1. Research
  2. Products & Topics
  3. Periodicals
  4. Konzept
January 20, 2015
Liquidity is profoundly important to markets and economies. Whether in oil, volatility or corporate bonds it has been changing significantly as the crisis plays out. Four of the features in this issue of Konzept tackle the myths, mysteries, realities and implications of the changing shape of liquidity for investors, for regulators and for issuers. [more]
Konzept Issue 02 Liquidity is profoundly important to markets and economies. Whether in oil, volatility or corporate bonds it has been changing significantly as the crisis plays out. Four of the features in this issue of Konzept tackle the myths, mysteries, realities and implications of the changing shape of liquidity for investors, for regulators and for issuers. Cover story The changing shape of liquidity To send feedback, or to contact any of the authors, please get in touch via your usual Deutsche Bank representative, or write to the team at research.haus@db.com Editorial Bringing economists, strategists and analysts together from across Deutsche Bank Research we try to explain, to rationalise and to challenge conventional wisdom. We take a good look at the long term fundamentals in the oil market, and explore the impact of “peak carbon” as opposed to the usual shibboleth, peak oil. In a similar vein we analyse deflationary periods over long sweeps of history and see if it really should be as feared as it is today. The features on market liquidity and volatility dig into the realities, and come up with fascinating insights into the underlying dynamics and explore the consequences. The feature on shaving draws out lessons from the declining levels of activity in the male grooming market – a bit of a stretch from credit default rates, but there is perhaps a link to be made. We look at the changing nature of capital flows, and think through the consequences of new global imbalances. Less obviously related, but of great interest are the articles about the future of the mortgage market in Europe, the risks and regulations in the world of shadow banking, and a unique view of mass customisation through the lens of the “maker movement”. If you do not know what a Raspberry Pi is, have a look. The world’s investors, regulators, governments have some challenges on their hands: deflation, the falling oil price, changing global capital flows, stresses in the Ukraine, shadow banking risk, reduced liquidity, low market volatility. Any one of them would merit serious research and attention, but all of them together add up to a constellation of topics that will have profound impact on the way economies and markets play out over 2015. We hope this issue of Konzept will provide some clarity, some insight, and, occasionally, something to smile about. January 19, 2015 Konzept Articles 06 Looking forward to deflation 08The capital of China is moving 10 United real estates of Europe 12 Smart customisation and Raspberry Pi 14Shadow banking—shades of grey 16 Macro-prudential supervision—no silver bullet Columns 68 Book review—best reads of 2014 69 Ideas lab—sleep 70 Conference spy—contingent convertible bonds 71 Infographic—Davos speak Konzept Peak carbon before peak oil 19 Ukraine—the flap of a butterfly’s wings 50 Credit magic— dodging defaults 56 Volatility—the finger and the stick 42 Features Corporate bonds—the hidden depths of liquidity 26 Shaving lessons for the consumer industry 36 A retort might be that the heavily indebted – often the young and the poor – see their debt burden rise when prices fall. If wages decline with prices it becomes more difficult to pay off nominally fixed mortgages or loans. Inflation, by contrast, reduces debt by the reverse logic, thus harming those who save and lend. Hence, the choice between inflation and deflation can be cast as a political debate over redistribution. Neither inflation nor deflation is likely to harm all segments of society equally. More often than not, this economic debate descends into economic tribal warfare, with one camp invoking Keynes as its spiritual leader, the other quoting Hayek or some other Austrian. Rather than add to this quagmire, how about examining the historical record of economic performance during periods of inflation and deflation? Thanks to painstaking work of economic historians such as Angus Maddison or Jan Luiten Van Zanden 1 , there is a vast dataset available that traces annual growth per capita and inflation for 30 countries back to the early 1800s. 2 With over 10,000 data points covering Indonesia to Peru, it is easy to get bogged down with issues over the accuracy of the historical data. However, by aggregating various data sources bridging more than two centuries – from 1800 to 2010 – a robust and fascinating pattern emerges. During years with falling prices, the median change in prices was -4.4 per cent, while during Economists love prices. They balance supply and demand. Prices provide the signal to shift resources from one part of the economy to another. So as long as relative prices move freely, one would think that hyper-rational economists should be relaxed about the aggregate price level. Yet, when taken out of their natural habitat of universities and put into central banks, economists become obsessive about preventing prices from falling. Their aversion to deflation is all the more peculiar because at street level everyone loves to see prices in the shops fall. Why this obsession? The common refrain from economists is that even when prices are falling, thus increasing purchasing power, workers are reluctant to accept cuts in their nominal wage. This wage stickiness in the face of deflation means that employers find their labour costs going up in real terms, and unemployment therefore will tend to rise – the Great Depression of the thirties is held out as the cautionary tale. But previous instances of deflation in countries such as Japan show that in the real world workers do accept wage cuts when faced with unemployment. Looking forward to deflation Bilal Hafeez Konzept 6 positive inflation years it was 5.1 per cent. If annual price changes below or above these median values are classified as periods of deflation and inflation respectively it is possible to measure the average per capita growth rate in each sub-sample. The headline result is that growth was exactly equal across inflationary and deflationary periods (1.6 per cent). Hence, global data over two centuries provide no reason to prefer inflation over deflation from a growth perspective. Regional patterns are even more instructive. Both North America and Asia have grown much more rapidly in times of inflation than deflation. During an average deflation year, the former shrunk by 1.3 per cent whilst growing at 1.5 per cent during inflationary years. The divergence is the same in Asia, with 0.6 per cent contrasting with 2.4 per cent. The Great Depression, of course, was the main contributor to the lowering of US growth. By contrast, Europe has experienced higher growth during deflationary periods than inflationary, at 1.7 per cent versus 1.4 per cent respectively. The negative correlation between prices and growth is particularly pronounced in Germany. Here the difference is not only the largest in Europe, with growth of 2.6 per cent during deflation against a measly 0.6 per cent during inflation, but also stable across the 19th and 20th centuries. In addition, Belgium, Finland, Greece, Spain, and Sweden, as well as the whole of Latin America, have had similarly positive growth experiences with deflation over the past two centuries as a whole. This is not to say that people living through deflationary times, or through periods of inflation for that matter, have always had good experiences. From a macroeconomic perspective, though, the jury still seems out on which of the two is the greater evil. Could there in fact be good deflation? Going back to economics 101, there are two ways to get lower prices: an increase in supply or a decrease in demand. The former could lead to good deflation if it reflects some boost in productive efficiency, higher real wages and robust demand for profitable assets. A negative demand shock would also lead to lower prices, but this would likely lead to bad deflation, where debt problems increase and asset prices fall against a background of slumping profits and high bankruptcy rates. Understanding the source of deflation is therefore critical. Simply trying to avoid deflation at any cost, which seems to have been the mantra of central bankers in recent decades, may not be the most prudent course. Indeed, by overcompensating with dovish monetary policy, financial instabilities may be created via asset price inflation. This seems to have happened in the 2000s thanks to central bank policies in the US and Europe. The ensuing crash in 2008 has now resulted in the possibility of deflation – the one thing that central bankers were aiming to avoid. There is an eerie parallel with the roaring twenties in the US and the ensuing Great Depression in the thirties. Inflation has fallen to close to one percent in the US, China, and UK, and close to zero in France and Germany, while the eurozone has entered deflation. It may be tempting to fear that growth will be weak as a result of a fall into deflation, but history suggests such pessimism may be unwarranted. Greece and Spain, for example, have seen their strongest growth over the past year or two when both experienced deflation. What matters more is how the bad debts from past crises have been cleaned up in the case of Europe, and the possible build up of excess in the UK, US and especially China. 1 The First Update of the Maddison Project; Re- Estimating Growth Before 1820. Maddison Project Working Paper 4. Bolt, J and J L van Zanden, (2013) 2 See www.reinhartandrogoff.com for an excellent database of long term data series on economic indicators Konzept7 We are used to thinking of China as the “factory of the world”. However, it is likely that major changes in the country’s economic model over the next five to ten years will cause it to flood the world with cheap capital – transforming China into “the world’s investor”. How the world adjusts to this deluge of capital will define the next round of economic expansion. One of the likely implications of this shift is that the world will have to either accept a return to an era of large global imbalances or risk a prolonged period of mediocre growth. China’s domestic investment currently accounts for a disproportionate 26 per cent of world investment, up from a mere 4 per cent in 1995. In contrast, the United States saw its share peak at 35 per cent in 1985 but now accounts for less than a fifth. Japan’s decline has been even more dramatic from a peak share of 20 per cent in 1993 to merely 6 per cent in 2013. Germany’s share has declined to 4 per cent of world investment and is now roughly the same as India’s. China’s dominance is driven by the fact that it saves and invests nearly half of its $10.5tn economy. However, it is difficult to fruitfully deploy $5tn in a country that already has brand new infrastructure, suffers excess manufacturing capacity in many segments and is trying to shift to services, a sector that requires less heavy investment. Moreover, China is ageing very rapidly and its working age population is already declining. This is why one should expect China’s domestic investment rate to decline sharply over the next decade. As the current account is the difference between the investment and savings rates, the decline in investment would generate large external surpluses unless savings also decline. The experience of other ageing societies such Sanjeev Sanyal The capital of China is moving Konzept 8 as Germany and Japan is that investment rates fall faster than savings rates. Both these countries have consequently run large, persistent surpluses. However, given China’s size, the scale of capital outflows could be so large that they could hold down the long- term cost of capital around the world even if all the major central banks tighten monetary policy. As the experience of three decades of yen appreciation shows, an appreciation of the Chinese renminbi will not correct the surplus and perversely may even add to it (after all, an appreciating currency further depresses investment in the tradable sector). Can emerging markets take advantage of this cheap capital? In recent months, there has been a chorus arguing that the global economy needs a sharp increase in investment, particularly in infrastructure. Former US Treasury Secretary Larry Summers published a Financial Times column titled “Why public investment really is a free lunch” while IMF Managing Director Christine Lagarde argued that an investment boost is needed by the world economy to “overcome a new mediocre”. India is potentially a big beneficiary of this age of low interest rates, especially given Prime Minister Narendra Modi’s vision of replicating East Asia’s economic success by increasing investment in infrastructure and manufacturing. However, from a global balance perspective, the country is unlikely to help absorb a significant portion of China’s excess savings. India’s share of world investment is merely 3.4 per cent and even a large expansion in Indian investment will not be able to make up for a small decline in China. In addition, the experience of the East Asian growth model is that it is ultimately sustained by mobilising rising domestic savings and pumping out exports. So, India may initially absorb some international capital but, in the long-term, may prefer to build foreign exchange reserves by running small deficits or even a surplus. Other emerging countries in Africa and Latin America may also benefit from cheap capital but are unlikely to absorb much of China’s capital. Studies have found that a sudden increase in public investment is likely to cause indebtedness rather than growth in developing countries. Thus, the recent call by the IMF and others to ramp up public infrastructure spending is really aimed at developed countries. However, even if Germany increases domestic investment, the country’s investment-savings gap is so large that the most to expect from Europe is that it does not add further to the global savings glut. In others words, a sustained revival in global economic growth boils down to a revival of infrastructure investment in the US. The country has the necessary scale to absorb China’s surplus and the poor state of its infrastructure provides many avenues for fruitful deployment of capital. The irony is that the IMF’s new mantra ultimately leads us back to large global imbalances. Far from decrying this as a major failure of global policy co-ordination, economists should accept imbalances as the natural state of being and try to manage the resultant distortions. Virtually every period of globalisation and prosperity through history has been accompanied by symbiotic imbalances. In each case, these imbalances caused economic distortions and complaints, but they can endure for surprisingly long periods. For instance, in the first and second centuries CE, the world economy was driven by Indo-Roman trade. Throughout this period, India ran a current account surplus and the Romans complained about the loss of gold and kept debasing their coinage – still, the system endured. The same can be said about the imbalances of the original Bretton Woods system which was sustained with European capital until the early 1970s and Bretton Woods Two with Asian capital until 2007, with the US providing the deficits in both cases. Thus, we need a Bretton Woods Three to get global growth going with China providing the capital and the US again absorbing a substantial portion of it. However, if Bretton Woods Three fails to take off for whatever reason, we should reconcile ourselves to a long period of mediocre growth. Cheap capital, in this scenario, will continue to support asset prices and depress yields. History suggests that some of this cheap money would inevitably find its way into trophy assets and bubbles. It would be better off in US infrastructure. Konzept9 differences in its policy transmission channels. The mortgage market is a particularly significant channel as it allows interest rate changes to affect household finances through mortgage payments. However, the effectiveness and importance of this channel differ across countries based on the characteristics of their mortgage markets. And there are some striking differences in mortgages within the eurozone. Comparing the key features across the big five European countries: The maximum loan-to-value ratios typically allowed