I believe these actions to remove various forms of accommodation are now having an effect on the economy by lowering inflation expectations. In my view, inflation expectations declined because actual inflation was below target for a long time, and the Fed’s actions to reduce accommodation led to a weakening of confidence that it was serious about bringing inflation back to target in a reasonable time frame.

The Federal Reserve should wait until there are clear signs that American paychecks and prices are rising before raising interest rates again, a U.S. central banker said Monday, warning that moving too fast would be a policy “misstep.”

Chicago Federal Reserve Bank President Charles Evans, who votes this year on monetary policy, said he broadly agrees with his colleagues who believe rates should rise gradually to about 2.7 percent over the next two years or so, from the current range of between 1 percent and 1.25 percent.

But he said inflation, running at 1.4 percent by the Fed’s preferred gauge, is too low, and voiced concerns that low inflation expectations will keep it from rising toward the Fed’s 2-percent inflation goal.

“We need to see clear signs of building wage and price pressures before taking the next step in removing accommodation,” Chicago Federal Reserve Bank President Charles Evans said in remarks prepared for delivery to the Economic Club of Grand Rapids. “A gradual and cautious approach continues to be the appropriate strategy.”

His comments stood in stark contrast to the confident tone adopted by William Dudley, chief of the New York Fed, who earlier Monday said inflation weakness is fading.

The Fed has raised interest rates twice this year, and last week policymakers pointed to one more rate hike this year and three next year. Fed Chair Janet Yellen said such increases are justified by improvements in the labor market and the conviction that inflation will return to 2 percent by 2019.

Evans said he is less optimistic about inflation. Returning inflation to 2-percent over the medium term, he said, calls for policies that generate at least the possibility inflation could exceed 2 percent.

“We should avoid taking policy steps that could be misread as a lack of concern over the inflation outlook,” said Evans. “In my view, that would be a policy misstep that would further delay achieving our inflation objective.”

Inflation in the eurozone hasn’t yet reached the European Central Bank’s definition of price stability and the path toward this goal will shape the ECB’s plan to end its bond-buying program, the central bank’s chief economist said Monday.

Peter Praet said the ECB remained confident that inflation would ultimately hit levels that were close to, but below, 2%, the ECB’s medium-term price stability target.

But “the evidence still shows insufficient progress toward a sustained adjustment in the path of inflation toward those levels,” Mr. Praet said in remarks in London and published on the ECB’s website.

Data released last week showed inflation in the eurozone was 1.5% on the year in September, lower than economists’ expectations. Moreover there was evidence that price pressures could be easing. Core inflation, which excludes prices of energy and food that the ECB has little influence over, stood 1.1%, its lowest level since June.

The reading for September may mark a peak for many months to come. That is because oil and food prices rose rapidly in the early months of this year, but have since moderated. Indeed, the ECB has warned that inflation is likely to dip below 1% at the start of next year, when it is likely to start to cut back on its bond buys.

Mr. Praet’s comments may suggest that the central bank is likely to be exceedingly cautious as it ends its bond purchase program. Markets expect the ECB to offer more detail on these plans at its meeting on Oct. 26th. The ECB currently buys €60 billion in bonds per month and is due to continue purchasing at that volume until the end of the year.

But investors are eyeing the October ECB meeting for clues about an expected gradual reduction in purchases next year.

“Such “sustained adjustment” is the principal contingency that has guided and will be guiding the introduction and withdrawal of our asset purchase program (APP) and, indirectly, of all the main components of our present policy,” he said.

Japanese companies' inflation expectations eased slightly in September from three months ago in a worrying sign the economy continues to struggle with a deflationary mindset.

Companies surveyed by the Bank of Japan expect consumer prices to rise 0.7 percent a year from now, lower than their projection for a 0.8 percent increase three months ago.

Firms also expect consumer prices to rise an annual 1.1 percent three years from now, unchanged from the previous survey.

Japan's economy has grown at a healthy pace this year, but consumer prices have eked out only small gains, which could hasten calls for the BOJ to either expand monetary easing or overhaul its approach to reflating the economy.

"Companies are more optimistic about overseas economies and don't expect domestic retail prices to rise that much," said Shuji Tonouchi, senior market economist at Mitsubishi UFJ Morgan Stanley Securities.

"We won't see an immediate change in the BOJ's policy, but this does show that monetary easing will have to remain in place for a long time."

The data come one day after the BOJ's tankan survey on corporate sentiment showed big manufactures are the most confident in a decade as global demand adds momentum to the economic recovery.

The tankan survey also showed companies expect the economy to lose a little momentum in the next three months.

Core consumer prices, which include oil products but excludes fresh food prices, rose 0.7 percent in August from a year earlier, marking the eighth straight month of gains but still well below the BOJ's 2 percent inflation target.

One BOJ policymaker called for expanding monetary stimulus at a policy meeting in September, raising concerns that the board could become divided.

The central bank next meets on Oct. 30-31, where it will update its forecasts for consumer prices. A lowering of the forecasts would put pressure on the central bank to take further steps.

The BOJ started the survey on corporate price expectations from the tankan in March 2014 to gather more information on inflation expectations, key to its current stimulus programme.

Seventh time lucky? Minutes of the Bank of Japan’s (BoJ) policy meeting in July, published on September 26th, showed that the central bank had, for the sixth time since 2013, pushed back the date at which it expected prices to meet its 2% inflation target—to the fiscal year ending in March 2020.

Four-and-a-half years since Haruhiko Kuroda took office as governor and embarked on an unprecedented experiment in quantitative easing (QE), the bank is still far from its goal. It has swept up 40% of Japanese government bonds and a whopping 71% of exchange-traded funds. The bank’s balance-sheet has tripled. It is now roughly the size of the American Federal Reserve’s.

Yet, despite his apparent failure, and despite a snap general election, Mr Kuroda may yet stay for another five years when his term runs out next April. If not, most of his likely successors are signed up to the same reflationary policy. At least one member of the bank’s board gave warning at its most recent policy meeting on September 20th-21st that the measures it has taken are insufficient to stoke the desired inflation. These include keeping short-term interest rates negative, at about -0.1%, and ten-year government-bond yields at around zero. Soon, however, debate might turn to the feasibility of the 2% target.

Many countries would be happy to have Japan’s problems, says Masamichi Adachi of JPMorgan Securities: full employment, soaring corporate profits and the third-longest economic expansion since the second world war. But with government reforms faltering, the BoJ’s role as custodian of “Abenomics” (the policies of the prime minister, Shinzo Abe), seems assured. A labour crunch may at last be working where government badgering of Japanese companies to pay workers more has failed. In a speech this week, Mr. Kuroda pointed to rising wages as a reason to hope inflation will pick up. Firms, he said, have been absorbing the cost to keep prices low, but will not be able to do so forever.

Not all share his optimism. Monetary easing is failing in one of its aims, says Sayuri Shirai, a former BoJ board member: to foster risk-taking corporate behaviour. Instead, the amount of cash hoarded by Japan’s companies has grown by about ¥50trn ($443bn) over the past five years and exceeds ¥210trn, a record.

With sluggish investment and demand, Mr Kuroda’s monetary blitzkrieg will continue. The risk, says Ms Shirai, is that monetary policy has become a crutch for the entire economy. Leaning on the central bank, some companies are reducing efforts to boost productivity and improve governance, she says. And, by becoming the largest shareholder in several companies, the bank is distorting the pricing function of the market, adds Nicholas Benes, of the Board Director Training Institute of Japan.

Mr Kuroda stunned the markets with QE in 2013 and has continued to surprise since with a string of policy innovations. But nobody, says Mr Adachi, can see when the BoJ will start to reduce its asset purchases, let alone trim its balance-sheet. Perhaps never. For all the problems its easy-money policy brings, many think it more costly to ditch it than to keep on digging.

The survey of consumer expectations, an increasingly valuable gauge as the Fed decides when to raise interest rates again, slumped despite predictions among respondents for a rise in gasoline prices.

The New York Fed report showed that one-year-ahead inflation expectations were 2.49 percent in August, down from 2.54 percent in July, marking the weakest reading since January 2016. The three-year measure ticked down to 2.62 percent, from 2.71 percent a month earlier.

Both measures have generally declined since the survey began in mid-2013, reflecting the years in which most U.S. inflation measures have fallen short of the central bank’s target. If the weakness persists, the Fed, which hiked rates twice this year, may put off its plans for another policy tightening by December.

Respondents - who were generally surveyed before Hurricane Harvey hit Texas in late August - expected gas prices to rise by 4.1 percent a year from now, up from 3.0 percent a month earlier.

The internet-based survey is done by a third party and taps a rotating panel of about 1,200 household heads.

Canada’s public pension funds, among the biggest in the world, are piling on risk with leveraged bets in a chase for higher returns, Moody’s Investors Service warns.

The nation’s six biggest pension funds have increased their average leverage to 24 percent, from 19 percent in 2009, in an effort to offset the impact of declining pension member contributions and low interest rates on their cash flow and investment returns, Moody’s said in an Oct. 3 report written by analyst Jason Mercer. That’s leaving the funds exposed to volatility in the returns they’re counting on to fund future pension payouts.

“They are definitely taking on more risk, and the question I ask them is, ‘Why take on more risk if you don’t need to?’” Mercer said by phone from Toronto. ‘Why not just invest in very low-risk securities and not worry about volatility?”

Long-term interest rates in developed countries are currently about half the 4 percent real return pension plans need to remain sustainable. Canada’s biggest pension funds have been targeting returns in the double-digits with their use of leverage and investments in illiquid assets such as real estate, infrastructure, and private equity, to compensate for a lower ratio of active members to retirees drawing benefits, Mercer said.

These strategies leave pension funds more exposed to potential macroeconomic shocks such as a weaker Canadian dollar or drops in equity or credit markets, Mercer said.

To be sure, Canadian pension plans have the financial strength and ability to take on risk, and Moody’s doesn’t see a credit-rating impact from the increased leverage anytime soon, Mercer said. If a pension fund’s leverage ratio were to increase above 50 percent, Moody’s would no longer rate the fund higher than its government sponsor, he said.

Ontario Teachers’ Pension Plan has the highest leverage, 33 percent, due to their large constituency of teachers retiring early and living longer, according to Moody’s.

“As a pension plan, we focus by necessity on our asset-liability balance,” OTPP spokeswoman Deborah Allan said in an email. “Leverage is key in our portfolio construction as we manage our asset mix and reduce our liability risk.”

Many Canadian pension funds, which were among the first to establish private equity arms to take active stakes in businesses in 1990s, have set up in-house hedge funds to invest in more complex derivatives like forwards, swaps and options while also employing debt strategies.

The combined assets of Canada’s six largest pension funds nearly doubled to almost C$1.4 trillion ($1.1 trillion) between 2011 and 2016, according to Moody’s. Investment income was the largest contributor to growth, with combined earnings contributing more than C$400 billion over the past five years.

Allocation to illiquid, non-public assets increased to 34 percent in 2016 from about 31 percent in 2010, according to Moody’s. A risk with these assets is that they rely on assumptions about their value, which can only be determined once the asset is sold and adds uncertainty to portfolio performance, Mercer said.

The exceptional credit quality of Canadian public pension funds is based on several key factors including highly-rated sponsors, high stability and predictability of future cash flows, predictable national and provincial legal systems and strong coverage of obligations by high quality liquid assets, Moody's Investors Service says in a new report. However, high leverage and less-liquid investments raises risks for pension funds.

"As in many other countries, Canadian defined benefit pension plans are facing adverse demographic shifts thanks in part to an aging baby boomer population," Jason Mercer, a Moody's Assistant Vice President says. "The active-to-retired ratio, a measure of the relative proportion of contributing members to retirees collecting benefits, has fallen for all six pension managers in the past 10 years as growth in retirees outpaces contributors."

In the absence of strong investment returns, higher contributions or reduced benefits, a lower active-to-retired ratio reduces a pension plan's funding ratio and increases the liquidity requirements of the plan. Net contributions for most pension managers have shrunk in the past few years as the relative proportion of retirees increase.

