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June 7, 2016
A lethargic economy, overwhelming refugee crisis, and a banking system that fails to inspire confidence— Europe seems besieged by intractable problems. Credible solutions exist but pursuing these requires policymakers to ditch decades of dearly-held beliefs, economic orthodoxy and dogma. [more]
How to solve Europe’s three biggest problemsJune 2016 A lethargic economy, overwhelming refugee crisis, and a banking system that fails to inspire confidence— Europe seems besieged by intractable problems. Credible solutions exist but pursuing these requires policymakers to ditch decades of dearly-held beliefs, economic orthodoxy and dogma. Cover story How to solve Europe’s three biggest problems revanchism). Only by resolving each of these problems swiftly does Europe stand a chance of long-term survival. We do not lack hope, however, and implore policymakers to keep an open ear to all ideas. Moving beyond Europe, our shorter articles address a wide array of topics. We explain how driverless technology might mean fewer cars on the road but would still provide a demand boost for automakers. Also driving demand of everything from cars in India to casualty insurance in the US is the weather. We explore the implications of this year’s anticipated shift from an El Niño to a La Niña pattern. Another industry desperate for fair weather to return is active fund management. Here we lay out the positive case for stock pickers. Finally, the battle that is raging over your next pay rise and its implications for the bond and stock markets is explained. The columns at the back of the magazine include a review of ‘Bloodsport’, a book that tells corporate America’s history through M&A deals. We then gather the best insights from Deutsche Bank’s Access Asia conference from our regular spy. And finally our infographic brings you back to Europe, as we highlight how different the continent is in reality from people’s perception of it. David Folkerts-Landau Group Chief Economist and Global Head of Research It is my pleasure to welcome you to the eighth issue of Konzept – Deutsche Bank Research’s flagship magazine for big ideas, important themes and out-of-the-box analysis. In this issue we tackle three of the most intractable problems facing Europe today: moribund economic growth, the refugee crisis and a banking sector that struggles to satisfy anyone even eight years after the financial crisis. Our three feature articles show that credible solutions exist provided that governments, policymakers, investors as well as the public can jettison dearly-held beliefs, economic orthodoxy and dogma. First up we call for the European Central Bank to end its ever-looser monetary policy. Even if it was the right path once, today the balance of trade-offs weighs more heavily to the downside. There are distortions galore, savers punished, speculators rewarded and all the while governments across Europe have been let off the painful reform hook. Likewise with the refugee crisis in Germany we lay out the three key areas where nativists and liberals should be able to find common ground in order to move the immigration debate forward. Most importantly the issue of cost and iniquity can only be resolved via reforms to the welfare system whereby benefits are phased in for new arrivals. As we explain, a tiered approach to social security is hardly the odious rarity claimed by some. It is a widespread practice around the world. Our final feature article looks at Europe’s banks and argues that it is time to allow the sector to do its job properly. While there is no doubt that finance lost its way pre-crisis and many reforms are overdue, it is fair to ask whether utility-like regulation is proving counter- productive. Banks are too nervous to lend, too burdened to provide liquidity to markets and too hobbled to finance entrepreneurial bets on the future. The effect on economic growth is becoming apparent to everyone. Likewise we question whether the system overall is safer, even if banks certainly are. We offer practical solutions to these three big problems because the European project is currently under attack from multiple angles (never mind Brexit, Greece or Russian 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 Konzept A lethargic economy, overwhelming refugee crisis, and a banking system that fails to inspire confidence— Europe seems besieged by intractable problems. Credible solutions exist but pursuing these requires policymakers to ditch decades of dearly-held beliefs, economic orthodoxy and dogma. Cover story How to solve Europe’s three biggest problems Articles 06 The car is dead, long live the car 08Scrip dividends—paper thin 10 La Niña—what’s the weather like? 12 The return of stockpickers 14 A new impossible trinity Columns 48 Book review—Bloodsport 49 Conference spy—dbAccess Asia 50 Infographic—perception versus reality Konzept Features Back to black— the ECB should raise interest rates 17 Bank regulation— let the lenders do their job 36 Immigration— making work pay 24 Sceptics see the billions that carmakers are plunging into the development of autonomous vehicles and on-demand services as a giant waste of money. Comparisons with the Concorde are rife and perhaps expected. Despite the supersonic jet’s technical superiority, it never recouped its cost of investment. But when it comes to cars, many of those naysayers think too simplistically. That is because carmakers are not investing in these technologies to try and create an incremental market. Rather, the cost of not doing so is dire. Many academic studies point out that self-driving cars will dramatically reduce the number of vehicles on the road. Indeed, one study by the University of Utah found that a single RoboTaxi could replace 12 conventional vehicles. Another study concluded that the entire population of Singapore could be served with one-third the current number of vehicles if they were all autonomous. That threat comes on the back of the rise of on-demand car technology companies, such as Uber and Lyft. Last year these firms generated $30bn in revenue in the US and yet they still only accounted for less than 0.1 per cent of miles driven. The theory holds that as calling a car becomes increasingly cheap and convenient, more vehicles will be taken off the road. One MIT study found that New York’s 13,500-strong taxi fleet could be reduced by two-fifths with on-demand vehicles. Perhaps unsurprisingly, the price of New York taxi medallions has halved from about $1m two years ago. If that isn’t enough, social attitudes regarding car ownership appear to be changing. While over 75 per cent of all Americans prefer to own a car, only 64 per cent of younger ‘Generation Y’ consumers view a car as their preferred method of transport. Furthermore, The car is dead, long live the car Rod Lache, Tim Rokossa, Ross Sandler, Johannes Schaller the proportion of 16-24 year olds holding a driver’s license has dropped from 76 per cent in 2000 to 71 per cent today. Similar trends exist in European countries. While most people will look forward to a world with less road congestion, carmakers fear a structural decline in the car market. And this just as they emerge from their post-crisis resuscitation. They shouldn’t worry. While the move towards on-demand and self-driving cars will certainly reduce the number of vehicles on the road, the industry can actually look forward to a resulting sales boost from the phenomenon. How is this possible? First, look at the effect of falling costs on future demand. On-demand services, such as Uber and Lyft, have generated explosive growth because they not only offer convenience but also significant cost savings. In the 20 largest American metropolitan areas, where over one-third of households reside, we estimate that four per cent of households would save money right now if they ditched their personal cars and used on-demand services instead. This rises to 14 per cent of households for dense urban areas such as New York or San Francisco. This is based on the average cost of an UberX being about $1.50 per mile. Extrapolate this to a world of autonomous taxis, where we think the cost could be two-thirds cheaper, and the case for not owning a car at all gets even stronger. Fewer cars on the road, though, does not necessarily translate into less congestion. That is because the behaviour of cars in the future will be different to what we observe now. In fact, both on-demand and self-driving vehicles will travel more miles than those driven by the cars they replace. All this extra driving matters because the life expectancy of a car is measured in miles (about 210,000), not years. So as fewer cars drive more miles, their replacement periods shorten. As a result, carmakers can expect increased sales. Take, for example, a family of four with two cars. The potential exists to down-size to one autonomous car that can drive itself between chauffeuring duties while parents are at work. Now extrapolate this to a world where 15 per cent of US vehicles are privately owned self-driving Konzept 6 cars, and they travel unoccupied 10-20 per cent of the time. We estimate this by itself will add up to three per cent to annual car sales. Now consider taxis and particularly an average New York cab which drives half its miles without any passengers. A driverless version will increase this proportion as it continually redistributes itself in relation to other cabs around the city in order to minimise pickup times. Additional sources of demand arising from on-demand and self-driving services should also be factored in. The young and elderly are the first obvious groups that would benefit from increased mobility. In fact, a study by KPMG estimates the mobilisation of these groups will add 13 per cent to the total number of miles driven. For the large automakers, such as GM, Ford, and Chrysler, the bigger opportunity is in the creation of their own mobility networks. That is, pursuing on-demand and autonomous cars is a means to change their business model and hedge against the risk that cars become commodities. Experience shows that customers who call a car via an on-demand platform do not care about the brand of vehicle that arrives. Therefore, as the proportion of car sales to on-demand operators rises, a recent McKinsey report estimated this could reach one-tenth of annual global sales, carmakers risk ending up in a position similar to many mobile phone makers – merely low- margin handset makers for Google’s Android. In creating their own network, carmakers also have the opportunity to address head-on one of their biggest problems, namely, the lack of profitability in selling standard small cars. Currently, the big firms make a loss of about $4,700 on each car they sell in the US while generating all their profits from truck and SUV sales. We estimate that each passenger car unit placed into an on-demand mobility network may add $53,000 to annual recurring revenue. That translates into $15,400 of earnings before interest and tax, or a 20 per cent return on invested capital. The shift to a recurring revenue model also reduces the industry’s cyclicality. So the sceptics who view carmakers’ investment as something analogous to building the supersonic Concorde should note a key difference. Unlike the Concorde, new car developments are not aimed at the super-wealthy. Rather they target the regular mass market. And if they also help alleviate automakers’ problem of chronic unprofitability within their car divisions then the investment will be money well spent. Konzept7 Please go to gmr.db.com or contact us for our in depth report, “Pricing the car of tomorrow, Part II – Autonomous vehicles, vehicle ownership, and transportation” Scrip dividends— paper thin Sahil Mahtani Those who subscribe to Rockefeller’s dictum that life’s only pleasure consists of receiving dividends have in mind the solid satisfaction of a cash payout. Yet in recent years investors have increasingly received their returns in more ethereal forms. Among these, the rise of buybacks has been much discussed, but what of its stealthier cousin, the scrip dividend, which provides a payout in stock? At best, the practice is a futile distraction and at worst a dangerous conceit that investors should be more wary of. The incidence of scrip dividends among large European companies has increased dramatically in recent years. Last year, 60 companies in the Stoxx 600 index resorted to the practice, compared with just eight in 2007. In the aftermath of the financial crisis, many hard-up banks looking to improve their capital ratios turned to this practice. More recently, energy firms battling the oil price decline have embraced the trend, with over a quarter of them offering scrip dividends last year while almost none did so before 2008. Effectively, offering the scrip allows the firm to maintain the headline dividend number while retaining precious capital. The big European oil companies paid out just over $40bn in total dividends in 2014. Two years and a halving of the oil price later, their headline dividend payments are down by less than one-tenth, a surprising achievement given operating cash flows are down by one-third over this period. However, strip away the scrip payments, which have ballooned from $4bn to $10bn, and cash dividends are also down by one-third. A typical example is the French oil giant Total’s introduction of an optional quarterly scrip dividend in 2014. By offering shares at a ten per cent discount to their market price, the company saw 54 per cent takeup of the scrip option, thereby saving €700m of cash in one quarter which annualized was a tenth of its capex for 2015. The alternative was for Total to slash its dividend by half or find €2.8bn of additional capital, both likely resulting in negative headlines and hits to the share price. Instead, Total’s share price was indifferent to the scrip announcement, even rising modestly on the day. Ironically, while a dividend cut and a capital issuance are perceived unfavourably, the two wrongs combined as a scrip dividend somehow make a right. By obfuscating the