Finance Committee on June 11th, 2020

[Pierre Poilievre, Conservative, Carleton, ON]

Thank you very much, Mr. Chairman.

Thank you for your answer. By the way, I'm glad you said that you're not trying to time the market. We didn't hire you as a day trader. We hired you because we know you have the brainpower to find good value and invest for the long run. That appears to be what you're doing.

I want to ask about interest rates. You're not a fortune teller, but you do understand finance better than almost anyone. I want to ask whether or not you worry that in two or three years, this extraordinary amount of new money pouring into our system could lead to inflation. I know that everybody claims the short-term problem is deflation, but I am talking about the medium term. All of this money is going to stay sloshing around in the economies of the world. If it does, then inflation will result and interest rates will have to go up to contain that problem.

First of all, do you agree with that? Second of all, how sensitive is the $409 billion you've invested on our behalf to future increases in interest rates?

[Mark Machin]

It's an excellent question.

The risk of inflation is real. It's quite possible. There have been massive deflationary pressures for years, whether they're from demographics, technology or globalization. Those things have resulted in deflationary pressures generally around the world. I think the first two forces are likely to stay in place. There is a question mark as to whether the third one is going in reverse. It could exacerbate a potential inflationary pressure over time.

As a fundamental forecast, we're not predicting, as a base case, inflation. If we look at world inflation, we expect inflation in our central economic forecast to be about 2.4% for 2022-23 and 2.5% for 2023-24. Inflation in Canada is similar, so in the 2.5% to 2.6% range, and in the U.S. it's 2.9% to 3.0%, in that time frame.

That's the central forecast. There are clearly risks. We publish interest rate sensitivity in the annual report, on page 165, and we show that if you hold all the other variables constant, a move of 25 basis points in nominal risk-free interest rates would result in an increase or decrease in value in the portfolio of about $2.5 billion. That's as of March 31. That's the sensitivity, basically. It's about $2.5 billion of sensitivity to the debt instruments in the portfolio. Putting it through the rest of the portfolio is a complicated exercise, but again, part of it would be making sure we have a diversified portfolio, sufficient investments in inflation-protected assets, a substantial real assets portfolio and substantial investments in equities, quite of few of which will perform reasonably well even in an inflationary environment.

[The Chair, Liberal, Wayne Easter]

We'll have to end that round there.

We'll go to Mr. Fragiskatos, and then to Mr. Cumming.

Mr. Leduc, I can see you. If you want to add a point, raise your hand and I'll let you in.

Mr. Fragiskatos.

[Peter Fragiskatos, Liberal, London North Centre, ON]

Thank you very much, Mr. Chair.

Mr. Machin, thank you very much for a really impressive presentation. You've been quite open with us on a number of issues.

I apologize if you raised this at the tail end of your testimony—you were hard pressed to conclude it—but I have a question on whether or not the CPPIB has an estimate, a projection, regarding the rate of return over the next few years. You cited the report of the chief actuary, and you mentioned that in their view this number has to be 3.95% to ensure the long-term sustainability of the fund—in other words, over the next 75 years.

Do you have an estimate of what you see as the rate of return over the next few years?

[Mark Machin]

These were the expected returns of the reference portfolio for the base CPP, from Q1 2020 to Q1 2025. Remember, that was at the bottom, and I gave those numbers. It's about 7.9%. That was the current modelling of our economics group the last time I had an update of that type for the reference portfolio overall.

[Peter Fragiskatos, Liberal, London North Centre, ON]

When were those projections made? Was it pre-COVID?

[Mark Machin]

It was April, post-COVID.

[Peter Fragiskatos, Liberal, London North Centre, ON]

Okay.

[Mark Machin]

There's a bit of a dip there, so you probably want to adjust those down based on the rally in markets between now and then.

I think there are two parts to your question. One is that returns are, obviously, from where the markets are at one point to where they are going to be, and that's clearly going to be significantly dampened by the time markets come back. At the same time, I think your underlying question is whether there will be dampened returns based on the underlying economic performance. As I said, we expect a swoosh-shaped economic recovery at the moment, with economic production back at pre-COVID levels by the second half of 2022. Markets generally precede that because they're always looking forward. It does factor in COVID, but this is for a period of up to 2025.

[Peter Fragiskatos, Liberal, London North Centre, ON]

My curiosity relates to the extent to which they factored in COVID.

[Mark Machin]

They did.

[Peter Fragiskatos, Liberal, London North Centre, ON]

For example, just a few days ago, as you would have seen, the World Bank estimated a 5.2% decline in global GDP over the next year. To be fair, it estimates that global GDP will rebound significantly by, I think, over 4% once we reach 2021. You've told us that we'll get back to pre-COVID levels of economic growth by 2022.

You cited a rate of return going forward over the next few years. Does that estimate take into account all of those different things? The IMF has come up with projections as well, for instance.

[Mark Machin]

Sorry, let me be a bit clearer. The numbers I gave you were returns for the overall portfolio, the benchmark for our portfolio, in fact. On an economic front, I also said the output would be back to the levels of GDP by the second half of 2022. Growth-wise, there's a swoosh, but we expect quite a sharp recovery. We expect Canada's GDP growth next year, for example, to be 8.1%. You can see it's down, but in the second half of this year we anticipate, hopefully, fairly rapid growth.