to house buyers vary between 70 and 90 per cent and have changed considerably over time. So the LTV of existing mortgages as a percentage of current property values will be even more widely dispersed. Germany has the largest mortgage sector (worth €1tn) but relative to its economy the German mortgage market is just 35 per cent of national output and declining, unlike anywhere else in Europe. By comparison, mortgages are a quarter of output for Italy, 60 per cent for Spain and over 100 per cent in Netherlands. The average mortgage term also varies significantly between eurozone countries. The Netherlands typically has long durations of 30 years, Germany 25 years, Spain 22, but France and Italy only around 15 years. German and French households mostly have fixed-rate mortgages. In both countries only 15 per cent of new loans last year were adjustable-rate mortgages. By contrast, in Spain The euro’s near-death experience led to calls for the continent’s monetary union to be bolstered by a banking union, fiscal union, capital markets union, political union – the list goes on. However, one area where greater harmonisation would be immensely beneficial to the conduct of a common monetary policy is Europe’s mortgage market. One obvious challenge facing the European Central Bank in designing monetary policy for 18 different countries is their differing business cycles. Today’s zero interest rate policy is arguably too loose for Germany’s housing market, yet still too tight for countries in southern Europe. Having one interest rate even for a single country is tricky, as economic cycles can differ from north to south or from urban to rural areas. London and the north of England are no more an optimal currency area than are Germany and Spain. And frankly, neither the ECB nor anyone else can do anything to synchronise the business cycles of European countries. The ECB though has another problem in formulating monetary policy: structural United real estates of Europe Jochen Möbert, Nicolaus Heinen Konzept 10 90 per cent of new loans were adjustable-rate mortgages, and recent data show that this increased during the euro crisis. Macroeconomic tools are unwieldy at the best of times, but these differences make the ECB’s task doubly difficult. An interest rate change will have a very different effect in countries with a large mortgage market, adjustable rates and high LTV ratios compared to those with a small mortgage market, low-LTVs and fixed rates. This fragmented transmission mechanism from policy to economy engenders unpredictability and uncertainty for policy makers. Therefore, harmonisation of Europe’s mortgage markets could be the way ahead. It has been on the political agenda for a long time already, and some degree of voluntary coordination has existed since 2001. However, it was not until February 2014 that a legislative process was completed at the European level with the aim to create a Union-wide mortgage market, called the Mortgage Credit Directive. The directive will need to be brought into national law by March 2016 – but delays may occur. The MCD will directly affect the mortgage business in some important respects, especially focusing on transparency and increasing competition. For instance, the directive requires that the riskiness of products such as ARMs and foreign currency loans be illustrated by specific warnings. The relationship between creditors and credit intermediaries will have to be disclosed; as a consequence, banks and credit intermediaries will have to adopt a new lending process, which is likely to be longer and more detailed. Moreover the requirement to use a standardised information sheet aims to enhance the comparability of credit offers and foster competition between banks. The directive also provides that borrowers have the right to repay a loan early. Finally, credit intermediaries will be allowed to extend their activities within the Single European Market if they comply with minimum standards – another boost for cross- border competition. The directive, while an important first step, disregards the key structural differences highlighted above. Agreement on topics such as tying practices and quality standards will not harmonise the market, leaving the ECB with a complex and unpredictable transmission mechanism for its monetary policy. What can be done? A real estate union would fit nicely into the big picture along with monetary union, banking union, and the ongoing debate on fiscal and capital markets union. The idea would be to harmonise rules and laws across the eurozone to establish a single market for real estate debt. That is easier said than done. The MCD experience shows that achieving harmonisation across all countries within a short period of time is almost impossible. Therefore a more prudent course of action may be to prioritise the speed of implementation over the number of countries participating. A viable two-part approach could be to first seek political agreement on long-term and systematic harmonisation that would take around 20 years and focus on creating a unified structure in the mortgage market. And then within the boundaries of the first step, target a rapid full harmonisation process that would take around five years and involve only a few countries with the mechanism of enhanced cooperation. The smaller group of countries could create sufficient regulatory gravity so that other countries could be induced to implement the standards as well. These steps could eventually result in a single transmission channel in the European mortgage market that would enhance the effectiveness of monetary policy. Whilst business cycles may remain out of step, this would at least reduce the size of the ECB’s challenge. Konzept11 Smart customisation and Raspberry Pi Alexander Düring The farewell gift bag for delegates at the recent Nato summit in Wales contained a Raspberry Pi. Designed in England and made in Wales, this pack-of-cards-sized personal computer is very cheap (around $30) and is designed to allow people to explore and customise computing technology. Nearly four million Raspberry Pi computers have been sold. But this is more than a fun little success story. Who bought them and why has broad implications for Europe’s economic future. The Raspberry Pi’s natural habitat is a sub-culture sometimes called the “maker movement”. Makers, do-it-yourself technology enthusiasts, use all kinds of kit to produce things such as talking moose heads, infrared bird boxes and balloons that take photos from near space. What unites them is technological curiosity, a little money and time, and a creative urge. Although makers are individualist creators, they depend on mass production. The Raspberry Pi, for example, shares its core processing unit design with Amazon’s Kindle and Apple’s older iPhones. AVR microcontrollers, a chip ubiquitous in maker products, are found in hundreds of millions of mass-produced consumer goods. The software tool chain for these chips is usually based on the GNU compiler collection which is also often used on personal computers and workstations. Ubiquity means low cost and that is what opens these tools to amateurs. The maker movement, in other words, stands on the shoulders of the giants of the telecom, computer and household goods industries. Using economies of scale and technology to tailor products for customers is known as mass customisation. As a business model it requires consumers who are prepared to pay a premium for an individualised product. Just as workers carry home the wages that they later spend as consumers, they also carry home knowledge that they apply when they select products Konzept 12 Mass customisation is essentially a supply concept, with the industry asking itself what it can do for the consumer. Looking at the demand side, makers are at the leading edge of mass customisation because the products they demand are unique. At the same time, the maker movement also represents mass ownership of complex parts of the production process. One conclusion from the millions of Raspberry Pis sold is that the market for mass customisation is large because a Pi is usually the start of an individual product, not a finished product in itself. A second conclusion is that the extent of electronics expertise, or the will to acquire it, is not confined to the staff in corporate development laboratories. Both conclusions have important ramifications for the future of European manufacturing. The linear extrapolation of the social developments in the 19th century was that there would be a widening gap between a badly educated proletariat on one hand, and an elite class of capitalists and inventors on the other. By contrast mass customisation requires a large degree of worker engagement because the workers need to be able to deal with frequent changes in the production process. Alienation of capital and labour is not an option for a mass customisation industrial society. The recent trend of outsourcing on the basis of labour cost, for example, falls into the old mental trap of assuming that workforce education is a secondary concern. The education system of a mass- customisation economy must provide a much wider range of training and qualifications. It is not enough to have a few elite institutions churning out thinkers, leaving the rest of the population as badly educated labourers. If that fiction has ever held, it is now unsustainable in an industrial landscape where customisation is needed. The educational structures in Germany and Japan, both of which are strong in high- value-added products, show a large variety of institutions between the top university layer and pure vocational training. The middle layer of education is of paramount importance not just for the competitiveness of their industries, but also for the demand. Trade unions often argue that not paying labour means no customers. Perhaps more importantly, not educating labour means no customers for high-margin products. Just as workers carry home the wages that they later spend as consumers, they also carry home knowledge that they apply when they select products. Looking to run a business on the basis of trying to make the next high-volume widget cheaper in a far-flung location not only short-changes labour but also the consumer. For European industry, this second conclusion is significant. Europe is an affluent market that can and will pay for mass customisation and it has the required labour setup to produce it. That connection is the lesson non-geeks can learn from the Raspberry Pi. Raspberry Pi costs only $30 $30 The Raspberry Pi measures only 86 x 56 x 21mm 86 mm Nearly four million Raspberry Pi computers have been sold 4m Konzept13 The headlines are everywhere: “KKR lends €320m to Spanish building group Uralita”, “Investors pour record sums into leveraged loan funds”, “Hedge funds replace banks as Europe property lenders”, “Zopa lends £250m in a year as peer-to-peer industry booms”, “…big buyout firms believe that the opportunity for future growth is in the provision of credit”. Welcome to the world of shadow banking. Banks have felt the regulatory and supervisory heat following the financial crisis. Regulatory requirements on asset quality, capital, leverage and liquidity have been raised materially and restrictions on bank activities have been imposed. As a result of economic and regulatory pressures, deleveraging banks have been retrenching or abandoning some of the businesses they traditionally dominated. This has left a void in the financial system that is increasingly being filled by other financial players – the shadow banks. Shadow banks are entities involved in leveraged credit intermediation, conducting maturity transformation by borrowing short- term and lending long-term just like traditional banks. The sector includes financial institutions such as money market mutual funds, hedge funds, structured finance vehicles, credit funds, peer-to-peer lenders, broker-dealers, real estate investment trusts or private equity firms. Even family offices are getting in on the act. By banking without a banking license, shadow banks are not subject to the regulatory scrutiny traditional banks face. This might not be a problem in itself as the capacity to absorb losses varies across financial entities. Some might suggest that the transfer of risk away from banks, particularly the too-big- to-fail ones, represents a welcome reduction in systemic risk. However, the opacity of shadow banks can create hidden vulnerabilities and allow them to grow unnoticed until they reach systemic proportions. In fact, since shadow banks do not benefit from deposit guarantees and access to central bank liquidity, they are more exposed to the risk of a “bank run” than traditional depositary institutions. Shocks can Michal Jezek Shadow banking— shades of grey Konzept 14 be transmitted from shadow banks to the rest of the financial system through various channels, including ownership linkages, withdrawal from certain markets, flight to quality and transparency, or fire sales during runs. In short, shadow banks may pose a severe systemic risk. Even size considerations may be misleading as it is not at all clear whether a collection of many smaller players in the shadow banking system presents meaningfully less risk than fewer larger players in the regulated banking system. This is especially so if many of the former are involved in a similar type of activity, all pursuing the same type of “profitable” business across the cycle. The Financial Stability Board estimates that at the end of 2013, global non-bank financial intermediation – the broadest proxy for shadow banking – reached $75tn, having grown by $5tn over the previous year. The size of the sector varies across geographies. Relative to bank assets, shadow banks represent about 175 per cent in the US, 60 per cent in the eurozone, 45 per cent in the UK, 25 per cent in other advanced economies and 50 per cent in emerging markets. The fastest growth of shadow banks in the last decade took place in emerging markets. Globally, non-banks represent approximately a quarter of financial intermediation, so their systemic importance can by no means be ignored. We have seen these risks already. The 1998 crisis of Long Term Capital Management presents a textbook example of a single hedge fund nearly bringing down the entire financial system. The collapse of the highly leveraged fund posed systemic risk via counterparty exposures and fears of forced liquidations. In the end, the Federal Reserve had to organise a private bail-out by creditor and counterparty banks. Similarly, shadow banks were involved at the inception of the most recent financial crisis. When the subprime collapse hit in the US, the shock was transmitted from conduits and structured investment vehicles – shadow banking entities – to banks and corporates worldwide, leading to a deep global crisis. For example, a run on money market mutual funds – another type of shadow banking entity – had to be stopped by government guarantees. A liquidity crisis caused by a run on shadow banks can quickly develop into a solvency crisis and inflict damage on the real economy. Unsurprisingly shadow banking has been on the agenda of global regulators for some time and there has been progress towards establishing a more robust regulatory and supervisory system. Current rules or proposals include: limits on bank exposures to shadow counterparts; mitigation of mutual fund run risks by using floating net asset valuation and redemption controls; capital and liquidity requirements; restrictions on maturity mismatches; incentives for simplicity and transparency in securitisation; and addressing risks associated with re-hypothecation. The Financial Stability Board is developing a methodology to identify systemically important non-bank, non-insurer financial entities. Without a doubt, the shadow banking sector benefits the economy by providing credit and broadening the scale and scope of financial services. However, as with any financial intermediation, the benefits do not come without risks. This presents a difficult balancing act, in partial darkness, for regulators and supervisors. To avoid overly restrictive regulation that could stifle these benefits, regulators should primarily focus on parts of the sector that are systemically important and on preventing regulatory arbitrage. Indeed, the very act of turning the lights on via enhanced risk monitoring of shadow banks should in itself significantly improve financial stability. Konzept15 The aim is to prevent the build-up of systemic risk by managing credit and asset price cycles thus increasing the resilience of the financial system to systemic shocks. Typically, these are instruments that can be used “structurally”, or in a time-varying fashion. In the latter case they are designed to moderate (or revive) credit flows – usually to the housing sector – and prevent pro-cyclicality and contagion of other sectors. It is this function that is in the policy spotlight today, especially in countries that do not have an independent monetary policy, where macro- prudential policies may be hoped to act as something of a surrogate interest rate tool. Luckily since the approach itself is not new we can examine some historical examples. The evidence suggests there are three big challenges. The first is leakages. In the last two decades macro-prudential policies have been adopted in a range of emerging market economies, but also in Denmark, Ireland, Hong Kong and Spain. The latter four are mainly smaller open economies, tightly integrated with their neighbours via capital flows. This raises questions about leakages. The evidence – from Asia, emerging Europe and a few advanced economy cases in the European Union – on using macro-prudential measures in an active, time-varying way is mixed. However, even in the eastern European cases, where countries are closely integrated with euro capital markets, there may have been a shock effect of up to two years, which slowed bank credit growth. 