true hit to dividend payments, scrip dividends also prevent a full scrutiny of management’s capital decisions. For instance, this year’s dividends exceed the earnings for five of the twenty Stoxx600 energy companies. The sector has not covered dividends from organic free cash flow for the past decade, using disposals to plug the gap instead. Rather than curtail capital spending, oil companies are now resorting to scrip payments while maintaining higher than optimal capital expenditures. Take Royal Dutch Shell, which reintroduced its scrip dividend program in 2015. But with the dividend not covered by free cash flow in three of the past six years, and requiring the oil price at $65 per barrel to break-even, the question to ask is whether planned capital expenditure is in fact useful or sustainable. Tough times demand clear thinking about the uses of capital but instead of tackling these issues head on, scrip dividends allow companies to fudge the competing demands from funding investment and distribution to shareholders. Sometimes companies attempt to “neutralise” the dilutive effect of scrip dividends through simultaneous share buybacks. For instance, from 2010 to 2014, Royal Dutch Shell’s scrip program Konzept 8 caused a nine per cent dilution which was partially offset by buying back seven per cent of stock. Surely, this is an entirely pointless and circular exercise with just a net loss of the transaction costs and fees involved. Also, companies typically offer discounts on the stock issued as scrip dividends, ten per cent in the case of Total, while making buyback purchases at market prices. This amounts to direct transfers from those opting for cash dividends to those who receive stock dividends. And sometimes other practical absurdities result. In Shell’s case, because Dutch rules treat buybacks as a form of payout and tax them, Shell eschewed buying the A-shares subject to Dutch withholding tax and only bought back its B-shares. But issuing in one share class and buying back another resulted in the B-shares trading at a ten per cent premium to A-shares, a disparity which did not unravel until the buyback programme was halted in May 2014. In a way, corporate managers have merely responded to growing investor demand for ever-higher payouts. Fund flow data show that inflows into Europe-based income funds began to rise in 2011 and accounted for over a quarter of all inflows into equity funds between 2012 and 2014. And relative to the one per cent blended average of 10-year yields on European sovereign debt, the nearly four per cent dividend yield on the Stoxx600 index is undoubtedly enticing. As yield-hungry investors reward companies offering higher payouts and dividends, a basket of consistent dividend paying stocks has outperformed the overall index for seven of the last eight years. Indeed, this basket currently trades at a 16 per cent price-earnings and seven per cent price-to-book premium versus historical level. This market adulation, though, may be overdone. Return on equity for the Stoxx600 index has fallen from 11-12 per cent in 2010 to seven per cent, never mind the 17-20 per cent just before 2008. Net debt to ebitda at five times remains relatively elevated but dividend growth has consistently outstripped earnings growth since 2010. Indeed, in the six years to December 2015, dividends per share have risen 55 per cent while earnings per share contracted by 7 per cent. No wonder, scrip dividends have become part of the toolkit for corporate managers making unsustainably large payouts to placate yield- hungry investors. The unsustainable nature of this practice is revealed by the fact that scrip dividends usually end up being a prelude to dividend cuts. One-fifth of the Stoxx 600 companies that offered scrips in 2014 went on to cut their dividends next year, twice the incidence of dividend cuts in the overall index. And over a longer time horizon, 40 per cent of the companies that offered scrip in 2012 cut their dividend in the next three years. Take Banco Santander as an example. When Ana Botin took charge in 2014, she slashed the dividend by two-thirds and moved to raise €7.5bn from investors. This was a departure from the post-crisis years under her father Emilio Botin, when Santander maintained its headline dividend while using scrip payments liberally. The handsome headline dividend pleased retail shareholders who supported the Botin family’s management, and was incentivised by Spanish law that exempted scrip dividends from income tax. The result was a preposterous situation where Santander’s dividend yield ranged from 9-17 per cent during 2010 to 2014, a period marred by Spain’s housing bust and the eurozone sovereign debt crisis. The use of scrip payments, without factoring in any other capital transactions increased Santander’s share count by 37 per cent from 2010 to 2014. Using market prices at the time of issuance this amounted to €16bn of protracted, backdoor recapitalisation. When it finally cut the dividend in 2014, Santander said the move would improve its fully-loaded core tier 1 capital ratio from 8.3 per cent to 10 per cent over the next year. Arguably, its scrip dividend policy allowed Santander to put off dealing decisively with its weak capital position for many years but eventually the bank had to face reality. Of course, for managers of a company short of cash a scrip dividend may be less obtrusive than an equity or debt raise or a dividend cut. Yet for precisely this reason the best way is to see a scrip dividend as an additional layer of obfuscation that demands greater shareholder scrutiny. Scrip payments allow some managers to defer tough capital allocation decisions that really matter while this complexity consumes time and resources. A futile distraction at best, a dangerous conceit at worst. Konzept9 Please go to gmr.db.com or contact us for our multi-asset essay, “Dodgy dividends” La Niña— what’s the weather like? John Tierney ”Everyone talks about the weather, but no one does anything about it.” Mark Twain’s quip aptly sums up the attitude of investors towards the important, if unpredictably evolving weather trends. One such change looks likely to be underway right now. Even as the El Niño weather pattern of the last couple of years winds down, meteorological experts (as of May) are predicting a 75 per cent probability of a La Niña forming during this summer. Investors would be advised to get a better grip of these underlying phenomena and the investment implications that follow. All the available historical evidence strongly suggests that investors do not start to price in evolving weather patterns until things are fairly far along. This investor apathy is perhaps explained by the shortcomings of weather science in forecasting accurately how emerging trends will evolve over the next few weeks let alone the next few quarters. However, what predicted upcoming weather changes lack in certainty, they make up for in their impact. The fortunes of global companies, commodities and even entire economies sway to the direction of prevailing winds. For instance, companies like Apple and Toyota suffered from the disruption to global supply chains caused by La Niña induced flooding in Thailand in 2011. Corn and wheat prices doubled in the summer of 2010 as it became apparent that La Niña- related drought conditions would hurt harvests. Meanwhile, India’s annual output growth since 1980 has averaged nearly nine per cent in the years when the La Niña phenomenon was playing out versus 5.8 per cent in other years. What is more, there is good reason for investors to pay even more attention to the current cycle that is potentially unfolding. The expiring El Niño was the second strongest on record. History suggests that strong La Niñas tend to follow big El Niño episodes. Further, a composite index of global monthly sea and air temperatures soared to a massive record in 2015, some five standard deviations above a trend line dating from 1980. It remains at extreme levels. This may abruptly return to a more normal range but for now, the risks appear to be tilted toward a strong La Niña and its resulting effects. Even though El Niño and La Niña are part of the common lexicon, their actual mechanics remain a mystery to many. Hence, a recap of what these powerful phenomena really mean is perhaps useful. In normal times, trade winds blow across the equatorial Pacific from east to west pushing warmer water westward where it tends to pool in a large area northwest of Australia and near Indonesia. The warmer water evaporates, forming clouds and bringing seasonal rains to Konzept 10 Australia and throughout Asia. Meanwhile, in the east and central Pacific cooler water rises from the ocean depths to replace the warmer water initially displaced by trade winds. The deep ocean water contains many nutrients that replenish the surface waters, supporting the maritime industry of western South America. Roughly every two to seven years this normal cycle is disturbed. This disturbance, if it takes the form of a slowdown or a reversal of the normal wind direction, is branded as El Niño. Conversely, a strengthening of the wind flows whilst maintaining their usual direction is classed as a La Niña. The effects of an El Niño are that warm water remains in the east and central Pacific instead of moving westward. The consequence is more than normal rainfall in the mid and east Pacific with far less rainfall in the western Pacific causing droughts across Australia, Southeast Asia and India. Also, since little or no water is displaced the normal cycle of cooler and nutrient-rich water rising to the surface does not occur thereby crippling South America’s fishing industry. Over the past 20 years, El Niños occurred in 1997-98, 2002-03, 2009-10, 2014-15, and 2015-16. The current El Niño has resulted in record droughts across Southeast Asia and India. The impact of the El Niño is felt far beyond the equatorial Pacific. In much of North America, particularly the west coast and the Pacific Northwest, temperatures tend to be milder than normal and rainfall may be higher. Recent El Niño conditions have contributed to record levels of agricultural production and falling farm commodity prices in the US. In addition, El Niño tends to reduce the risk and intensity of the Atlantic hurricane season. Residents of eastern United States, and property and casualty insurance companies consequently, can thank El Niño for the relatively calm autumns of the past two years. La Niña often – but not always – follows El Niño, sometimes shortly afterwards, other times with a lag of a year or more. As the east to west trade winds become more powerful than normal the El Niño-warmed water is driven further westward than usual, and colder than usual water rises to replace the displaced water in the east and central Pacific. Recent La Niñas happened in 1998-99, 1999-2000, 2007-08, 2010-11 and 2011-12. La Niña, of course, has the opposite effects of El Niño, generating heavier than usual monsoon conditions in eastern and northern Australia and across Southeast Asia and India. If the La Niña episode is strong, low-lying areas are at risk of flooding. During the La Niña episode in 2011 there was major flooding in Queensland, Australia and Thailand. The floods crippled much of Thailand’s manufacturing base and disrupted global supply chains over the following year, severely affecting global companies ranging from Apple to Toyota. The ocean economy of western South America returns to normal but the land-mass may be drier than usual. For North America, La Niña brings weather conditions that are hotter and drier than usual. At its extreme, a severe drought in the Midwest impairs crop yields, potentially driving agricultural commodity prices higher. In 2008 and 2011 drought conditions pushed corn and wheat prices two to three times higher, and after recovering somewhat they jumped 50 per cent in 2012 as La Niña returned. It also means hurricanes in the Atlantic gather stronger momentum. La Niña was a factor in the formation of Hurricane Irene in 2011 and SuperStorm Sandy in 2012, both of which ravaged northeast US. With such far-reaching implications, investors should pay closer attention as it becomes clear in the coming months whether La Niña is coming, and with what force. A moderate La Niña will benefit Southeast Asia and Australia by bringing an end to the prevailing drought conditions and improve the production of agricultural commodities like rice. The risk is that a very powerful La Niña event causes widespread destructive flooding that offset the benefits of more rain in the region. Meanwhile, commodities including corn, wheat and soybeans, could be exposed to sharply higher prices from potential drought and diminished yields in the US, south Brazil and north Argentina. The eastern seaboard of the US may also see a resumption of a severe hurricane season, property damage, and disrupted oil and gas production in the Gulf of Mexico. Ignoring Oscar Wilde’s jibe that conversation about the weather is the last refuge of the unimaginative, investors do need to talk more about the subject. And more promptly than they have in the past, perhaps, even do something about it. Konzept11 It’s a nightmare that active fund managers keep trying to wake up from. After a torturously long period of underperformance, the last thing stockpickers wanted this year was high-profile losses being suffered by some of the world’s foremost investors. The result is an industry straining to justify its existence. But for all the analysis of individual stock picks gone awry and the failures of specific strategies, a little- discussed element may be looming unnoticed. It concerns the curious state of dispersion in the market, something that has been strangely absent since the financial crisis but which appears to be returning. Dispersion is the spread between the returns of different assets. Of course, this is constantly changing and it can be hard to objectively judge whether these moves are justified when comparing different asset classes. The equity market, though, is different as performance can be more easily compared with changes