[Peter Fragiskatos, Liberal, London North Centre, ON]

You said 8.1%. That relates to what, sorry?

[Mark Machin]

That's for the next calendar year for Canada. If you do this on a quarter-on-quarter basis, for the third quarter of this year we anticipate Canada will rebound over 18%, and then in the fourth quarter over 17%. This is quarter-on-quarter annualized growth.

[Peter Fragiskatos, Liberal, London North Centre, ON]

I understand.

[Mark Machin]

Going into next year, it's 14% and then 10%, and then it moderates again in the second half of next year.

[Peter Fragiskatos, Liberal, London North Centre, ON]

Thanks very much.

I also want to ask you a question related to the CPPIB's global focus and approach.

One thing that has been looked at is the monumental growth we have seen in the value of the fund. My understanding is that in 2006 the value of the fund was $96 billion, at least according to CBC News. It's now well over $400 billion. One reason for this, which has been pointed to, is the global focus that has taken shape over that time. We have, as you mentioned in your presentation, nine offices globally: two in the U.S., two in Europe, two in Asia, one in Brazil and one in Australia. You talked about the 1,800-plus employees who normally would have been stationed in those offices around the world. You said that they are now working from home.

To what extent is this limiting the ability of the CPPIB to carry out its work and grow the value even higher, or is it limiting this at all? Will these employees end up staying at home? Do you have any thoughts on that?

[Mark Machin]

It's a great question about how we run the operations now. We all hope this will be over sooner rather than later, but if it's not, we'll still have to operate on the basis we can. We can operate safely, and can run our process, the portfolio, all the risk systems, etc.

I think where it limits things is with people flying in and out of countries. I'm very grateful for the fact that we have people in these countries, because it can be very challenging, if you don't have people on the ground in these countries and you're trying to fly people in an out, to look at your assets, examine issues that are arising in those assets or make new investments. The fact that we have people in Australia, India, the U.S. and South America means that we're not going to have problems with people not being able to fly in and out, with massive quarantine periods at both ends or with all the risks that people are going to have to undertake. If they're in-country, they can look after our assets and the risks, and find new opportunities because we have the offices there. I'm quite grateful that we have that footprint in place.

[Peter Fragiskatos, Liberal, London North Centre, ON]

Thank you very much.

[The Chair, Liberal, Wayne Easter]

Thank you.

You're substantially over, too, Peter.

We'll go to Mr. Cumming and then on to Mr. Fraser.

James.

[James Cumming, Conservative, Edmonton Centre, AB]

Thank you, Mr. Chair.

Thank you for appearing today, for your candid responses to the questions that have been put in front of you, and for meeting with me prior to this meeting. I appreciate very much the responses you gave me at that time as well.

It's a net return of 3.1% and, as we all know, a tough last quarter, COVID-related. With the direct investments you're doing, which have become a more significant part of the portfolio, do you think it has fairly factored in the impact on those direct investments and those companies that have been impacted by COVID? They wouldn't line up with your year-end, and certainly you have to do some adjustments. Can you comment on that?

[Mark Machin]

Yes. That's a terrific question.

One of the things I did when I sat in my seat as CEO four years ago was to focus on our private market valuations. We had pretty good private market valuations, private asset evaluations, but we wanted to make sure that they were world-class. When my chief financial and risk officer, Neil Beaumont, arrived, we sat down shortly after he was hired and said, “Okay, we're going to make this approach really world-class.”

We said that we were going to make sure that we have independent teams of valuers who are incredibly rigorous, and they have the call, they have the pen—the investment teams don't have the call—and also that we have an incredibly rigorous and much more regular approach to private asset valuations. I didn't know that something dramatic would happen on my watch, but both of us looked at each other and thought, “The chances are, with this expanding recovery, it probably will happen on our watch.” We wanted to be prepared for it.

In fact, again, it's super lucky. If you go to our website, you'll see that on January 24, Neil Beaumont put up an interactive video showing how we do our private asset valuations and how had we improved and that this was the approach. We didn't know that we were about to hit a massive market event and would be able to test that process, but we're super glad that we did and super glad that we put it out for the public to understand how we were doing that approach.

As we came in through this and looked at it year-round, we took a really hard look and took some really tough marks on the valuation of our private assets, so they really do represent the value of those assets at that point in the market. They're a true representation of the value of those assets, whether it's private equity assets, real estate assets or infrastructure assets. There were some tough conversations, obviously, with investment teams that believed in the long-term value of these assets, but we wanted to make sure that they were truly right.

Also, then, we have an independent audit approach that comes in, makes sure and goes through a very large number of those assets again. They do their work to make sure that those really are robust valuations. We were quite satisfied with the fact that we had been.... My chief financial risk officer won't like me saying that we were “conservative” on it, but I think he would say we got the right valuations—

[Pierre Poilievre, Conservative, Carleton, ON]

There's nothing wrong with that.

[Mark Machin]

I think we got the right valuations.