2 In some Asian cases, measures did Politicians, regulators, bankers; almost without exception they missed the wood for the trees in the run up to the global financial crisis. The supervisory systems in place focused on the viability of individual financial institutions in isolation, whilst monetary policy targeted price stability. What was missing was anyone with a mandate to ensure the stability of the entire system. In this context the term macro-prudential supervision has emerged. Macro-prudential supervision aims to preserve financial stability by preventing the build-up of systemic risk and containing shocks to the financial sector and the real economy. It takes a market-wide perspective of the financial system as a whole rather than assessing risk institution by institution. 1 The measures deployed include limiting loan-to-value ratios, incremental reserve requirements, and selective capital weightings. Macro-prudential supervision— no silver bullet Nicolaus Heinen in conjunction with Max Watson, Programme Director, Political Economy of Financial Markets, University of Oxford We are very sorry to report that Max Watson, a long-standing and highly valued friend of Deutsche Bank Research, died on 14 December 2014. We respectfully include this article in his memory Konzept 16 not slow mortgage lending but did indeed build bank resilience. 3 The evidence typically shows, however, that the impact of measures does wear off as arbitrage flows kick in. 4 The second big challenge concerns political economy and conflicts of interest. If macro- prudential supervision is exerted by institutions that are not politically independent, measures taken may initially be too mild – such as in Ireland and Spain in the years before the crisis. In the eurozone, the European Systemic Risk Board as a part of the European Central Bank assumed the macro-prudential supervisory role in 2011. However, the ECB can object to, but not prevent, national measures and at the same time may impose its own measures. Obviously this is a recipe for overlapping or even contradictory policy. Moreover, it means that the ECB as supervisor faces a wide range of capital buffers set by national authorities. 5 To this end, the ECB’s competences in monetary policy, banking supervision and macro-prudential supervision constitute a far-ranging concentration of interacting powers – and bear the risk of conflicts of interest. 6 A final challenge in the experience of macro-prudential policies is a lack of consensus about adequate warning indicators and critical thresholds. This is particularly true for the level of credit relative to a country’s gross domestic product. An internationally comparable common catalogue of indicators, thresholds and methodology would allow transparency in advance as to when and how policy would operate. These challenges are relevant for jurisdictions beyond Europe as well. The US, experiencing a long period of very low interest rates, is increasingly alert to the potential of macro-prudential measures – but with a marked emphasis on structural approaches and on the question of how to address systemic risk from non-bank institutions too. The Financial Stability Oversight Council was set up in the US in 2009. It is regarded to have a broader mandate than its European peer and has stronger intervention powers as conflicts of interest in the field of sovereign authority do not arise. Meanwhile China, as it shifts towards market-based policies, is evidently concerned about how to craft sectoral policies in a more macro-prudential fashion. Nevertheless, China’s macro-prudential supervisory regime is still developing. The IMF in 2013 concluded that the effectiveness of macro-prudential supervision was constrained and mainly untargeted in China, while huge systemic risks prevailed. 7 In conclusion, the jury is out regarding the full impact that time-varying macro-prudential approaches can deliver in dampening credit booms in large open economies. This is also true in regards to the potential need for co- ordination in an extreme downturn of the credit and economic cycle, when interest rates may approach zero. These considerations also underscore the importance of the complementary, “structural” use of macro-prudential measures – which is not aimed to vary measures actively and frequently over the cycle but to maintain prudent sectoral ratios and constraints on activities over time. Macro-prudential measures are increasingly seen as an important weapon in the policy armoury. But they are no silver bullet. So far, it remains to be seen whether macro- prudential supervision can release monetary policies across the globe from their currently crucial role as intervention forces of last resort. Extreme situations may call for additional strong responses, and fiscal or monetary measures need to be kept in reserve. 1 Macro-prudential supervision: in search of an appropriate response to systemic risk, Deutsche Bank Research by C Weistroffer (2012) 2 IMF Article IV consultation reports for Bulgaria, Croatia and Romania 2006-08 3 Loan-to-value-ratio as a macroprudential tool – Hong Kong SAR’s experience and cross-country evidence”, BIS Paper 57. Basel: Bank for International Settlements. “The Operation of Macroprudential Policy Measures: The case of Korea in the 2000”, BOK Working Paper No 2013-1, Seoul: Bank of Korea. Both by JK Lee (2012) 4 Do Loan-to-Value and Debt-to-Income Limits Work? Evidence from Korea” Deniz Igan and Heedon Kang, IMF Working Paper WP/11/297. Washington: International Monetary Fund. D and HK Igan, (2011) 5 EU Banking Union – right idea, poor execution. Deutsche Bank Research: EU Monitor. B Speyer, (2013) 6 EU Banking Union – do it right, not hastily. Deutsche Bank Research: EU Monitor. B Speyer, (2013) 7 How effective are macroprudential policies in China? IMF Working Paper 13/75. Washington: International Monetary Fund. B Wang and T Sun (2013) Konzept17 Konzept 18 Forecasting is always a challenge – many believe impossible. At least rationalising the past, while not always straightforward, is easier. For example, the oil price’s biggest annual fall in a generation – a halving in 2008 – was justifiable in hindsight given the global economic meltdown. It is strange, therefore, that no one seems to have anything clever to say about last year’s 45 per cent oil price rout – the second worst annual decline in 30 years. Rineesh Bansal, Stuart Kirk Peak carbon before peak oil 19 Konzept Perhaps the experts are embarrassed they did not predict it. To be fair the usual reasons for a collapse in oil do not seem to apply. Hence, more radical hypotheses must be explored. One is presented here: the weather is to blame. Why look elsewhere for an explanation? For one thing world growth of between 3 and 3.5 per cent during last year, while not spectacular, was not disastrous either. By the historical relationship between output and oil consumption, growth in 2014 should have added an incremental 1 to 1.5m barrels per day to oil demand. And despite ubiquitous stories of a supply glut, last year’s production increase was also about 1.5m barrels per day. Other factors such as a rising dollar certainly had an impact, though oil priced in other currencies fell sharply as well. Nor are the themes of US shale, weaker Chinese growth or the complexities of Middle East politics particularly new. But last year was remarkable for other reasons. First it was the hottest ever recorded – beating the previous high in 2010. Second, China and the US, the world’s biggest carbon dioxide emitters, agreed a deal in November to curb future emissions. With the two nations that account for half the planet’s total CO2 emissions on board, there is now much greater optimism for a global agreement at the UN Climate Conference in Paris later this year. And a deal with stringent CO2 emission limits in order to honour previously agreed climate change targets means accepting that the entirety of the world’s known fossil fuel reserves cannot be extracted and burned. Such a conclusion would change everything to do with the oil industry. For starters the fundamental fear of running out of oil that has plagued the world for more than a generation would be replaced by the realisation that much of the available oil will remain unburned in the ground. In this scenario the nature of oil changes from being a scarce commodity that increases in value with time, to a perishable good governed by “use it or lose it” dynamics. Peak carbon rather than peak oil becomes the primary driver of oil prices. This is not the stuff of fantasy. The former chief executive of BP, Lord Brown, recently described this issue as an “existential threat” to the oil industry. Ed Davey, the British Energy Secretary, has warned that fossil fuel companies could be the “sub-prime assets of the future” while highlighting the investment risk they pose to pension funds. Think tanks such as Carbon Tracker have emerged, and even central banks are catching on. The Bank of England has initiated a formal assessment of the potential financial stability risks emanating from large oil companies losing vast chunks of their reserves to climate change targets. Voices from across business, politics and regulators are starting to take notice. What is the logic behind peak carbon? At the 2010 UN Climate Conference in Cancun countries agreed to restrict average global warming to a maximum of two degrees Celsius relative Konzept 20 to the pre-industrial period. This was a huge step forward. Bear in mind that about 0.8 degrees of this warming has already taken place. 1 Since that conference scientists have developed a CO2 budget framework to assess the progress towards meeting this temperature target. Estimates from the Intergovernmental Panel on Climate Change show that to reduce the probability of breaching the two degrees global warming target below one-third, total carbon dioxide emissions since the 19th century need to be kept below 3,670 gigatonnes. Based on historical emissions of CO2 and other global warming substances, that leaves a balance of just 1,000 Gt to spend. 2 With current annual greenhouse gas emissions of 55Gt and still growing, this entire CO2 budget will be exhausted in less than two decades – well before the world runs out of fossil fuels. Of course, any number of things could stop this scenario unfolding. There is a chance, however small, that future evidence conclusively contradicts the scientifically established link between human activity, CO2 emissions and climate change. Or perhaps technological progress, for instance the faster adoption of CO2 capture and storage, could ease the constraints on burning carbon. It is also possible that the political commitment to enforce the two degrees target wanes, allowing for the continued unfettered use of fossil fuels. But rather than bet on these or other unforeseen events to prevent the dramatic from occurring investors should at least consider the implications of peak carbon coming to pass. One is clear: oil demand has to come down over time to meet climate change targets. Under a hypothetical International Energy Agency scenario that restricts the concentration of greenhouse gases in the atmosphere to 450 parts per million in the future (giving a better than even chance of meeting the two degrees target), CO2 emissions have to peak in 2020 and thereafter fall by 2.5 per cent a year through to 2035. The corresponding forecast for oil demand is a decline of 0.5 per cent a year, compared with a 1.5 per cent a year increase over the last two decades. The recent US-China deal will require new policies that reduce their oil demand by 15bn barrels or around 10 per cent over the next 15 years. 3 That is a lot of electric cars among the one billion new cars on the road between now and 2035. Falling demand also raises questions about the oil industry’s obsession with expanding reserves. The world is sitting on reserves worth over 50 years of current production for both oil and gas and over a century’s production worth of coal. The life of oil reserves has doubled in the last 30 years as the industry has replenished them at a much faster rate than oil production. Burning all of these reserves would release CO2 emissions amounting to 2,500 gigatonnes, or 2.5 times the remaining budget of 1,000 Gt. To put it plainly, if the currently agreed climate change targets are to be met with any reasonable certainty, over half the proven fossil fuel reserves would have to stay where they are – underground. Seen in the alternative light of a “use it or lose it” dynamic, 21 Peak carbon before peak oil If the currently agreed climate change targets are to be met with any reasonable certainty, over half the proven fossil fuel reserves would have to stay where they are—underground Konzept 22 23 Peak carbon before peak oil OPEC’s refusal to cut production at its last meeting in November seems perfectly rational. This new world offers OPEC members much less flexibility to shift revenue over time and hence maximising production before the peak carbon deadline is what matters. OPEC members are sitting on oil reserves worth over a century of current production – compared with 25 years for non-OPEC producers – and have the most to lose from a CO2 constrained future. If such a fear is behind their decision, expect the taps to stay fully turned on as producers rush to monetise their assets. Note the comments by the Saudi Arabia’s energy minister last month that even $20 oil price won’t reverse OPEC’s decision. Indeed it was an anomaly anyway that the lowest cost supply from Saudi Arabia was expected to be cut to stabilise prices rather than higher cost supply exiting. While that was possible in a supply constrained market, in a demand constrained world that no longer works. Rather low cost producer OPEC would increase production to compensate high cost supply being closed down. The bonanza of lower oil prices for the West would come at the expense of living with the fear of renewed over-reliance on Middle East oil. But on the positive side, perhaps international tensions over resources would ease. With Arctic oil reserves out of the equation, for example, countries might not go to the lengths of planting titanium flags on the sea floor beneath the North Pole. And how would oil companies adapt to this brave new world? The global oil industry spent $650bn on exploration and development of new reserves last year – or two-thirds of total upstream spending. That number has increased six fold since the turn of the millennium even after adjusting for inflation. And this investment is producing diminishing marginal returns in terms of new reserves being added. The finding and development costs for the big-seven oil majors have trebled over a decade to nearly $30 a barrel of oil equivalent. In comparison their operating production cost (excluding taxes and royalties) is just $10 per barrel. If the two degrees target means no more exploring, the latter number is closer to where margin costs for the industry lie, with obvious implications for oil prices. And oil left in the ground means a big chunk of the industry’s current net asset value goes with it. The world spent five per cent of its total output on oil between 2011 and 2013, up from just one per cent in the late 1990s. For an input so important the halving of the oil price last year not only surprised everyone but needs an explanation. 