1. Research
  2. Products & Topics
  3. Periodicals
  4. Konzept
November 25, 2014
It is fashionable to say Germany is heading down the path of post-bubble Japan. But what if the Japan to worry about is not the deflationary 1990s but the previous decade when golf club memberships swapped hands for millions of dollars? And just as there is a risk investors fail to apply the lessons of a rising sun to Germany, there is a danger that Japan’s post-bubble era is ignored by China and South Korea. [more]
Konzept Issue 01 Rising and setting suns—Japan’s lessons for Germany, China and South Korea November 2014 It is fashionable to say Germany is heading down the path of post- bubble Japan. But what if the Japan to worry about is not the deflationary 1990s but the previous decade when golf club memberships swapped hands for millions of dollars? And just as there is a risk investors fail to apply the lessons of a rising sun to Germany, there is a danger that Japan’s post-bubble era is ignored by China and South Korea. Page 21 Cover story Rising and setting suns— Japan’s lessons for Germany, China and South Korea Innovation is one of the core values of Deutsche Bank. It helps us find sustainable solutions for our stakeholders and evolve our thinking about the future. This new magazine from Deutsche Bank Research represents such innovation. It is a new way of delivering our best ideas to clients and the wider world. The format is as accessible as the content is original. I look forward to reading Konzept regularly. Anshu Jain Co-Chief Executive Officer Deutsche Bank that extreme inequality hinders growth, but we do not know the level at which the negative effects kick in. Finance and bankers are lightning rods in this debate, as we show in this issue. Hence Konzept aims to stimulate but is deliberately not dogmatic. We let others preach, for example, that structural reforms are essential around the world even though the impact from reforms takes time (and time we may not have). Just look at the historical examples of misery imposed in the name of sound economics. Winston Churchill taking the UK back onto the gold standard at an over-valued exchange rate in 1925 was a huge mistake. Likewise, policies post the Plaza (or Louvre) agreements in the 1980s probably set Japan on its way to the lost decade. That academic researchers have found it hard to provide useful insights into the dynamics of modern economies has created an exciting opportunity for others to take up the challenge. And much of the best thinking on the crucially important issues of the day is now found within global hedge funds and investment banks. Indeed it makes sense that the unceasing demand for economic and financial analysis is met by commercial groups. Every day we appreciate first-hand the importance of investors making big calls, of institutions setting their strategies and of policy makers implementing correct macro and regulatory policies. Finally I would like to extend my special thanks to Guy Ashton for his outstanding leadership of this initiative to draw out the best from Deutsche Bank Research. I hope you find Konzept essential reading. David Folkerts-Landau Group Chief Economist Member of the Group Executive Committee 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. The world of economics and finance arguably faces more unresolved questions and unmet challenges than at any time in the last hundred years. As part of Deutsche Bank’s continuous effort to push the frontiers of research I asked our best and brightest talent to break with consensus and write about topics that help us understand what lies ahead. This is the first issue of what I hope you will find to be a fascinating as well as fun and easy-to- digest magazine. Our motivation is the difficulty in deciphering modern market economies. Indeed my own beloved profession failed to anticipate most of the big market dislocations over my working life, from the Latin American debt crisis in 1980s through to the eurozone’s recent travails. Konzept does not have a crystal ball either, but by pushing contributors to gaze beyond their core disciplines we hope to deliver fresh insights and ideas. Then again, we must acknowledge the impossibility of ever satisfactorily explaining the dynamics of major macro economic variables. But many of us involved in this magazine have toiled for decades in the vineyards of political economy and financial markets experiencing what works and what does not. Sometimes it is just a gut feeling – but it is hard to articulate this experience into predictive power. Hence macro economics becomes an exercise in persuasion. For example we know that quadrupling the supply of money or gold, such as during the Iberian plundering of the Inca Empire, raises prices. But we do not know how long this takes. Likewise our cover story compares the lessons of Japan to Germany, China and South Korea – but appreciates that outcomes and timings may be very different. We also know that deficit spending helps when there is insufficient demand, but we never know the appetite of investors to hold more sovereign debt – a topic of relevance in Europe today and one we reference in our piece about the bond conundrum. Similarly we can intuitively sense Editorial Konzept Germany—lessons from a rising sun 21 The contours of CoCo land 38 Cyber insecurity 46 The big debate— secular stagnation 54 China and South Korea— lessons from a setting sun 30 Financiers in literature— written down 60 Articles 06 US capex—don’t be depressed 08 Love in a tropical climate 12 Ready for the robot revolution 14 Age does not weary them 16 The bond conundrum— ECB’s high grade squeeze 18 On your Marx—bankers vs politicians Columns 68 Book review—The Birth of Korean Cool 69 Ideas lab—secrets of investment success 70 Conference spy—oil and gas 71 Banking at the box office Features Konzept But what is missing in both company and national accounts is the fact that companies are meeting their capex needs by spending relatively less. Firstly, what they are investing in is getting cheaper. The prices for most non- residential investment categories have been falling relative to broader measures of inflation since the mid-1990s. While the general price level has risen by 45 per cent since 1995, industrial-related prices have gone up only by 40 per cent and transportation prices by 25 per cent. Meanwhile, equipment prices (including technology and computer-related investment) have actually fallen by a fifth over the past two decades. Indeed, real (as opposed to nominal) non-residential investment as a proportion of GDP is near an all time high of 13 per cent. This is in line with the crazy dot.com years and with 2008 levels when rising commodity and oil prices drove a surge in natural resources-related capital expenditure. The second reason companies are seemingly spending less is because they are investing differently. There has been a steady shift in the composition of non-residential investment away from what is defined in the national accounts as structures (mainly buildings) to computers, software, and intellectual property. Consequently, real non-residential investment excluding structures is now at a record high relative to GDP. Again, relative levels of inflation have distorted the picture. It looks bad that structures-related investment has fallen in real terms from 6.2 per cent of GDP to 2.7 per cent since the early 1980s. But over the same period intellectual property investment rose from one to four per cent of GDP. More important, however, is that the structures category has experienced significant inflation since 1995 with prices rising 230 per cent. It is hardly surprising that companies have been substituting it with cheaper and presumably more productive capex. Companies are required to expense some of this new capex under US accounting rules, which further depresses capex as reported in company financials. So corporate America’s capital expenditure