in a company’s underlying fundamentals. To do this, we first look at dispersion in stock market (total) returns excluding energy stocks, whose recent troubles skew the data. This analysis shows that compared with the pre-crisis years, overall dispersion dropped by about one-quarter before a recent uptick. In other words, different stocks have been giving investors increasingly similar returns. Breaking this down further, the dispersion of returns between individual sectors has almost halved. Said differently, the stock market performance of sectors has become more homogeneous. This would make sense if companies themselves were becoming increasingly similar. Yet their fundamental performance does not show this. Return on equity data show that high- return companies are improving further while low-return companies are deteriorating. The spread between the median return on equity for the top-quartile of companies and the median for the bottom quartile has widened by about 25 per cent since the financial crisis. Profitability is also diverging. If we rank the S&P 500 by ebitda margin, for example, the gap between the median for the index and the median for the bottom quartile has widened from 12 to 15 percentage points over the past two years. This increased divergence is largely the result of companies at the bottom end of the spectrum deteriorating further. In fact, the median for the lowest quartile has almost halved to 4.5 per cent in that period. This divergence between fundamentals and stock market returns suggests that investors are ignoring the differences in the quality and earnings of individual stocks and are merely sharing their cash with companies relatively evenly. There are a few reasons for this phenomenon. The first is the influx of money into the passive investment market. Last year, about $400bn flowed into passive funds in the US, double the level of five years ago. Meanwhile, investors withdrew almost $300bn from active funds. The $700bn difference is the culmination of a trend towards passive investing that has been gaining traction this century, particularly since the financial crisis as active managers have underperformed the market. This has taken the total amount of money in passive funds in the US to about $4tn, equivalent The return of stockpickers Luke Templeman Konzept 12 to over one-fifth of the market value of the S&P 500. It is growing quickly, too. At the turn of the millennium, money managed in passive funds was just one-tenth the size of actively managed funds. Now the proportion has quadrupled. As investors turn to passive strategies, all this ambivalent money begins to distort the market. Forced passive allocations effectively prop up companies that do not deserve it. Conversely, a fair premium is not paid for a company in relatively better shape. You can see this happening in price to earnings ratios. For the first ten years of this century, the market- weighted price to earnings multiple traded above the median. Since the crisis (and coinciding with the rise of passive investing) this has switched and indeed the gap between the equal- weighted average and the market-weighted average has widened. This suggests that a disproportionate amount of money has flowed into underperforming companies. The current obsession with dividends is another cause of lower dispersions. Theory says payout ratios should not affect total returns. But shareholders want companies with higher dividend yields and are increasingly valuing stocks based on their payout. In fact, the dispersion of dividend yields is at about its lowest since 2000 and has halved over that time. In response, companies are maximising their dividends even if their fundamentals do not justify it. This situation has led to the dispersion of payout ratios across the S&P 500 hitting its highest level this century. Ditto for share buybacks. The $690bn in announced US buybacks over the last decade is half as high again as the previous decade. And the number of buybacks has almost tripled over the last five years as lower quality companies have joined in. This has made for riskier companies – an index of 50 of the most reliable dividend payers has seen debt levels roughly double compared with ebitda over the last five years – yet the dispersion of returns has fallen anyway as anyone doing a buyback was rewarded. Investors should not be complacent about living in this world of low or constant-return dispersion. The business-friendly conditions that have typified the post-crisis years appear to be tightening and that will likely lead to an increasing gap between good and bad quality companies. As that gap widens the difference with market values will become even starker. For starters, the unemployment rate in the US has been close to its natural rate of about five per cent for over a year. Wage pressure seems inevitable and should have a disproportionate impact on lower quality firms. In addition, if the price of oil continues to rise, companies will face the prospect of absorbing the cost themselves or attempting to pass it on to customers. The varying degrees of success that firms experience here will put further upwards pressure on dispersion. Signs of rising stock market dispersion can already be seen. Since hitting its low at the end of 2014, dispersion has rallied by one-fifth. As tends to be the case with rising dispersion, it occurs during times of market stress and the main incidence of rising dispersion occurred in the third quarter of 2015 and first quarter of 2016. Should this trend continue, there are several ways in which investors can position themselves. First, active management becomes more attractive. That is, in a high dispersion environment the market value of a stock should more quickly revert to its intrinsic value. So managers who pick the right or wrong stocks will be rewarded or punished more quickly. The knock-on effect of a better active environment is that passive investing becomes relatively less attractive. If the flows into passive funds begin to slow, the effects of increasing dispersion could magnify. That is because, in one sense, money held passively is akin to a reduced free float of a stock. So with proportionately more money trading actively at the margin, the volatility of share price returns increases. Second, investors should consider their exposure to segments in major indices. In the years before and during the crisis, the market- weighted S&P 500 and its equal-weighted counterpart tracked each other. As the gap between the dispersion of market returns and intrinsic values has widened since then, the equal-weighted index has outperformed. Essentially, cash has flowed from the larger, usually higher-quality, stocks into the smaller sort. If overall market dispersions continue to rise, these flows are likely to reverse. If the trend of rising dispersion in market returns continues to revive the battered stockpickers, the real nightmare for the growing number of investors in passive funds will be that they have entered the wrong market at just the wrong time. Konzept13 Please go to gmr.db.com or contact us for our multi-asset essay, “Return of fundamentalism” A new impossible trinity Rineesh Bansal How much of a pay rise should you get? Before hastily answering, “a lot”, consider that the implications could be an ensuing crash in the stock or bond market. In the simplified parallel universe that economic models tend to represent, workers’ hourly wages should go up to compensate them for two factors, the increase in their output per hour and the overall rise in prices. Hence, the living standard of workers, that is their inflation- adjusted pay, improves over time in-line with their productivity. However, this formulation rests on the assumption that the allocation of the spoils of economic output between labour and other stakeholders does not change over time. In the real world, of course, wage growth is determined by the relative bargaining power of workers and employers. Therefore, actual wage increases deviate from the productivity and inflation based fundamental premise described above and lead to changes in labour’s share of economic output. In the US, for almost the entire second half of the last century, these deviations were relatively small in magnitude and not persistent in any one direction. This meant that for decades the labour share of output moved in a narrow range around its long-run average of 63 per cent. Starting in the mid-1990s, however, wage increases consistently fell short of compensating workers for rising prices and their productivity gains. The result was a substantial decline in labour’s share of output, reaching a low of 57 per cent in 2012. The concomitant effect was soaring corporate profit margins, since labour’s share of output is just the flipside of business profitability. Whereas before the 1990s, net profit margins were range-bound, mean-reverting around their average of 7.5 per cent, the last two decades saw a sustained increase taking them to a record 12.5 per cent in 2012. For workers, though, there is some good news as this two-decade trend might be reversing with the labour share of output rising and corporate profit margins declining by two percentage points from their 2012 peak. Even as companies have enjoyed a Goldilocks scenario of low commodity prices, modest wage pressures and rock-bottom interest costs, corporate America is still somehow mired in what is sometimes called a ‘profit recession’. That is because even though nominal wage growth has been weak by historical standards, it is still outpacing the combination of even lower inflation and abysmally low productivity growth. The stalling productivity of American workers has been the bugbear of the post- financial crisis economic recovery. Over the last five years US labour productivity growth averaged a meager 0.5 per cent per annum, the lowest since the second world war except for a brief period during the deep recessions of the late 1970s and early 1980s. There is intense ongoing debate among economists for the reasons and longevity of this ongoing productivity slump. Sanguine views of the productivity Konzept 14 slump dismiss it as a measurement error or a cyclical phenomenon whereas more concerned forecasters treat it as a structural problem likely to persist into the foreseeable future. The longer the current slump carries on, the more the structural camp led by the likes of Robert Gordon gains ascendancy. The sheer scale of the current slump recently forced the Congressional Budget Office to downgrade its projections of potential productivity over the next decade. At the very least, investors need to confront the awkward possibility that productivity will remain stuck near current depressed level of 0.5 per cent per annum for an extended period and hence contemplate the implications. What about the outlook for nominal wages in this scenario? Since the financial crisis, US wage growth has averaged just over two per cent per annum, about half the rate in the pre- crisis years. Notwithstanding some modest uptick in recent months, Janet Yellen, the Federal Reserve Chair, has publicly admitted surprise at the lack of greater upward wage pressures despite the labour market approaching most estimates of full employment. The Federal Reserve has interpreted this outcome as a sign of further hidden slack in the labour market and a reason to keep rates low. Monetary policy is bolstered by political efforts to boost wage growth as well. In particular, there have been a slew of recent announcements in various jurisdictions to introduce and mandate substantial increases to minimum wages. The rising prominence of the ‘Fight for $15’ campaign in the current US presidential election underscores the political momentum behind this trend. With the labour market approaching full employment, the Federal Reserve taking its cues for withdrawing monetary stimulus from wage growth, and intensifying political will to see workers’ incomes growing faster, it is entirely feasible that wage growth accelerates to its pre-crisis rate approaching four per cent. While wage growth gets most of the attention, what is crucial for economic outcomes is not just the cost of an hour of a worker’s time but also the worker’s output during that hour. If policymakers manage to push wage growth higher to pre-crisis levels of four per cent but productivity fails to pick- up from its current 0.5 per cent growth rate, there will be severe negative implications for financial markets. Consider two possible scenarios in this situation. Firstly, the labour share of output, and therefore corporate profit margins, remain constant at current levels. This implies inflation has to rise to 3.5 per cent. This would decimate many fixed income investors given current inflation expectations for the next five years are barely over one per cent. In some ways, signs from the Federal Reserve that it is willing to let the economy ‘run hot’ for some time, that is, tolerate inflation above its two per cent target also point to such a scenario. Conversely, if the Fed chooses to enforce its two per cent inflation target religiously, the labour share of output should grow at 1.5 per cent per annum. The historical relationship with corporate profit margins suggests that margins would halve from their current level of ten per cent over the next 3-4 years. With the US stock market at record highs, equity investors do not seem prepared for such a scenario panning out. These are just two hypothetical scenarios to highlight the potential debilitating effects for equity and bond investors if nominal wage growth accelerates to pre-crisis levels with productivity growth still stuck at current low levels. The actual outturn might deviate from these scenarios on a number of parameters. For instance, productivity growth, which has historically tracked wage growth with a two- year lag, could pick up once wages start rising. Or, despite their best efforts, policymakers might fail to lift wage growth higher to pre-crisis levels as companies react to falling profitability by shedding labour. Or the burden of wages rising faster than productivity might be shared between bond and equity investors. The point though remains, the cost of lower productivity growth has to be picked up by someone in the economy – by workers in the form of slower growth in wages and living standards, bond holders in the form of higher inflation or stock investors in the form of lower profit margins. When forming their assessment of possible future outcomes, investors should bear this framework in mind. An economy stuck in a low productivity growth rut forces policymakers to make tough choices. Of these three desirable outcomes, high nominal wage growth, reasonable inflation, and steady corporate profits, policymakers can choose any two, but only two. Konzept15 Please go to gmr.db.com or contact us for our multi-asset essay, “A new impossible trinity” Konzept 16Konzept 16 Konzept David Folkerts-Landau Back to black— the ECB should raise interest rates Over the past century central banks have become the guardians of economic and financial security. They have been endowed with the power to set interest rates to safeguard our currencies. Some central banks, such as the Bundesbank and Federal Reserve, are respected for achieving monetary stability over many business cycles, often in the face of political opposition. But central bankers can also lose the plot, usually by following the economic dogma of the day. When they do their mistakes can be catastrophic. 