1 International Energy Agency, Redrawing the Energy-Climate Map, June 2013 2 UNEP 2014. The Emissions Gap Report 2014. United Nations Environment Programme 3 Speech by Lord Browne, former Chief Executive of BP, Nov-2014 Konzept 24 While oil has seen volatility in the past, its defining characteristic of being a supply-constrained scarce commodity has remained unchanged. If the world takes its climate change commitments seriously, then the dynamics of oil will be altered beyond recognition. Oil will become constrained by the level of demand allowed under CO2 emission limits and this will have implications for the behaviour of countries, companies and consumers alike. Perhaps last year’s fall was the first rumbling of this upcoming profound change. 25 Peak carbon before peak oil Corporate bonds—the hidden depths of liquidity Konzept 26 A lack of liquidity in the bond market is an ongoing sore spot for many buy side investors. The unexpected high yield market selloff last summer has increased focus on this issue. While the classic definition of liquidity may be the ability to buy or sell bonds in reasonable size without materially affecting market prices, recently the term has been used more colloquially when comparing how bonds – especially corporate bonds – trade now versus the pre-crisis period. Complaining about a lack of liquidity has come to include an inability to transact in large size, as well as an unwillingness of dealers to use their balance sheets to “buffer” markets during more volatile periods. John Tierney, Kunal Thakkar Konzept27 And there is widespread concern about the lack of liquidity in the event of a major and disorderly selloff around the time the Federal Reserve starts raising rates. There is no question the structure of the corporate bond market has changed since the crisis. The asset management industry, for example, is growing and becoming more concentrated increasing its demand for liquidity. Liquidity providers (mainly investment bank dealing desks) on the other hand are shrinking. Beset by regulatory and cost pressures investment bank dealers have eliminated proprietary trading desks, scaled back inventories, and now focus almost exclusively on market making. But liquidity has been surprisingly robust and adaptable, supporting record levels of issuance and steady growth in trading volumes. Yet there remains a perception that the over-the-counter, request-for-quote dealer model is broken. Much as many people would like to change it, the reality is that the corporate bond market remains dependent on dealers providing balance sheet to facilitate price discovery and liquidity. Even though the market is slowly migrating towards electronic trading platforms this technology today is little more than an automated computer interface on top of the existing system. No one has come up with a new way to ensure a liquid corporate bond market. Maybe it is time to start thinking about keeping what works. If regulatory and profitability pressures drive dealers to keep reducing their commitment to corporate bond trading, liquidity problems could become a self-fulfilling prophecy. Who would provide the liquidity then? How has the market arrived at this situation? One reason is growth. Over the past 30 years there has been a massive shift in credit risk from banks to capital markets investors. The share of corporate bonds in US non-financial corporations’ capital structure went from about a third in 1985 to 60 per cent in 2014. Meanwhile the banks’ share of commercial loans dropped from 30 to 10 per cent. Since 2007 alone the corporate bond market has grown by nearly a half, to $10tn, while commercial loan portfolios shrank by six per cent as banks struggled to meet higher capital requirements and companies aggressively refinanced loans with corporate bonds. Needless to say, this growth in capital market-financed credit has led to commensurate growth in the asset management industry. The industry has also become more concentrated. Data compiled by McKinsey suggest that the top 20 US asset managers increased their market share of global assets under management from 22 per cent in 2002 to almost 40 per cent by 2012. 1 There is no reason to think fixed income and corporate bond funds did not experience similar shifts in concentration. 1 Searching for profitable growth in asset management: it’s about more than investment alpha. McKinsey and Company, September 2012 Konzept 28 These trends raise a number of potential issues for market liquidity. As assets under management grow the demand for market making services also rises. With more assets controlled by fewer managers, many of whom are probably using similar models and investment strategies, there is increased risk of herd-like behaviour, especially when market sentiment shifts or important new information emerges. Operational lapses, such as a major cyber attack or fraud of some type, can potentially cause systemic risk issues, such as a sudden need to sell securities to meet redemptions in a volume the market is unable to handle. So far these issues have not been a significant part of the debate on liquidity. There has been talk of requiring mutual funds in illiquid assets to levy exit fees or otherwise limit redemptions, and the Securities and Exchange Commission has recommended that funds conduct stress tests of their ability to meet unexpectedly high redemptions. The discussion has focused much more on the dealer community. Paradoxically just as asset managers were increasing their demand for liquidity, the collapse of Bear Stearns, Lehman Brothers and Merrill Lynch significantly cut the ranks of bulge bracket dealers. Granted, these firms were absorbed into other banks, but not without considerable elimination of duplication and overlap. In addition, now that banks are subject to higher capital requirements they have cut the inventory side of their business to between one-quarter and one-third of pre-crisis levels. In other words, the business model has shifted primarily to market making. Despite these changes, the corporate bond market has worked surprisingly well in recent years. Median investment grade bid-offer spreads – a classic liquidity marker – were in the 0.2-0.3 per cent range before mid-2007 and blew out to more than one per cent during the crisis. Since then spreads have moved tighter and are now around 0.4 per cent. Trace data (a compilation of all US corporate bond trades) show that the daily average trading volume of corporate bonds has been gradually rising, from $14bn before 2008 to around $20bn over much of last year, with high yield accounting for more than one-third of the total. So, surprisingly, the growth in corporate bond trading has actually kept pace with the growth in outstanding bonds. It also turns out that the rolling realised volatility of daily spread changes of the major corporate bond indices are surprisingly similar across the pre- and post-crisis periods. For investment grade bonds, there is little difference in either the general level of volatility or the behaviour of volatility spikes. Spread volatility in the high yield market has frequently been ower in recent years than before the crisis. It has been vulnerable to temporary spikes in both periods with post-crisis spikes (such as during the taper tantrum of 2013 and the 2014 summer selloff) modestly higher than pre-crisis spikes. For a market supposedly broken, the day-to-day trading pattern of corporate bonds has 29 Corporate bonds—the hidden depths of liquidity been pretty stable. The truth is it has always been characterised by occasional selloffs even during benign times. Another common liquidity-related complaint is that even when trading activity is up, it is more difficult to trade in large size, such as in blocks of $1m to $5m or more. The reality is more nuanced. The primary metric used to support this claim is a decline in average trade size (based on Trace data), from $700,000- $800,000 before 2008 to $550,000-$600,000 over the past year. But such a move is not meaningful because the number of daily trades has roughly doubled since the crisis, largely due to electronic trading activity where trade sizes tend to be small. Unfortunately Trace does not provide useful data on the distribution of trade size so there is no way of knowing to what extent these declines reflect fewer large trades or many more small trades. Discussions with traders and salespeople indicate that block trades still occur. It is possible that the volume of large trades has not changed much, but the growing concentration of asset managers has led to greater demand for large trades. Even though broad market indicators suggest the corporate bond market is more liquid than most people realise, there remains the belief that several major structural changes in the corporate bond trading model have made trading more difficult. For example many cite the paring of dealer inventories and the unwillingness of dealers to buffer the market against sudden selloffs. The first accusation may well be true but again the second is largely a myth. To understand why, remember that before the crisis when capital was not an issue, dealers in effect maintained two closely related but separate businesses – inventories and market making. The inventory business entailed holding corporate bonds primarily to earn carry. Savvy traders with deep knowledge of bonds and credits would acquire attractive bonds and hold them indefinitely until an opportunity arose to sell them at a gain. This was a relatively low-risk, cash cow of a pursuit. The market-making side, meanwhile, involved moving bonds in the door and then back out the door again. There was never a problem acquiring (or shorting) bonds and then warehousing them, but the intent was to hold positions short term. Most likely a dealer would have been reluctant to take on risk without an exit strategy. During a selloff, perhaps triggered by a change in sentiment or bad news, dealers did not simply buy bonds to buffer the market. They would buy attractive bonds opportunistically, but also quite likely would contribute to the selloff by trying to lighten their inventory. Hence the buffer accusation implies that dealers were fulfilling some form of public service. Dealers may not always do smart things or have the right view about the market but they tend not to mix business with charity. Today, however, dealers have largely abandoned the carry-based inventory model due to higher capital requirements as well as possible conflicts with the Volcker rule, which prohibits Konzept 30 proprietary trading. Dealer inventories are now used primarily to support market making by temporarily warehousing bonds. The resulting loss of revenue has made dealers more careful about providing loss-leader market making services, contributing to the sense corporate bond trading is more difficult today. A related change in the dealer model has been the demise of proprietary trading desks – also due to higher capital requirements and the Volcker Rule. Prop desks once thrived and were a steady source of liquidity to market makers largely thanks to the structured credit boom. This boom often resulted in mispricing between bond and credit default swap markets. Prop desks would then step in, buy a bond and buy CDS protection and earn money with little or no credit risk. Later when the mispricing disappeared, they would unwind their trades. This provided an additional source of two-way flows. This trade worked well until the Lehman default when bond credit spreads widened far more than CDS spreads, exposing trades to mark-to-market losses. A sudden need to unwind these trades surely exacerbated the spread widening of corporate bonds during the financial crisis. Nowadays dealer prop desks have been replaced to some extent by players in the shadow banking system such as hedge funds, private equity and sovereign wealth funds. It is hard to say how active or deep this sector is. Anecdotal evidence suggests shadow liquidity providers have been willing buyers of corporate bonds in stressed markets, but at levels lower than indicative dealer quotes. Not surprisingly, many people have not wanted to trade at these levels, which has contributed to the perception that it is difficult to trade corporate bonds. In any case, this liquidity source is almost certainly less reliable than pre-crisis dealer prop operations. Corporate bond liquidity also seems more difficult today because investors are treating the 2005 to 2007 period as normal, rather than viewing those years as the aberration they surely were. A fairer comparison would probably be the pre-2005 era, but there is a lack of data for that period. The best that can be said for now is that post-crisis liquidity conditions are more likely to be closer to normal than not. Another problem for market makers today is that the corporate bond market has been predominantly one-sided, with asset managers primarily trying to buy bonds. Some of this is cyclical in nature. A benign credit cycle with few defaults and a low rate environment has caused more fixed income investors to turn to the corporate market to pick up yield. Investors have also been reluctant to sell because it is often difficult to reinvest the cash. But there is a structural element to this as well, as a concentration of credit risk with relatively few asset managers may be giving rise to more herd-like behaviour. The fact is that a one-sided market is almost by definition going to have less than perfect liquidity. Even if dealers were able 31 Corporate bonds—the hidden depths of liquidity So on balance corporate bond market liquidity is not quite the problem it is made out to be. Barring some major shock the market should be able to handle whatever unsettled conditions end up accompanying the eventual change in Fed policy if trading capacity and liquidity remain more or less as it is today Konzept 32 to maintain larger inventories and some kind of prop business (although without the fizz supplied by the pre-crisis structured credit market), it is likely there would be similar liquidity issues today. For a market-making model to work, there have to be buyers and sellers. And that requires a certain ongoing tension and plurality of views about the future that leads to a rough balance between buyers and sellers at any point in time. Paradoxically, Fed policies aimed at simultaneously stoking investor risk appetite while also trying to reduce risk and volatility have taken much of that vital tension between buyers and sellers out of the market. As noted earlier, this situation has already raised concerns about the risk of a disorderly and costly selloff around the time when rates eventually rise. But an unintended near-term consequence may have been to compromise market liquidity. If policymakers and regulators are concerned about market liquidity perhaps the best thing they could do at this point is step back from policies aimed at creating certainty. Counter-intuitive as it sounds, adding a bit of volatility to the mix could increase liquidity by bringing about a better balance between buyers and sellers. So on balance corporate bond market liquidity is not quite the problem it is made out to be. Barring some major shock the market should be able to handle whatever unsettled conditions end up accompanying the eventual change in Fed policy if trading capacity and liquidity remain more or less as it is today. The risk is that business economics force more dealers to scale back corporate bond trading before a viable alternative emerges. Many of those critical of the dealer-based market making model assume that major asset classes such as corporate bonds – especially the investment grade variety – should share the liquidity characteristics of rates, equities or forex markets. To the extent that corporate bonds do not, the dealer is viewed as the problem. Ideally in this world the corporate market would migrate away from the current over-the-counter model to an exchange or electronic platform, thus largely cutting dealers out of the process. Granted, this technology has worked well for equities, forex and Treasuries (apart from a few major glitches such as the 2010 equity flash crash or last October’s intraday surge in Treasury prices), in large measure because these products are highly standardised. The corporate market is anything but standardised. In the iBoxx dollar corporate index, for example, there are over 900 companies, 1,200 issuers (some companies issue bonds via multiple operating units) and more than 4,200 bonds, all