"Weaker net cash flows make funds more dependent on market performance to maintain current funding levels, but low interest rates hinder the funds ability to make returns strong enough to offset the net cash flow pressures," says Mercer.

Moody's says funds that increase leverage and illiquid assets to ensure they can generate returns sufficiently high enough to mitigate the funding pressures from aging demographics and low interest rates also increase the pension fund's asset risk in the event of a market correction.

Pension managers facing cash flow pressures as a consequence of the low interest rate environment have adapted by combining scale, leverage and investment strategies. Through a mix of investment returns, increasing leverage and member contributions, Canadian pension funds have substantially increased their scale; and are among the largest pension managers globally.

Between 2011 and 2016, the combined assets of the six largest Canadian pension managers nearly doubled to almost CAD1.4 trillion. Investment income has been the largest contributor to this asset growth, with a combined earnings contribution of over CAD400 billion in the past five years.

The average leverage of the largest six funds has increased to 24% from 19% since 2009. This strategy entails higher risks for pension managers since leverage magnifies not only gains, but also losses.

The report "Canada - Public Pension Managers: Aging population, low interest rates drive higher investment risk, a credit negative," is available to Moody's subscribers at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1057573.

When reflecting on the last financial crisis, some investors faced severe funding issues. The most prominent case was from the university endowment of Harvard Management Corporation who issued a bond of more than USD 1bn to fund their future capital calls and considered selling a private equity portfolio of around USD 1.5bn, when the average discount on the secondary market was between 40% and 50%. Even CalPERS (the largest US pension fund) sold some of their listed stocks in order to be prepared for potentially paying future capital calls for private equity funds according to an article in the Wall Street Journal.

Listed private equity vehicles which ran an over-commitment strategy experienced similar issues. APEN, a Swiss-listed vehicle had to go through significant restructuring, adding a new financial structure as well as selling on the secondary market so as not to lose any of its private equity assets. It should be noted, however, that many pension funds and insurance companies investing in private equity did not have to take drastic measures during this time period and were able to cope with the change in cash flow profile because they managed their risks from the outset by limiting their allocation to private equity. Additional reasons for the limited allocation to private equity have been the possibility for them to match it with their incoming cash flows, the possibility to liquidate other liquid assets beforehand and having more diversified portfolios.

• Hedge funds: 10% of OTPP's portfolio is in portable alpha strategies investing in top hedge funds all around the world that offer a high Sharpe and non-correlated returns (HOOPP is smaller than OTPP and doesn't invest in external hedge funds yet but it recently committed capital to an external CLO manager). Most of the hedge funds in Ontario Teachers' (and CPPIB) are on Innocap's managed account platform to control liquidity and other risks very closely.
• Internal absolute return strategies: Both OTPP and HOOPP do a lot of arbitrage strategies internally that require expertise. These arb strategies and other strategies (like risk-parity) require the use of leverage. This is intelligent levering up one's portfolio to reduce overall risk.
• Internal repo operations: Both OTPP and HOOPP do a lot of repos in their fixed income portfolio, effectively leveraging up their bond portfolio.Again, this is wise and requires internal expertise you need to pay for. 
• Emitting bonds for private markets: All of Canada's large pensions (or almost all) are now issuing bonds to expand their investments in private markets (real estate, infrastructure, private equity and natural resources). Again, this is smart leverage, using capital markets to borrow cheaply to invest in an investment that will offer excellent long-term cash flows. 

California governments likely will make do with fewer teachers, parks employees and other public workers while they struggle to absorb fast-rising pension costs in the next few years, a former state lawmaker argues in a study released this week through Stanford University.

Read more here: http://www.sacbee.com/news/politics-government/the-state-worker/article176849926.html#storylink=cpy

Former Democratic Assemblyman Joe Nation projects that many cities, counties and school districts will double their spending on pensions by 2030, “crowding out” their ability to fund public services.

The trend is an acceleration of the swelling pension costs that most California governments have recorded since the dot-com crash in the early 2000s, when pension plans that had been over-funded suddenly had to catch up with investment losses.

“As painful and as steep as these increases have been since 2003, my best estimate is that we are only about half way through these increases,” said Nation, who is now a researcher at the Stanford Institute for Economic Policy Research. “If you’re a public agency and you went from paying $1 million a year to $10 million a year, that’s an enormous increase. You’re likely to go from $10 million to $20 million by the year 2030.”

The new report assesses pension spending for a sampling of 14 California government agencies, including state government. Nation wrote that state spending on pensions is expected to rise from $8.5 billion this year to $17.3 billion in 2029-30.

Nation found pension costs outpacing growth in projected revenues across the board. That leaves government agencies less room for amenities like parks, social services and, in some cases, the ability to hire new employees to replace retiring workers.

For the city of Sacramento, pension costs are expected to climb to $150 million by the 2022-23 budget year, up from $42.4 million in 2008-09 and $88 million this year.

“Our revenues cannot keep pace with these cost increases,” said Sacramento Finance Director Leyne Milstein. So far, she said, the city has not had to leave vacancies open because of the rising retirement expenses.

Nation’s report adds to a drumbeat of recent complaints from local government leaders about rising pension costs. They’ve been more vocal since the California Public Employees’ Retirement System last year lowered its projected investment return rate, a decision that required its member governments to pay more to fund their workers’ pensions.

Last month, representatives from a dozen cities attended a CalPERS board meeting and complained that rising pension costs are becoming a“gradual strangulation” on public services.

“In three to four years our cash flow is going to be gone,” Oroville Finance Director Ruth Wright told the CalPERS board. “We don’t even know how we are going to operate past four years. We have been saying the bankruptcy word, which is not very popular.”

School districts also are ramping their spending on pensions to make up for shortfalls at the California State Teachers’ Retirement System. Both CalPERS and CalSTRS are underfunded, with each holding about 68 percent of the assets they’d need to pay benefits they owe to current workers and retirees.

Visalia Unified School District, an example in Nation’s study, spent $10.8 million on pensions in 2009-10. It’s projected to spend $46 million in 2029-30.

Nation also looked at two California cities that declared bankruptcy during the recession. In Stockton, pension costs are expected to hit $88 million in 2029, up from $41.5 million today. In Vallejo, they’re on track to reach $52 million in 2029, up from today’s $24.7 million.

Nation’s work was funded partly by the Laura and John Arnold Foundation, a nonprofit organization created by former hedge-fund manager John Arnold. The organization has funded pension-reform efforts around the country.

Dave Low, chairman of the union-supported Californians for Retirement Security, said CalPERS and CalSTRS are slowly digging themselves out of the losses they suffered during the recession. As a result, they’re asking public employers to kick in more money for pensions.

Historically, spending on pensions has fluctuated, bottoming out in the dot-com boom when CalPERS was so well-funded that many employers took a holiday from contributing to their employee pension plans.

Low suggested that local governments struggling with pension costs take their concerns to their unions, where the two sides could negotiate ways to save money until the retirement plans are on better footing.

“You don’t recover from the Great Recession in two or three years. It takes decades,” he said. “We happen to be in the up cycle right now. The question is, because we’re on the up cycle, do we take pensions away?”

Cities and counties across the U.S. are going broke trying to keep up with public pension debt. The pension crisis was the topic of a Stanford University media workshop that KPIX 5 attended this week.

“It’s the albatross around the necks of cities and counties,” Stanford Professor of Public Policy Joe Nation said about public employee pensions. “Unless we do something the system may not survive.”

The biggest system in the country is in California, the public employee retirement system known as CalPERS. The problem is the pension fund doesn’t have nearly enough money to cover the cost of current and future employee pensions. It’s short according to some estimates by a trillion dollars. “That’s equivalent to eight years of the entire state budget,” said Stanford Professor of Economics Jeremy Bulow.

Critics say CalPERS has been hiding the enormity of the problem the same way a gambler hides their losses – by assuming that in the future, there will be huge and unlikely returns on their investment. Officially, CalPERS assumes a 7.2 percent annual rate of return on their investments -but most economists believe 3 to 4 percent is more realistic.

“What you were hearing a bit today are folks saying that the return rate should be lower,” said Richard Costigan, who sits on the CalPERS Board of Administration. Last December the CalPERS board voted to cut the assumed return from 7.5 percent to 7 percent.

But a smaller amount from investments means more has to come from governments and employees. “This is the difficulty,” said Costigan. “If you lower the discount rate you push up the contribution level of employers and employees to address the unfunded liability.”

Bottom line: cities, counties, school districts and ultimately taxpayers are footing a much bigger and likely more realistic bill. CalPERS estimates about a third of local and state budgets go to pay for public pensions. Experts at this recent pension workshop estimate it’s closer to 60 percent and growing. “Retirement spending has doubled in the last five years, and you ain’t seen nothing yet,” said Stanford public policy lecturer David Crane.

That could bankrupt some local governments. But San Jose’s former mayor Chuck Reed, who pushed hard for pension reform, says it’s a bitter pill that we all have to swallow. “You’ve got to put more money in,” said Reed. “All of these solutions … you’ve got to put more money in.”

• US pension storms from nowhere aren't going to magically disappear. The pension storm cometh and if deflation hits the US, rates plunge to record lows and we get the worst bear market ever, it's game over. What is going on in Kentucky can easily happen in Illinois, New Jjersey and elsewhere in the US, including California. So, we need to come to grips with the global retirement reality and address a looming crisis. 
• The problem with a lot of right-wing outfits who say they're fiscal conservatives is they want to shift everyone over to "cheaper" 401(k) plans. Never mind the brutal truth on defined-contribution plans which shift retirement risk entirely onto employees, leaving them exposed to pension poverty, as long as John Arnold pays lees taxes so his wife can buy more Louboutin shoes and whatever else her heart desires, he's a happy camper. 
• The big problem -- and I've said this plenty of times -- is no matter what you do, the pension crisis is getting worse and it is deflationary. Yes, these are long-term liabilities, but when the funded status of US pensions keeps deteriorating as they get squeezed on private equity and hedge fund fees, soaring pension costs start impacting state and local budgets. 
• Something is wrong at US public pensions and in my opinion, they're not run well, they have the wrong governance and there is way too much political interference. On top of this, state and local governments haven't been topping them up and unions and governments were all too happy taking contribution holidays in the glory tech bubble days (make contribution holidays illegal).
• Say what you want about Canada's pensions piling on leverage but they've got the governance and risk-sharing model right here which is why most of our large plans are fully-funded or close enough to being fully-funded. 
• Some people think fully-funded US pensions aren't worth it, and while they raise valid (left-wing) points, the truth is many US public pensions are chronically underfunded and will not be able to sustain another financial crisis. At one point, public pensions need to get real on the assumed return, public-sector unions and governments will have to raise contribution rates and if that's not enough, they will cut benefits and even raise taxes to make up the shortfall. Period, there is no getting around this. California and Illinois remind me a lot of Greece, and in some ways things are worse there. 
• Until we reach the boiling point, the pension"crowding out" effect will continue taking a big chunk out of public budgets, leaving less money for governments to spend (fiscal austerity = more deflation).

When work begins on a new, 42-mile commuter rail system here this year, it will also be a groundbreaking moment for Michael Sabia, head of Quebec’s largest pension fund.

Not only is his fund, Caisse de dépôt & placement du Québec, financing 51% of the 6 billion Canadian dollar (US$4.8 billion) project, but Mr. Sabia has structured the deal so it will manage the building and operation too. Even as many pension funds are getting bolder about chasing higher returns, it’s a high-stakes bet that exposes Caisse to the operating and financial risks of Montreal’s biggest transit project in half a century.

“We’re an organization that wants to build,” said the 64-year-old Mr. Sabia in an interview at the sprawling glass headquarters of the pension fund, which manages C$286.5 billion of assets.

Montreal’s new transit system, which is set to begin operating at the end of 2020, “is going to show the world that a pension fund can do this,” he said.

It’s the latest example of Mr. Sabia’s aggressive, hands-on brand of managing investments at the fund. Even in Canada, where pension funds have a history of activism, he is known for deep involvement in the companies in which Caisse takes a stake, leading a shareholder push to limit the boardroom influence of Bombardier Inc.’s founding family and also ensuring Canadian jobs were preserved after Lowe’s Co s. takeover last year of Canadian home-improvement chain Rona Inc.