17 17 For example, in the 1920s the Reichsbank thought it could have 2,000 printing presses running day and night to finance government spending without creating inflation. Around the same time the Federal Reserve allowed more than a third of US deposits to be destroyed via bank failures, in the belief that banking crises where self-correcting. The Great Depression followed. Admittedly these mishaps happened almost a century ago. Surely institutional improvements, above all the independence of central banks, together with better data and more sophisticated theoretical and econometric models, have improved things? Sadly not. It has only been ten years since the so-called Jackson Hole consensus saw central bankers tolerate rampant credit growth. They justified their inaction with the fact that inflation was under control – at least by traditional measures. We know what happened next. So it is incredible that yet another mistake is being made by the ECB and other central banks so soon. Today’s blunder is ever-looser monetary policy to the point of negative interest rates and the purchasing of nearly every asset class under the sun. This time the popular dogma is that a lack of demand is causing sub-par inflation. And having arrived at this conclusion, central banks find evidence to back their policies everywhere. This is known as confirmation bias in behavioral economics. Alternative explanations are being brushed aside. Those, such as the ECB, that are convinced they have the only correct analytical approach are described as “hedgehogs” by Philip Tetlock in his book Superforecasting. If you then add in the problem of “group think” you can see how the likes of Mario Draghi defend ever-looser monetary policy by arguing that all major central banks are doing the same thing. When a problem persists – in this case as inflation keeps undershooting – it can only mean that even more of the same medicine should be applied. The ECB’s behaviour in recent years is therefore understandable. Likewise that it has lost its way as policy has become more and more desperate. When reducing interest rates to levels not seen in twenty generations did not stimulate growth and inflation, the ECB embarked on a massive programme of purchasing eurozone member debt – quantitative easing. But the sellers of sovereign debt to ECB did not spend or invest their proceeds, they just placed their money on deposit with their banks, and these banks in turn placed it with the ECB. Which explains why the ECB went to the logical extreme: it imposed negative interest rates on deposits. Currently almost half of eurozone sovereign debt is trading with a negative yield. No doubt if this fails to stimulate growth and inflation, the next step will be so-called helicopter money. Future students of monetary history shall study these events while shaking their heads in disbelief. Konzept 18Konzept 18 The ECB’s policy mistake does not end with interest rates. It also underwrites the solvency of its members as purchaser of last resort of sovereign debt – the so-called Outright Monetary Transactions programme. This has caused risk-spreads to all but disappear from government bond markets. Countries no longer fear that failure to reform their economies or reduce debt will raise the cost of borrowing. In fact, total indebtedness in the eurozone has been rising. Furthermore, badly needed labour, banking, political, educational and governance reforms have been slowed or abandoned. So significant are these mistakes that monetary policy is now the number one threat to the long-term existence of the eurozone. This seems counterintuitive given the ECB is famous for being “ready to do whatever it takes” to preserve the common area. But trying to stimulate growth and inflation with ever-lower rates and bond purchases, while at the same time removing incentives for structural reforms, is creating massive fault lines. Potential cracks are everywhere. Inflation is barely above zero, well below the ECB’s mandated target. And with growth anaemic, debt levels in some countries, most importantly in Italy, are not sustainable without the OMT backstop. Thus the ECB is failing in its other mandated duty to promote sustainable economic and financial stability. The sell-off in shares in February is an ominous reminder how close we are to another bank crisis. Guardians of our wealth, such as insurance companies, pension funds and savings banks, are simply not viable if they cannot earn a positive spread. Indeed, last month Germany’s financial watchdog warned that low interest rates were a seeping poison for financial institutions. Bafin is concerned that some pension funds may fail to provide guaranteed benefits and worries that half of German banks require additional capital. Bafin’s president even suggested that banks should increase prices and cut costs. Likewise, Bundesbank board member Andreas Dombret recently warned that low and negative rates may force banks to increase fees. Meanwhile, ever-looser policy signals to the average consumer or Mittelstand firm, the creators of jobs and growth, that the eurozone is seriously sick, and getting sicker. Uncertainty means people save more and capital expenditure remains stagnant. It is folly to think negative interest rates — perceived as a radical emergency measure — can possibly change this mind-set. It will surely do the opposite. In fact, there is increasing evidence that the influence of monetary policy via the confidence channel is becoming more important but has actually gone into reverse. One survey showed that only a third of European citizens trusted the ECB in November, 19 19 Back to black—the ECB should raise interest rates Konzept 20 Monetary policy is now the number one threat to the long-term existence of the eurozone. Trying to stimulate growth and inflation with ever-lower rates and bond purchases, while at the same time removing incentives for structural reforms, is creating massive fault lines. Konzept 20 an all-time low. In Spain it was 22 per cent. Even Germans, who until 2007 were among the biggest believers in the ECB, are losing faith. That is quite a change to Jacques Delor’s observation in 1992 that not all Germans believed in God but they all believe in the Bundesbank. Even beyond the confidence channel the ECB seems to be getting fewer bangs for its monetary loosening buck. A reasonably close correlation between the size of the ECB’s balance sheet and an index of monetary conditions has been in decline since last April, suggesting decreasing returns. One reason is because lenders not earning a healthy spread cannot extend credit even if they wanted to. The first quarter bank lending survey showed how soggy this growth channel has become. In fact, negative rates result in higher borrowing costs as banks cannot pass negative rates on to depositors. Furthermore, ultra-cheap money is causing other distortions that will be hard to reverse without even greater pain. For example, abundant capital is supporting businesses that would not be viable under normal conditions. Return hurdle rates are too low, which results in misallocated capital being spent on the wrong projects. Industries requiring consolidation remain as they are. Equity prices for below-average firms stay elevated. The reality is that positive interest rates are fundamental to market-based economies. They are the price of forgoing consumption today in order to pay for investment which produces returns tomorrow. Through positive rates capitalism lays the ground to create prosperity. And not just via the behaviour of companies – virtuous savers intuitively understand this too. Every man and woman on the street has a sense that current policy seeks to force profligacy and indebtedness. While this makes sense to a theoretical economist, it is an affront to citizens who work hard and dream of a comfortable retirement. Worse, the poor suffer disproportionally while the rich, with share portfolios or apartments in Berlin or Munich, rejoice at the surge in asset prices due to ultra-low funding. Yet ever-lower rates were not inevitable. There was an alternative path. Given wide support for the eurozone, reforms could have been enacted that did not compromise the central bank’s ability to use monetary policy to stimulate growth or achieve its inflation target. Instead, as the self-appointed purchaser-of-last- resort of sovereign debt, through the OMT program, the ECB has underwritten the solvency of its over-indebted members. Countries no longer fear that failure to reform their economies or reduce debt will raise the cost of borrowing. The OECD’s reform responsiveness measure clearly shows that reform momentum has slowed, most prominently in the countries which had been helped the most. But even for those such as Italy that did 21 21 Back to black—the ECB should raise interest rates not participate in the OMT programme, reform responsiveness slowed, although momentum picked up again last year. The exception is France where reform momentum never picked up at all. Looking back, the ECB should never have usurped the role of saviour of the eurozone. Its president is disingenuous to blame politicians for failing to act. It is he who enabled them to postpone the hard choices. This has prevented a more sustainable solution and undermined our democratic processes. Furthermore, as policy keeps failing to deliver stability while creating a host of distortions in asset markets, it undermines our democratic process even more – contributing to the splintering of power and rise of fringe politics. For example, the controversy about the ECB’s policy has reached a new level in Germany, with Finance Minister Wolfgang Schäuble allegedly blaming the central bank for half of the populist party AfD’s success in recent elections. Meanwhile, in April the CDU/CSU’s parliamentary groups had strongly attacked the ECB for its zero/negative rates policy and suggested that the German government should intervene, thereby, indirectly questioning the ECB’s independence. What, then, should be done? The priority is breaking the negative spiral of lower confidence engendered by ever-looser policy. Therefore, the ECB should consider reversing its policy of negative interest rates as soon as practically possible. Moving back into the black would immediately instil confidence across the eurozone. It would buoy savers, while the small rise in borrowing costs for spenders and investors would be swamped by the positive signal the change of approach would convey. Many economic models already indicate that policy rates should be higher than they are today. One developed by the German Council of Economic Experts found that by the end of last year the ECB had already pushed its refi-rate below justifiable levels. Our own Taylor-rule estimates also suggest monetary policy is too loose. And our projections, which are not far from ECB staff forecasts, show an increasing gap over time compared with implied interest rates. That is not to say the ECB should risk throwing out the baby with the bathwater. The Federal Reserve’s cautious course after its first rate hike last December clearly shows the need to be careful. Still, with the collateral damage of its current policies increasingly evident – in financial markets, the real economy as well as politically – the ECB should start preparing markets for its first rate hike. This has to be accompanied by a gradual return to a market- based pricing of sovereign risk. The ECB needs to stand down and eliminate its backstop for financially weaker sovereigns. It has to trust the political process to deal with the inevitable debt problem Konzept 22Konzept 22 and potential crises in one or several member countries. The ECB should focus on insulating national banking systems, the transmitters of monetary policy, from sovereign debt problems. Incentives for governments to undertake structural change need to be restored to promote growth in the years to come. Reversing policy is never easy, but in 1979 Chairman Volcker proved that even the Fed could radically change its view of how the world works. The eurozone needs a similar about-face by the ECB before it is too late. The longer radical monetary policies persist the greater the damage in terms of lost patience in countries such as Germany. The cost of the current policy is not just economic but political too – it has reduced support for the eurozone and given credence to its critics. Rarely has an institution held such sway over the economic and political future of an entire continent. But this is not the time for slavishly following a doubtful economic dogma — it is the time for common sense. The longer the ECB persists with unconventional monetary policies, the greater the damage it will inflict on the European project it purports to be supporting. 