with varying credit ratings, coupon rates, maturities, and structural features such as covenants and call or put options. The iBoxx dollar high yield index includes about 1,100 companies and nearly 2,300 bonds. With such diversity it is rarely possible to consistently match buyers and sellers in real time. And unlike most major asset classes and markets where pricing is readily available most corporate bonds do not come with price quotes. Hence the 33 Corporate bonds—the hidden depths of liquidity request-for-quote process where dealers state prices for specific bonds is more than a convention – it is a crucial part of the market making and trading process. The over-the-counter dealer model evolved and survives to this day because corporate bond trading requires someone to price bonds and commit balance sheet to support trading whether by placing bonds in inventory or temporarily warehousing them. BlackRock has proposed that the corporate bond market could be more standardised if companies issued bonds according to a well-defined schedule and at set maturities similar to the Treasury market. Even assuming issuers would agree to such a policy (doubtful), it is difficult to see it making much difference. In the investment grade index, only 88 companies have 10 or more bonds outstanding, accounting for about one-third of total bonds. (It is unlikely less frequent issuers would be able to commit to a standardised issuance schedule). Assume issuers did agree to support four tranches – 3-years, 5-years, 10-years, and 30-years; eventually (in a best case scenario) the total bond count might decline by 15 per cent to 3,500 or so. That may be a step in the right direction, but not a very big one. And forget about the high yield market. Only eleven companies have ten or more bonds outstanding. Electronic trading platforms may be the future. Indeed, they already handle an estimated 40 per cent of all investment grade trades and a fifth by volume. But today’s technology is simply computer interfaces sitting on top of the existing request-for-quote dealer market-making model. Investors still interact (if indirectly) with dealers to buy and sell bonds, and dealers still commit balance sheet to facilitate trades. Electronic platforms are used mostly as a cost-effective way to handle small trades of less than $250,000. Larger trades continue to be done by voice, mostly because in today’s regulatory environment there is more negotiation around committing balance sheet. The bottom line is that the move to electronic trading has yet to yield a new paradigm for trading corporate bonds where no one commits balance sheet to facilitate trading and liquidity. There has been a move to create peer-to-peer platforms where buy side investors can interact directly with each other to offer and buy bonds, but for this approach to gain momentum asset managers will have to invest significant resources in infrastructure and change their cultures and business models. Even if this were to happen quickly it is questionable whether it would provide satisfactory price discovery in the absence of dealer input and it would not address the problem of one-sided markets – and might saddle a lot of asset managers with costly overheads and few trades to show for it. In conclusion, perhaps it is time to recognise that the corporate bond trading model is not broken and indeed it has arguably become far more efficient. And until someone comes Konzept 34 up with a robust way to trade corporate bonds without the need to commit balance sheet to facilitate liquidity, there is a fundamental need for the current model to remain in place. But the problem is that dealers have difficulty covering operating costs and their cost of capital. One possibility is that bid/offer spreads widen to better reflect costs. If the buy side resists, dealers may scale back further until they gain pricing power. Alternatively investors will have to accept shadow banks as fallback liquidity. And if dealers retreat before a new trading paradigm emerges who will provide liquidity and balance sheet should an apocalyptic liquidity event occurs? The Fed? Footnote Several excellent white papers addressing different aspects of bond liquidity have been published in recent months: 1. The Liquidity Challenge: BlackRock Investment Institute, June 2014 2. Market-making and proprietary trading: industry trends, drivers and policy implications. Bank for International Settlements, November 2014 3. The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market. International Capital Market Association, November 2014 For a perspective on how policy makers are viewing the liquidity issue please see 2014 Annual Report. Office of Financial Research, US Department of the Treasury 35 Corporate bonds—the hidden depths of liquidity Shaving lessons for the consumer industry Konzept 36 The “shower and shave” has been a routine for men across the developed world for over a century. Capturing this ingrained habit is a global oligopoly – dominated by Gillette – with uncommonly attractive pricing power, distribution and margin structure. Such features have made shaving one of the most privileged categories across all consumer products. Executives everywhere long to emulate this “blade and razor approach”. Razors have come to symbolise sustainable value creation – a business model where the sale of a device is followed by a steady stream of consumables revenues, extending product cycles and generating annuity- like cash flows. Bill Schmitz, Faiza Alwy The greatest feature of the business is the almost endless chain of blade consumption, each razor paying tribute to the company as long as the user lives. King C Gillette, creator of the world’s most popular safety razor Konzept37 So compelling was shaving that Procter & Gamble paid nearly $60bn, or 18 times cash flow, to acquire Gillette in 2005. The plan was to plug the new business into its colossal distribution network, while expanding the market into developing economies as incomes grew. The acquisition of Gillette, even considering the big premium paid, was expected to be a game changer. But since the financial crisis the once unthinkable has occurred: the shaving model has stopped working. And why this has happened should serve as a cautionary tale for investors who fail to consider the economy’s impact on consumer preferences and usage behaviour. In the past 12 months, for example, the volume of refill razor blades in America has fallen by an astonishing 11 per cent. This category has been stable for as long as anyone can remember. Even disposable razor sales declined by another three per cent over the period, continuing several years of disappointing and below trend growth. Something changed. Unfortunately for the likes of P&G the reasons for these declines are many. Nor do they seem to be fixable with traditional remedies such as increased marketing spend or incremental innovation. Spurring demand with lower prices is also not a desirable option given the significant profits the category still contributes to P&G as well as its main competitors Energizer (Schick) and Bic. Globally these three players control over 85 per cent of the shaving market with P&G commanding 90 per cent of the industry’s highest margin profit pool on its own. So what has happened? Broadly speaking the reasons underlying the problem shaving currently faces are the flip-side of why the industry was successful in a more robust macro environment. Back then pricing was increased by more than three per cent each year, with even bigger hikes when the latest products hit the market. This was possible due to Gillette’s dominant share as well as its competitors’ desire to ride on its pricing coattails. Retailers were also complicit, enjoying the profits that came from higher price tags. During those vibrant economic times, paying a few pennies more per use in return for a more comfortable shave was not much of a consideration. But stagnating disposable incomes have stretched shaving budgets to the limit. Top-end razor prices in today’s environment almost seem fanciful. Since 2009, the cost per refill razor blade has increased by over a third. And while the cost per use has only gone up by a little more than five cents, there is now sticker shock at paying $20 for a four pack of blades. Perhaps a limit was inevitable. Over the last six years more than 100 per cent of the industry’s growth has been driven by price and product mix – volumes have contributed nothing. At US warehouse club retailer Costco, the price for a year’s supply of blades is now so high that many consumers refer to this offer as “the mortgage pack”. Konzept 38 Is it the industry’s own fault then? Actually the “price and comfort” framework that has driven the category is quite sensible given weak demographic trends in developed markets. In countries such as the US population growth is low but upward mobility high. Given this dynamic Gillette operated by a concept called PUPY, or profit per user, per year. With volume growth ancillary, the primary strategy is to entice consumers to pay more by trading up, and then to shave more by reducing discomfort. Hence the strategy amounted to adding a blade and boosting the price, adding a blade and boosting the price, ad infinitum. In the end, comfort became less relevant as marginal gains diminished, with recent products such as Gillette’s FlexBall razor competing more on ease and speed of use. Now many argue that PUPY is dead, a conclusion that cannot really be known until a more stable economic cycle emerges and disposable incomes expand again. Nevertheless at the heart of the matter is whether it is indeed the economy that is driving the migration to lower priced disposable razors and less frequent use, or are facial hair trends changing for other reasons? There is a chicken and egg situation here. Is the trend towards scruffy David Beckham style stubble and hipster beards a reaction to expensive razors or did the trend come first, ending a once successful business model? To answer this last question requires a deeper dive into current trends. Certainly the unthinkable is happening as far as industry participants are concerned: there is a clear acceleration in the trading down from higher price and margin shaving products to lower priced disposable razors. While disposables may not be as close or as comfortable as five blade, diamond coated, spring loaded premium razors, so much R&D and marketing resources have now gone into creating and encouraging use of these products that they now seem to be good enough for many consumers. Since 2009 disposable razors have gained more than five per cent of dollar market share in the shaving category, while refill razor blades have lost over seven per cent. Direct-to- consumer concepts are also starting to gain traction in the selling of disposable razors with social media trumpeting their superior value and convenience. For instance, the Dollar Shave Club, where members pay a monthly fee to receive razors by post, was started by a consumer tired of paying so much to shave. From not existing five years ago it now sells over 50 million units per annum and has secured venture capital funding to expand in other categories with the same value message. To better understand these changing consumer preferences Deutsche Bank commissioned a proprietary shaving survey of over a thousand men in America aged between 18 and 60, reflecting the country’s income, ethnicity and geographic composition. 39 Shaving lessons for the consumer industry The findings are a wake-up call for the industry to say the least. For instance, almost a third of respondents said that they shave once a week, which included men with full beards or facial hair such as goatees or moustaches. When asked about their current habits 70 per cent said they are shaving the same amount, a fifth admitted to shaving less frequently these days with only 11 per cent are shaving more than historically. These usage numbers are more worrying for the industry than they look because a growing subset of younger men has embraced full body shaving, even compete body hair elimination. Gillette, for example, has some interesting instructional videos on the internet to help better understand this trend and has recently launched a body shaver in some markets. More encouragingly facial hair prevalence is declining according to the survey as the economy picks up and more men head back to work – although that does not stop them opting for a disposable razor. Three quarters of respondents said they intend to shave off their facial hair in the next year. Meanwhile on the chicken and egg question a full two thirds of men cited style trends or other factors as driving their decision to grow facial hair. Only two per cent cited costs – an encouraging number if you work in marketing for Gillette – while a third stopped shaving due to the inconvenience. Still, once the decision to start shaving again had been made, almost half of respondents said price was the important driver of their shaving purchase. Hence it is the other half – the ones who said they are price sensitive yet bought a car or smart phone over the last year – that Gillette has to lure back to its premium razors. The household spending study compiled by the US Census Bureau also shines a light on where consumption in shaving products is headed, as it does the broader consumer packaged goods industry. The study confirmed many of the findings in the Deutsche Bank survey. It seems that consumer behaviour in the shaving category is not dissimilar to the dynamics seen in other packaged goods markets. The credit cycle is important here. Consumer packaged goods seem to enjoy an expansion phase early in an emerging economy’s growth, but then stall for a while as consumers borrow to finance more expensive durable goods. Consumption for things like razors then expands again once households have purchased all the cars, phones, televisions, computers and washing machines they need. Perhaps what is going on in America right now is a latent consumption of durable goods post-crisis, with cheaper packaged goods such a fancy razors bearing the brunt. Looking at all consumer staples products sold in food, drug and mass market retailers (accounting for 90 per cent of total consumption) volumes have declined for four years, according checkout counter data. Yet vehicle lease, license and rental payments increased by over a fifth in 2013, despite a tax-driven 11 per cent decline in household Konzept 40 income after taxes. Spending on beverages, food and household and personal care products has also barely budged, even as prices rose. These trends suggest there is money is available for razor blades. Then there are out-of-the-blue factors to consider such as the unexpected success of the Movember charity campaign, where men across the world grow moustaches and facial hair to foster awareness of male health issues such as prostate cancer. Tracking searches of “grow a beard” on Google shows significant spikes in search activity in and around the November (facial hair) growing season as part of the campaign. Shaving volume trends show mid to high-single digit sequential declines between the three months to the end of September and three months to the end of December in each of the last three years. King C Gillette, creator of the world’s biggest and arguably best safety razor company was right for a long time when he said there was an almost endless chain of blade consumption. But the path the industry has taken since the onset of the 2008 recession does call into question traditional thinking surrounding one of world’s most stable, predictable and profitable categories. How consumers value products, being a function of benefits and cost, has been turned on its side during this stagnating period of economic growth. Preferences have shifted away from benefits and closer to cost. For manufacturers and marketers of branded consumer products, those ignore these shifts and continue with an unchanged business model do so at their peril. If what is currently happening in the US can happen to one of the world’s greatest consumer products categories, it can surely happen anywhere. If you are interested in more details, please go to gmr.db.com or contact us for our in-depth report: The quest for relevance – lessons from the US shaving market malaise 41 Shaving lessons for the consumer industry Volatility—the finger and the stick Konzept 42 Imagine you are asked to balance a long stick on your finger. By placing it vertically on your fingertip, the stick could fall either left or right from its initial position because standing upright is unstable. However, in trying to keep the stick vertical you instinctively (and randomly) wiggle your finger. The added randomness – “noise” – acts as a stabiliser of an otherwise unstable equilibrium. 