story is really a positive one. But that is very different from saying that private investment overall – which includes both residential and non-residential investment – is not depressed. Far from it. The truth is that most of the shortfall in investment these days is due to low residential investment, not capex. As a percentage of GDP, residential investment is nearly two percentage points below the long- term average of about five per cent. Indeed if the housing sector were to return to normal tomorrow, America’s economy could soon be humming along at four per cent or more – instead of the 2.5 per cent currently. Hence any improvement in investment and GDP growth will need to come from the residential sector primarily. Anyone looking to corporate capex to help lead the next surge may find they have a long wait. Commentators are fond of blaming corporate America for skimping on capital expenditure despite record levels of cash and profits. Greedy executives prefer to spend shareholders’ funds on pursuits to boost share prices such as buybacks rather than investing for the long term – or so the accusations go. Others point the finger more directly and argue that a lack of spending is responsible for America’s soggy post-crisis economic recovery. But the critics are wrong for two simple reasons: companies are investing in different classes of assets compared to the past, and the prices of those assets have been getting relatively cheap. Adjust for pricing and mix, and capex levels are near record highs. So how is it that most people conclude that capital expenditure is at low levels? Well, for a start the aggregate accounts of America’s largest non-financial companies are quite clear that capex as a percentage of earnings before interest, tax, depreciation and amortisation has been declining steadily over the past 30 years. During the 1990s spending by listed corporates ran at around 40 to 45 per cent of ebitda. Following the dot.com bust in 2000 this dropped to about 35 per cent. But the percentage has been even lower than that since the financial crisis. Indeed, excluding the energy sector, which has been investing heavily in the shale oil boom, capex to ebitda has recently been running below 30 per cent. Published accounting data, however, provide little by way of additional detail to further analyse this troubling trend. So it makes sense to look at the big picture investment trends in the national economic accounts produced by the US Bureau of Economic Analysis. The best proxy for corporate capex in the national accounts is nominal non-residential investment. And this is indeed depressed as a percentage of gross domestic product. From the early 1980s to 2008, investment to GDP was mostly in the 13 to 14 per cent range. Then following the financial crisis it sank to less than 11 per cent of nominal GDP and has since struggled back to about 13 per cent. US capex— don’t be depressed The structures category has experienced significant inflation since 1995 with prices rising 230 per cent Rise in the general price level since 1995 45% 230% Industrial-related prices have gone up only by 40% 40% John Tierney Konzept 6Konzept7 meantime the WHO has determined that the current Ebola outbreak is an “extraordinary event” so it is ethical to offer unregistered drugs and vaccines, despite unproven clinical profiles. The tragedy is that for many other tropical diseases effective treatment is available but inadequate healthcare access and poverty prevent the most vulnerable from benefiting. Big Pharma’s activities in this area look philanthropic. But is this the only motivation? The industry is also making a strategic long-term investment in building brand, goodwill and distribution infrastructure with the countries, governments and customers of tomorrow. The tropics (comprising 144 nations and territories) produce around a fifth of the world’s gross domestic product and are currently home to more than 40 per cent of the world’s population, reaching 50 per cent by 2050. While many of those blighted by tropical diseases are citizens of the world’s poorest nations today, economic development in the coming decades is likely to mean these countries will constitute the pharmaceutical industry’s customers of the future. To this end many pharmaceutical companies routinely provide services and skills that extend well beyond the basic provision of medicines, such as training doctors and nurses, participating in health education campaigns, improving supply chain logistics (a major issue for distant rural communities), researching and developing new medicines and vaccines on a not-for-profit basis and foregoing or pooling intellectual property protection so that local manufacturers can produce critically needed drugs. GlaxoSmithKline, Sanofi and Novartis have shown outstanding commitment to tropical diseases. GlaxoSmithKline and Sanofi in particular have highly pro-active, industry- leading approaches as well as a broad range of relevant drugs and vaccines (they jointly lead in the supply of vaccines for the developing world). Each has dedicated market access units for the poorest nations and multiple support programs to improve health education, training and capacity. The pair’s dedicated research and development spend substantially exceeds that of their peers. Novartis deserves particular credit for its central role in the supply of anti- malarial drugs in Africa and its Novartis Malaria Initiative access program. Meanwhile, Bayer and Roche have lower levels of investment but play key roles in the provision of drugs for sleeping sickness and HIV/Aids respectively. In the short term the most engaged companies may benefit from attracting the interest of investors looking for socially responsible enterprises. The full payoff, however, may take years, even decades, to materialise. But those companies that lead the way with this apparently philanthropic investment surely stand to reap significant rewards. They will know and understand local culture, they will have built relationships with local authorities and they will have a stake in the healthcare infrastructure they are developing. Curiously, the companies themselves are not making much of their socially responsible credentials, or explaining the longer term payoff story to their investors. But it seems that this investment is a whole lot smarter than it appears at first sight. If you are interested in more details, please go to gmr.db.com or contact us for our in-depth report “Tropical diseases; social responsibility, neglected market”. There has been a big change in the way Big Pharma has behaved over the last decade or so. GlaxoSmithKline, Sanofi, Novartis and others have dramatically increased the help they provide, largely for free, to some of the world’s poorest people in some of the world’s poorest nations. In the past, aid in combating tropical disease from Big Pharma involved simply handing over bulk supplies of relatively basic, usually off-patent drugs. Nowadays, by contrast, some of the leading pharmaceutical companies are going a lot further. They are donating newly developed products, improving access to their medicines and vaccines through heavily discounted or even zero pricing, waiving patent rights to allow local manufacture, collaborating in research, and investing in the healthcare infrastructure of affected countries. Revenues are minimal and are far outweighed by the costs. GlaxoSmithKline, for example, donated drugs last year with a wholesale value of over £500m and spent in the region of £100m on research into tropical disease. The catalyst for change was the World Health Organisation. In 2010 it published a report on neglected tropical diseases setting out specific targets for the eradication of certain diseases and some degree of control of the remainder. The report led to the landmark London Declaration in 2012 in which the pharmaceutical industry, governmental and non-governmental organisations, notably