23 23 Back to black—the ECB should raise interest rates Immigration— making work pay Konzept 24Konzept 24 Immigration is a polarising subject at the best of times. But the current gulf between nativists and liberals in Germany over the refugee crisis is widening to a point of no return. We are not there yet, despite the loss of support for Chancellor Merkel’s party in recent state elections and the rise of anti-immigration Alternative for Germany. The priority therefore should be to find common ground on the two fundamental areas of vehement disagreement, namely the acceptable levels of migration and the underlying cost-benefit trade off that it offers. Once a compromise is reached on these two thorny issues, practical solutions to integrate migrants more efficiently, like tiering benefit payments or suspending the federal minimum wage, need to be explored. Immigration— making work pay Konzept25 Konzept25 First, the debate around the appropriate number of migrants that should be allowed into the country needs to be resolved. Those in Germany who argue against higher levels of immigration do so based on a false choice between admitting migrants and turning them away. Unfortunately, this view fails to recognise that a higher level of global migration has become inevitable. The relatively younger and poorer populations of the developing world are growing fast. Egypt, for example, had a population half the size of Germany in 1975 but has since overtaken Germany with over 80m people today. The 180m people living in Nigeria are likely to grow to more than 400m by 2050. When the economist Paul Collier modelled future migration flows, he concluded that migration from poor countries to rich ones will accelerate for three reasons. For starters, the gap in incomes between the rich and poor world will remain wide. At the same time more migrants are reaching an absolute level of income at which savings can be accumulated to invest in departure. Finally, the economic and social cost of migration is falling as the pool of friends and relatives available to welcome migrants deepens. Consequently, he argued, the world is entering a period of disequilibrium where the number of migrants can only rise and rise. It is no wonder, therefore, that even governments that have promised to restrict immigration have found it almost impossible to deliver. And even the most strident nativists are no doubt becoming uncomfortable with the levels of force required to restrict migration, let alone trying to prevent it entirely. This also explains, perhaps, why countries increasingly prefer to outsource the dirty work. For example, Europe is already trying to deal with migration via proxies such as Turkey or Macedonia. The quid pro quo of nativists acknowledging the inevitability of higher migration is liberals accepting that inflows need to be limited to manageable levels with a sensible cap agreed and enforced. Critics of Germany’s open door policy are also right to point out that the country is already doing more than its fair share. Of the 1.25m asylum-seekers who arrived in the European Union last year, Germany took more than a third. Relative to the size of its population, Germany has accepted the fourth most people within the 28 member states. This intake of asylum-seekers, refugees and others has raised net immigration to a record level of more than one million, surpassing even America for the year. Europe is without question enduring the biggest refugee crisis since the second world war with the UNHCR reporting a million people crossing the Mediterranean by sea. However, it is not certain that a comprehensive EU-wide solution can succeed in tackling this unfolding crisis. The so-called Dublin regulations for the registration and acceptance of asylum seekers in the Konzept 26Konzept 26 European Union are broken. Frontline countries such as Greece, Italy, Hungary and Spain are overwhelmed and have either shut their borders or are permitting asylum-seekers to enter Europe without appropriate checks, while leaving the route northward open. Whatever the ultimate policy configuration, including stricter controls and aid for border countries and relocation assistance, something must be done to deter flows into Germany to manageable levels. This is a precondition of any future solution on which both sides of the immigration debate can agree. What should a cap be set at? Following a methodology used by economists Choi and Veugelers that takes into account a country’s population, output, unemployment and the current rate at which residence permits are granted, we calculated a theoretical immigration absorption capacity for Germany assuming it were to accept “as many” migrants as America did via its lawful permanent residency program, also known as a green card. As per this model, Germany should be able to grant 245,000 residence permits per year for a substantial period of time, a number that is in line with the 240,000 residence permits that Germany did indeed grant in 2014, a year of relatively high migration. That is not to say Germany should emulate America blindly or that the US is perfectly comparable to Germany. In fact, America’s high population of unlawful migrants as well as relatively younger age structure means Germany could possibly accept more migrants in the spirit of this comparison. But as a rough estimate, 250,000 people per year is a sensible order of magnitude. Moving beyond the debate on migrant numbers, an honest acknowledgment of both the costs and benefits of migration is required. Focusing on one or the other must be recognised by both sides of the debate as deceitful and counterproductive. To gain the ear of immigration naysayers, Germans with more open views must not downplay the initial costs of integrating new arrivals and in particular refugees. Meanwhile, nativists need to be convinced of the bulk of academic literature on immigration that calculates a negative drain on resources in the short run, though not in the long run. Chancellor Merkel sums up the correct way of thinking when she says that taking in refugees requires “time, effort and money,” but countries have always “benefited from successful immigration, both economically and socially.” Regarding the upfront cost of the latest wave of asylum- seekers, the German state paid out €2.4bn in benefits in 2014, or 60 per cent more than it did in 2013. One fifth of this went on healthcare, a tenth on pocket money, more than a quarter on in-kind benefits including lodging and substance payments while relocation and travel costs accounted for over a quarter of the money spent. Moreover, once an asylum-seeker is recognised 27 27 Immigration—making work pay Nativists should be less hard-line and acknowledge the rights of everyone to welfare eventually. Meanwhile, liberals must recognise the unfairness of immigrants receiving all the trappings of citizenship without hitherto having paid anything into the societal pot. Konzept 28 Konzept 28 as a refugee or a person who cannot be legally deported, they have the right to basic income benefits, as any resident. This includes Hartz IV, welfare benefits and education and participation benefits. Of course there are costs beyond immediate financial considerations too. Germany’s emergence as a main destination for migrants also puts a huge short-term strain on the existing order. Labour markets need to adapt as workers in direct competition with migrants – and not necessarily just the lowest skilled – are challenged. Migration also poses challenging cultural questions, with some arguing that those from different cultural backgrounds are inherently difficult to integrate into German society. Others worry about the dangerous backlash from both right and left-wing populism. Yet while short term costs must be better acknowledged in the interest of honesty and compromise, proponents of higher migration should themselves be making a better fist at explaining why the long term benefits outweigh the upfront spending. Over the life cycle of a migrant, for example, fiscal costs are neutralised by the impact of immigration on the pension system. When the OECD surveyed the impact of migration on public finances it found that migrant households obtained 70 per cent more in social assistance and 50 per cent more in housing allowances than the native-born, but about 50 per cent less in pensions. Of course, the first two costs are front-loaded while the benefits occur later. The survey also pointed out that direct fiscal transfers were not the only component worth watching. Indirect fiscal impacts, for example via value-added tax and excise taxes, as well as spending on public education and health, should be considered. Equally important is the general impact on national output, wages, employment, the capital stock and productivity. When the OECD factored these effects in, they found that overall in the long run migration was neither a burden nor a major panacea for the public purse. What is more, this OECD study was based on the assumption of a stable if not growing population. In the context of a shrinking population, which is the situation in Germany, the lift provided by migration to potential economic growth becomes even more crucial to the safety of public finances. Indeed, the native German population has been declining for more than four decades. But the impact has been masked by incoming migration. For example, between 2010 and 2015 the domestic population declined by 932,000 while the overall population grew in size by 820,000 people thanks to 1.8m net immigrants. Compounding this problem is the trend of a rapid ageing of the population. At 46 years old, the average age is second only to Japan’s in the rich world, making Germany the greyest country in Europe. Already one in 20 Germans is over 80. Germany has had 29 29 Immigration—making work pay one of the lowest fertility rates in the industrialised world, while at the same time life expectancy has increased. The result is a dependency ratio (the ratio of population under 14 and over 65 over the working age population) that has been rising since 1985. And the ageing problem is only set to worsen. The absolute peak in Germany’s working age population occurred in 1998. As the post-war baby boomers begin to retire in earnest starting in 2020, they will leave a substantial gap in the potential size of the workforce. According to the Federal Statistical Office, the number of working age people will decrease from 49m to 40m by 2040 under current policies. The current demographic trends will impose a heavy fiscal burden on the public finances. This is particularly pressing in a country with a contributory welfare system, financed directly through social contributions of the working age population. One analysis found that public benefits (pensions, health and long- term care) to the elderly in Germany are expected to rise to a quarter of output in 2040 from 17 per cent today. If that burden cannot be met by taxation, it will be done through borrowing and redistribution. Net public debt as a percentage of output will rise to 104 per cent by 2040 from just 50 per cent today if borrowing pays for all the growth in public benefits. More important than fiscal accounting, however, immigration needs to be sold as a necessary investment in Germany’s future. Such a case can be made with numbers. Over a ten-year view, our forecasts assume the influx of refugees to Germany will remain high for the next three years and then drop back down to the average seen during the first ten years of this millennium of 50,000 per annum. Our model also assumes that Germany fares better in competing for skilled talent as a result of an increasingly positive international reputation. Overall, net immigration tails off in the medium term down to 200,000 people per year. Under this scenario – which admittedly involves a relatively smooth integration of immigrants into the labour market, large initial investments and a tremendous social effort – potential economic growth falls from the current 1.5 per cent to approximately one per cent. In the absence of this immigration boost, potential growth would collapse to around 0.5 per cent over the ten-year period. The boost to potential growth is driven by an increase in the labour force of some 1.7m people instead of it shrinking by 4.5m. Already Germany’s economy is signalling the need for more people. The unemployment rate remains at the lowest level since reunification. There has also been a sharp increase in vacancy periods. The average days a job opening remains vacant in Konzept 30Konzept 30 Germany is at 84 days currently, compared with half that in 2000. It is not hard to imagine a future in which labour shortages become more common. There are more long term benefits from immigration worth banging home to the doubters. During America’s mass migration in the 19th century, for example, economists have found that capital flows tended to follow labour flows. One study by economists Williamson, Hatton and Kevin O’Rourke illustrates this effect dramatically. They found that if immigration had stopped in 1870, the resulting labour scarcity would have been so profound it would have raised the 1910 wages by a quarter. However, in a second simulation, their model adjusts for capital flows responding to the surge in labour supply. In this case, the wage effect was far less, around nine percent, suggesting that capital “would have stayed home had international migration been suppressed.” Finally, the economic case for higher immigration must also be made qualitatively. There is substantial evidence showing that diverse societies are more vibrant, socially flexible and innovative. Economies with more immigrants have a higher degree of dynamism and mobility that boosts the underlying rate of productivity and output growth. Migrants, in this argument, are a form of positive selection – they dare the hazards, want something better, crave freedom and they do not yet feel entitled. For instance the success of Silicon Valley has long been known as driven by migrants. Another study found that 40 per cent of Fortune 500 companies were founded by immigrants or their children. Indeed, many of America’s greatest brands – Apple, Google, AT&T, Budweiser, Colgate, eBay, General Electric, IBM and McDonalds – just to name a few, owe their origin to founders who were immigrants or the children of immigrants. Apple’s Steve Jobs was the child of an immigrant parent from Syria. Home Depot an immigrant from Russia; Clorox, from Ireland; Oracle, from Russia and Iran; eBay from France and Iran, and so on. And even when the new arrivals are low-skilled, migration seems to augment the host economy’s innovation capacity due to its effect on specialisation. During the mass emigration of Cubans to America in 1980, over 120,000 people entered the US labour market – about half settling in Miami and half in the rest of Florida. Many of these migrants were low-skilled and had poor English. Nevertheless, a recent study found an associated increase in patents in Florida, especially in technological categories with low barriers to entry. This, the study suggested, could be because individual inventors had access to a large supply of low-skilled labourers, and were able to hire them to do housework, child care and other manual work. This allowed these inventors to substitute themselves away from housework and spend more time inventing, leading to an increase in patents. 