Now, under the Montreal rail deal with the Quebec and Canadian governments, he will deploy about 400 Caisse employees and contract workers to construct and operate an electric light rail in exchange for fees based on the number of commuters. Unlike most pension funds, which invest in infrastructure through bonds or specialized funds, Caisse under Mr. Sabia is seeking to grab a bigger share of public-works projects by offering a suite of financial, construction and operating services.

“What Michael is doing is way outside the mainstream of pension investing,” says Jim Leech, former chief executive of Canadian pension giant Ontario Teachers’ Pension Plan. While a number of Canada’s big pension funds have been major investors to own and upgrade airports and ports, Mr. Leech says, “none are building from the ground up.”

The project has also grabbed the attention of U.S. officials from cash-strapped states who have noted that the Quebec government had to put up only C$1.3 billion—just about 20% of the project. Mr. Sabia has met with half a dozen U.S. governors in the past year to explain the train deal and promote Caisse’s model for U.S. public works.

Mr. Sabia said his unusual approaches reflect the goals of Caisse, which was founded in 1965 under a dual mandate to increase returns and enhance the Quebec economy. Mr. Sabia has sought to invest in projects such as Montreal’s transit system to “reinject” more prosperity in local communities.

“I really believe in this deeply,” said Mr. Sabia, as he raked his hand through a thicket of silver hair. Too many businesses, he said, “have not thought carefully enough about the social consequences” of investing.

His interest in such social consequences was influenced by his late mother, Laura Sabia, a prominent champion of women’s rights and a city councilor in his hometown of St. Catherines, Ontario. Her advocacy taught him “about the importance of being sensitive to and involved in public issues,” he said.

Before Mr. Sabia started in 2009, Caisse had long been seen by critics as the financial arm of Quebec governments, which on occasion pressured the fund to prop up struggling local businesses or block takeovers by outsiders. But when he was hired, he had unusual leverage: Caisse had recently announced a C$40 billion decline in net assets.

The “searing event,” said Mr. Sabia, was such a threat to its ability to pay pensions that he was able to push for more independence to ensure “this can never happen again.”

Now, he argues a more effective strategy for improving the fortunes of Quebec businesses and communities is to support global expansion, even if it leads to foreign takeovers.

But Mr. Sabia has made clear any such takeovers will be on Quebec-friendly terms. When a group led by TPG Capital made a bid in 2015 for Montreal’s iconic Cirque du Soleil, in which Caisse was an investor, Mr. Sabia personally negotiated long-term local job and head-office protections with the private-equity fund’s co-founder James Coulter.

Mr. Sabia’s path to the top of Canada’s second-largest pension fund is as unorthodox as some of his investment moves.

His career began in Canada’s federal civil service, where he oversaw a major overhaul of the national tax system. He then landed a senior executive assignment to help turn around the Canadian National Railway Co. Later, he was named CEO of Canada’s largest telecommunications company, BCE Inc.

When the Quebec government announced his appointment as the fund’s first non-Quebec CEO who had no investment experience, local media and politicians were so outraged that one Quebec columnist described the controversy as a “full-fledged political scandal.”

But the fund’s assets have more than doubled since it reported net assets of C$131.6 billion in 2009. It has delivered an annualized return of 10.6% in the past five years.

When the Montreal transit system is completed, Mr. Sabia said he would promote it as “proof of concept” that his pension fund can compete for bigger roles in some of the $1 trillion infrastructure projects promised in the U.S. by President Donald Trump.

“This is how we can differentiate ourselves,” he said.

Corrections & Amplifications

Caisse de depot et placement du Quebec is Canada’s second largest pension fund by net assets. An earlier version of this article incorrectly said it is the third largest. (Oct. 6, 2017)

I just finished covering the International Pension Conference of Montreal and PSP's fiscal 2017 results where I noted that PSP's CEO André Bourbonnais is concerned about investor complacency and rightfully warned institutional investors are underestimating valuation and regulatory risks of infrastructure, mistakenly looking at these investments as a substitute for bonds.

In a private conversation with me at last year's pension conference, Leo de Bever, AIMCo's former CEO, told me he thought some of the infrastructure deals were being priced at "insane levels". I can't tell you which deals he mentioned (will let you guess), but he did add this: "what the Caisse is doing with this greenfield infrastructure project is truly innovative and can pay off in a huge way if they get it right."

I agree. There is no large pension in the world which is doing anything close to what the Caisse is doing in terms of a purely direct major greenfield infrastructure project where it controls everything from A to Z.

In order to do this project, CDPQ Infra went out and recruited people with the requisite skill-sets, people with operational experience developing and managing mammoth greenfield projects (not just MBAs and dealmakers but engineers with MBAs who worked at large construction engineering companies like SNC Lavalin and elsewhere).

"Almost 100 years ago, my grandfather arrived here in Montreal with nothing, nothing, nothing in his hands. Why did he stay here? Because he was convinced that Quebec is an open society," Mr. Sabia said. "I grew up with this perception. I am not going to accept your position. I have an understanding of Quebec and I chose to work here - over a lot of other opportunities in Asia and in the United States - to render service to Quebec."

Toronto-based Starlight Investments has formed an institutional partnership with Canada's Public Sector Pension Investment Board and the Alberta Investment Management Corp. (AIMCo) to acquire up to $1.3 billion of multifamily properties across the southern and western regions of the U.S.

"We are entering into this newly formed partnership with great excitement and expectations," said Neil Cunningham, senior vice president, global head of real estate and natural resources at PSP Investments. "We are looking forward to working closely with Starlight and AIMCo to assemble a large, professionally managed, institutional quality portfolio of multifamily properties in select U.S. markets."

The partnership is looking to acquire recently constructed, garden-style multifamily communities in the suburban markets of Atlanta, Austin, Dallas, Denver, Orlando, Phoenix and Tampa. The partnership will target submarkets that demonstrate superior rental income growth potential due to positive multifamily dynamics including compelling population, economic and employment growth.

The partnership's first acquisition is Parkhouse Apt. Homes, a Class A, garden-style, multifamily property constructed in 2017 in the Denver suburb of Thornton, CO. The 465-unit complex at 14310 Grant St. sold for $121.6 million or about $261,505 per unit.

"We are extremely pleased to acquire the first in a number of multifamily properties with two prominent global institutions and continue the expansion of the Starlight U.S. multifamily platform," said Daniel Drimmer, CEO and president of Starlight Investments.

PSP Investments is one of Canada's largest pension investment managers with $135.6 billion of net assets under management as of March 31, 2017. Alberta Investment Management is one of Canada's largest and most diversified institutional investment managers with more than $100 billion of assets under management.

Starlight Investments ("Starlight") is pleased to announce its institutional partners in connection with its previously announced Partnership (the "Partnership") as the Public Sector Pension Investment Board ("PSP Investments") and the Alberta Investment Management Corporation ("AIMCo"), on behalf of certain of its clients. In addition, Starlight is pleased to announce that the Partnership has commenced its acquisition program with the purchase of Parkhouse Apartment Homes ("Parkhouse"), a 465-unit, Class "A", garden style, multi-family property constructed in 2017, and located in Denver, Colorado.

"We are entering into this newly formed Partnership with great excitement and expectations," said Neil Cunningham, Senior Vice President, Global Head of Real Estate and Natural Resources at PSP Investments. "We are looking forward to working closely with Starlight and AIMCo to assemble a large, professionally managed, institutional quality portfolio of multi-family properties in select U.S. markets."

"AIMCo is pleased to enter the Partnership and excited about the opportunity to expand our multi-family footprint to new markets," said Micheal Dal Bello, Senior VP, Real Estate of AIMCo. "The Partnership capitalizes on the synergies of our respective investment programs and creates a long-term platform to generate the returns required of our clients and stakeholders."

The Partnership was formed to acquire U.S.$1.3 billion of Class "A", recently constructed, garden style multi-family communities located in the suburban markets of Atlanta, Georgia; Austin and Dallas, Texas; Denver, Colorado; Orlando and Tampa, Florida; and Phoenix, Arizona. Specifically, the Partnership will target submarkets that demonstrate superior rental income growth potential due to positive multi-family dynamics including compelling population, economic and employment growth.

"We are extremely pleased to acquire the first in a number of multi-family properties with two prominent global institutions and continue the expansion of the Starlight U.S. multi-family platform," added Daniel Drimmer, CEO and President of Starlight Investments. "We look forward to building a premium multi-family portfolio in conjunction with PSP Investments and AIMCo."

Denver is one of the fastest growing U.S. metro areas with the lowest unemployment rate. The city is consecutively voted as the best place for businesses to grow by Forbes, with employers continuing to relocate and add jobs at a considerably faster rate than the national average. Denver is also a city where millennials, who are a key renter demographic, are the largest and fastest growing population group.

Parkhouse is ideally located in the prosperous northern corridor of Denver. The downtown is approximately 25 minutes to the south, providing easy access to major employment centres and entertainment. Within walking distance to Parkhouse is access to major retail hubs and local hospitals. Parkhouse is a luxury complex consisting of 20 three-storey garden style apartment buildings, offering top of the market amenities including two clubhouses with fitness and business centres, a games room and a bike and ski repair shop. Outdoor amenities include two resort style swimming pools, outdoor kitchens, neighborhood parks and walking trails. For more information, visit www.liveparkhouse.com.

About PSP Investments

The Public Sector Pension Investment Board (PSP Investments) is one of Canada's largest pension investment managers with $135.6 billion of net assets under management as of March 31, 2017. It manages a diversified global portfolio composed of investments in public financial markets, private equity, real estate, infrastructure, natural resources and private debt. Established in 1999, PSP Investments manages net contributions to the pension funds of the federal Public Service, the Canadian Forces, the Royal Canadian Mounted Police and the Reserve Force. Headquartered in Ottawa, PSP Investments has its principal business office in Montréal and offices in New York and London. For more information, visit www.investpsp.com or follow us on Twitter @InvestPSP.

About Alberta Investment Management Corporation

Alberta Investment Management Corporation (AIMCo) is one of Canada's largest and most diversified institutional investment managers with more than $100 billion of assets under management. Established on January 1, 2008, AIMCo's mandate is to provide superior long-term investment results for its clients. AIMCo operates at arms-length from the Government of Alberta and invests globally on behalf of 32 pension, endowment and government funds in the Province of Alberta. For more information, please visit www.aimco.alberta.ca.

About Starlight Investments

Starlight Investments is a Toronto-based, privately held, full service, real estate investment and asset management company driven by an experienced team comprised of over 120 professionals. Starlight currently manages $7.5 billion of multi-family and commercial properties through funds, JV's and club deals. Starlight's portfolio consists of approximately 35,000 multi-family units, of which 34,000 are across Canada and 11,000 across the U.S., along with over 4.6 million square feet of commercial properties throughout Canada. For more information, please visit www.starlightinvest.com and connect on LinkedIn at www.linkedin.com/company/starlight-investments-ltd-.

The partnership is looking to acquire recently constructed, garden-style multifamily communities in the suburban markets of Atlanta, Austin, Dallas, Denver, Orlando, Phoenix and Tampa. The partnership will target submarkets that demonstrate superior rental income growth potential due to positive multifamily dynamics including compelling population, economic and employment growth. 

The Alpha Data Centre Fund (ADCF), managed by Keppel Capital's wholly owned unit, Alpha Investment Partners, is receiving another shot in the arm from Canada Pension Plan Investment Board (CPPIB), which is investing up to US$350 million of capital, with an option to invest another US$150 million.

CPPIB's latest commitment and option will bring the ADCF's total fund size to up to US$1 billion, doubling the Fund's initial target size of US$500 million.

When fully leveraged and invested, the Fund will potentially have assets under management of about US$2.3 billion, said Keppel Capital, the asset management arm of Keppel Corporation.

Jimmy Phua, CPPIB managing director and head of real estate investments for Asia, said: "The continued strong growth in data requirements globally has driven demand for quality data centre space, particularly in the Asia-Pacific region where digital infrastructure is relatively under-developed. By investing alongside the ADCF, CPPIB is able to gain exposure into this critical sector."