1 So long as the noise is administered carefully, the stick remains vertical, or “metastable”. The withdrawal of noise becomes destabilising. Aleksandar Kocic 1 The equilibrium concept rests on a simple push-pull mechanism whereby any instability is countered by attractive forces, which tend to restore it. In the vicinity of equilibrium, attractive forces are sufficiently strong to overpower the destabilizing pressures. Far away, those forces tend to weaken, and return to equilibrium becomes problematic Konzept43 The dynamic of the stick and finger captures the post-crisis interaction between the markets and monetary policy. Two paradoxes illustrate this connection and in doing so explain much of the current angst felt by investors. The first is that at a time of huge change following the financial crisis volatility has been near record lows for an extended period. The finger has stopped wiggling and for a short while at least the stick is beautifully poised. Indeed low volatility has come to define markets, with carry trades a popular wager on no change. The second paradox is that good economic news is now the most feared risk. No one wants any randomness to return, they prefer the stick to be still. Hence central banks are caught. Without the wiggles that define a healthily functioning financial system the stick will fall over. But investors take fright as soon as they move their finger. How have policy makers got themselves into this mess? It began when they discovered that post-crisis change was as necessary as it was politically impossible. Hence the goal became to first stabilise markets, and then prevent (or slow down) change that could interfere with the normalisation of economic conditions. This meant unprecedented injections of liquidity, moving risk from private to public balance sheets and finally a reduction of volatility. The consequence of rock bottom interest rates and low volatility across the board was a high degree of correlation between different market sectors, with central bank flows and the distortions those introduced also contributing. Many markets became an extension of monetary policy. This in turn crowded out private investors, their participation now a function of liquidity injected. As a consequence most asset classes simply started moving on the back of US inflation expectations as this was the main expression of quantitative easing. 2 But risk does not disappear. It can only be transferred or postponed by temporarily suspending the existing transmission mechanisms. Therefore the intrinsic contradiction of the policy response to the crisis – that is, suspend the laws of the market in order to save them – is resolved only by understanding that the suspension is temporary. The finger has to start wiggling again. In other words the question of exit becomes an essential part of the stimulus from inception. That explains the tense dialogue between markets and central banks the moment the conditions show any sign of improvement. So how should policy makers proceed? Ideally the reversal of post-crisis monetary policy would occur in three separate acts: the unwinding of correlations, then a return of volatility and finally the interest rate hikes themselves. The first act, which began in mid-2013 with talk of tapering, has more or less been completed, 2 More liquidity injection, which became synonymous with higher expected inflation, was the catalysis of the risk on trade and vice versa, deflation risk was a risk-off trigger Konzept 44 though not without consequences. Correlations have reverted to their pre-QE patterns and are unlikely to go back to where they were two or three years ago. The second act, a return of volatility, is yet to really take off, not withstanding recent jitters around Russia and oil prices. Mostly each attempt by the Fed to inject volatility back into the market has met with rejection. Goodness knows how central banks are going to move to act three and actually raise rates. The big problem is that compared with its pre-crisis role monetary policy has changed from being shock-generating to shock-attenuating. As such, policy now has moral hazard inscribed into it, encouraging bad behaviour and penalising dissent – that is, there is a negative carry for not joining the crowd, which further reinforces bad behaviour. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create a liquidity problem. Years of accommodative policy has resulted in one-sided positioning and commensurate fears of what could happen when the liquid days come to an end. Such complacency, which has already become endemic, is likely to play an increasingly adverse role the longer markets continue to operate as they have in recent years – even becoming an impediment to sound policy should economic conditions improve. Under the existing operational regime, any unanticipated change in the Fed’s position (a sharp twitch of the finger) could prove disruptive for markets. In this way, although volatility remains depressed, the risk is being pushed to the tail as data sensitivity increases over time. The longer the stick remains still, the more surely it will fall. But for now at least volatility remains low irrespective of the economy or the actions of the Fed, and volatility’s inability to find any support has been a recurrent theme. For example, rates volatility has been a hostage of monetary policy since the first days of QE. The nationalisation of mortgage negative convexity (the mortgage purchasing program) has only been part of the story. Mortgage convexity hedging disappeared now that risk resides on the Fed’s balance sheet. Indeed the transmission mechanism between homeowners and capital markets no longer works. This further encourages volatility selling and extinguishes realised volatility. In the absence of any movement in rates an option loses value with time – any attempt to own volatility is penalised. Meanwhile, duration investors have also had to respond to artificially compressed rates and volatility. In this environment they tend to move into credit as credit is higher yielding and low volatility underplays its riskiness. Again, the longer this persists, 45 Volatility—the finger and the stick So while keeping volatility low has been an essential part of the recovery process, returning it to the market will prove to be much trickier. The problem is that the comfort provided by the stimulus has overwhelmed other considerations Konzept 46 the more attractive and crowded credit becomes, potentially creating difficulties when rates and volatility normalise. Nor have equity markets been immune to this low volatility world. Indeed, few investors would say that the US equity market is near record highs because companies are in the best shape of their lives. For one thing, persistently low rates and tight credit spreads have led to continuous buybacks. Also helping is the fact that under accommodative monetary policy equities have become positively convex. Stocks are not only supported by strong data, but weak data as well because this implies continued accommodation. This implicit optionality has made equities particularly attractive for investors. Of course, as the debate surrounding the Fed’s exit intensifies this optionality will become yet another feature of a market under strain. For example, the US equity market reacts positively to weak payroll data (which investors think are key to the timing of rate hikes), and negatively to strong numbers. In terms of importance for risky assets, the market perceives monetary accommodation as more significant than actual improvements in the labour market. The prospect of an economic recovery has assumed a perverse logic whereby good news became bad news and vice versa. So while keeping volatility low has been an essential part of the recovery process, returning it to the market will prove to be much trickier. The problem is that the comfort provided by the stimulus has overwhelmed other considerations. What makes things even harder is that the rebound in growth has not been robust, undermining confidence that without accommodation the economy could thrive on its own. Therefore monetary policy has to be unwound in a way that does not increase volatility too much. This will require extraordinary fine tuning. Unfortunately, previous Fed cycles offer no guide here. What would an unwinding, however delicate, mean for markets? Because monetary policy has consisted of withdrawing negative convexity from rates and adding positive convexity to risky assets, a reversal implies injection of negative convexity to rates and the withdrawal of positive convexity from risky assets. Given this simple reality, it is hard to imagine how rates could not become more volatile and risky assets could not lose their appeal, especially if the unwinding becomes disorderly. And given the amount of capital parked in these credit and equity carry trades a disorderly unwinding is almost inevitable. The stick will drop with a clatter. Where does that leave the market for volatility? Precise assessments of the richness or cheapness of volatility remain elusive and depend on the valuation metrics used. On the one hand, it is easy to see how artificially low volatility has reduced the space for policy unwinding and encouraged the misallocation of capital. When that reverses, watch out for volatility spiking higher. 47 Volatility—the finger and the stick On the other hand, it is hardly ridiculous for investors betting on lower volatility to continue to think that rates will have to stay lower for longer than the market is expecting given fragilities in the economy. Or perhaps the hikes themselves push the economy back into a slump, akin to what happened in Sweden after its central bank raised rates in 2010. Volatility, although near historical lows, could easily move even lower. Investors positioned for a return of volatility have to ask themselves in what way will it return? Certainly it is unlikely volatility will reappear in the same way it was taken out. In all likelihood (and this may already be happening) volatility is going to come back via the currency channel. Foreign exchange volatility has been the worst performer when compared with other volatility markets due to the inactivity of the central banks. But given moves in the last few months perhaps its time has come. After the mid-October shock in rates and equity, volatility has been moving away from rates and equities into the forex market (or from the US in general to Europe) where uncertainties are becoming less ambiguous. Given the unresolved problems with Europe’s economy, there are multiple outcomes that could either further weaken the euro or alternatively result in its strengthening. If the European Central Bank missteps, volatility could rebound. However, even if there are appropriate accommodations in place, this will not ensure calm. That is really down to growth. That said, if the problems in Europe are addressed this would reduce the downside risk to the US recovery and possibly allow the Fed to begin gradually tightening monetary policy. With foreign central banks engaging in inflationary monetary policy, buyers of duration would maintain a bid at the long end and would be happy to take on some risk. In that environment, the forces which lead to stronger dollar would also be supportive of higher yields, and US equities would probably benefit. A successful unwinding as described above would be a mirror image of a stagflation scenario (lower equities, high rates, weak dollar) that would follow a total loss of central bank credibility. The main feature of such a benign market would be that all three assets, stocks, bonds and the dollar, could rally for an extended period of time. This would be very unusual. Generally, for any two of those assets to rally, the third has to sell off. While there would be occasional departures from such a world, it is possible that it would set a baseline for how the market would trade over the near term. A successful unwinding might even mark the beginning of an entirely new investment landscape. The stick stays upright with investors now happy watching the finger wiggle. Konzept 48 49 Volatility—the finger and the stick Ukraine— the flap of a butterfly’s wings Konzept 50 Russia refuses to tolerate a Ukraine closely aligned with the West. Supporting secession in regions with substantial ethnic Russian populations and annexing the Crimea, it drew the line with arms and troops. The West eschewed a military response. Instead, it implemented mild economic warfare, sanctioning individuals and financial institutions close to President Putin, limiting loan maturities, and hitting at distant future export revenue by blocking Western firms from participating in Russian energy development. Peter Garber Konzept51 The limited official freeze triggered general private sector avoidance of new credits to Russia and capital flight, pushing Russia into recession. The military conflict is now paused in an uneasy ceasefire, but the need further to rationalise rebel-held territory and the weakening economic and financial condition of Ukraine imply that the status quo is unlikely to endure. While costly to Russia, the sanctions did not deter it from consolidating the seceding regions. Since the US lacks large trade or financial connections to Russia, the risks to the European Union were the limiting factor on sanctions. Both the EU and Russia were unwilling to bring current Russian energy exports in play because of the large potential damage to both economies. For Russia, the potential loss of reputation as a reliable supplier was a big factor. Both seemed prepared to live with that status quo as the conflict played out. But in the last few months OPEC’s market power suddenly has disintegrated as Saudi Arabia seeks to maintain market share against marginal interlopers. This has brought the price of Brent crude oil down by 55 per cent from July to January. The rouble has collapsed exactly in parallel with Brent rather than with sanctions. Russia’s economic staying power in an extended economic war has declined, and time seems against it. Backing away from its demands in Ukraine and seeking some lesser mutually acceptable, face-saving compromise seems most probable. But President Putin has now spoken in quasi-religious terms about the Crimea and wants at least a neutral Ukraine. One marketing rationale for establishing the euro was geopolitical. The euro would lead to a politically unified Europe that would punch with equal weight against then superpowers like the US, Russia, and now China. Europe’s most powerful neighbour might have taken that either as potentially threatening or mere advertising hype. In any case, in the 1990s, Russia was too weak to remonstrate; and in the next decade Russia and the EU became close economic complements. But in that decade, the EU and Nato kept expanding eastward, incorporating as enthusiastic new members every state except Belarus, Moldova, and Ukraine. By the time the expansion arrived at Ukraine, perceived advertising hype had apparently morphed into perceived serious threat. If Russia is resolute in consolidating its gains and is convinced that the West is engaging in a make or break strategic challenge, might it now be tempted to venture much larger resources to break the cohesion of the West even if the odds are not promising? By eight times, the economies of the US and EU each dwarf that of Russia, whose 2013 gross domestic product was $2tn. If an expanded economic war hits each side with equal absolute costs, the percentage damage to Russia would be far larger. Konzept 52 It is evident that, if the political cohesion of the West were equal to that of Russia, Russia’s strategy would best avoid more economic warfare. However, there are clear fracture lines in European institutions. So Russia may find the best of a bad set of odds in trying to break up the EU politically by expanding its currently minor actions in the economic and financial war. The EU is already close to losing a member as the UK may seek to leave in a year or two. The eurozone itself nearly disintegrated of its own contradictions in 2012 and since then has been held together by massive promises of central bank credit, freighted with a stifling and demoralising austerity in the periphery. Fearing further loss of market for their exports or energy disruption, some periphery countries have been wary of tougher sanctions. Strong euro