the Gates Foundation – a major driving force – and the WHO all joined forces to tackle these diseases. There is undeniably a moral and humanitarian imperative to relieve the burden of tropical diseases. The WHO estimates that 1.2bn people annually are at high risk of malaria (mainly in sub-Saharan Africa) while 1.4bn are affected by the neglected tropical diseases. The latter include dengue fever, which is fast becoming the most prevalent threat. This year has also seen a devastating and unprecedented outbreak of Ebola virus infection in Africa. Concerted international efforts are underway to develop a treatment or vaccine for it. In the Love in a tropical climate Mark Clark, Tim Race, Richard Parkes Konzept 8Konzept9 Konzept 10Konzept11 robots. Japan holds more patents in this space than any other country and has a competitive edge in the key areas of advanced sensors and small motors. Companies such as Sony and Panasonic may have lost their crowns to Apple and Samsung years ago but in robots Japan rules like it is the 1980s all over again. Domestic production by industrial robots has shot up over the past two years after grinding higher for the preceding three decades. It will accelerate further as relaxed safety regulations allow for broader workplace adoption and improvements make robots capable of performing a wider range of jobs. Fanuc, the country’s biggest company in this industry, is developing new sensitive robots that can work safely with their human colleagues. Kawada’s Nextage robot comes on wheels so it can be moved around easily, increasing its versatility dramatically. Nextage has a head with 3D vision, a torso and two arms which enable it to pick up soft sheets and transparent objects. Mitsubishi Electric has sold 10,000 units of a model that handles small components in home appliance assembly lines. Of course other countries do not want to be left behind. The South Korean government, for example, has stumped up more than a billion dollars to support the country’s robot industry which at the moment is heavily orientated towards shipbuilding and auto manufacturing. Medical equipment producer Curexo now sells Robodoc, which performs orthopaedic surgeries, while the Samsung Group has developed a machine-gun-toting and grenade-launching sentry robot. The SGR-A1 has been tested along the demilitarised zone on the North Korean border. China, faced with its own demographic issues, is also catching up fast. Mainland sales of industrial robots numbered around 4,500 in 2005 but are projected to hit 340,000 in 2015 – putting the country on a par with Japan in absolute terms. There is still a long way to go, however. A ratio of 23 robots to 10,000 industrial workers still leaves China with only a tenth of Japan’s penetration. Nor will Japan stand still. Prime Minister Abe, who chairs a committee on the Realisation of a Robot Revolution, recently said he aims to double the size of the market for industrial robots to $11bn per year by 2020. This is not just a production-side story, though. The market for service robots is projected to rise twenty-fold to the same size as the market for industrial robots over the same period. This is about much more than automated vacuum cleaners – cute as they are. At one end of the spectrum exoskeletal Smartphones have transformed our lives in the past decade and already feel old-hat. Soon, though, you may not be able to turn around without bumping into a human- sized robot. Manufacturers are finally hitting a sweet spot where robotics technology is sufficiently advanced and cheap to be adopted en masse. The robot age will demand huge social adjustments as well as creating tremendous investment opportunities. Japan is the vanguard. The country’s focus on incremental efficiency gains and higher-end manufacturing, driven by its shortage of cheap labour and hitherto relentlessly appreciating currency, have made it the world’s biggest market for industrial robots are being rolled out to do everything from assisting in the cleanup of Fukushima to helping the elderly and aiding in the provision of nursing care. Already Cyberdyne rents out Hybrid Assistive Limb suits to assist people with walking difficulties and in 2016 Panasonic will start selling a $9,000 competitor with sensors that detect when wearers are attempting to stand or sit up, easing the load on their upper body or knees. And others are working on more flexible ‘power suits’ that incorporate artificial muscle fibres into clothing. Meanwhile the other end of the spectrum has been staked out by billionaire entrepreneur Masayoshi Son, founder and chief executive of SoftBank. In June he introduced Pepper to the world – a child-size friendly android featuring cloud-based emotional intelligence. Each machine learns from the experiences of its clones. He follows Honda’s long line of experimental Asimo humanoids and Sony’s Aibo dogs. Pepper is already on duty meeting customers and gathering data at Softbank’s flagship Omotesando store. Sales to the general public are due to begin next year – first in Japan and then in the US, priced around $2,000. While many countries are scrambling to establish their own robotic ambitions Japan seems to have a distinct advantage for now: its naturally open and positive social attitude towards such technologies. You can experience it at the wild robot restaurant in Shinjuku, famously fitted out at cost of $135m. Or at Tokyo’s Miraikan museum, which features disturbingly realistic woman and child (Otonaroid and Kodomoroid) robots that have silicon skin and artificial muscles, as well as a minimalist Telenoid doll that facilitates surrogate communication. Indeed, by the time the 2020 Tokyo Olympics roll around, spectators stand a good chance of being guided by a female droid named Aiko Chihira developed by Toshiba. The robot revolution is well under way. Ready for the robot revolution James Malcolm Konzept 12Konzept13 over their younger counterparts. 2 Older workers, it seems, are more than able to leverage their skills and experience in the labour market. Another study by Dr Burtless shows that education is a key factor that influences the labour market participation rates of workers in the 62 to 74 year old age group. Two- thirds of older American men with doctoral or professional degrees were still working compared to just one-third of high school graduates. For women the proportion was half versus one-quarter. 3 While older workers are holding their own in white collar roles, one may be tempted to think that younger workers have a big advantage in physically demanding blue collar jobs. The Japanese fishing industry for one displays a contradictory trend. According to government statistics, over a third of Japanese fishermen are over 65 while 13 per cent are even over 75. In contrast, 15 to 24 year olds make up only three per cent of fishermen. Not only have older workers used skill and machinery to stay in business, younger workers seem to be daunted by the physical rigours of the work. 4 The unwillingness of younger workers to take up this physically demanding job is causing serious worries about the future of the fishing industry in Japan. So it is wrong for governments, policy makers and companies to view ageing societies as full of unproductive retirees and medical invalids. Senior citizens are increasingly both willing and capable of participating formally in the workforce. And this is before accounting for their significant contributions in voluntary community service and other activities. Hence societies will need to change in many ways to accommodate these trends. For instance, rather than build ever more retirement homes, urban design will have to adapt to the needs of senior citizens who wish to continue to work. Similarly, the education system has to become friendlier to older students wanting to upgrade their skills. Given that people will routinely work into their 70s, it will probably be common for workers