The ADCF was launched in July 2016 by Alpha amid strong interest from institutional investors for quality alternative asset classes.

This fund taps the experience of Keppel Data Centres - a 70-30 joint venture between two Keppel group entities, Keppel Telecommunications & Transportation Ltd and Keppel Land - that has designed, built and managed data centres for more than a decade.

Canada Pension Plan Investment Board has decided to make an initial investment of up to $350 million, with an option to invest another $150 million, in Alpha Data Centre Fund, the asset management business of Singapore's Keppel Corporation.

CPPIB's latest commitment and option will bring the ADCF's combined and co-investment interest up to $1 billion, double its initial target size of $500 million, Keppel said in an exchange filing today. "When fully leveraged and invested, the fund will potentially have assets under management of approximately $2.3 billion."

ADCF is managed by Alpha Investment Partners Limited, the private fund management arm of Keppel Capital, a Keppel Corp unit.

Keppel Corp is best known for its rig building and property businesses.

There is no question that the data center landscape in South East Asia is a vibrant and growing one, with many new developments and happenings taking place in the region. A significant proportion of the action in this region is centered on Singapore, where many data center operators are busy building their second or even third data centers.

For example, Telin Singapore in June held a groundbreaking ceremony for its Telin-3 data center, which will be built on the first plot of land awarded at the Singapore data center park. On its part, Digital Realty will have its second data center here converted and ready for an estimated late-2015 first phrase delivery, while 1-Net’s 1-Net North data center is currently scheduled for completion by the first quarter of 2016.

Cloud providers too, have been setting up in the island nation to tap into the growing demand in this region. The name list includes the likes of Amazon Web Services (AWS), Microsoft Azure, Digital Ocean, GoDaddy, and Linode, to name a few.

Interestingly, the country is also the place where East meets West, with Aliyun, the cloud division of China’s Alibaba Group, announcing in August that its second overseas data center and international HQ will be set up in Singapore.

Acquisitions are also happening as larger players turn their attention to the region. Colt acquired KVH last year, and more recently, the Hong Kong and Singapore based Pacnet was acquired by Australia’s Telstra as it sought to strengthen its subsea network and data center assets in the region.

Innovation in the region

Local challenges have also resulted in some developments that may be viewed as unorthodox or even frowned upon elsewhere. In land-scarce Singapore, both Equinix and Google have opted to build a new data center right next to an existing one, with the latter having built its first ever multi-level data center here.

For Equinix, building its third data center (SG3) across the road to SG1 gives it the advantage of running direct fiber links to the many telecommunication operators and network providers that already have a Point of Presence there.

When it comes to Google, the reason presumably has to do with the fact that there is no need to build at a separate location, not when you consider the lack of natural disasters, excellent security, and relatively low number of violent crimes.

In Indonesia, the JK1 data center in Jakarta that was built as part of a partnership between Equinix and PT Data Center Infrastructure Indonesia (PT DCI) is fed by an on-site power station to mitigate the risk of an unstable power grid and to protect it from local power shortages.

For all the progress and innovations, much work remains to be done when it comes to sustainability here, especially in the dense urban areas where traditional sustainable energy options such as hydroelectricity, solar and wind power are not available.

This has not stopped some such as Singapore from promotion the use of high-grade reclaimed water it calls NEWater for cooling data centers. More needs to be done, however, and it will be interesting to see where the future will take us.

Alpha Data Centre Fund has taken a 70% stake in the asset through a 70-30 joint venture, known as Thorium, with Keppel Data Centres.

Keppel Data Centres developed the 16,900sqm facility which is spread over five floors. More than 25% of the space has been committed.

Alpha, itself a subsidiary of Singapore’s Keppel Group, raised US$130m (€113m) for the fund in a first close a year ago.

Many years after la Révolution tranquille (the Quiet Revolution), Quebec has a serious reverse racism problem which is ingrained in its large public and private organizations. Many anglophones and ethnics have given up hope living here and the ones that stayed are pushing their children to leave this province or stay and face reverse discrimination.


I'm not going to mince my words here, and I can look in the eyes of Louis Vachon, Guy Cormier, André Bourbonnais and many other French-Canadian leaders who sit on the board of Finance Montréal or le Cercle Finance du Québec and tell them this province is going down the tubes in terms of diversity in the workplace and they're either going to take concrete actions to promote it at all levels of their organization or Quebec as we know it is doomed in the future.


By the way, I would say the exact same thing to Premier Philippe Couillard and Prime Minister Justin Trudeau who has no clue what a mafia the federal public service has become in terms of getting in and how it regularly ignores important diversity laws. When our own public institutions aren't practicing diversity in the workplace, it sets a terrible example for private organizations.

In particular, and let me be crystal clear here, the way Canada's large public and private organizations treat people with disabilities is a national disgrace and travesty.


I blame our leaders at public and private organizations for this national disgrace. They make every excuse in the book for not hiring competent people with disabilities at all levels of their organization but at the end of the day, they know I'm right to criticize them openly and publicly and I challenge them to show me the numbers to prove I'm wrong.


Anyway, don't get me started on that topic, discrimination in all its ugly forms makes my blood boil, just like it made Michael Sabia's blood boil when he had to defend his Québécois roots to the likes of Jean-Martin Aussant years ago.

As someone who was diagnosed with Multiple Sclerosis 20 years ago and lives discrimination I will do everything in my power to expose the plight of people with disabilities (I'm actually one of the lucky ones, doing relatively well, but have seen way too much injustice to keep my mouth shut on this national travesty).

Central banks continue to focus on consumption inflation, not asset inflation, in their decisions. Their attitude has supported one bubble after another. These bubbles have led to rising ­inequality and made mass consumer inflation less likely.

Since the 2008 financial crisis, asset inflation has fully recovered, and then some. The US household net worth is 34 per cent above the peak in 2007, versus 30 per cent for nominal GDP. China’s property ­value may have surpassed the total in the rest of the world combined. The world is stuck in a vicious cycle of asset bubbles, low consumer ­inflation, stagnant productivity and low wage growth.

The US Federal Reserve has indicated that it will begin to ­unwind its QE (quantitative easing) assets this month and raise the ­interest rate by another 25 basis points to 1.5 per cent. China has been clipping the debt wings of grey rhinos and pouring cold water on property speculation. They are ­worried about asset bubbles.

But, if recent history is any guide, when asset markets begin to tumble, they will reverse their actions and ­encourage debt binges again.

Recently, some central bankers have been puzzled by the breakdown of the Philipps Curve: that falling unemployment rates would lead to wage inflation first and consumer price inflation next. This shows how some of the most powerful people in the world operate on flimsy ­assumptions.

Despite low unemployment and widespread labour shortages, wage increases and inflation in Japan have been around zero for a quarter of a century. Western central bankers assumed that the same wouldn’t happen to them without understanding the underlying reasons.

The loss of competitiveness changes how macro policy works. Japan has been losing competitiveness against its Asian neighbours. As its population is small, relative to the regional total, lower wages in the region have exerted gravity on its ­labour market. This is the fundamental reason for the decoupling between the unemployment rate and wage trend.

The mistaken stimulus has the unintended consequences of dissipating real wealth and increasing inequality. American household net worth is at an all-time high of five times GDP, significantly higher than the bubble peaks of 4.1 times in 2000 and 4.7 in 2007, and far higher than the historical norm of three times GDP. On the ­other hand, US capital formation has stagnated for decades. The outlandish paper wealth is just the same asset at ever higher prices.

The inflation of paper wealth has a serious impact on inequality. The top 1 per cent in the US owns one-third of the wealth and the top 10 per cent owns three-quarters . Half of the people don’t even own stocks. Asset inflation will increase inequality by definition. Moreover, 90 per cent of the income growth since 2008 has gone to the top 1 per cent, partly due to their ability to cash out in the ­inflated asset market. An economy that depends on asset inflation always disproportionately benefits the asset-rich top 1 per cent.

There have been so many theories on why inequality has risen. The misguided monetary policy may be the culprit. Germany and Japan do not have significant asset bubbles. Their inequality is far less than in the Anglo-Saxon economies that have succumbed to the allure of financial speculation.

While Western central bankers can stop making things worse, only China can restore stability in the global economy. Consider that 800 million Chinese workers have ­become as productive as their Western counterparts, but are not even close in terms of consumption. This is the fundamental reason for the global imbalance.

China’s model is to subsidise ­investment. The resulting overcapacity inevitably devalues whatever its workers produce. That slows down wage rises and prolongs the ­deflationary pull. This is the reason that the Chinese currency has had a tendency to depreciate during its four decades of rapid growth, while other East Asian economies experienced currency appreciation during a similar period.

Overinvestment means destroying capital. The model can only be sustained through taxing the household sector to fill the gap. In addition to taking nearly half of the business labour outlay, China has invented the unique model of taxing the household sector through asset bubbles. The stock market was started with the explicit intention to subsidise state-owned enterprises. The most important asset bubble is the property market. It redistributes about 10 per cent of GDP to the government sector from the household sector.

The levies for subsidising investment keep consumption down and make the economy more dependent on investment and export. The government finds an ever-increasing need to raise levies and, hence, make the property bubble bigger. In tier-one cities, property costs are likely to be between 50 and 100 years of household income. At the peak of Japan’s property bubble, it was about 20 in Tokyo. China’s residential property value may have surpassed the total in the rest of the world combined.

How is this all going to end? Rising interest rates are usually the trigger. But we know the current bubble economy tends to keep inflation low through suppressing mass consumption and increasing overcapacity. It gives central bankers the excuse to keep the printing press on.

In 1929, Joseph Kennedy thought that, when a shoeshine boy was giving stock tips, the market had run out of fools. Today, that shoeshine boy would be a genius. In today’s bubble, central bankers and governments are fools. They can mobilise more resources to become bigger fools.

In 2000, the dotcom bubble burst because some firms were caught making up numbers. Today, you don’t need to make up numbers. What one needs is stories.

Hot stocks or property are sold like Hollywood stars. Rumour and ­innuendo will do the job. Nothing real is necessary.

In 2007, structured mortgage products exposed cash-short borrowers. The defaults snowballed. But, in China, leverage is always rolled over. Default is usually considered a political act. And it never snowballs: the government makes sure of it. In the US, the leverage is mostly in the government. It won’t default, because it can print money.

The most likely cause for the bubble to burst would be the rising political tension in the West. The bubble economy keeps squeezing the middle class, with more debt and less wages. The festering political tension could boil over. Radical politicians aiming for class struggle may rise to the top. The US midterm elections in 2018 and presidential election in 2020 are the events that could upend the applecart.

Volatility Adjusted SP500, as of Friday’s closing metrics, has reached an historic extreme printed a handful of times since 1971. In other words, going forward, either SP500 declines in value or SP500 realized volatility rises.Rare (mathematical) juncture in time/price (click on image).

In the summer of 1974, Treasury Secretary William Simon traveled to Saudi Arabia and secretly struck a momentous deal with the kingdom. The U.S. agreed to purchase oil from Saudi Arabia, provide weapons, and in essence guarantee the preservation of Saudi oil wells, the monarchy, and the sovereignty of the kingdom. In return, the kingdom agreed to invest the dollar proceeds of its oil sales in U.S. Treasuries, basically financing America’s future federal expenditures.

Soon, other members of the Organization of Petroleum Exporting Countries followed suit, and the U.S. dollar became the standard by which oil was to be traded internationally. For Saudi Arabia, the deal made perfect sense, not only by protecting the regime but also by providing a safe, liquid market in which to invest its enormous oil-sale proceeds, known as petrodollars. The U.S. benefited, as well, by neutralizing oil as an economic weapon. The agreement enabled the U.S. to print dollars with little adverse effect on interest rates, thereby facilitating consistent U.S. economic growth over the subsequent decades.

An important consequence was that oil-importing nations would be required to hold large amounts of U.S. dollars in reserve in order to purchase oil, underpinning dollar demand. This essentially guaranteed a strong dollar and low U.S. interest rates for a generation. Given this backdrop, one can better understand many subsequent U.S. foreign-policy moves involving the Middle East and other oil-producing regions.

