Year of the Fire Monkey
2015 started off great, but finished weak. With three bullets of quantitative easing (QE) and forward guidance from the U.S. Federal Reserve, one would assume 2016 would have some level of positivity. 2016 is the year of the Fire Monkey and with that institutional investors need to be aware of hidden risks and signals. Large asset owners such as sovereign funds, mega endowments and pensions are becoming increasingly concerned with negative nominal interest rates and the continued pace of quantitative easing by Japan and Europe. In fact, the Bank of Japan is continuing its large-scale asset purchasing program, taking a page from the Federal Reserve. The Japanese central bank is seeking to dampen expected returns in domestic government securities, thereby encouraging money to flow into Japanese corporate debt, equities and other asset classes. With deflationary figures being reported in major economies, low rates are probably here to stay. The implications of close-to-zero or negative interest rates will continue to make “risky” assets appear less risky, forcing asset owners into illiquid ownership of more assets – just look at asset managers buying up alternatives firms.
However, the United States’ public debt spirals faster out of control, forcing a conscious reassessment by the American public.
If a pension has a 7.5% annual return target and a yield on Treasuries nets around 1.82%, asset owners will have to crank up the risk ratchet. Will negative interest rates become a normal policy move? The Bank of Japan signaled its willingness to traverse into negative interest rate territory. Before the move, large asset owners like Japan’s Government Pension Investment Fund (GPIF) began shifting billions out of Japanese government bonds into domestic equities and other asset classes. Japan Post Bank is looking at investing private equity, real estate and possibly infrastructure.
Deflation should not be investors only jarring concern. The U.S. federal debt was around US$ 9.99 trillion in 2008. In 2016, the federal debt surpassed US$ 19 trillion. It is true the United States is viewed as the world’s safe haven. In September, the Qatar Investment Authority (QIA) and PSP Investments opened up offices in Manhattan – a sign of confidence. The China Investment Corporation (CIC) also recently shuttered its Toronto office for NYC digs. The concept of sovereign creditworthiness is essentially the measure of a state’s ability to pay off its debt, or roll over its debts as they mature, in a relative fashion. However, the United States’ public debt spirals faster out of control, forcing a conscious reassessment by the American public. In reality, it’s one mega confidence game. Luckily for now, the U.S. can keep doing this, other countries cannot.
As pensions increase allocation to real assets, the developed infrastructure space becomes crowded. Many prominent Canadian pension giants like Canada Pension Plan Investment Board (CPPIB) and AIMCo have left the table, as intense competition for assets have driven up valuations for illiquid assets. Some public investors like AIMCo have started selling off infrastructure holdings, like its investment in Chile, the Autopista Central de Chile, a Santiago-based toll road infrastructure asset.
Emerging markets remain mired in tenebrific trenches. These headwinds are affecting companies like Dutch-listed ArcelorMittal, the world’s biggest steelmaker. Over the course of 2015, the price of iron ore fell by over 40%. What’s worse? ArcelorMittal’s 2015 loss of nearly US$ 8 billion was four times as much compared to 2014. Fund managers such as Aberdeen Asset Management, being singled out by the financial press, was plagued by withdrawals from large clients such as sovereign funds. To be fair, other asset managers suffered outflows. Franklin Resources Inc. stated that investors emptied out US$ 20.6 billion in the fourth quarter. Emerging market specialist managers are refocusing which markets they want to focus their efforts on. Ultra low or negative interest rates, increasing debt loads by governments, emerging market turmoil and excessive demand for illiquid assets are factors to watch for in 2016.
This article is written by Michael Maduell and his opinions are his own and not officially of the Sovereign Wealth Fund Institute.
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