secessionist parties may soon become dominant in Spain, Italy, or Greece. This would open the door once again to the existential euro crisis with its potential for financial and economic disaster and an end to an expansive EU. With its small economic weight, are there any targeted economic moves that could Russia possibly implement to foster further disintegration? Although both sides have avoided seriously blocking it thus far, Russia’s energy trade with the EU seems to be its only serious economic lever. Early on, petroleum and natural gas were discussed as possible economic warfare weapons, mainly in the context of adding to each side’s costs in some cost/benefit calculation, but not as a potential means of shattering an unstable EU political equilibrium. Petroleum and natural gas exports constituted almost 70 per cent of Russia’s 2013 export revenues, with most going to the EU – 80 per cent of its petroleum and almost all its piped natural gas. The collapse of the oil price has had a far better strategic effect for the EU than significant petroleum sanctions on Russian trade would have produced. Russia started with an overall trade surplus of $180bn in 2013 largely thanks to $285bn of petroleum export revenues. But following the 55 per cent fall in the oil price future petroleum exports will be about $157bn per annum lower than previously. To add to that, most of its long-term gas contracts are indexed to a moving average of petroleum prices; so by spring 2015 its gas revenues can also be expected to fall by over $30bn. Russia’s current potential to purchase foreign merchandise from export earnings has fallen by up to 40 per cent. New foreign credit has disappeared, and non-intervention to conserve foreign exchange reserves is its current policy. Under these conditions, Russia’s ongoing capital flight must generate a yet wider trade surplus. So Russia’s overall demand for imports must be pushed down: the collapse of the rouble exchange rate is the medium of this demand collapse. As the price of petroleum drops yet more as OPEC members lose 53 Ukraine—the flap of a butterfly’s wings discipline, Russia’s economic power to withstand the current geopolitical contest will drain quickly. In the near term, is there still a window for Russia to use its 30 per cent market share in EU petroleum consumption to shatter the unstable economic and political equilibrium in the EU before its economic power shrinks enough that it has insufficient endurance to carry out the task? Suppose that Russia were to remove a large fraction or all of the six million barrels per day of its petroleum exports to the EU from the market. Each EU country is obliged by directive to maintain petroleum reserve stocks of at least 90 days of consumption, and this has been generally satisfied across the union with either government strategic reserves or required private storage. The response would be a general release from these stocks to offset the immediate volume disruption. The potentially acute supply problem would last only a few months: the EU would scramble to redirect the remaining world supplies sufficiently long before reserve stocks could become critical. Ultimately, the reduction in global supply would raise prices, perhaps undoing much of last year’s price decline. But there would be no acute shortages in the EU, even temporarily, so the only macroeconomic impact would be the reversal in petroleum prices. Even this situation would be temporary, because Russia could not withstand the revenue loss for long in an unfruitful game. An intended EU-shattering crisis would not happen, and the investment of lost revenues to achieve it would be futile. Petroleum is therefore an unpromising mode of attack. What about gas? Russia’s natural gas exports generated revenues of $75bn in 2013. Russia has real market power in its natural gas supply to Europe because substitution out of gas usage is not easy and sufficient redistribution of existing supplies within the EU and from outside is technically infeasible. Finding a key node in the production mechanism with few substitutes is the holy grail of economic warfare. This makes natural gas Russia’s best candidate as an economic weapon. Overall, Europe receives about 30 per cent of its gas from Russia. Most of the EU’s eastern members receive upwards of 80 per cent. Germany receives 35 per cent. Gas can be shared around the EU to some extent, but eastern members would have to absorb much higher cuts if gas came into play. Clearly, gas can be employed to generate a supply recession in some countries as industries dependent on it for energy and as raw material are forced to reduce output. How large might such a recession be, and would it impact the most politically demoralised countries sufficiently to break the eurozone? That depends on the redistribution efforts that the EU, recognising it as a temporary though highly threatening condition, makes to maintain consumption in the most affected Konzept 54 countries to minimize the spillover dynamics. It also depends on how long Russia can financially bear the loss of revenue without itself faltering. Though the odds are very long, playing the natural gas card is the only chance to reverse the strategic tide running against Russia in this economic contest. This scenario is a suggestion of the possible, not the probable. But if the geopolitical challenge dominates policy, trying to change its structure from a losing contest with a monolithic opponent into one against a collection of squabbling middle-sized and small countries would be a temptation. 55 Ukraine—the flap of a butterfly’s wings Credit magic— dodging defaults Konzept 56 Credit portfolio managers have nightmares about defaults. Though infrequent, defaults are a basic driver of credit portfolio performance. They can and do destroy reputations. Therefore building a portfolio with significantly fewer defaults than the market average is a key goal for portfolio managers. Jean-Paul Calamaro, Kunal Thakkar Konzept57 In this context few investors are aware of the amazing characteristics of iTraxx Europe – the most liquid portfolio in the European credit spectrum. Since inception in 2004 it has shown consistent and exceptional resilience, suffering only one default in a decade that included a vicious cyclical downturn. This result not only eclipses that of comparable portfolios, it also raises some important questions for investors. For starters: is this sustainable? What factors contribute to this outperformance? Is this dynamic to be found in other benchmarks around the world? In short, is there a rational explanation for this exceptional outcome, or is the iTraxx Europe pure magic? iTraxx Europe is the reference investment-grade credit index traded in Europe. It comprises 125 equally-weighted credits and comes in a number of maturities with the five-year index being the most liquid. An important feature of the index is that it rolls every six months into a new “on-the-run” series. Changes in index composition can take place at the roll. Liquidity is the main factor driving selection of individual credits at the roll, subject to well- defined credit-quality and sector-composition constraints. Since June 2004 there have been 22 index series covering in excess of 240 individual credits. That the restructuring (not a default) of Thomson SA in late 2009 has been iTraxx’s only credit event seems incredible. But calculating how incredible requires a comparison with similar portfolios. This is harder than it seems. The best approach is to compare default performance with portfolios that have the same rating composition at inception. Take iTraxx Europe series nine, for instance – the on-the-run index that started trading in March 2008, six months before the Lehman bankruptcy. To produce portfolios with the same rating composition as the index, credits from the broad rated universe as of March 2008 are randomly drawn. The rating performance of each portfolio through to maturity (five years later in June 2013) is tracked and the number of defaulted credits, if any, is noted. The number of such potential portfolios runs in the billions of billions – thankfully, some mathematical tricks allow for this exercise to be performed quickly. This analysis is then repeated across different index series to observe the default performance of iTraxx Europe over history. The results show that iTraxx Europe consistently either lands at the top or fares much better than the average similarly-rated portfolio. Beating iTraxx Europe from a default perspective starting with similarly-rated portfolios would have proved extremely challenging over the years. The number of defaults, however, is only one element that makes the index superior to comparable portfolios. Ultimately, Konzept 58 investors are interested in (avoiding) losses. On this measure too, our analysis finds that iTraxx Europe performs better than the broader market. The one and only loss iTraxx Europe has experienced resulted in a reasonably high recovery of 65 per cent. That is considerably above the average recoveries of 41 to 46 per cent observed over similar five-year periods. Indeed, the gap between indices in terms of market losses is even wider than that for defaults – an impressive achievement. So the iTraxx Europe has been exceptionally default- resilient. Do other liquid credit indices around the world perform better than their comparable markets as well? The iTraxx Europe’s investment grade counterpart in the US – the Markit CDX North American Investment Grade index – also comprises 125 investment grade credits. But the similarity ends there. Unlike the iTraxx Europe, the CDX.NA.IG has fared materially worse in terms of defaults than the average portfolio of similarly-rated US credits. For example, the CDX.NA.IG’s series ten 1 index is among the 1.7 per cent worst-performing portfolios, whereas the iTraxx series nine sits in the top 3.9 per cent in Europe (see box for explanation of methodology). In other words, beating the US benchmark’s default record over the years was almost guaranteed. A randomly selected portfolio (but with the same rating composition at inception) would have had an overwhelmingly better chance of suffering fewer defaults. To be fair, focusing on losses produces a less damning picture. But that is only because two of the defaulted US credits to be found across a number of indices, namely Fannie Mae and Freddie Mac, had above 90 per cent recovery rates. That dampens the impact of the poor defaults, although losses are worse than or comparable to the average losses for similarly-rated portfolios. It is worth stressing that in the context of this discussion, it does not matter that the iTraxx Europe series nine had no defaults, while CDX.NA.IG series ten incurred default losses. This may simply be a reflection of an inferior initial credit quality of the American indices’ portfolio. What we are interested in is how the two benchmarks rank relative to portfolios with the same rating distribution and geographic location. That Europe’s benchmark index should be in the top four per cent while its US equivalent sits in the bottom two per cent is astonishing – portfolio comparisons are rarely that extreme. What about other credit indices, even outside the investment grade space? Are they market beaters like iTraxx Europe when it comes to default resilience? For example, the iTraxx Crossover and CDX.NA.HY (high yield) are two liquid benchmarks comprising non-investment-grade credits. Their performance is 1 CDX.NA.IG and iTraxx Europe index series are off by a digit owing to the earlier beginnings of the former. 59 Credit magic—dodging defaults in line with that of portfolios of similar ratings, according to our analysis. Sticking to indices that began trading six months before the Lehman bankruptcy, we find that 46 per cent of portfolios would have had fewer defaults than iTraxx Crossover series nine. And the index suffered about one and half times the average loss suffered by similarly-rated portfolios. Meanwhile, the default performance of CDX.NA.HY series ten was worse than almost 60 per cent of similarly-rated portfolios, with losses 1.4 times the average portfolio loss. In other words, these benchmarks were ripe for beating. Unfortunately our analysis cannot be extended to indices such as iTraxx Japan, iTraxx Asia or iTraxx Australia because the pool of rated credits is too small to provide a robust sample. But it can be said with confidence that iTraxx Europe is remarkable. It has weathered the last decade practically unscathed from a default perspective and has typically been among the most default- resilient portfolios with the same rating composition. But what factors are behind this unparalleled outperformance, and can it be sustained in coming years? The following six factors go some way in explaining the “magic” of iTraxx and provide hope for its continued outperformance. 1. The credit selection process at iTraxx Europe’s index rolls is quite exclusive. As a basis from which to source credits, the index administrator creates a long list of the most liquid credits over the previous six months, from which the 125 credits are ultimately chosen. 2. The credit rating criteria are stringent. Only credits rated Baa3, BBB- and BBB- or better by Moody’s, Standard & Poor’s and Fitch, respectively, qualify for inclusion. Baa3/ BBB-/BBB- rated credits on negative outlook or negative watch from even one of the agencies are excluded. CDX. NA.IG in America, on the other hand, accepts BBB- or Baa3 credits on negative outlook. According to a Moody’s study, the probability of a downgrade for credits on negative outlook over a five-month period is approximately 15 per cent. 2 Rating slippage and consequently portfolio credit- quality deterioration originating from the lowest-rated credits is therefore less likely for iTraxx Europe than for CDX.NA.IG. The impact of different inclusion criteria is most visible in the peripheral exposure of successive iTraxx Europe series. A relatively large number of peripheral credits stood on the investment grade/high yield boundary over the years. Credits that were put on negative outlook 2 Effects of Watches, Outlooks, and Previous Rating Actions on Rating Transitions and Default Rates, Moody’s Investors Service, 3 August 2011. We read the figure of 15 per cent from a graph, so the figure is only approximate Konzept 60 by any of the three major rating agencies were discarded for inclusion in the incoming series at the roll. As peripheral credits were downgraded, incoming index series took on a larger share of core credits to maintain high credit quality at inception. In 2006, for example, peripheral credits accounted for almost one-fifth of total credits. This proportion steadily dropped to as low as eight per cent and is now just under ten per cent. 3. iTraxx Europe also imposes strict sectoral diversification. Five sectors are represented at every roll in fixed proportions. This adds some a-cyclicality to portfolio selection. Historically, sectors that have been in fashion have experienced a material rise in leverage – for example, financials in 2006-2007 or telecoms in 1999-2000. As liquidity increased these sectors would have grown to dominate the index if it were not for sectoral diversification rules, with the predictable result once the deleveraging process began. Thus, diversification helps create more rating stability and ultimately fewer defaults. 4. Downward credit migrations have been relatively low. Credit migrations show the extent to which individual credits tend to migrate away from their original rating. The financial crisis and the sovereign crisis in Europe contributed to dramatic downward pressure on ratings. Moody’s European rating drift (rating upgrade minus downgrade rate) is a good gauge of this pressure. This has been negative for the past seven years, reaching levels of minus 30 per cent for extended periods – implying that 30 per cent more companies are being downgraded than upgraded. As a result, we would expect ratings of index series to have experienced considerable downgrades over the years. But that has not happened in the iTraxx Europe. With downward rating migrations low, it is no surprise that defaults have been low as well. 5. iTraxx Europe has a set of core credits that appear frequently across series. These credits account for approximately half of the index and are the backbone of its resilience and stability. Their ratings tend to be at the higher end of the quality spectrum. CDX.NA.IG also benefits from having a stable core of credits retained from one index series to the next. In contrast, CDX.NA.HY and iTraxx Crossover do not have a recurrent core group of credits in any meaningful sense. 