Recent developments in technology and geopolitics, however, have already ignited a process to bring an end to the financial system predicated on petrodollars, which will have a profound impact on global financial markets. The 40-year equilibrium of this system is being dismantled by the exponential growth of technology, which will have a bearish impact on both supply and demand of petroleum. Moreover, the system no longer is in the best interest of key participants in the global oil trade. These developments have begun to exert influence on financial markets and will only grow over time. The upheaval of the petrodollar recycling system will trigger a resurgence of volatility and new price trends, which will lead to a renaissance in macro investing.

Let’s examine these developments in more detail. First, technology is affecting the energy markets dramatically, and this impact is growing exponentially. The pattern-seeking human mind is built for an observable linear universe, but has cognitive difficulty recognizing and understanding the impact of exponential growth.

Paralleling Moore’s Law, the current growth rate of new technologies roughly doubles every two years. In the transportation sector, the global penetration rate of electric vehicles, or EVs, was 1% at the end of 2016 and is now probably about 1.5%. However, a doubling every two years of this level of usage should lead to an automobile market that primarily consists of EVs in approximately 12 years, reducing gasoline demand and international oil revenue to a degree that today would seem unfathomable to the linear-thinking mind. Yes, the world is changing—rapidly.

Alternative energy sources (solar power, wind, and such) also are well into their exponential growth curves, and are even ahead of EVs in this regard. Based on growth curves of other recent technologies, and due to similar growth rates in battery technology and pricing, it is likely that solar power will supplant petroleum in a vast portion of nontransportation sectors in about a decade. Albert Einstein is rumored to have described compound interest (another form of exponential growth) as the most powerful force in the universe. This is real change.

The growth of U.S. oil production due to new technologies such as hydraulic fracturing and horizontal drilling has both reduced the U.S. need for foreign sources of oil and led to lower global oil prices. With the U.S. economy more self-reliant for its oil consumption, reduced purchases of foreign oil have led to a drop in the revenues of oil-producing nations and by extension, lower international demand for Treasuries and U.S. dollars.

ANOTHER MAJOR SECULAR CHANGE that is under way in the oil market comes from the geopolitical arena. China, now the world’s largest importer of oil, is no longer comfortable purchasing oil in a currency over which it has no control, and has taken the following steps that allow it to circumvent the use of the U.S. dollar:

• China has agreed with Russia to purchase Russian oil and natural gas in yuan.
• As an example of China’s newfound power to influence oil exporters, China has persuaded Angola (the world’s second-largest oil exporter to China) to accept the yuan as legal tender, evidence of efforts made by Beijing to speed up internationalization of the yuan. The incredible growth rates of the Chinese economy and its thirst for oil have endowed it with tremendous negotiating strength that has led, and will lead, other countries to cater to China’s needs at the expense of their historical client, the U.S.
• China is set to launch an oil exchange by the end of the year that is to be settled in yuan. Note that in conjunction with the existing Shanghai Gold Exchange, also denominated in yuan, any country will now be able to trade and hedge oil, circumventing U.S. dollar transactions, with the flexibility to take payment in yuan or gold, or exchange gold into any global currency.
• As China further forges relationships through its One Belt, One Road initiative, it will surely pull other exporters into its orbit to secure a reliable flow of supplies from multiple sources, while pressuring the terms of the trade to exclude the U.S. dollar.

The world’s second-largest oil exporter, Russia, is currently under sanctions imposed by the U.S. and European Union, and has made clear moves toward circumventing the dollar in oil and international trade. In addition to agreeing to sell oil and natural gas to China in exchange for yuan, Russia recently announced that all financial transactions conducted in Russian seaports will now be made in rubles, replacing dollars, according to Russian state news outlet RT. Clearly, there is a concerted effort from the East to reset the economic world order.

ALL OF THESE DEVELOPMENTSleave global financial markets vulnerable to a paradigm shift that has recently begun. In meetings with fund managers, asset allocators, and analysts, I have found a virtually universal view that macro investing—investing based on global macroeconomic and political, not security-specific trends—is dead, fueled by investor money exiting the space due to poor returns and historically high fees in relation to performance. This is what traders refer to as capitulation. It occurs when most market participants can’t take advantage of a promising opportunity due to losses, lack of dry powder, or a psychological inability to proceed because of recency bias.

A current generational low in volatility across a wide spectrum of asset classes is another indicator that the market doesn’t see a paradigm shift coming. This suggests that current volatility is expressing a full discounting of stale fundamental inputs and not adequately pricing in the potential of likely disruptive events.

THE FEDERAL RESERVE is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.

I have been fortunate to ride substantial bets on big trends, earning high risk-adjusted returns using time-tested techniques for exploiting these trends. Additionally, I have had the luxury of not participating actively full-time in macro investing during this difficult period. Both factors might give me perspective. I regard this as an extraordinarily opportune moment for those able to shed timeworn, archaic assumptions of market behavior and boldly return to the roots of macro investing.

The opportunity is reminiscent of the story told by Stanley Druckenmiller, who was promoted early in his investment career to head equity research at a time when his co-workers had vastly more experience than he did. His director of investments informed him that his promotion owed to the same reason they send 18-year-olds to war; they are too dumb to know not to charge. The “winners” under the paradigm now unfolding will be market participants able to disregard stale, anomalous concepts, and charge.

RELATEDLY, THERE IS a running debate as to whether trend-following is a dying strategy. There is plenty of anecdotal evidence that short-term and mean-reversion trading is more in vogue in today’s markets (think quant funds and “prop” shops). Additionally, the popularity of passive investing signals an unwillingness to invest in “idea generation,” or alpha. These developments represent a full capitulation of trend following and macro trading.

Ironically, many market players who wrongly anticipated a turn in recent years to a more positive environment for macro and trend-following are throwing in the towel. The key difference is that now there is a clear catalyst to trigger the start of the pendulum swinging back to a fertile macro/trend-following trading environment.

As my mentor, Bruce Kovner [the founder of Caxton Associates] used to say, “Nobody rings a bell at key turning points.” The ability to properly anticipate change is predicated upon detached analysis of fundamental information, applying that information to imagine a plausible world different from today’s, understanding how new data points fit (or don’t fit) into that world, and adjusting accordingly. Ideally, this process leads to an “aha!” moment, and the idea crystallizes into a clear vision. The thesis proposed here is one such vision.

The Federal Reserve is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.

"The limits to CB prowess are now in full manifestation via political+social volatility.  It is this apparent and rising political and social volatility which is forcing central banks to shift from expansion to contraction of their aggregate balance sheets."

The head of the world’s largest asset management company said investors’ appetite for those assets could move long-dated yields below those of shorter-term debt.

That condition, known as an inverted yield curve, is often considered a precursor to recession and could presage a decline for stocks.

“If there is a risk, it’s that,” Fink said in an interview. “I hope the Federal Reserve pays attention.”

However, he said he did not see an inverted yield curve materializing within the next year as global economic growth accelerates.

Nothing can stop these central bank-controlled markets. Janet in Wonderland and her global colleagues are in control (or so they want you to think), which is why Jim Chanos and other short-sellers are losing money this year as markets melt up.

Is it time to party like it's 1999? Are we on the cusp of a major parabolic market breakout that will last a couple of more years?

Before you get all excited, let me share with you what one astute hedge fund manager I know, Dimitri Chalvasiotis, sent me last Friday after the close:

Volatility Adjusted SP500, as of Friday’s closing metrics, has reached an historic extreme printed a handful of times since 1971. In other words, going forward, either SP500 declines in value or SP500 realized volatility rises.Rare (mathematical) juncture in time/price (click on image).

In other words, get ready for some rock 'n roll, the silence of the VIX won't last forever, and even if markets keep melting up, all that's happening is downside risks are mounting.

Joe Lonsdale, a founding partner at 8VC, wrote a comment on CNBC, In defense of private equity:

The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does.

The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

Technological innovations and centralization of farming operations – from the green revolution to the present – enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant.

This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services.

The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does.

The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

Technological innovations and centralization of farming operations – from the green revolution to the present – enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant.

This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services (click on image).

As the example of agriculture illustrates, there are multiple ways to increase economic productivity. One is to build and finance companies with entirely new innovations, typically the domain of the entrepreneur and the venture capitalist.

Another is to improve the way existing companies work, often by merging many smaller companies to form one large one, or restructuring management goals and employee incentives within a company.

This is typically the domain of the "private equity" firm or a large acquisitive corporation. The two methods sometimes complement each other: when a VC-backed entrepreneur develops a new technology, corporations or PE-like firms often scale the product and quickly spread it throughout the economy.

How private equity works

Today, a private equity or "PE" firm is a company that raises funds from institutions and wealthy individuals and then invests that money in buying and selling businesses. PE firms are usually "activist" investors, which means that rather pursuing a passive buy-and-hold strategy, they are involved in managing (fixing…or screwing up) the internal operations of the businesses they acquire.

Imagine you're an investor who wants to make the economy run more productively by improving as many businesses as you're able to, starting with those with the most potential for improvement. You pore over a map of the economy which shows how different sectors have evolved, which business models have proven effective, where consumer demand is trending, and rafts of other economic data. You want to do more with less – but how?

The leaders of private equity firms find themselves in exactly this position, and employ some of the following strategies:

• Combining back offices of multiple firms to cut redundant costs. Sometimes PE firms will bundle several companies within an industry vertical to reduce supply chain costs. They may also combine an ailing company with a healthy company so that the former can develop better processes and become more productive.
• Aligning incentives by increasing CEOs and operational officers' stake in their business. This technique rewards management for increasing company growth and performing a successful company exit.
• Rescuing and restructuring businesses that are squandering resources. A common target for a PE firm is an older company which lacks financial discipline, perhaps with inefficient middle management, or where executives spend money on private jets and extravagant parties. This kind of firm benefits immensely from the tutelage of private equity firms experienced at leading and running businesses. By aligning rewards with performance (rather than nepotism or tradition), PE firms can make portfolio companies much more productive.
• Locating great sectors and geographies to invest in. PE firms may be able to spot undervalued industrial sectors or localities that others have missed. Capitalizing these areas allows them to develop and thrive at their full potential.
• Using equity capital more efficiently. The capital markets are highly competitive, and securing loans ("leverage") for deals requires finesse. Though the popular press often disparages "financial engineering", reorganizing a company's capital structure can free up money to deploy to other parts of the business or the economy. Of course, irresponsible leverage makes a firm more likely to fail. But the market accounts for this – investors in private equity firms carefully monitor their investments. A PE fund with failed portfolio companies will have trouble raising as much money and freely determining how to allocate it next time around.

A good example is Carlyle's buyout of Hertz Corporation in 2005.

After the buyout, Hertz improved operational efficiency in a variety of ways – for instance locating car cleaning and refueling services in the same parking lots. Not only did these improvements raise Hertz's value by $3B, they forced the entire car rental industry to respond with innovations of their own. During the same period, Avis-Budget and Dollar-Thrifty profit margins and labor productivity increased substantially.

Another example of private equity techniques at work is the brewing industry. The average worker at a North American brewing company is 7x as productive as his counterpart in 1950. (According to "Brewed in North America: Mergers, Efficiency, and Market Power," an academic paper published April 28, 2016, by Paul Grieco, Joris Pinkse and Margaret Slade.)

Private equity groups such as 3G Capital, which merges and restructures brewing operations, have made the industry much more efficient.

Private equity and its discontents

The classic critique of private equity is that it employs financial engineering tricks, such as increasing leverage and minimizing tax liabilities, rather than making real operational improvements.

Venture capitalist Michael Moritz of Sequoia recently claimed, for instance, that PE is akin to "making a small down payment on your neighbors' house; paying for the balance by taking out a mortgage secured by their savings, jewelry, silverware and car; selling off the contents of their property; and then siphoning off some of the loan for yourself."

Similar invectives were hurled around during the 2012 electoral campaign of Mitt Romney, who helped create Bain Capital. Like any industry, PE is occasionally corrupt – as for instance when it charges inmates high rates on interstate phone calls, in partnership with crony state governments.

But the image of private equity as a parasitic form of business completely misses the point.

The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.

