Juggling Dynamite

Public pensions have reported a median -7.9% for the fiscal year ended June 30–their biggest loss since 2009 (data published in The Wall Street Journal). This figure reflected the returns for traditional publicly traded investments like stocks and bonds to the end of the second quarter. However, illiquid assets, including private equity funds (PE), represented nearly a quarter of their portfolios, and those asset values have not been updated since March 31.

Through a decade of central bank risk suppression, yield-desperate investors, institutional and retail, crowded into illiquid funds and products in the hopes of hitting return targets far above risk-free rates. This was always a dangerous strategy. See Pensions brace for private equity losses:

In the coming weeks and months, public pension funds will calculate the second-quarter performance of their private-market assets based on estimates they receive from investment managers. Warning signs are already visible in the secondary market, where investors can buy and sell private-equity assets midway through the life of the investments.

Investors who bought private-equity assets on the secondary market this year paid an average 86% of the value assigned to those assets in 2021, according to data collected by investment bank Jefferies LLC from transactions it worked on.

…the investor relies on the manager to provide an estimate each quarter of what the investment is worth. Managers come up with these estimates by trying to assess the current value of the private companies they hold based on a mix of factors, such as internal or outside evaluations of the companies’ current and future performance and the trading prices of comparable public companies.

Private equity managers will not reveal their actual returns until later in December, and then those numbers will factor into the 2022 returns of pensions and other holders.

In March 2020, private equity managers expressed relief that they did not have to report market declines in real time and that locked in periods prevented clients from redeeming funds for several months.  The quick v rebound into 2021 saved them from having to book early losses and sell illiquid assets to meet cash-out requests.

Barring a miracle rebound this time, an extended bear market is afoot, and redemption requests and liquidation selling will be harder to avoid.

PE rode free-money waves like the rest, but for all their touted sophistication, in the 10 years ended June 30, 2021, PE returns matched the S&P 500 index with less liquidity.

With the Russell 2000 and tech-heavy Nasdaq both -30% year to date, the S&P 500 -23% (its biggest loss since 2008), the US high-grade bond index -19.24% (the worst return since the 1970s) and the average 60% equity and 40% fixed income portfolio -19.3% to September 23, 2022, PE wizards are about to disappoint. Especially the many that levered to magnify returns.

I have long thought that a housing bust and ugly recession might finally catalyze a serious crackdown on money laundering in Canada. Apathy has been the status quo while asset prices were rising. Now, as prices plunge and pain spreads, public tolerance should shift.

Realty reports show that many properties bought in early 2022 are being sold months later, with losses greater than 20%. Rapidly vaporized capital begs questions about who is taking such losses and whether washing illicit funds was the objective.

The recent Agenda discussion with Steve Paikin is a good primer on the present state of affairs and how it is aided and abetted by weak regulation and oversight, as well as many accountants, lawyers, lenders, casinos, financial firms, politicians and real estate agents that continue to profit from tainted transactions and funds. Wilful blindness is very expensive for our country as a whole.

In 2019, the U.S. State department called Canada a “major money laundering country.” And just this past summer, the picture of what that looks like became much clearer with British Columbia’s Cullen Commission, which detailed the millions of dollars being cleaned through casinos, real estate, and fake financial transactions of myriad sorts. To help us understand this issue, we welcome Marc Tassé, forensic accountant and lecturer at the University of Ottawa’s Faculty of Law and at the Telfer Executive MBA program; Sasha Caldera, Beneficial Ownership Transparency campaign manager at the non-governmental organization, Publish What You Pay Canada; and Rita Trichur, senior business writer and columnist for the Globe and Mail.   Here is a direct video link.

Hiking the US Fed funds rate a further .75 yesterday, now 3 to 3.25% (from 0 to .25% in March), Chair Powell acknowledged that unemployment will rise, adding: “Nonetheless, we’re committed to getting inflation back down to 2%.” Powell reiterated that his board plans to raise US base rates a further 1.25% (4.25 to 4.5%) by year-end.

The Fed’s GDP growth forecast was lowered to just .2% in 2022 and 1.2% in 2023 and well below the 2.5% US GDP growth capacity estimate–a whopping slack in resource utilization. This is the closest a central bank will ever come to acknowledging an incoming recession. 

The US dollar index (DXY) leapt 1% to a 20-year high above $111, and stock and commodity markets slumped, with every S&P 500 sector lower on the day.

The US 2 and 30-year Treasury yield curve inverted 58bps, the most since 2000, with short-term yields rising and long-term rates rolling over on the weakening economic outlook.

Word to the wise: historically, equity markets have not bottomed until after the Fed abandons its tightening plans and slashes rates again for several months, dropping short yields and re-steepening the yield curve.

If December 2022 ends this hiking cycle, followed by loosening efforts again in the first half of 2023, it could suggest a stock market bottom sometime in late 2023. Only time will tell.

The last six months of falling asset prices have been about rising interest rates (lower discounted cash flows), negative real wages and slowing consumption (sales). The following six will likely be focused on negative earnings trends and financial contagion, with credit strain and defaults spreading through highly levered corporations and households globally.

As central banks now break the asset bubbles they helped to form, the return of principal is back in vogue, and the yields for cash and the most secure bonds–the highest since 2007–offer an attractive harbour from capital implosion. This is when North American government bonds typically outperform.