6. iTraxx Europe’s constituents tend to be large companies, which adds to resilience. There is no specific rule 61 Credit magic—dodging defaults Few investors are aware of the amazing characteristics of iTraxx Europe—the most liquid portfolio in the European credit spectrum Konzept 62 That Europe’s benchmark index should be in the top four per cent while its US equivalent sits in the bottom two per cent is astonishing— portfolio comparisons are rarely that extreme 63 Credit magic—dodging defaults prohibiting smaller companies from inclusion, but liquidity criteria indirectly tend to skew holdings this way. Moreover, many companies in the index have strong links to government or are of strategic importance for national economies. This shields the companies from severe pressure in downturns. Our analysis shows that iTraxx Europe’s inherent structure fosters resilience. In addition, the macro backdrop in Europe should be supportive of high grade credit. Investment grade companies are typically extremely averse to degrading to high yield and engage in actions to preserve their ratings. Repeatedly downgraded European growth expectations mean that we can expect investment grade companies to take a conservative approach to financial management. What is more, the various quantitative-easing or QE-like programs currently in place, as well as those being contemplated by the European Central Bank, offer further support for the asset class, if indirectly. And pressure on rating downgrades has finally subsided after seven difficult years. All of this augurs well for the index’s ongoing resilience to defaults. So for iTraxx Europe, the magic looks set to continue. Konzept 64 Credit selection is at the core of our methodology to test default resilience. Take for example iTraxx Europe series nine, for which all 125 credits were rated investment grade in March 2008 and focus on single-A credits. There were 51 single-A credits at the time, sourced from 306 in the rated universe. Fifteen of these credits defaulted over the next five years. Portfolio managers who owned 51 single-A credits out of the 306 available then and held these for five years could have experienced vastly different outcomes. Skilled managers would have had no defaults, while unlucky ones could have experienced a default rate as high as 29 per cent (15/51). We then repeat the exercise across credit ratings to construct a default distribution. We call this distribution Empirical Default Distribution. An EDD shows all possible default outcomes sourced from equally-rated portfolios and their associated chance of occurrence for a given historical period. EDDs can be thought of as representing the collective default performance of portfolio managers who would have held portfolios with the same initial ratings over a given time period. EDDs provide an unbiased benchmark against which to measure the default performance of a given index or portfolio. For the five-year period starting in March 2008, the broad universe of rated credits from which all iTraxx Europe- like portfolios are sourced had a total of 20 defaults. Thus, any of the portfolios with the same rating composition as the index experienced anywhere between zero and 20 defaults, with two to four defaults being the most likely. It is extremely unlikely that a portfolio manager would have ended up with all 20 defaults, whereas 3.9 per cent of portfolios would have ended up with no defaults and 14 per cent with exactly one default. iTraxx Europe series nine index experienced no defaults and thus was in the top 3.9 per cent of performers in our analysis. Testing default resilience 65 Credit magic—dodging defaults 66Konzept Columns 68 Book review—best reads of 2014 69 Ideas lab—sleep 70 Conference spy—contingent convertible bonds 71 Infographic—Davos speak 67 Konzept At the end of 2014, we asked our readers for their favourite books of the year and a few lines on why. Here are the more unusual ones. Owning the Earth, by Andro Linklater A sweeping history of land ownership and how it has been instrumental in building the institutions for capitalist economies. Put simply, to own or transfer ownership of land, you need contract law, financing, surveyors and law enforcement. It reminded the reader of De Soto’s The Mystery of Capital that made waves in the early 2000s. The Creation of Inequality, by Kent Flannery and Joyce Marcus While everyone focused on Thomas Piketty’s Capital in the Twenty-First Century as the seminal book on inequality, this reader feels The Creation of Inequality, (subtitled How Our Prehistoric Ancestors Set the Stage for Monarchy, Slavery and Empire), is more original. With their expertise in anthropology and archaeology, the authors look at how inequality has changed across thousands of years and across thousands of cultures. One finding is that the most equal societies are kin-based hunter-gatherer communities. Getting Things Done, by David Allen Originally published in the early 2000s, the time management approach described in the book has since developed a cult following. The ideas remain as fresh today as ever before. Crudely put, the approach hinges on two habits. First, get all the “to do’s” out of your head and on to paper. This stops them gnawing away at the back of your mind. Second, create very clear action-oriented lists. So have a list called “emails” – which tell you who you have to email, have another for “calls” and so on. Simple, but effective. Do No Harm: Stories of Life, Death and Brain Surgery, by Henry Marsh If you think you understand risk and responsibility, think again. Henry Marsh writes about his career in neurosurgery, giving readers an insight into what it is like to take on the awesome risks of cutting into a patient’s brain. A fascinating tour of the intersection of medical science, philosophy, and ambition, this book puts the average working day of a banker into perspective. What Works for Women at Work, by Joan C. Williams and Rachel Dempsey The best summary of the thinking on the distinct challenges women face. The four big ones are Prove-It-Again (women get assessed on past experience, men on future potential), the Tightrope (women have to avoid being too feminine or too masculine), the Maternal Wall (unlike men, when women have kids they are viewed as no longer being ambitious) and the Tug of War (other women can hold women back). The Nurture Assumption, by Judith Rich Harris A Harvard-trained psychology student who left her PhD track when her professors (in the 1960s) told her she didn’t have much potential and was anyway just going to have children. She co-authored textbooks until quite late in life when, confined to her bed with an illness for many years, she came up with a revolutionary theory on the primary influence that determines personality other than genetics, which accounts for roughly 50%. The other 50%? The child’s peer group, and not, as commonly held, the family. A seriously eye-opening conclusion and a balm to guilt-inducing theories which imply that if you don’t parent perfectly your little ones will end up seriously impaired. It turns out the best thing you can do is to get them into a good peer group. Book review— best reads of 2014 Bilal Hafeez Konzept 68 In our most popular Ideas Lab talk to-date leading European sleep specialist Professor Adrian Williams, clinical director of the Sleep Disorders Centre at Guy’s and St Thomas’ Hospital in London addressed questions such as why we sleep, what happens if we do not and, among the less soothing topics, why bad things sometimes happen at night. The evolution of human sleep has been dictated by social developments. Prior to the industrial revolution, humans tended to sleep twice during a night. But 18 hour factory shifts meant an end to the “double sleep”. In the decade between 1998 and 2009 the percentage of the population saying they sleep less than six hours per night jumped from 12 to 20 per cent. We sleep to avoid premature death, reduce the risk of heart disease and strokes, prevent depression and control weight. Indeed, studies have shown that rats deprived of sleep die after about two weeks. They lose their fur and experience dramatic weight drops even if food intake is increased. No human being has so far managed to stay awake that long. In 1959, the American radio personality Peter Tripp went eight days without sleeping to raise money for the health charity, March of Dimes. A few days into his “wakeathon” Tripp began hallucinating and apparently suffered serious psychological illness in the aftermath of the stunt. It is not necessary to stay awake this long before the effects of sleep deprivation kick in. Performance begins to decline in the 16th hour of being awake. The effects of sleep deprivation resemble those of alcohol. 22 hours of wakefulness are comparable to being seriously drunk. Clearly, bad things happen if we do not sleep. Even more puzzling is the question of what actually happens when we sleep. One way to define sleep is based on observation: a sleeping person is relatively inattentive and immobile. Psychiatrist William Dement once defined sleep as something we do to prevent sleepiness. But far from the passive event it appears to be, sleep is in fact a multi-stage process repeating itself throughout the night. Rapid Eye Movement sleep – the state in which most dreaming occurs – is normally entered into at 90 minutes intervals and lasts progressively longer towards the end of the sleeping session. Most of the night is spent in non-REM sleep, and this is further subdivided into stages characterised by varying levels of brain activity. Make sure you get your REM sleep. Rats deprived of this type of sleep drop dead within four weeks. Sufficient sleep is clearly important. But what about sleeping disorders? They come in various forms and represent one of the commonest complaints in medical practice. Almost a third of the population suffers from insomnia in any one year, while up to a tenth struggles with excessive work-time sleepiness (hypersomnia). The third and final category, parasomnias, includes disorders such as sleepwalking, sleeptalking, sleepsex and nocturnal eating. These occur during non-REM sleep and, as the descriptive nature of the names suggest, we do not really understand them. What we do know is that such disorders are highly inheritable and are worsened by lack of sleep. Another form of parasomnia is REM sleep behaviour disorder. This refers to the special instance when the physical paralysis normally characterizing REM sleep is not existent. Consequently, a person suffering from REM sleep behaviour disorder is not prevented from physically acting out of his or her dreams. In the most extreme case this resulted in a sufferer murdering their partner during a dream enactment. Far more common (luckily) are instances of screaming, kicking and jumping out of bed. On that note, sleep tight. Ideas lab—sleep Elise Nilssen Konzept69 This annual conference brings together investors, regulators, issuers, rating agencies, risk managers and data vendors. The market view CoCo pricing is driven by technical factors with a much smaller role for fundamentals. While the initial issuance was in dollars, more recently euro issuance has thrived because of healthy demand in Europe. An irrational investor focus on yields has resulted in higher spreads on euro-denominated issues relative to dollar-denominated ones. However, few players engage in cross-currency hedging to pick up this extra spread. Liquidity is mostly good, with some investors using Additional Tier 1 (AT1) CoCos as a high-beta play on a broad rally. The differences in instrument features do not matter much in market pricing. Since CoCos are not eligible for broad indices, they have a reduced base of natural buyers. With more issuance to come, the key question will be how large the prospective demand is. These technical factors will continue to drive valuations. The regulators’ view Regulators are supportive of CoCos, for example by allowing the tax deductability of coupon payments despite the equity-like features of these instruments. As it seems hard to establish the risks for investors, more standardisation might help the market. CoCos are yet untested by a trigger or a coupon suspension – would such an event be idiosyncratic or systemic? The European Union’s Bank Recovery and Resolution Directive increases write-down or conversion risk for CoCos as authorities will have the power to bail in capital instruments at a very early stage. For AT1s, this risk competes with contractual trigger terms. The European Banking Authority is drafting guidelines for bank viability assessment, which should give investors more clarity on the point of resolution as an important aspect of bond valuation. While there are some quantitative indicators, the final decision will be based on expert judgment. The issuers’ view This particular issuer decided not to distribute to retail clients as it Notes from the The World of CoCos conference organised by the KU Leuven at the St Pancras Renaissance Hotel in London last month seemed impossible to explain all the risks fully. Greater standardisation of these instruments is “absolutely needed” to help in this regard. In the meantime, a ban on retail investments is probably a good thing. A fund manager’s view Ratings are not a good guide to valuing CoCos. Instead, fund managers have to rely on their own quantitative and qualitative analysis. This is a complex asset class and a lot of investors need to outsource investment decisions. As a result, spreads include a “specialist premium” that should come down as CoCos become mainstream. Recent spread widening means more resources can be spent on hedging via equity puts. As a credit specialist, the manager also hedges interest rate risk. A rating agency’s view The environment has changed with the establishment of resolution frameworks, and a new bank rating methodology has been developed. A special model-based approach, overlaid with expert judgment, is used for high-trigger CoCos as they may experience loss before the bank reaches the point of non-viability. An index provider’s view The iBoxx CoCo index family was launched in November 2014. Only Basel 3 compliant and rated CoCos with an objective trigger point issued after the 1st January 2013 are eligible. Total return swaps based on these indices will allow investors to go long or short the CoCo asset class at the macro level. Conference spy — contingent convertible bonds Michal Jezek Konzept 70 Infographic — Davos speak Pre Crisis Post Crisis Word clouds based on World Economic Forum reports from 2004 to 2008 and from 2009 to 2014. Word clouds powered by WordItOut.com 71 Konzept The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively “Deutsche Bank”). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report. Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. In August 2009, Deutsche Bank instituted a new policy whereby analysts may choose not to set or maintain a target price of certain issuers under coverage with a Hold rating. In particular, this will typically occur for “Hold” rated stocks having a market cap smaller than most other companies in its sector or region. We believe that such policy will allow us to make best use of our resources. Please visit our website at http://gm.db.com to determine the target price of any stock. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor’s currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors’ own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the “Characteristics and Risks of Standardized Options,” at http:// www.theocc.com/components/docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document. The risk of loss in futures trading and options, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures and options trading, losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor’s home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001), and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank’s prior written consent. Please cite source when quoting. Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analysts about the subject issuer and the securities of the issuer. In addition, the undersigned lead analysts have not and will not receive any compensation for providing a specific recommendation or view in this report: Bilal Hafeez, Sanjeev Sanyal, Michal Jezek, Nicolaus Heinen, Jochen Moebert, Alexander Düring, Rineesh Bansal, Stuart Kirk, John Tierney, Aleksandar Kocic, Jean-Paul Calamaro, Kunal Thakkar, Jean-Paul Calamaro, Bill Schmitz, Faiza Alwy, Peter Garber. Konzept 72