in their 40s or 50s to return to university and completely change professions. Meanwhile, younger people need to recognise that they will have to work a lot harder to keep up with their grandparents. The rapid greying of the world’s population is the subject of many newspaper columns and scholarly articles. Readers are left with images of countries weighed down by retirees, underfunded pension plans and medical systems on the verge of collapsing under the exponential increase of ageing invalids kept alive by expensive drugs. While economies may well be hurt by a lack of younger workers, and health systems will indeed come under strain in ageing societies, recent studies highlight the need to radically change our mental image of senior citizens. It is true that ageing is already quite advanced in a number of developed countries. In Japan, for example, the proportion of over 60s is due to rise from a third of the population to 40 per cent by 2040. The ratio will be similar for Germany by then, too. Developing countries are generally younger but some are ageing fast enough to catch up soon with the developed world. Estimates for 25 years from now show the over 60s accounting for 30 and 40 per cent of the Chinese and South Korean population respectively – higher than the US in both cases. But people are living longer because they are healthier. This implies they can remain socially and economically active for much longer. Indeed, it appears that today’s senior citizens can give the young a run for their money. A survey of 20 developed countries by Gary Burtless and Barry Bosworth of The Brookings Institution found that despite the crisis, workforce participation rates of 60 to 64 year olds rose on average by 1.5 percentage points a year between 2007 and 2012. 1 This was accompanied by a significant increase in participation by those in their late 60s and early 70s. Moreover the rise in participation rates appears to be accelerating. Why is this happening? Are older workers somehow clinging to jobs by accepting lower pay? Far from it. The 2011 data from the US shows that men aged between 60 and 74 enjoyed a 22 per cent premium in hourly pay over those aged between 25 and 59. Similarly, older women enjoyed a premium of 10 per cent 1 Impact of the Great Recession on Retirement Trends in Industrialized Countries, Brookings, by Gary Burtless & Barry Bosworth, November 2013. 2 Is an Aging Workforce Less Productive?, The Brookings Institute, by Gary Burtless, June 2013. 3 Can educational attainment explain the rise in labour force participation at older ages?, Centre for Retirement Research, Boston College, by Gary Burtless, September 2013. 4 Population of Fishermen Hit by Earthquake, Aging, Japan Real Time, by Jun Hongo, September 2014. Age does not weary them Sanjeev Sanyal In Japan, the proportion of over-60s is due to rise from a third of the population to 40 per cent by 2040. Over a third of Japanese fishermen are over 65 while 13 per cent are even over 75 40% 13% Konzept 14Konzept15 peripheral countries’ bonds instead. What is more, if volumes are light then price signals are likely to be distorted by insufficient supply. This has implications for economic analysis. For instance, Japanese rates were never affected by tight supply dynamics, so likening them to current low eurozone triple-A yields would be misleading. Meanwhile for the ECB the implication is twofold. First, large scale government bond purchases need to be designed to take into account the limited availability of the highest rated bonds to buy. Second, current market levels may already be distorted. As breakeven inflation rates are correlated with nominal yield levels, the famously low five year-five year forward rate may owe more to expectations of QE than to the underlying change in the outlook for inflation. So the decline in market- implied inflation expectations – cited by the ECB as a reason to engage in asset purchases – may actually be due to expectations of QE. Both implications suggest that buying government bonds will be more difficult – and perhaps less warranted – than many in the market think. While everyone rightly or wrongly seems to be waiting for the European Central Bank to start buying government bonds as a form of quantitative easing, there is an important question to ask: who is the ECB going to buy them from? Take triple-A rated debt for example. Foreign exchange reserve managers at the world’s central banks are unlikely to offer their holdings for sale to the ECB in any size. The reason is that when eurozone interest rates were cut to negative levels back in June the rate was also applied to cash held at the ECB by central banks from outside the eurozone. These banks will not want to sell safe, liquid, euro-denominated assets to the ECB in return for cash with negative interest. And switching out of euros is not an option as it would likely negate the purpose of accumulating foreign exchange reserves in the first place – that is, the relevant country’s domestic currency would appreciate. Similarly, fund managers with passive management mandates are unlikely to be able or willing to sell their assets (however rated) either. Being obliged to match the country allocations of their benchmark, they have to hold on to the underlying securities. So it is important to know how much of the triple-A rated sector in the eurozone is freely tradeable. This requires a comprehensive picture of bond ownership. And the reality is that less than 40 per cent of the eurozone triple-A market appears to be freely tradeable – that is, not held by sticky investors such as index trackers and forex reserve managers at central banks. This compares with 50 per cent for the American market and almost 90 per cent in Japan. The end point of all this for investors is clear. They are almost forced into a default position of being underweight triple-A eurozone bonds and overweight riskier bonds from peripheral countries. The lack of availability of core bonds at reasonable prices forces this underweight position. And investors put cash that cannot go into core country bonds into The bond conundrum— ECB’s high grade squeeze The end point of all this for investors is clear. They are almost forced into a default position of being underweight triple-A eurozone bonds and overweight riskier bonds from peripheral countries. If you are interested in more details, please go to gmr.db.com or contact us for our in-depth report “The Bund Conundrum”. Alexander Düring Konzept 16Konzept17 The Federal Reserve, for example, now has a balance sheet equivalent to a quarter of output, compared with five per cent a decade ago. Commercial banks’ balance sheets by contrast have remained at 70 per cent. But the reality is that bankers are not even in the ten least trusted professions in America – a list led by politicians, advertisers, actors, lawyers and insurance agents. Where attitudes have turned is in Europe. For example, in Italy and Spain bankers are the second least trusted professionals. In Germany and France, they are the sixth least trusted and in the UK they are the tenth least trusted. Once again most suspicion is reserved for politicians. Everyone loves firefighters, however. So Europeans tend to see bankers and public servants as intertwined. That makes sense. In the early stages of many new nation states the explosion in government debt for wars was synonymous with growth in the banking sector. Adam Smith referred to the then private Bank of England, founded in 1694 on the basis of a £1.2m loan to the government, as a “great engine of state”. New trade routes and poor international legal norms spurred investment banking. Land reform and colonial expansion resulted in the parcelling up of land, contract law and mortgages. But there is another problem with Marx’s solution. State-owned or dominated banking industries are no better than private ones at averting crises. If anything they do worse. Japan, with its