Furthermore, enabling companies to do more with less allows workers to specialize in other areas, and frees up wealth with which investors and management can capitalize internal improvements or ventures in other regions of the economy. PE firms succeed to the extent that their portfolio companies succeed, and to the extent that their portfolio companies succeed, America prospers.

Another conventional critique levelled by Moritz is that PE destroys millions of jobs when cutting costs at portfolio companies. This is empirically false – the private equity industry as a whole is responsible for large job creation as well as destruction, with only modest net job losses.

But the deeper fallacy with this argument is that full, constant employment is falsely seen as the ultimate good in America's economy.

If we wanted to create full employment it would be easy: we could simply ban 20th century agricultural technology, immiserating millions of Americans and forcing them back into farm labor. It's easy to intuit that this would be a bad idea, but it's harder to imagine the economic progress that layoffs and labor migration imply.

In truth, creative destruction of antiquated jobs and invention of new forms of labor drives productivity growth, and PE firms are integral to this process.

Finally, some argue that PE only enriches a select few at the expense of ordinary Americans. In fact, the largest investors in PE are American pension funds, which have committed hundreds of billions of dollars to the American private equity industry.

PE assets make up 9% of CALPERS' portfolio, for instance, and have generated an annualized net return of 12.3% over the last ten years. When private equity firms succeed, every state government pension plan, university endowment, and large philanthropic endowment shares in their profits. It's no stretch to say that the primary beneficiary of the private equity industry is the American public.
Private equity and venture capital

Private equity and venture capital have much in common, and The Economist is partly correct to characterize VC as "private equity for fledglings".

Like their counterparts in PE, VC funds have long lifespans, which allows partners to cultivate long-term growth in portfolio companies rather than focusing on quarterly showings. And like private equity firms, the modern VC is actively involved in coaching and advising its portfolio companies (though ironically, PE is often more hands-on and entrepreneurial than VC because the latter has the more limited discretion of a minority shareholder).

Jim Coulter of TPG noted that whereas VC is in the business of mutation, PE is in the business of evolution. Where VCs fund "mutant" start-ups that offer completely novel technological innovations, private equity firms facilitate the process of natural selection to ensure that only the "fittest" companies survive. This is an important distinction between the two industries, and there are other technical differences. But broadly speaking, you can't believe in the fundamental value proposition of the venture capital industry unless you believe in the basic paradigm of investment, assistance, and economic repair pioneered by PE.

We believe that in the coming decade, segments of the private equity and venture capital industries will converge and adopt similar strategies. Returns will disproportionately accrue to firms that combine the best of each. In the 1980s – the heyday of the private equity industry – firms such as KKR, Blackstone, Carlyle and Apollo tapped the under-deployed resources of banks to purchase, restructure, and resell corporations.

But leveraged buyout (LBO) techniques are now "commoditized," and the industry is extremely saturated: PE backs 23% of America's midsized companies, and 11% of its large companies. The private equity industry remains valuable, but in order to generate unusual returns it must "evolve" itself.

PE firms have always tried to harness new innovations, but a surge of new information technologies has made it increasingly valuable for some private equity firms to partner with leading entrepreneurs and technologists – many of whom are located in Silicon Valley. Commercial data is exploding in volume and variety, and metrics are becoming much more precise. Private investors of the future will use technology platforms to evaluate formerly uninteresting assets as hidden stores of data, which will make their businesses and industries more efficient. New information will allow top investors to better assess consumer demand, supply chain logistics, and industry-level shifts, as well as determine where to open channels of communication and dedicate resources. Data-driven PE firms will save resources, increase their margins, and become more valuable to their partners.

Venture capitalists able to draw on the top networks of talented leaders and builders in Silicon Valley were among the first to develop an armamentarium of data-driven procedural improvements for their portfolio companies. Hybrid groups such as Vista were among the first to pioneer these techniques in the buyout space. Private equity firms working closely with venture capitalists and technologists may be able to unlock assets that others have not leveraged and build technology cultures to iterate on solutions that make these assets more productive. Some may even reclaim 1980s or 1990s-level returns.

At the same time, the best VCs will begin to imitate and adopt PE strategies. Scaling major technological breakthroughs in certain industries requires armies of people and significant resources – private equity's bread and butter. VCs may also begin to increase their return on equity capital of late-stage portfolio companies with debt financing, drawing on the private credit divisions of investment banks, PE firms and more.

There is still a large cultural rift between the two worlds; the culture of Silicon Valley is very different from the "Wall Street" mentality of the American financial establishment.

Fortunately, open-minded individuals in each field are establishing rapport and exchanging insights. We have been lucky to add luminaries including Henry Kravis and Geoff Rehnert as investors and advisors to 8VC, and Sir Deryck Maughan as a board partner. Communication and cooperation between our industries will only continue to improve as the distinction between elite private equity and venture capital investors becomes less meaningful.

Conclusion

Critiques of PE reflect a naïve understanding of what creates economic prosperity. Private equity investors are an integral part of the economy, and should be celebrated for making our country wealthier. The confluence of the venture capital and private equity industries will only make each more productive, strengthening and fine-tuning the economy. Savvy, competitive investors able to build, buy and fix companies will continue to stimulate growth by allowing us to do more with less – the only way to create prosperity.

Private equity managers tend to inflate returns when public markets do well, according to research from Massachusetts Institute of Technology’s Sloan School of Management.

A Sloan paper written last month found that buyout fund and venture capital managers, who have some discretion in calculating investment performance, are influenced by public equity gains posted after a quarter has ended. When public markets are subsequently up, private equity managers rate their own performance higher for the quarter gone by, according to the study.

“We make no claim that this behavior is intentional,” Megan Czasonis of State Street Corp.’s research group, Mark Kritzman, a senior finance lecturer at MIT, and David Turkington, a senior vice president at State Street Associates, said in the paper. “It is quite plausible that private equity managers subconsciously produce positively biased valuations merely because they are optimistic.”

[II Deep Dive: Most Private Equity Managers Think Returns Will Fall]

The researchers studied company-level valuation data from State Street Global Exchange’s private equity index, which represents more than half of all global private equity assets. For the first three quarters of the year, they found that private equity valuations were higher if public markets performed well immediately after the quarter ended. But when subsequent public market performance was negative, private equity valuations were not affected.

By contrast, venture capital managers did tend to downgrade their own valuations following several periods of persistent public equity losses.

“Private equity performance is not recorded immediately after the end of the quarter,” the researchers explained. “Instead, it is released over a period of one to three months.”

The reporting delay means private equity managers may be influenced by public equity market performance after the quarter is finished, according to the study. But in the fourth quarter, when private equity valuations are audited, the performance inflation disappeared.

“Private equity managers are less inclined to produce biased valuations when they are faced with audits,” the researchers said in the paper. “As such, we should expect private equity to produce, on average, higher returns relative to the public market in the first three quarters than in the fourth quarters.”

Private Equity is an asset class that has garnered increased interest from institutional and accredited investors since the Financial Crisis, with Pension Funds and Family Offices demonstrating especial keenness. The driving force for the fervor is that PE investors are attracted to investment premiums for assuming PE’s poor liquidity and reduced degree of single asset transparency. Investors are also attracted to the perception of PE’s lower level of pricing volatility. In this article we explore some of the valuation shortcomings that investors are exposed to when owning Private Equity funds. ‎

GPs Want to Value Assets as High as Possible

When a Private Equity fund is recently established it can contain a large component of portfolio assets whose valuations are unrealized. When placing a quarter-end value on such unrealized assets, the General Partner (“GPs”) typically uses valuation techniques that adhere to certain industry guidelines that offer a great degree of flexibility. This self-assessment practice opens investors up to the possibility that GPs will utilize high comparable multiples that contribute to increasing the fund’s overall valuation. The GP is motivated to do so because the higher the portfolio’s asset size, the greater will be the size of the GP’s compensation that is derived from management fees.

LPs Have Trouble Identifying Source of Performance

When acquiring an investment in a PE Fund, Limited Partners (“LPs”) must accept the lack of transparency in performance. For instance, return calculations are not provided at the investment level. As such, the LP cannot identify the sources of returns, thus rendering the manager evaluation of skill or luck to a mere a guessing exercise. LPs have no way of objectively assessing as to whether GP performance explanations yield truth or fiction. LPs must make certain to assess whether they are being properly compensated in exchange for PE Fund’s investment performance transparency being stacked in the GP’s favor.

GPs Are Often Structured With Poor Valuation Controls

GPs often perform portfolio asset valuation internally which can yield poor policies, procedures and controls. Valuation policies are often structured to allow for too much flexibility, which can lead to artificially high net asset values (NAVs) and misleading internal rates of return (IRRs). The GPs’ valuation discretion can also produce a lack of consistency in valuation among different investments. Furthermore, the absence of an independent, third-party valuation agent makes it difficult to confirm valuation accuracy. Even then, some independent evaluators lack expertise at pricing hard-to-value assets. To top it all off, it is not common practice to have a valuation committee as part of a GP’s corporate governance program.

Concluding Remarks

The first step towards working in investors’ best interest of is to adopt best practices. The CFA Institute has developed standards referred to as he Global Investment Performance Standards (GIPS) that provide guidance to properly value Private Equity investments. It is very unlikely that GPs will adopt GIPS on their own. Moreover, regulators are likely to lack the necessary courage to make GIPS a requirement any time soon. Henceforth, we propose that institutional and accredited investors band together and demand adherence to GIPS. Walking away from non-GIPS PE funds will eventually get the message across. Eventually, GPs will be looking to check the GIPS box to satisfy investor needs. If GIPS is implemented across PE firms and on a broad basis, this enhanced integrity would benefit all stakeholders. That is something worth striving to achieve and there is no better time than the present to set the wheels in motion.

When reflecting on the last financial crisis, some investors faced severe funding issues. The most prominent case was from the university endowment of Harvard Management Corporation who issued a bond of more than USD 1bn to fund their future capital calls and considered selling a private equity portfolio of around USD 1.5bn, when the average discount on the secondary market was between 40% and 50%. Even CalPERS (the largest US pension fund) sold some of their listed stocks in order to be prepared for potentially paying future capital calls for private equity funds according to an article in the Wall Street Journal.

Listed private equity vehicles which ran an over-commitment strategy experienced similar issues. APEN, a Swiss-listed vehicle had to go through significant restructuring, adding a new financial structure as well as selling on the secondary market so as not to lose any of its private equity assets. It should be noted, however, that many pension funds and insurance companies investing in private equity did not have to take drastic measures during this time period and were able to cope with the change in cash flow profile because they managed their risks from the outset by limiting their allocation to private equity. Additional reasons for the limited allocation to private equity have been the possibility for them to match it with their incoming cash flows, the possibility to liquidate other liquid assets beforehand and having more diversified portfolios.

After months of planning and closed-door negotiations, Gov. Matt Bevin and GOP legislative leaders on Wednesday released a plan they say begins to tackle Kentucky’s multibillion-dollar pension debt while honoring promises to retirees and public employees.

As expected the plan calls for transitioning most public employees from traditional pension plans to 401(k)-like plans – but it does so in a much more gradual way than recommended by the Bevin administration’s pension consultant.

New workers and teachers will go into 401(k)-like plans, but instead of immediately shifting current state and local government workers to 401(k)s, those workers would be able to remain in their current pension plans for 27 years.

Current teachers with 27 years of service also would be moved to the 401(k)-style savings plans. But their plans will be more generous than those of other public employees to compensate for the fact that teachers do not draw Social Security benefits.

To avoid a rush of teacher retirements, those teachers will be given an option of remaining in their current traditional pension plans for three additional years.

And both current and future workers in “hazardous duty” jobs like law enforcement would not go into the 401(k)-type plans. They would retain their current pension benefits instead.

The plan also would bring legislators, who have more generous benefits, into the retirement system of other state employees. And it would end the ability of teachers to use accumulated sick days to boost their pension benefits – but not until July 1, 2023.

And the plan would begin to pay for pensions under a new approach “that mandates hundreds of millions more into every retirement plan, making them healthier and solvent sooner,” a summary of the plan said.

“If you are a retiree, if you are working to be a retiree at some point, you should be rejoicing,” Bevin said. “... It guarantees by law that your pension is going to be funded. There will be no more kicking of the can down the road.”