31 31 Immigration—making work pay If a consensus can be achieved on the appropriate levels and the long-term desirability of higher migration into Germany, the focus must shift to more practical solutions of integrating migrants more efficiently. It is in everyone’s interest after all, that the transition from pain to gain is as brief and smooth as possible. The priority here should be a transformation of Germany’s social welfare system from rigid and homogeneous to one where benefits for immigrants are phased in over time. This is the most equitable way to keep integration costs down. Nativists should be less hard-line and acknowledge the rights of everyone to welfare eventually. Meanwhile, liberals must recognise the unfairness of immigrants receiving all the trappings of citizenship without hitherto having paid anything into the societal pot. A phased approach to welfare helps bridge the divide. There is precedent too; tiered benefits systems are already common the world over, including in Germany. At the moment the consensus seems to be that the state should move asylum-seekers into the welfare system as quickly as possible, for example by making designated refugees immediately eligible for Hartz IV payments. Yet it is obvious that newcomers cannot be integrated in their hundreds of thousands without jeopardising the system’s viability. Integrating immigrants in a way that is consistent with Germany’s international obligations at the same time as safeguarding the welfare state requires policy innovation. Milton Friedman famously noted that free immigration cannot coexist with a welfare state over the long run. He argued, provocatively, that illegal Mexican immigration into America only worked for Mexicans, for the Mexican state, and for the US precisely because it was illegal. “Why? Because as long as it’s illegal the people who come in do not qualify for welfare, they don’t qualify for social security, they don’t qualify for all the myriads of benefits that we pour out from our left pocket into our right pocket, and so, as long as they don’t qualify, they migrate to jobs. They take jobs that most residents of this country are unwilling to take, they provide employers with workers of a kind they cannot get – they’re hard workers, they’re good workers – and they are clearly better off.” Obviously “better off” here means in comparison with the jobs or conditions those workers might have had in their own countries. That is why they moved in the first place. But Mr Friedman was also making the following point: welfare states require those with higher incomes to pay more than they receive while those with lower incomes receive the opposite deal. This redistribution channels public resources towards lower income households. But it also means welfare states Konzept 32 are fundamentally incompatible with policies favouring free movement if such policies tilt the fiscal balance too far towards lower-income households. Naturally, few would tolerate a Germany in which newcomers received no benefits and natives received everything. Yet most would accept and consider more equitable a country in which benefits for immigrants were phased in over a longer time period. In some ways Germany already does this. For instance, even under the comparatively generous social code, access to some payments, such as child benefit, are restricted for seasonal workers, students and certain temporary residence permits. Likewise from 2007 to 2014, Romanian and Bulgarian nationals with no employment history were restricted from social security support, even though they were entitled to live in Germany. Admittedly, the latter were transitional arrangements yet they were tolerated for seven years. Even today Germany mandates non-EU skilled migrants under the blue card programme to buy health insurance for themselves and their relatives, a cost that does not apply to other residents. Meanwhile, in the current UK Brexit debate, Germany and other European countries have confirmed that member states may restrict EU residents from social benefits if they arrive solely for the purpose of claiming them. While some of these examples will not be applicable to the refugee crisis, the fact is Germany makes distinctions between what taxpayers owe to different categories of migrants all the time, and can make them again. In fact, every country tiers benefit payments to a greater or lesser degree. Any examination of the welfare system for migrants across the EU reveals the sheer diversity of social models. Countries routinely modify access to benefits for migrants using tools such as minimum residence periods, rules governing the export of benefits, minimum employment periods or migration- specific conditions. Distinctions are often made between long-term residents, researchers, blue-card holders, single permit holders, seasonal workers and intra-corporate workers. Under the equal treatment provision of the EU free movement directive, migrant workers are mostly entitled to same rights as nationals, but non-EU workers on temporary permits are in a different category. For instance, imagine a non-EU citizen, say from Indonesia, who comes to Europe on a temporary permit and has worked for six years. If they suffer an accident at work that requires them to take some years off, they would not be entitled to sickness benefits in cash in Belgium, Cyprus, Estonia, Germany, Italy and Portugal. They would not be entitled to disability benefits in Belgium, Italy, Cyprus, Czech Republic, Greece, Portugal and Sweden. They would not be entitled to guaranteed minimum 33 33 Immigration—making work pay resources, which insure the poorest, in ten member states (including Austria, Portugal and Slovenia). And they would not have access to maternity benefits in Finland, Ireland and Sweden. What is true in Europe is even truer elsewhere. In the US the major public benefits programs have always prevented some non-citizens from securing assistance, even if they were residents. For example, the food stamps program, non-emergency Medicaid, Supplemental Security Income, and Temporary Assistance for Needy Families have always been ineligible to undocumented immigrants and those on work visas. Moreover, after new federal welfare and immigration laws were introduced in 1996, some of these programs even became ineligible to lawful permanent resident non-citizens. There are, therefore, plenty of ways to provide asylum- seekers and other migrants with the opportunity of a pleasant life that comes with moving to Germany without burdening the country’s fiscal system unduly. A temporary cut to the relatively high German minimum wage of €8.50 is one example, justified by the fact that a significant share of refugees have to spend a longer amount of time on workplace familiarisation, language and training, until they acclimate – all at the expense of effective working time. The idea is to bring wages in line with their productivity to maintain demand for migrant labour. France’s minimum wage, which has contributed to the country’s high youth unemployment rate, should be cited to justify such action. Again, Germany has been here before. Productivity-oriented wages were the rationale behind the Agenda 2010 reform package and wage moderation of the 2000s, which created the broad-based employment gains Germany had never considered possible. Other tiering mechanisms could also be introduced. For example, why not ask migrants, but not refugees, to pay a higher rate of tax until they naturalise as citizens? Or compel migrants to contribute to social service for a certain period in order to earn their citizenship? The general principle is to loosen physical borders and at the same time build stronger ties of obligation – fiscal and otherwise. A new settlement along these lines would allow the current wave of migration to become a political and economic opportunity, far outweighing the fiscal costs, discomforts and political risks. A tiered welfare system is the most effective tool to reduce the integration strains from immigration – and an equitable solution to the legitimate objections by nativists to unfettered welfare access for those yet to make their contributions to society. But there are other ways to help make the transition from short-term pain to long-term gain as fast and smooth as possible. The obvious examples are education and training. Konzept 34Konzept 34 Here again an honest assessment of the situation would help moderate the debate. Liberals simply have to concede that many migrants are low-skilled and not suited to the vacancies in the German economy – initial protestations that only the most educated refugees were arriving were unhelpfully incorrect. For example a recent Ifo institute survey among people in refugee camps reckoned while a tenth have a university degree about two thirds do not have any formal qualifications for a job at all, compared to 14 per cent among the domestic German population. Of course reliable numbers on the skills of the current migration wave is not available. Indeed, other data suggest that estimates of the skills of migrant refugees may not be as uneconomic as some suppose. Consider that a fifth of current job openings across the country now require no formal qualification – that is about 100,000 jobs right there, notwithstanding language issues. Opponents of immigration should also note that another fifth of openings require formal educational qualifications, exactly the same proportion of refugees who supposedly have finished secondary education, according to a recent study by the Swedish Employment Services in 2014. The current migration crisis, if mishandled, has the potential to tear apart Germany’s cherished consensus driven social model. However, it also offers a unique and exciting opportunity to solve multiple long-term problems facing the country. If people on both sides of this debate can demonstrate some empathy for the legitimate arguments of the opposing camp, a workable solution to the crisis is not beyond reach. 35 35 Immigration—making work pay Bank regulation— let lenders do their job Konzept 36 “In the middle of our life’s journey, I found myself in a dark wood, for the straight path was lost.” What was true of Dante’s allegory has also been true of bank regulation since the crisis. It was supposed to make banks safer, improve conduct and boost lending. Yet eight years on banks remain something to worry about. Konzept37 The sell-off in European bank shares in February this year was an ominous reminder that markets remain unsure whether the eurozone banking system is strong enough to survive a future crisis. Meanwhile clients chafe against reduced trading liquidity and credit provision, while risk has migrated to less regulated shadow banks, providing an illusion of safety that will surely seem quixotic after the next crisis. Somewhere along the way, the straight path in the re- regulation of banks was lost. While banks have boosted capital and are undoubtedly safer, investors have increasingly found them uninvestable. It cannot be a positive signal, for instance, that from 2009-2013, only two banks per year were started in the US, compared with 100 per year from 1990-2008. In Europe, too, the number of banks has fallen by a fifth compared with a decade earlier. This consolidation is in many cases desirable but it also reflects how unattractive the banking industry appears to new capital. Investors have shunned banks on the public markets too, sending the index of European banks down to a price to book value of 0.6 times. That is hardly surprising given returns on equity for the sector have not exceeded five per cent in the past five years, let alone the industry’s cost of capital of around nine per cent. This is not what a healthy banking system looks like. The bureaucracy of financial regulation, never diminutive even in ordinary times, has now grown to eye-watering levels. Employees in JPMorgan’s mortgage business, reportedly completed 800,000 hours of compliance training in 2014 alone. Compliance groups in the large global banks now run to thousands of people. For instance, HSBC has increased its headcount associated with compliance by six-fold to 9,000 people since 2010. Around a tenth of the bank’s 255,000 full-time employees now work in risk and compliance. Similarly, JPMorgan has hired 8,000 people in compliance since the crisis. The associated costs are far from trivial. HSBC spent nearly $3bn in 2015 on programs to detect financial crime, up a third from the previous year. Similarly, UBS spent $1bn in 2014, or a quarter of its profit for the year, on regulatory requirements. For a number of banks, every decline in the cost base wrung out from cost-savings initiatives has been swallowed by greater regulatory