intimate link between government industrial policy and bank lending in the 1980s, could not prevent the subsequent decades of stagnation. Moreover, an IMF study of all the major bank crises since 1970 found that indeed state ownership of banks was a common factor, with governments owning 30 per cent of bank assets on average across crises. It seems that state-directed lending only adds to instability. If direct government control cannot solve the problems that led to distrust in banks unfortunately it is also not clear new regulations can improve trust either. The financial crisis showed every type of banking system to be vulnerable, from capital markets-oriented banks in the US and small regional banks in Europe to high-street banks in Britain. That is because the reality is that bankers themselves are not primarily to blame. The root cause of the crisis was a binge in credit that fuelled household debt (and in some cases government debt) and a real asset boom that eventually went bust. Thinking about new regulations and reforms in that light gives cause for concern. Complex products such as collateralised debt obligations may well have diminished, but the fuel for property booms – mortgages – remains. Likewise, the drive to shift markets onto electronic platforms may raise the spectre of more flash crashes. What is more, the central thrust of reforms does not address the issue of how to restrain vested parties, whether politicians, bankers or homeowners, from fuelling asset price booms, or how to encourage new lending during downturns. It also seems as if an overly legalistic, rather than scientific, approach is being taken to reform. America’s Dodd-Frank Act came to 400,000 words. This compares with the 30,000 words that were needed for the Banking Act of 1933 also known as Glass-Steagall enacted after the Great Depression. The complexity It seems as if bankers are public enemy number one these days. They caused the financial crisis, they rig markets, they are paid too much – and the poor tax payer has to keep bailing them out. Karl Marx summarised the reason for this hatred in Das Kapital : Usury centralises money wealth where the means of production are dispersed. It does not alter the mode of production, but attaches itself firmly to it like a parasite and makes it wretched. It sucks out its blood, enervates it and compels reproduction to proceed under ever more pitiable conditions. Hence the popular hatred against usurers… Marx’s solution to this antipathy was a “centralisation of credit in the hands of the state, by means of a national bank with state capital and an exclusive monopoly”. If more state involvement is the answer then the financial crisis moved things in that direction. On your Marx— bankers vs politicians Bilal Hafeez of financial products has been replaced by complexity in regulatory requirements. No wonder that as well as not being trusted, the banking sector is not favoured by investors. That seems harsh as banks have now completed the bulk of work in order to conform to new regulations. Capital ratios have increased to around ten per cent and leverage ratios are on their way to five per cent. Higher market volatility, the growth of securitisation in Europe and financial deepening in emerging markets should all help investment bank revenues keep pace with nominal economic growth. That said it is hard to see the positives for the sector through the fog of potential litigation to come. Though impossible to forecast, most analysts reckon that the bulk of conduct related fines have now been paid or reserved for. The low market valuation of banks, amongst the lowest of all sectors, suggests that much of the bad news has already been well priced in. Finally, it may be fun to ask: what would firefighters – the world’s most trusted profession – do if they were at the helm of reforming the financial sector? Perhaps they would employ their method of controlled fires, whereby parts of the forest are allowed to burn in order to remove the dead wood which would otherwise be fuel for spontaneous conflagrations. It is surely healthier to let some banks fail in order to prevent systemic crises later. Yet preventing all bank failures seems to be the priority for policymakers around the world. No wonder trust is so low for politicians and bankers. Konzept 18Konzept19 Stuart Kirk, James Malcolm, Bilal Hafeez Cover story It is fashionable to say that Germany is heading down the path of post-bubble Japan. Similar demographic trends and export dependence? Check. Slow growth and falling inflation? Check. Five year bund yields down to Japanese levels? Check. Hence it seems that investors are right to consider Japan when assessing the future risks to Germany. But are they are looking at the wrong Japan? Germany— lessons from a rising sun Konzept21 Konzept 20 What if the Japan everyone should be worried about is not the deflationary zombie land of the 1990s but rather the 1980s boom, when golf club memberships swapped hands for millions of dollars and the country’s shares accounted for almost half the world’s market capitalisation? Of course, there is a real risk of stagnation in Germany, as there is across Europe. Recent data points are soft and getting softer. Even so there is a danger that as loose policy becomes entrenched in order to help weaker members of the eurozone its strongest country eventually overheats. Indeed, there are signs that Germany is warming up already. It seems fantastical to contemplate such a reversal in mind- set. Not only does bubble-era Japan feel as if it happened on another planet, Germany seems to be deflating before our eyes. Output growth has fallen from above five per cent in 2011 to barely above one per cent today. Inflation is sub-one per cent. Exports have slumped since the summer. In Washington last month, European Central Bank chairman Mario Draghi took a barely veiled swipe at Germany when he said: “For governments that have fiscal space, then of course it makes sense to use it. You decide to which country this sentence applies.” Finance minister Wolfgang Schäuble, having denied Germany is anywhere near a recession, has just announced a €10bn investment package. The language of irrational exuberance this is not. Yet in order to understand how Germany could become a rising rather than a setting sun requires going back to the genesis of Japan’s boom. In essence the explosion in asset prices during the 1980s was merely the extrapolation of the country’s remarkable post-war recovery and catch-up with the west in income levels and manufacturing prowess. But as with Germany today Japan also faced pressure to reduce its trade surplus, deregulate and stimulate domestic demand. Interest rates were cut several times against the central bank’s better judgement – the then deputy governor Yasushi Mieno confiding that it felt like sitting atop a pile of dry tinder in early 1986. Flush with savings the country’s banks cast around for new borrowers and found a ready market in property developers. Japan’s relatively underdeveloped financial markets surged and major corporations were given direct fundraising access via new products. And before long traditional values of conservatism in investment, consumption and regulatory behaviour were swept away by a torrent of money and a groundswell of wealth. It is worth considering this last point some more because Germany is also a country famous for priding itself on a set of beliefs and personal characteristics that seem totally incompatible with the formation of bubbles. School children learn about the hyperinflation of the 1930s and the perils of not balancing the books. Even today as growth seems to be weakening both at home as well as across Europe there is outrage in many corners Worse, the recent recovery in Europe seems again to have faltered. It seems fantastical to contemplate such a reversal in mind-set of Germany at the suggested fiscal loosening in countries such as France