Some immediate response to the plan questioned Bevin's statement that all promises have been kept.

"I think the plan includes some very harsh cuts to benefits," said Jason Bailey, executive director of the Kentucky Center for Economic Policy. Bailey said the handouts summarizing the plan say cost-of-living increases for teacher retirement benefits would be suspended for five years and that teachers and other public employees will have to pay more for health care benefits.

The governor released the framework for the reforms at a news conference in the Capitol with the top leaders of the General Assembly’s Republican majorities – House Speaker Jeff Hoover, of Jamestown, and Senate President Robert Stivers, of Manchester.

Bevin has said all year that he would call a special legislative session in 2017 for lawmakers to pass a reform plan to set the state on course to pay off pension debts. Those debts are officially listed at more than $40 billion, but Bevin estimates them at more than $64 billion.

The plan released Wednesday is only an outline of the bill to be considered. And Bevin did not say when that session will begin.

“As soon as we are ready,” he said when asked when he will call the session. “There’s still a little ‘I’ dotting and ‘T’ crossing” before that announcement, Bevin said.

The plan is much friendlier to employees and retirees than many of the highly controversial recommendations offered in August in a report by the administration’s Philadelphia-based consultant – PFM Group. It does not, for instance, call for raising the retirement age for public employees or the clawing back of any benefits earned by current retirees.

“Nothing is changing for retirees," Bevin said. "They’re going to be getting everything they’re getting now.”

And Bevin also said he believes that the terms of the 401(k) plans that will be offered to employees and teachers are generous. “It will be a very good plan.”

Jim Carroll, president of the advocacy group Kentucky Government Retirees, said he appreciated the effort to respect the contractual rights of current state workers but said he believes it would be illegal to “arbitrarily” reduce an employee’s pension benefits after 27 years.

Carroll also said that the toughest decisions now must be made during the 2018 regular legislative session, when lawmakers must find the money for the new approach to funding pensions.

“We’re going to need to hear from leadership how they’re going to come up with the money,” Carroll said.

[...] scraping a defined-benefit plan to replace it with a defined-contribution plan is a really horrible idea. It shifts retirement risk entirely onto workers and leaves them all exposed to pension poverty down the road. That's the brutal truth on DC pensions, they're far, far inferior to large, well-governed DB plans.

The public-sector unions and retirees should fight tooth and nail to maintain DB plans but they will need to share some of the risks attached to these plans in order to see them regain fully-funded status.

The biggest problem is lack of governance. You can almagate all these plans at the state level, increase the retirement age for some and even introduce some form of shared-risk but if you don't get the governance right, Kentucky's defined-benefit plans won't survive and this will impact the state in a very negative way (both in terms of attracting qualified people to the public sector and in terms of economic activity).

Hurricane Harvey devastated Houston and other cities in Texas but they will rebuild that great state. Kentucky's pension hurricane has been going on for years and very few were paying attention, let alone sounding the alarm.

And now, I'm afraid to say, Kentucky's pensions are finished, irrevocably changed and the future of public defined-benefit plans in that state is grim at best. Welcome to America's new pension normal.

Sweeping changes recommended for Kentucky’s public pension systems would cost taxpayers and public employees more money while making public employment far less attractive to future generations, according to a report released Monday.

PTA was hired to examine the PFM Group’s recommendations by two groups critical of those proposals, the Kentucky Public Pension Coalition and the Kentucky Retired Teachers Association.

Although the Bevin administration paid the PFM Group nearly $1.2 million for its advice, Republican lawmakers meeting privately with Bevin to draw up a bill for a special legislative session on pensions have said that not everything the PFM Group suggested will be included.

A spokesperson for Bevin did not respond Monday to a request for comment about the report by Pension Trustee Advisors.

The crux of the PFM Group’s proposals — that it would be cheaper to provide public employees with largely self-financed defined-contribution accounts — isn’t accurate, Fornia wrote.

For one thing, he said, either the state of Kentucky will have to spend millions of dollars every year to cover the new costs of Social Security for school teachers or else it will have to force that burden onto local school districts. At present, teachers get pensions, and they are excluded by law from Social Security withholding.

Changing to 401(k) accounts would also cost the state more than maintaining the model it has used since January 2014, which is known as a hybrid cash-balance plan, Fornia wrote. Under the PFM Group’s proposals, Kentucky simultaneously would have to pay down tens of billions of dollars in unfunded pension liability from past years as well as the higher administrative costs and investment fees associated with defined-contribution plans, Fornia wrote.

“The proposed plan for future employees quite simply is more expensive,” Fornia wrote. “There is no savings to Kentucky or its public workers from the proposed changes.”

From the viewpoint of public employees, the loss of pensions means an end to financially secure retirements, Fornia wrote. Even if state workers and school teachers contribute the maximum sums allowed to their 401(k) account every pay period and enjoy an unbroken string of good fortune in their stock market investments, which seems doubtful, they are likely to run out of money if they survive into their 80s, he wrote.

The change also would end the disability pensions that thousands of injured or sickened public employees in Kentucky have used to retire early when medically necessary, Fornia said. Under the model proposed by the PFM Group, future workers would be left with no such safety net.

Finally, Fornia challenged the idea that defined-benefits pensions don’t work. They work fine when you pay the bills on time, he wrote. Fiscally prudent states that properly funded their retirement systems, such as South Dakota, Oregon, Wisconsin, North Carolina, Tennessee and New York, aren’t struggling today. But Kentucky governors and legislators failed for most of the last two decades to adequately fund the state’s two major pension systems, leading to the massive shortfalls the state faces now, Fornia wrote.

“It is disingenuous to simply conclude that defined-benefit programs are inherently not sustainable,” he wrote.

• States top them up regularly and contribution holidays are made illegal
• They get their investment assumptions right to discount future liabilities
• They get the governance right to manage more assets internally and lower costs
• They adopt a shared-risk model which forces the plan's sponsors to share the risk equally, meaning if they run into trouble and there's a deficit, they need to raise contributions or cut benefits (typically lower cost-of-living adjustments) or both to make up for the shortfall and get back to fully-funded status

Here are the numbers. Peak chase-for-yield by institutional investors?

Most of the brick-and-mortar retailers that have filed for bankruptcy protection to be restructured or liquidated over the past two years have been owned by private equity firms – including the most recent major casualty, Toys ‘R’ Us. Part of how PE firms make money is by stripping capital out of their portfolio companies via special dividends funded by “leveraged loans” – more on those in a moment – leaving these companies in a very precarious condition.

So just how much have PE firms paid themselves in special dividends extracted from their portfolio companies? $4.76 billion in the third quarter, bringing the year-to-date total to $15.3 billion. So the year-total for 2017 is going to be a doozie.

In all of 2016, this sort of activity – “recapitalization,” as it’s called euphemistically – amounted to $15.7 billion, up from $10.5 billion in 2015, according to LCD, of S&P Global Market Intelligence. LCD’s chart shows the quarterly totals (click on image):

“This high-profile recap activity is a sign of the times in today’s still-overheated leveraged loan market,” LCD says:

Deals such as these typically proliferate when there is excess investor demand, allowing borrowers to undertake “opportunistic” issuance, such as corporate entities refinancing debt at a cheaper rate or, here, PE firms adding debt onto portfolio companies, then paying themselves an often hefty dividend with the proceeds.

As private-equity-owned retailers that are now defaulting on their debts have shown: this type of activity where cash is stripped out of the portfolio company and replaced with borrowed money is very risky.

Leveraged loans are provided by a group of lenders to junk-rated over-indebted companies. They’re structured, arranged, and administered by one or several banks. But leveraged loans are too risky for banks to keep on their balance sheet. Instead, banks sell the structured products to loan mutual funds or ETFs so that they can be moved into retirement portfolios, or they repackage them into Collateralized Loan Obligations (CLO) to sell them to institutional investors, such as mutual-fund companies.

A record $947 billion in leveraged loans are outstanding. They trade like securities. But the SEC, which regulates securities, considers them loans and doesn’t regulate them. No one regulates them.

So why can PE firms strip record cash out of their portfolio companies while loading them up with this risky debt? Because credit markets have gone nuts.

After years of yield repression by the Fed and other central banks, there is huge demand for products that yield just a little more, regardless of the risks. “Excess demand scenario” is what LCD calls this phenomenon. “Hence the relative surge in dividend deals, which are popular with private equity firms, for obvious reasons.”

Despite the risks, as LCD gingerly points out, “institutional investors are keen to maintain strong relationships with private equity shops, which borrow frequently, so in bull credit markets these deals continue to find a home.”

And these already risky leveraged loans have been getting even riskier for investors: In the first half of October, 82% of all leveraged loans issued were “covenant lite,” almost matching the full-month record of 84%, in August, according to LCD. As of September 30, 72.9% of all US leveraged loans outstanding had a covenant-lite structure, the highest proportion ever. So $690 billion in leveraged loans were covenant lite.

This chart shows the surge in the proportion of covenant-lite loans to total leveraged loans over the past three years (click on image):

So what’s the big deal? When there is no default, there is no problem. But when defaults do occur – as they have a tendency to do – or before they even occur, investors in covenant-lite loans have less recourse and fewer protections, and losses can be much higher. As long as investors clamor for risky debt in their energetic chase for a little extra yield, these covenant-lite loans are going to fly.

The leveraged loan market has been sizzling. The S&P/LSTA US Leveraged Loan 100 Index has now set an all-time high on every single day from September 25 through October 15. And that’s how it has been pretty much since the recent low on February 11, 2016 (click on image):

In this kind of Fed-engineered credit market, where risks no longer matter, and where institutional investors are chasing yield and plow with utter abandon other people’s money into risky assets, it’s logical that PE firms are stripping as much cash as they can from their portfolio companies before these companies – like so many retailers now – are toppling.

Why is anyone still buying retailers from private equity firms? Read…  IPO in March, Crushed Today: PE Firm Pushes another Retailer into Brick-and-Mortar Meltdown

Correctly describing the situation and demand driving pricing and terms cov lite or cov free. However a lot of data is presented in absolute terms and not relative terms, i.e. relative to a) LBO investment activity (more means more original loans) and b) LBO portfolio holdings (with holding periods lengthening there is more room / demand for Lev Recaps).

More important: Picking Retail (a sector I am quite familiar with) is also a cheap shot as the secular changes from e-commerce/ Amazon are re-rating the whole brick & mortar business, who are broadly screwed with or with or without PE ownership.

The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.

The red part is pretty obviously false if you look at the history of any of the high-profile acquisitions and the guys who engineered them out there. And let's not forget that "redeploying company assets" was often shorthand for "stealing the pension fund."

The PE industry is pretty much why there are so few US pension systems left in private industry. The PE guys make out and leave dust in their wake -- sometimes. Perhaps there are ethical PE companies, but there are lots of them that just steal, and until there is a way to tell the difference, the industry will suffer from a bad name.

It sounds much better when you call it "redeploying assets" or "enhancing productivity", doesn't it?

I like this line, from a linked article at the same site: "Why are investors still buying brick-and-mortar retailers – or anything – from PE firms? No one knows. But inexplicably, it’s still happening."

U.S. stocks traded higher on Friday after the Republicans took a step toward achieving tax reform.

The Dow Jones industrial average rose 123 points, reaching an intraday record. UnitedHealth and Goldman Sachs both rose about 2 percent to lead advancers. Shares of JPMorgan Chase, meanwhile, hit an all-time high after also jumping 1.4 percent.

The S&P 500 also notched an intraday all-time high, advancing 0.4 percent as financials led advancers by rising 1 percent.

PayPal was among the best-performing stocks in the index, rising 4 percent after the company reported better-than-expected quarterly results.

Celgene shares were the worst performers on the S&P 500, falling 10 percent after the company said it will discontinue trials on a drug aimed at treating Crohn's disease.

The Senate approved a $4 trillion budget measure Thursday by a 51-49 vote. Passing a budget unlocks reconciliation, which enables the GOP to pass a tax bill with a simple 51-vote majority in the Senate. Using the tool removes the need for winning Democratic support, which would likely sink a GOP tax measure.