spending. That is not difficult to imagine considering that in the US alone, the decentralised financial regulation system means a large bank may find itself regulated by seven different authorities: the Securities and Exchanges Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Financial Industry Regulatory Authority (FINRA), the Office of the Comptroller of the Currency Konzept 38 (OCC) and the Consumer Financial Protection Bureau (CFPB). In addition, each state will have its own banking authority. This additional burden seems particularly pointless since it is not clear that much of the tide of rule-making is even accomplishing what it set out to do beyond the most general of objectives. As British regulators pointed out, EU bonus cap rules that were designed to curb excess pay only served to increase fixed pay as a percentage of total pay, while total pay remained stable. The proposed financial transactions tax, which 11 EU members have postponed for now, would shrink the derivatives business in Europe by 70-90 per cent. Moreover, it would increase foreign exchange hedging costs for European corporates by 300 per cent. And that is according to the European Commission’s own estimates. This rule inflation is excessive in absolute terms but also relative to history. In the US, the Glass-Steagall legislation of 1933 came to 37 pages. Meanwhile, the 2010 Dodd-Frank bill is an eye-watering 2,300 pages, and that is before counting the 22,000 pages of rule-making that the agencies charged with Dodd-Frank rulemaking have published to implement the legislation. As the process remains unfinished, the estimated 2,260,631 annual labour hours required to comply with these new rules must surely be an underestimate, as must be their equivalent of over 1,000 full-time jobs 1 . The Basel I agreement of 1988 was only 30 pages long, while Basel II in 2004 came in at 347 pages, and Basel III in 2010 added up to 616 pages, and this is before the millions of calculations needed to complete banking models that assign different risk weights for individual loan exposures. When the Bank of England’s Andy Haldane looked at the matter in 2012, he pointed out that the Federal Reserve has required quarterly reporting by bank holding companies since 1978. In 1986, this covered 547 columns in Excel, by 1999, 1,208 columns. By 2011, it had reached 2,271 columns. “Fortunately,” he added, “over this period the column capacity of Excel had expanded sufficiently to capture the increase.” At Deutsche Bank the burden of regulatory disclosures has resulted in an annual report of around 600 pages, six times as many as 25 years ago. It is not just page inflation. Readers unfamiliar with AFS, CFR, CPR, CVA, DRE, DVA, EAD, FVA, IMM, LCR, LGD, MREL, NQH, NSFR, SFT, SNLP or TLAC, would struggle to comprehend many of the issues in a modern bank’s annual report. Needless to say, instead of dismantling the relationship between governments and their domestic financial sector, recent regulation has instead fortified an ever-larger regulatory-financial complex. The buildup in new rules means ex-regulators have an 1 “The dog and the frisbee” – speech by the Bank of England’s Andy Haldane at the 2012 Jackson Hole symposium. 39 Bank regulation—let lenders do their job augmented ability to earn remuneration because they are among the few people au fait with the rules and the personalities involved. Surely a perpetual expansion of an entrenched techno-financial regulatory complex is not what the public wanted after 2008. The philosophy that underpins the current approach to bank regulation was perhaps best summarized by Neel Kashkari, the newly appointed President of the Minneapolis Fed, in February. He called for treating banks operationally like large nuclear power plants, including “holding so much capital they virtually can’t fail.” The idea of banks as utilities has also been widely discussed in Europe and this explains much of the post-crisis agenda. After all, regulators now influence charges and fees on products, payout ratios and dividends, remunerations, senior recruitment, compliance and supervision and financial controls similar to those on large public utilities. The utility analogy also works when you consider that banks have effectively been tasked with quasi-state functions, such as vetting criminals via the know your client (KYC) rules, reporting suspicious transactions and activities, freezing accounts and transactions, and enforcing international sanctions. This is much in the same way as utilities must fulfil climate change obligations and serve lower-income customers. Similarly, only if you treat banks like nuclear power plants does the improvement in balance sheets post 2008 seem inadequate. European banks may have raised close to €360bn from shareholders since the beginning of the financial crisis in 2008. The quantity and quality of capital may have improved, with the tier one capital ratio for eurozone banks up to 13.5 per cent from just eight per cent in 2007. Moreover, new liquidity and leverage requirements may have led to a six-fold increase in eurozone bank holdings of cash while cutting leverage down by a third compared to 2008. Yet none of this would satisfy the critic demanding 100 per cent safety. The banks-as-utility approach to regulation needs to be countered head on. It is flawed for a number of reasons. First, it ignores how utilities are actually regulated. Fortress balance sheets and heavy regulation are only part of the quid pro quo. The other part is the need to attract private investors by offering high enough returns. That is usually done by protecting product or distribution channels in a given market to guarantee financial viability. In Europe, for example, utility regulators still guarantee returns for monopoly networks (though not the unbundled retail or generation businesses.) The French gas network allows pre-tax real returns on capital of 4.7 per cent, with achieved after-tax nominal returns on equity typically being above ten per cent over the last decade. It would be impossible to apply this model to banking. For one thing, imagine the political outcry were regulators to Konzept 40 guarantee European banks a certain amount of minimum required profits by limiting competition. Moreover unlike natural monopolies such as energy networks, there are no significant financial products offered by banks that cannot also be offered by non- banks. So even if it was desirable, protecting product streams may not even be possible in financial services. For example, commercial banks used to be the only significant source for large businesses to take short-term loans (90-180 days) but that service is now offered by money market funds as well. Without guaranteed returns, the utility analogy in fact works more as a caution than as a guide. Consider the power generation segment of the utilities market where European policy has consisted of a mix of guaranteed prices (mostly for wind and solar) and market prices (for hydro, nuclear, and fossil fuels). This has led to instability in the market with low profits and a lack of security of supply at the same time. In fact, nuclear is the most relevant example here because it faces ever tougher safety regulation but ever lower prices and profits. That approach to regulation has in fact endangered firms like RWE and EDF, with the former suffering most from the German nuclear phase-out mandated by the government. Just as demanding ever tougher safety regulations amidst ever lower market prices has been a recipe for the closure of nuclear power, demanding a bank business model that complies with ever-increasing financial regulation alongside ever-higher levels of capital is a formula for killing the banking industry. That seems to be what is happening today, where a combination of heavy regulation, a weak European economy, and a negative interest rate environment means profitability has been sharply hit leaving banks unable to achieve their cost of capital. Banks broadly have four sources of revenues: net interest income, fees, trading income and other revenues. In Europe, all have declined in recent years. Between 2010 and 2014, revenues for the largest banks in Europe fell by ten per cent from €500bn. Trading revenues have contracted by a quarter while net interest income, which makes up over half of revenues, is down a tenth. Of course, bank profitability has been hurt by negative interest rates as banks cannot pass these onto depositors. Simultaneously, lending rates have fallen, reducing their net interest margins banks. The impact of unconventional monetary policy is worse in Europe than in the US. During the US quantitative easing period from 2010-2014, bank loan margins declined by 19 per cent yet interest income was steady at $240bn because annual loan growth was robust, at around five per cent. In Europe loan growth is too weak to do the same. The stress is perhaps most evident in Italy where net margins on new loans are 74 basis points lower that on the existing stock. As the front book becomes the 41 Bank regulation—let lenders do their job back book, margins could compress by about a third. Assuming a stable loan mix and no repricing of liabilities, annual loan growth needs to be ten per cent to keep net interest income constant over the next four years, yet it is just one per cent today. The only real opportunity for banks these days to generate profits are bank fees. Europe’s largest banks have increased the fees and commissions share of their revenues to 28 per cent compared to 26 per cent just a few years ago. Yet even this recent increase in fee-based income is receiving significant pushback. The European Commission is starting to take a serious look at the extent of bank fees while in the US, the Dodd-Frank act of 2010 set up a consumer protection agency for banking that has controlling high bank fees on its agenda. Ironically for proponents of utility banking, trading safety and profitability is ultimately a false choice. That is because retained earnings are the main source of capital for banks to meet higher capital requirements and any subsequent growth in risk-weighted assets. An unusually stark example can be seen in the US where under government control, post-crisis Fannie Mae and Freddie Mac, now profitable, disbursed their profits entirely to the US Treasury, bypassing shareholders and keeping their equity cushions slim. As a result, leverage in Fannie and Freddie rose by 2-3 times between 2012 and 2014 as book value shrank, making them less valid as standalone entities (if they ever were). To the extent that a banks-as-utility regulatory approach leads to structurally lower returns even for outperforming banks, it will ultimately prove self-defeating, with consequences for growth and stability. There is a third reason the utility analogy falls flat. The consequences of failure in a nuclear reactor are unambiguously devastating whereas in finance there is substantially less clarity. Just take the US railroad speculations of the 19th century, where banks lent to railroads through several cycles of speculation, exuberance and capitulation, notably culminating in the panics of 1819, 1873 and 1893. In the last one, nearly 500 banks and 156 railroads (about a quarter of the existing railroads) failed. Yet by 1850, 9,000 miles of railroads had been built and by 1900, around 200,000 miles of track had been built. The railroads facilitated the circulation of goods and services, the mobility of labour, and laid the foundations for the contemporary American economy. A similar story can be told about the expansion of the telegraph in the mid 19th century as well as laying the fibre- optic cable in the 1990s, all of which left a trail of bankruptcies in their wake. In all these three cases, did finance fail or did it succeed? Arguably, it would not have been possible to have so many railroads, telegraphs or fibre optic cables without that Konzept 42 cycle of exuberance and pessimism within finance. That is just not the same with nuclear power, where failure has no upside. In extremis, one conclusion is that there is limited attractiveness to a risk-free financial system, because it also implies a system that is not particularly innovative or supportive of growth. The same conclusion is absurd when applied to a nuclear plant. What is needed is a system with a more coherent regulatory approach, one in which banks are treated not as public utilities but as banks, where safety and entrepreneurship must coexist side by side. Just as offense is often the best defence, profitable banks will often be the safest. Regulators can keep increasing the amount of capital banks hold by augmenting rules on capital, leverage and liquidity for instance. But if they simultaneously increase costs by regulating bank processes at a granular level, then they are depressing bank profitability and making banks less investable and therefore less safe. And all this presumes we know what a safe banking system looks like. Forrest Capie, the historian of the Bank of England, has pointed out that financial regulation may be the preferred cure-all of an overly legalistic society for the much more fundamental problem of low trust. Indeed it may be a myth that the last financial crisis was the product of deregulation since the period of British history with the lightest regulation was the one with the fewest banking crises. There were no financial crises between 1866 and the 1974 stock market crash, as Professor Capie counts the 1930s as an economic crisis not a financial one. With our knowledge of financial crisis prevention at a relatively primitive state, some humility may be in order. Today, banks are backing away just as volatile markets need them the most, and capitalism is under severe strain just as global economic growth so desperately needs a boost. While banks must certainly earn the right to be more lightly regulated and encumbered, and have certainly been poor self-regulators in the past, there is a danger in hobbling them too much. Nor will it happen that banks become so small that they cease being systemically important and hence a non-issue for governments. So long as they are systemically important, oversight is justified. But given the nastiness of the financial crisis and the scant public sympathy for banks it is completely understandable that governments and regulators have overreacted. The irony is that by burdening banks to their limits, financial regulation is now having a serious detrimental effect on the real economy and the very taxpayers governments are hoping to protect. 