and Italy. Indeed, it remains Berlin’s main policy goal to run a balanced budget by next year. But you would have been considered mad to warn of excesses in early 1980s Japan too – a country that worked hard and lived within its means, in contrast to those spendthrift Americans. The Bank of Japan shared a similar phobia of inflation to the ECB. Indeed every employee learned about the disastrous hyperinflationary wartime experience where resources were so scarce and banknotes depreciated so fast that it was only worth printing them on one side. If animal spirits can run rabid through the gaps in Japan’s strict social norms and institutional structures then they can do so again absolutely anywhere else too. That includes fiscally sensible, savings-loving Germany as much as its southern eurozone peers. Remember that it did not take long for the Irish or Spanish or Greeks to cast aside years of relative underperformance to embrace lifestyles associated with overheating economies. With monetary policy calibrated to help post-integration Germany, interest rates were too low for too long in the periphery. And boy they enjoyed themselves. So why couldn’t the same thing happen in Europe again? When a single interest rate is applied to 18 countries the only possible result is that it is not appropriate for them all. And right now monetary policy is focused on assisting the peripheral members that blew-up hardest during the financial crisis. Such a policy is understandable. Real output in Spain for example remains six per cent below its 2008 peak. Portugal’s economy is seven per cent smaller than before the crisis. Not even in Ireland, which deserves credit for a rapid recovery, has the economy surpassed the glory days of seven years ago. Those numbers also say nothing of the loss in potential output across the periphery. Deviations from trend growth rates may take a generation to make back, if ever. Worse, the recent recovery in Europe seems again to have faltered. The IMF recently cut its growth forecast for this year from 1.1 to 0.8 per cent and now puts the chance of a eurozone recession in 2015 at nearly 40 per cent. During the last quarter no growth was registered at all. Inflation too will not stop falling. Headline consumer prices that were rising at a three per cent clip in late 2011 are barely positive today – up 0.3 per cent in September. Core inflation, which excludes more volatile items such as energy prices and food, has also declined to just 0.8 per cent. More worrying, inflationary expectations are heading south too. Central bank president Mario Draghi is supposedly focused on a barometer of where inflation is expected to be in five years’ time, starting five years hence. This measure is now at its lowest point ever, based on interest rate swaps. Konzept 2223 Germany—lessons from a rising sun Hence many economists not only expect low European interest rates indefinitely but reckon the combination of weak growth and the threat of deflation makes full-blown quantitative easing likely, despite legal, economic and political opposition. Thus it is hard to imagine prolonged loose policy not being a reality for both the weakest and the strongest states in the eurozone. And the most robust member of the eurozone is without a doubt Germany. Of course it is the biggest economy. And although it does not currently lead the pack on every indicator, such as 6.7 per cent unemployment (Austria’s is lower) or on 2015 growth forecasts (Latvia’s is 3.7 per cent), Germany wins out overall. What is more with a positive budget balance and current account surplus worth seven per cent of national output no country in the eurozone rivals Germany in terms of optionality. Not that Germany needs to prove itself in order to be worried about the appropriateness of policy. Simply being stronger than the average member means that interest rates are too loose. But it is not just logic that suggests a mismatch between monetary conditions and the German economy. That reality arrived back in 2010 when (but for a brief blip last year) the country’s nominal growth rate moved above its 10-year government bond yield. The inflection point was significant because from 1992 to 2010 the opposite held true (but for another blip right at the pre-crisis peak). The implications were inherently deflationary up until now. Are there any signs that Germany is in the embryonic stages of a Japanese-style period of booming asset prices and Van Gogh purchases yet? Yes there are – and the first indication can be found in the same place it was in Tokyo, Dublin and Madrid: real estate. Property prices are surging in Germany at the moment and have been since 2010 – perhaps coincidentally just as bund yields fell below nominal growth. For example in the past four years residential prices are up a fifth and monthly building permits by 70 per cent. There is currently a mini-boom across the board from apartments and existing homes to new houses. The term “betongold” or “concrete gold” is widespread. Even mortgage approval numbers are rising in a country famous for renting long-term. And why wouldn’t you borrow? The first year interest rate for the average fixed rate mortgage has fallen from almost four per cent three years ago to 2.5 per cent today. As with all hot property markets it is becoming harder to isolate reality from apocryphal tales of greed and excess. Yes, Philippe Starck is designing a trendy new luxury apartment block in the Mitte district of Berlin. But will it really have red leather on the walls of the lobby, and will a concierge actually deliver milk straight to your fridge? About half of all new buildings in Germany are being bought off-plan by foreigners, led by Russians or maybe Chinese. Or was that a quarter of new buildings? It scarcely matters – you just have to buy now! Nor is it just residential property warming up. Commercial property prices have also jumped. In addition both domestic and overseas developers are willing to take much more risk. Across Germany’s big five cities of Berlin, Dusseldorf, Frankfurt, Munich and Stuttgart about half the buildings due for completion over the next couple of years are speculative, meaning the soil was turned before tenants had signed leases. That may be a sign of a healthy market where supply is rushing to keep up with demand. But the point is that even the Japanese property boom started life grounded in solid fundamentals – this is how all bubbles begin. Likewise there are positive dynamics underpinning residential property. Immigration reached a twenty year high last year and apartment completions have been drifting lower for decades. And of course by almost every measure the Germany property market is a long way from excess. It is in fact dead cheap. Prices in real terms are flat since 1975 and post crisis nominal prices have barely risen by a third. What is more, relative to average incomes German real estate represents better value than anywhere in the developed world, excluding Japan. Ditto for prices versus rents, whereby Canada and Australia are twice as dear. Still, only twenty years ago Britain was cheap on this measure and recently a parking space in London’s Knightsbridge went on the market for £300,000. The two other places to look for evidence that inappropriate policy is beginning to overcook things are equity markets and domestic services. The insanity surrounding Japanese stocks during the late 1980s is legendary (see box) as were the shopping habits of salarymen and their wives. Nothing in Germany comes close for the time being. But there are some worrying signals that have been mostly ignored amidst the recent clamour over weaker economic data. For a start the German stock market’s DAX Index hit an all time high in June and despite rolling over recently is up 80 per cent since the euro-wobble in 2011. Over three years German shares have easily matched the surge in world equities while returning a third more than UK stocks, for