"The market was very excited about tax reform last year after the election. But come the first half of this year, those expectations dropped. Recently, expectations of tax cuts have started to creep up," said Rui De Figueiredo, CIO and co-head of the Solutions/Multi-Asset Group at Morgan Stanley Investment Management.

"The Republicans are so on the hook to get something done that those in-party divisions are likely to be resolved in order to get tax reform done," De Figueiredo said.

Investors have recently seen a higher likelihood of a new tax plan coming from the GOP after the House passed another budget bill earlier this month.

Rising expectations of lower corporate taxes have helped stocks rise to record highs recently, along with strong corporate earnings and solid economic data. The Dow first crossed above 23,000 earlier this week.

"We continue to set new highs and that does put people on edge at times," said Tom Anderson, chief investment officer at Boston Private.

"We've gone a long time without a 5 percent correction. But we continue to be bullish on stocks. We think this stock market is supported by fundamentals," Anderson said.

Wall Street also looked to corporate earnings on Friday, as General Electric and Honeywell, among others, reported quarterly results. Honeywell reported earnings per share that were in line with expectations while GE posted a big miss on its bottom line.

GE shares slipped 0.2 percent and briefly fell more than 8 percent in the premarket.

"Let there be no debate, this quarter was undoubtedly worse than expected," JPMorgan analyst C. Stephen Tusa, Jr. said in a note Friday. "It is becoming increasingly clear that this is a "workout" of a set of business that are impaired for whatever reason (macro and/or micro) generating essential zero FCF, and management is fighting to salvage value, not a simple restructuring."

Investors also looked to Washington as President Donald Trump has reportedly completed interviews with all five of the candidates that he's considering for the role, including current Chair Janet Yellen.

The decision could potentially be announced next week, Reuters reported Thursday citing a source familiar with the matter.

Politico reported late Thursday that Trump was leaning toward appointing Fed Governor Jerome Powell as the next head of the central bank.

The most important chart to pay attention to right now is the iShares iBoxx $ High Yield Corp Bond ETF (HYG) which has been on tear as US high yield spreads hit a record low (click on image):

I want you to look at that monster run-up and ask yourself how sustainable is this going forward. In fact, things have gotten so out of whack in credit markets that Lisa Abramowicz of Bloomberg reports junk-bond traders are increasingly just buying stocks (follow Lisa on Twitter here, she posts great stuff).

All this just reinforces my belief that the bubble economy is set to burst and when it does, deflation will hit the US and we will experience the worst bear market ever, crushing many chronically underfunded pensions and pretty much all institutional and retail investors.

Are financial bubbles inversely correlated to disposable income?  "Since 1970, every time asset values have risen above 520% of households disposable income (the dashed line in the chart, click on image) then the US has been in a bubble and a subsequent crash has followed...This has simply meant asset values growing much faster than households income or households capability to sustain those price increases. The depth of each crash has been relative to the overshoot of asset values on the upside."

Janet Yellen, the Federal Reserve chair, has warned that there is an “uncomfortably high” risk that the central bank will have to deploy crisis-era stimulus tools again — even in the case of a less severe downturn than the Great Recession.

Her comments come as President Donald Trump considers a sharp change of direction at the Fed which could see him install new leadership that is much more dubious about the Fed’s use of quantitative easing.

Ms Yellen said in a speech that the US economy had made “great strides” but that policymakers may be unable to lift short-term rates very far as the recovery proceeds.

This could leave the Fed once again leaning on quantitative easing and forward guidance on the future rate outlook when the economy hits a downturn, she suggested.

“The probability that short-term interest rates may need to be reduced to their effective lower bound at some point is uncomfortably high, even in the absence of a major financial and economic crisis,” she said in a speech in Washington DC.

Former Fed governor Kevin Warsh and John Taylor, a Stanford University economist, are among those who have criticised the US central bank’s decision to swell its balance sheet to $4.5tn as it battled the crisis. Both are candidates to take over from Ms Yellen if Mr Trump declines to give her a second term when her current one expires in February.

Conservative lawmakers on Capitol Hill have also long been critical of the Fed’s unconventional monetary policy, and some have warned that the Fed was risking a major flare-up in inflation and asset bubbles because of its stimulus programmes. Some GOP lawmakers have been agitating for a new regime at the Fed, signalling support for both Mr Taylor and Mr Warsh.

Mr Trump has signalled a decision on a new Fed chair could come soon, and in an interview with Fox Business to be broadcast this weekend the president suggested Ms Yellen remains in contention for a second term. Mr Trump also singled out Mr Taylor and Jay Powell, who is currently on the Fed board, and hinted that they are leading candidates.

The president added that there are a couple of other contenders, whom he did not name. They are likely to be Mr Warsh and Gary Cohn, the director of the National Economic Council.

In her speech, Ms Yellen pointed out that most Fed policymakers only expect to lift the federal funds rate to about 2.75 per cent in the coming years, well below previous norms, suggesting there will be little room to cut rates again when a new downturn strikes. This meant the Fed needed to remain prepared to deploy new rounds of asset purchases.

She also defended the Fed’s payment of interest on excess reserves held by commercial banks — an unpopular mechanism with some lawmakers but one that has allowed it to set rates without being forced to dramatically cut the size of its balance sheet.

Ms Yellen said unconventional policy should be used once again if the Fed has to cut its target range for the federal funds rate to near-zero levels, from about 1-1.25 per cent now.

“Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades,” Ms Yellen said.

“The bottom line is that we must recognise that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound.”

Let me conclude with a brief summary. As a result of the Great Recession, the Federal Reserve has confronted two key challenges over the past several years: One, the FOMC had to provide additional policy accommodation after short-term interest rates reached their effective lower bound; and two, subsequently, as we made progress toward the achievement of our mandate, we had to start scaling back that accommodation in the presence of a vastly expanded Federal Reserve balance sheet.

Today I highlighted two points about the FOMC's experience with those challenges. First, the monetary policy tools that the Federal Reserve deployed in the immediate aftermath of the crisis--explicit forward rate guidance, large-scale asset purchases, and the payment of interest on excess reserves--have helped us overcome these challenges.

Second, in light of evidence suggesting that the neutral level of short-term interest rates is significantly lower than it was in previous decades, the likelihood that future monetary policymakers will have to confront those two challenges again is uncomfortably high. For this reason, we must keep our unconventional policy tools ready to be deployed again should short-term interest rates return to their effective lower bound.

The deep recession triggered by the financial crisis technically ended in the summer of 2009. Despite eight years of economic growth, the labor market improvements have been disturbingly uneven.

Several factors are contributing to the wide range of outcomes which, in turn, have led to stark contrasts in how different groups of consumers and business owners view the current economic environment. I’ll briefly discuss only three of the factors: education, technology and geography. This last category can also be described as “location, location, location” and hasn’t received adequate attention from policymakers.

Declines for high-school educated Americans

Even before the financial crisis, some workers and their families were falling behind, with an ever-widening gap in household incomes linked to level of education. In 2000, for example, the median household income in which the head of household had a high school diploma was about $50,000. A household headed by someone with a college degree was about $100,000. Since then, on an inflation-adjusted basis, the high school-educated family has experienced a decline of about 15% in household income to $43,000. The decline for a college-educated family was about 3% to $97,000.

Technology causing shifts in how workers do their jobs

Long-term structural changes have also had dramatic effects on individual earners and their families. Much has been written about the job losses in the manufacturing sector. Although some politicians point to the role of imports, by far the larger factor has been the use of technology and increased productivity of workers in this sector. Studies have suggested an 80/20 split, that is, 80% of the job losses can be attributed to enhanced productivity, and much of the remainder to global competition. Of course there are variations based on the specific industry within the manufacturing sector.

Throughout the economy, increased use of technology is causing shifts in how businesses interact with customers and how workers do their jobs. There have been pronounced changes in many sectors, including retailing, media and some professional services. The growth in STEM-specific jobs has outpaced the rest and wages, at about $95,000 per year, are roughly double those for the overall private economy. But only 7.2% of US workers are in STEM jobs.

Location, location, location 

Geography is a critical factor which is often overlooked. The attached chart clearly shows the wide gap in job creation by location in the US (click on image below). Since the peak of employment before the financial crisis, the overall economy has created jobs at an anemic pace. Between 2007 and 2014 the aggregate increase was 1.1%. But we need to look below the surface of the national averages. There have been sustained job losses in rural areas and in smaller towns and cities. But, the nation’s largest cities experienced a sharp 8% increase in jobs during this period. The areas surrounding these primary cities also benefited as being part of the regional ecosystem.

Courtesy: Abby Joseph Cohen

The success of communities can be linked to multiple factors. These include the presence of growing industries, higher levels of education, welcoming of newcomers, and the magnetic appeal of public infrastructure and cultural institutions. It is worth noting that broad policy tools, such as monetary and fiscal stimulus, may not be sufficiently targeted to help the communities that are currently struggling. Instead, the “business models” of the cities that are currently thriving show that long-term public investment in education, infrastructure (roads, schools, communication, etc.), and health care can pay long-term dividends in the form of job creation and wage growth.

1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.

Average statistics camouflage what is happening in the economy, which could lead to dangerous miscalculations, most importantly by policy makers. For example, looking at average statistics could lead the Federal Reserve to judge the economy for the average man to be healthier than it really is and to misgauge the most important things that are going on with the economy, labor markets, inflation, capital formation, and productivity, rather than if the Fed were to use more granular statistics. That could lead the Fed to run an inappropriate monetary policy. Because the economic, social, and political consequences of an economic downturn would likely be severe, if I were running Fed policy, I would want to take this into consideration and keep an eye on the economy of the bottom 60%. By monitoring what is happening in the economies of both the bottom 60% and the top 40% (or, even better, more granular groups), policymakers and the rest of us can give consideration to the implications of this issue. Similarly, having this perspective will be very important for those who determine fiscal policies and for investors concerned with their wealth management. We expect the stress between the two economies to intensify over the next 5 to 10 years because of changes in demographics that make it likely that pension, healthcare, and debt promises will become increasingly difficult to meet (see “The Coming Big Squeeze”) and because the effects of technological changes on employment and the wealth gap are likely to intensify. For this reason, we will continue to report on the conditions of “the top 40%” and “the bottom 60%” separately (as well as on the averages), and we encourage you to monitor them too.

The unemployment rate dropped to 4.2% in September, its lowest since February 2001, and yet consumer loan defaults keep creeping up.

In fact, the divergence between the labor market on one hand, and consumer credit performance on the other, is at a record (click on image). What figures?

UBS analysts led by Matthew Mish and Stephen Caprio set out to answer that question, and their findings highlight the financial difficulties many millennials are facing.

According to Mish and Caprio, there are two cohorts that have been left behind by the labor market: lower income households, and millennials.

"The most underappreciated factor explaining consumer stress is the two-speed recovery in US consumer finances," they said.

The two strategists dived into the Fed's latest Survey of Consumer Finances to calculate a bunch of metrics, including the the levels of debt to assets and income across different age cohorts. Those ratios are near record levels, with the millennial debt-to-income ratios in line with 2007 levels (click on image).

And that might not tell the whole story. The Fed survey suggests 38% of student loans are not making payment, while the structural shift from owning a home and paying a mortgage to renting means that more households are paying rent and making auto lease payments. In other words, they might have significant outgoings that aren't being captured in the debt figures.

"We believe this is particularly problematic when assessing the financial obligation ratios of US millennials and lower-income consumers," UBS said.

So what does this mean? Here's UBS:

"Longer term, the two-tier recovery in consumer finances suggests key segments of the US population (lower income, millennial households) are more financially vulnerable than aggregate consumer credit metrics imply. In turn, these groups will be more sensitive to fluctuations in labor market conditions and interest rates ceteris paribus."

That's a touch worrying, especially at a time when interest rates are going up.

For context, millennials hold 18% of debt outstanding, according to UBS, and make up 19% of annual consumer expenditures. Together, the two cohorts "left behind," lower-income households and millennials, make up about 15% to 20% of debt, and 27% to 33% of expenditure.

So if they're struggling, it has the potential to negatively impact the economy pretty significantly.