43 Bank regulation—let lenders do their job There is only one thing worse than a rival eating your lunch: watching them eat it in your own house. American investment bankers already own the top five league table spots worldwide thanks to their prime seats in their large home market. Now they are gobbling up the lion’s share of business in Europe too. This year, according to Thomson Reuters data, should be the first in which US banks account for the majority of investment banking revenues in Europe, the Middle East and Africa – long the preserve of European banks 1 . It is shocking how quickly Europe’s investment banks have given up the high table. JPMorgan and Goldman Sachs have swapped the number one position between them since 2013. Now with Bank of America, Citigroup and Morgan Stanley muscling in as well, only one non-US investment bank – my employer – remains in the top five. Less than a decade ago European investment banks had almost twice the market share as American banks in their home region. Why is this happening? Increased regulation has forced European banks to retreat from many investment banking products and services. New rules on proprietary trading, capital requirements and ring fencing have resulted in a €1tn decline in risk-weighted assets. Include leverage and this equates to as much as €5tn less money at work. American banks, meanwhile, have doubled their fixed income, commodities and currency assets since the financial crisis. Worse, Europe’s banks are retreating just as global transactions have exploded in size. For example, $30tn-worth of corporate bonds has been traded globally this year, twice as much as a decade ago. Likewise the amount of equity capital raised for European companies has doubled since 2012. Only players with serious risk-absorbing capacity can stomach such transactions. So long as European investment banks are shrinking, business will go elsewhere. Does it matter? After all, Europe copes with Google having a 90 per cent share in search. Eight out of ten films shown in German cinemas are made in Hollywood. It matters because investment banking is different to biotechnology or unconventional energy – yet two more industries where America leads the world. Investment banking is a strategic asset, integral to the free-flowing of goods, services and savings that creates wealth. Brussels would never allow its skies to be owned by America, yet US banks now control 40 per cent of Europe’s primary issuance market. US versus European banks Konzept 44 Europe cannot lose something so valuable. American regulators already have sway over every bank transacting in dollars. If US banks also control access to investors as well as every market in which they trade, the global financial system will become even more American than it already is. It is embarrassing enough that Europe is reliant on the US military to protect it. As the world’s biggest importer and exporter of services, it would be equally embarrassing for Europe to rely on US investment banks. Relying on American investments banks is even more risky given Europe desperately wants to grow its capital markets to make corporates less reliant on direct bank lending. But raising money and doing deals requires opening themselves up to US banks, which have long standing relationships with US corporates. The conflict of interest here is obvious. And in a future crisis would American investment banks consider shutting their Paris or Chicago operations first? So how does Europe avoid losing yet another industry to America? First, companies across Europe must implore their homegrown banks not to retreat to their respective domestic markets. This way lies more risk and costs, and reduced variety and ambition. Second, European regulators must stop punishing their own just as their US cousins do everything possible to support their banks. Third, Europe needs deeper capital markets and a less fractured retail banking system. Finally, the ECB has to consider how its policies are damaging the region’s banks – indeed this is why its policies are not working. Banks remain tainted by the global crisis and subsequent scandal. But almost a decade later Europe cannot starve its banks to death while leaving the largest economic bloc in the world to healthier rivals. The implications of such an historic mistake would take generations to reverse. 1 “The United States dominates global investment banking: does it matter for Europe?”, Charles Goodhart and Dirk Schoenmaker, Bruegel Policy Contribution, Issue 2016/06, March 2016 45 Bank regulation—let lenders do their job 46Konzept Columns 48 Book review—Bloodsport 49 Conference spy—dbAccess Asia 50 Infographic—perception versus reality 47 Konzept Book review— Bloodsport John Tierney If you live long enough you start reading histories of times that you lived through, and perhaps even participated in tangentially. Bloodsport, by Robert Teitelman, is an anecdote-filled tale of how the M&A boom of the 1980s reshaped corporate America and contributed to the ethos that produced Enron, the 2008-09 financial crisis and perhaps even the rise of Donald Trump and Bernie Sanders. For this reviewer, it brings back memories such as riding an elevator with Kidder Peabody’s M&A whiz Marty Siegel before his fall from grace; and following the twists and turns of DuPont’s bid to buy Conoco in 1981. While the topic itself is well-covered terrain, Mr Teitelman, former editor of The Deal takes a far more sweeping view of American corporate history. He opens with the rise of the conglomerate in the 1960s when Wall Street’s merger business was all about relationships and friendly deals. As the 1970s brought high inflation, sluggish growth, and stagnant stock prices, many wondered if USA Inc. had lost its edge. Hostile deals became more common. As the 1980s unfolded, the stage for the M&A boom was set and many of its cast of characters were in place. M&A lawyers Joe Flom and Marty Lipton had well-established practices. Bruce Wasserstein at First Boston had formed a classic Mr Inside/Mr Outside partnership with Joseph Perella to break into the blue chip advisory business dominated by the likes of Morgan Stanley. And Michael Milken was running his well-oiled junk bond machine at Drexel Burnham Lambert. These characters drove a host of fascinating deals such as RJR Nabisco, Time/Warner, Unocal/ Boon Pickens and Revlon/Ronald Perelman. Mr Teitelman explores in detail how many of today’s standard M&A tactics came about. Somehow two-tier bids, poison pills, white knights, greenmail, and junk bond-financed all-cash offers, are transformed from dreary finance jargon into colourful strategies to cajole raiders and targets into action. Even more interesting than the deal chronicles though are the parts of the book where Mr Teitelman muses on the wider impact of M&A on corporate governance practices. The breakdown of the model where corporations serve multiple stakeholders, to the view that the corporation exists to serve shareholders is explained through the lens of dealmaking. Alongside the practitioners in the Wall Street trenches, academic economists and lawyers – known as the Chicago School – were applying the efficient market hypothesis and agency theory to redefine the corporation and justify hostile takeovers. Essentially, if managers as agents of shareholders did not have incentives to run the company as efficiently as possible and a bidder offered a higher price it indicated that an efficient market had priced the agency cost, and that a company was obligated to accept the offer. Even in the face of mounting evidence that markets could be less than efficient, and that mergers didn’t necessarily result in better operating results, these academic arguments provided the intellectual underpinnings of the M&A boom through the 1980s. Curiously, for a book about M&A, it has very little to say about the ongoing human cost of the constant rendering and restructuring of corporate America over the past 40 years. Mr Teitelman does note in the concluding paragraphs that the 20-year trend of aligning senior managers’ interests with shareholders through stock options has left workers and middle managers “silenced as voices in corporate governance… (but they) make up the great mass of American voters (and) possess great if occasional power”. When the next chapter in the M&A saga is written it may have less to do with the record $5tn of deals in 2015 (which did little to move the needle on sluggish economic or profit growth) and more to do with what those angry voters do. Konzept 48 Conference Spy— dbAccess Asia James Russell-Stracey For a second year in a row your conference spy has just returned from snooping around Deutsche Bank’s flagship Access Asia conference. Almost 2,000 investors spent three days in Singapore meeting over 200 companies and listening to 70 group presentations. Here is a summary of the best bits for readers who could not make it. Overall the conference was circumspect given the plethora of global risks around – a mood captured by keynote speakers David Folkerts- Landau and Madeleine Albright. No surprise, therefore, that the busiest booth was the one showing the escapist joys of virtual reality. Your spy donned new goggles from HTC and Sixsense, which were described as early stage models, “like an iPhone 1”. But as one fund manager exclaimed: “Just think what the 6S will be like!” Between punching the air participants learned that while gaming and entertainment are the early beneficiaries of virtual reality, the scope for enterprise usage is much wider. For example, education, surgery, test driving a car or on-line shopping could all be transformed in ways previous generations would not have imagined. This ability to conceive transformative technology requires an education system that stimulates creativity was the theme of Sir Ken Robinson’s speech. He said that in Singapore, for instance, there is now a policy commitment to move away from regimented education. That said, upbeat presentations by numerous internet players at the conference suggest corporates are finding the talent they need from China’s annual class of seven million graduates. Alibaba’s Joe Tsai also highlighted the power of household balance sheets – with over $700bn in savings – to transition China’s economy away from exports and investments. As disposable incomes have risen 12 per cent annually, entertainment, leisure and travel spending will drive Alibaba’s expansion over the next decade. This trend will also change the physical landscape. Joe predicted that shopping malls would reverse their current 70:30 split – away from shops and towards cinemas, leisure and food and beverage. He also told clients how the Chinese internet market will become more internationalised. For example, Uber’s position is already being challenged by Apple’s $1bn venture with rival operator Didi, illustrating a trend towards convergence with investment flowing both ways. Still, this view of globalisation was partly at odds with two political speakers that followed. Gideon Rachman of the Financial Times pointed to the US election and Brexit as significant risks to global trade. Likewise, Madeleine Albright warned that domestic issues and a rise in nationalism are driving a backlash against globalisation. She said that electorates are being led towards solutions that are “simple, dogmatic and wrong”. On Asia specifically, the political focus of the conference kept returning to tensions in the South China Sea. Most agreed that competing claims in the region are pushing many countries closer to the US. That would be no bad thing under Obama’s policy shift towards Asia. But everyone agreed that things could become combustible under a more confrontational American administration. Finally, what about investment risks in Asia? Participants voted China’s credit market as the most relevant concern for Asian portfolios. Just over half the audience in one poll worried about a Chinese sovereign rating downgrade and a fifth feared an Indian downgrade. The consensus view is that Asian markets are now a beta trade on either China or oil – which explains why most participants are long the dollar. The consensus also questioned whether central banks alone can solve the world’s problems any more. They certainly could in a virtual world at least. Your spy will have to wait until next year’s conference to see how central banks fare over the next twelve months. Konzept49 Infographic— perception versus reality What percentage of the population do you think are foreign-born? Germany UK France Italy 100% 50% 0% Germany UK France Italy 100% 50% 0% What percentage of people do you think do not affiliate themselves with any religion? Germany UK France Italy 100% 50% 0% What percentage of the people aged 20 years or over do you think are either overweight or obese? Survey responses Reality Konzept 50 Germany UK France Italy 100% 50% 0% Germany UK France Italy 100% 50% 0% Germany UK France Italy 100% 50% 0% What proportion of the total household wealth do you think the wealthiest 1% own? What percentage of working age women do you think are in employment? What percentage of people in your country live in a rural area? Data from Ipsos MORI surveys conducted in October 2015. For more details see “Perils of Perception 2015” at www.ipsos-mori.com 51 Konzept The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice and may differ from views set out in other materials, including research, published by Deutsche Bank. 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 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. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made. 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