example, in local currency terms. Up until last month the forward price/earnings ratio of the DAX had doubled since late 2011. Again, few would venture that German companies are expensive. For example, a current valuation of 12 times forward earnings would have been laughed out of a Ginza nightclub a quarter century ago. That said, a €6bn market capitalisation for Rocket Internet (despite having no profits) following its Frankfurt initial public offering last month shows Germans investors are as susceptible to craziness as anyone else. Naturally, if policy is too loose for too long then eventually there will be more fun and games to be had in catering for domestic punters than making things that can be sold in foreign Property prices are surging in Germany at the moment Some worrying signals that have been mostly ignored amidst the recent clamour over weaker economic data Konzept 2425 Germany—lessons from a rising sun But the truth remains that few ever recognise the early stages of exuberance as attention is typically being diverted the other way. Konzept 2627 Germany—lessons from a rising sun markets. So it is that even after the subdued mood over the summer services confidence survey levels remain four times higher in Germany than for the eurozone as a whole. A broader consumer sentiment survey has been rising almost continuously since the crisis and almost pipped the 2006 peak over July and August. To be sure the domestic mood has soured in the last couple of months and there is no doubt Germany is being buffeted by a slowdown in the rest of Europe and in emerging markets as well as by issues closer to home such as Russia. And it may be that the sparks required to ignite a good old fashioned asset price boom are simply not hot enough to counter the chill from external economic and geopolitical forces. But the truth remains that few ever recognise the early stages of exuberance as attention is typically being diverted the other way. Today European policymakers are going all-in to shore up their common project with an intense and singular focus on not replicating the mistakes of Japan’s two lost decades. There is a better than even chance they will succeed. Those investors positioned for dusk across Germany should be watchful lest the sun is actually rising instead. At its peak Japan’s equity market constituted 42 per cent of global market capitalisation and Toyota was making more money from trading derivatives than selling cars. Shares in the elite Industrial Bank of Japan rose sixteen fold between 1984 and 1989 to a price/earnings ratio of 170 times. It did not matter that IBJ’s free-float was just four per cent – a $130bn market cap ($250bn today’s money) transformed its appetite for risk. Infamously, IBJ got involved with Osaka hostess-turned- restaurateur Nui Onoue, who channelled stock tips to her sponsors via a giant ceramic toad in weekend séances. The “Dark Lady” became the world’s largest individual speculator until the market collapsed and the $20bn she had borrowed was found to have been fraudulently obtained. She took down the bank’s chairman and two small lenders, ending up with a twelve-year jail sentence and personal debts exceeding $3bn. Property prices were out of this world. With Tokyo fast becoming an international financial centre, it was claimed that 250 super high-rise buildings would need to be built. Prices were marked up to the point where the capital’s landmass was worth more than Canada and the value of its Imperial Palace grounds – which you can run round in about 40 minutes – could buy the entire state of California. The government’s Management and Coordination Agency valued Japan’s land at ¥2,000tn – $15tn at the time, or about four times that of the US with twenty-five times the area. In a Japanese version of tulipmania, golf club memberships were traded like stocks. Koganei Country Club to the west of Tokyo cost over $3m to “join”, plus green fees. Organised crime could not resist getting in on the act. Ibaraki Country Club turned out to have minted around 52,000 subscriptions rather than the 2,830 officially sanctioned. The urge to splurge pervaded every facet of life and reached across the globe in the form of tourist spending and the acquisition of trophy assets, some of which were national icons. Naïve students embarked on the study of Japanese as a short-cut to riches. Then when the Bank of Japan called time and the bubble began to deflate, everyone watched in disbelief as layer upon layer was painfully peeled back and the mess of what had really been going on became plain for all to see. Now that’s what I call a bubble Konzept 2829 Germany—lessons from a rising sun Just as there is a risk investors fail to apply the lessons of pre-bubble Japan to Germany, there is a danger that Japan’s post-bubble era is ignored by the likes of China and South Korea. No doubt both countries would still love to see themselves as rising suns. The latter’s economy is forecast to grow 3.6 per cent this year, a pace many countries only dream of. China’s economy is still expanding at twice that rate. Yet Japan’s experience remains the perfect warning of what happens when hitherto successful catch-up models mature, impeding future growth. Stuart Kirk, James Malcolm, Bilal Hafeez China and South Korea— lessons from a setting sun Konzept 30Konzept31 China should be first to heed Japan because it shares so many bubble-era parallels. Eye-popping statistics for starters. For example China poured more concrete in a three-year building period post-2008 than the US did over the entire 20th century – and since the global financial crisis has extended new credit equivalent to the entire US banking system. As with Japan’s boom years, capital expenditure has contributed nearly two-thirds of China’s output growth. Indeed, China is ahead in terms of investment as a share of national income (nearly a half versus 30 per cent in Japan) and corporate leverage (more than 200 per cent of output versus 100 per cent, respectively). Sure, China is in an earlier stage of development than Japan was in the 1980s, but the pace of growth has been staggering by any yardstick. Both countries share a history of financial repression too. Direct interest rate caps as well as a lack of alternative investment products made credit for investment abnormally cheap. Yet the real surge in Japanese spending in the late 1980s was primarily warrant-financed, which rendered capital all but free as the stock market surged. Similarly for China it was the eased access to off- balance sheet lending in a bid to offset the effects of the global financial crisis that made credit super-abundant. In both cases borrowers went berserk investing on the basis of extrapolated growth trends, insisting that Pax Japonica or the New Chinese Century made conventional comparisons inappropriate. The only fear was of being left behind. But regulators in Japan called time at the end of 1980s – as they have done in China. And a similar chain of events is now being played out. Growth in Japan slowed, revenues were hit and debt payments were missed or rescheduled. Creditors pulled back and firms retrenched. Trust was imperilled by a lack of transparency, as policymakers kidded themselves they were acting in the national interest by withholding the true scale of the problem. Policy supports were piecemeal and economic forecasts ratcheted steadily down to the point where recovering to even relatively recent growth rates seemed fanciful. Sound familiar? Whereas China’s economy expanded by more than 14 per cent in 2007 and 10 per cent as recently as 2010, the consensus for next year is just seven percent. Prior to 2012 the last sub-eight per cent growth came in the wake of the Asian financial crisis – and to find a number below seven one has to go back to the post-Tiananmen (circa four per cent) dips. Further weakness seems inevitable with China’s property market having cracked and negative wealth effects spilling over to consumers and borrowers. Large real estate overhangs tend to breed prolonged downturns as excess capital stock takes so long to use up. What does it all imply for sustainable levels of Chinese activity? Potential growth is neither directly observable nor an objectively derived bottom-up number. It reverts to realised growth and not vice versa. In Japan’s case, potential growth was pegged at around four per cent in 1990, 2.5 per cent in 1995, one per cent in 2000, and only half of that by 2010. Hence a good outcome for China in a couple of years may not even top five per cent. (Those worrying about social stability should remember that labour- intensive services jobs have overtaken manufacturing jobs and that the overall workforce is shrinking.) Chinese policymakers recognise all of this and are surely better prepared than their Japanese counterparts were. Beijing also benefits from a strong leader who seems up to the task of taking on vested interests and making hard choices. Plus China has a large stock of state assets to sell via the promotion of mixed- ownership enterprises and more open capital markets. But as in Japan’s case there will be no ultimate resolution without major debt write-downs. South Korea seems prosaic by comparison with China, and merely risks slipping into a Japanesque post-industrial funk. Over the past 50 years South Korea has followed the classic state-led development model under a series of five year plans initiated by the current president’s father, Park Chung-hee. As the author of the economy’s plans, Park observed Japan’s model, amongst others, and its focus on industrial development and exports. So his daughter Park Geun-hye, might do well to learn some lessons from Japan’s deflationary period. People forget how recent South Korea’s growth spurt was. As late as the early 1970s South Koreans were still poorer than their North Korean neighbours and did not live as long. Yet as cheap government-sponsored financing and technology transfers facilitated the rapid development of sectors such as steel, chemicals, shipbuilding, autos and electronics, an economic miracle to rival Japan’s took place. The country experienced one crisis with events sparked by Thailand’s devaluation in the late 1990s. But following an IMF package South Korea implemented a series of debt write-offs and structural reforms while benefiting from a strong pickup in external demand. Its private sector took up much of the slack from Japan’s demise, and now boasts some of the world’s biggest players in shipbuilding, electronics and cars. But just as the world was becoming accustomed to Gangnam rap and Galaxy phones, cracks in this successful growth model appeared. Blue-chip stock prices have dropped like stones with Samsung Electronics down a quarter over the past year and Hyundai Heavy Industries 80 per cent below its 2011 high. Their core markets are plagued by overcapacity such that aggressive investment and expansion strategies have become a liability. This is a product of weak global demand, US and Japanese competitors staging a comeback and Chinese and Indian upstarts wresting low- end market share. China should be first to heed Japan because it shares so many bubble-era parallels South Korea seems prosaic by comparison with China Konzept 3233 China and South Korea—lessons from a setting sun But just as the world was becoming accustomed to Gangnam rap and Galaxy phones, cracks in this successful growth model appeared. Konzept 3435 China and South Korea—lessons from a setting sun Samsung Electronics, for example, sits atop $60bn in cash, almost twice Apple’s pile, has a workforce three and a half times the size of Apple’s yet has a market capitalisation just over a quarter its US competitor’s. Restructuring, which is to say downsizing, is a foreign solution – although corporate cousin Samsung Heavy Industries is exploring just this route. The same goes for bigger share buybacks or dividend payouts. These are usually rejected on the basis that management remains on the lookout for acquisitions and investments in order to expand. Such problems are feeding a sense of existential crisis in Korea. Sentiment has not fully recovered from April’s tragic Sewol ferry disaster, which highlighted broader issues such as the use of unsupervised irregular labour, cosy state-chaebol relations and irresponsible media reporting. Demographics increasingly invite unhappy parallels with Japan. Meanwhile South Korea’s central bank has undershot its 2.5 to 3.5 per cent inflation target for 27 months – the latest release was 1.1 per cent. No wonder a new finance minister has warned that the economy is falling into a low- level equilibrium. He means to beef up a recent $40bn stimulus package and press the Bank of Korea for further rate cuts. While Korea has significant scope to respond with conventional policy, Japan’s experience warns against being half-hearted. (More recently Prime Minister Abe has shown the advantages of comprehensive, coordinated and simple goals.) Parknomics made a fleeting appearance earlier this year, vaguely defined as “market economics with a human face.” But it was soon dropped as the president, Park Geun-hye, sought distance from her Japanese counterpart to play the wartime-victim-versus- unrepentant-nationalist card. Park’s preference today is to talk up reunification as an inevitable, even imminent, “bonanza”. Hence the myriad preparation committees, infrastructure plans and exploratory financing requests. It is a worthy goal, but it is hard to see how reunification will solve South Korea’s problems quickly. Besides, the topic does not have much resonance with the country’s youth and much hinges on the capricious leadership up north. As with China there are many lessons to learn from the period when the sun started to set on Japan. But it is harder to imagine how South Korea can be provoked into a dramatic reorientation against the dying light. Life is simply too comfortable as yet. Demographics increasingly invite unhappy parallels with Japan Japan’s past is useful to help understand the likes of Germany, China and South Korea – if not in the way people sometimes think. But there are lessons we can all learn from watching where the country is heading now. For example, Japan’s future may help answer thorny questions such as: How serious is secular stagnation? Can lost growth be recouped? Should countries pursue active fiscal solutions or are large state debts mere accounting identities? And is the relationship between demographics and growth ultimately deterministic? There are good reasons for hope. Japan has swung from utter seclusion to extreme openness, from authoritarianism to liberal democracy, from rags to riches and from despair to exuberance. And then often back again. In a consensus orientated and relatively homogenous society, when people embrace change they do so suddenly and overwhelmingly. The trigger is typically a run of extreme or traumatic events. Thus it took less than two decades to transform the country from feudal to modern after Commodore Perry forced it out of 200 years of isolation in 1854, and the same span to revive phoenix-like from World War II. The path to Abenomics was paved by twenty years of deflation, policy paralysis and social angst. But it was only the triple whammy of global financial crisis, Tohoku earthquake and Senkaku / Diaoyu Islands spat that finally seemed to shake the nation out of its hopelessly resigned, almost catatonic state. Shinzo Abe re-emerged as the right man in the right place, articulating by a carefully crafted ‘third way’ forward that broke the country’s twenty year Keynesian stimulus – Schumpeterian creative- destruction impasse. It played up the parallels by which under Korekiyo Takahashi Japan beat deflation in the early 1930s and offered a new source of hope. Two years on, Abenomics really is paying dividends. The spectre of deflation has been dispelled, corporate profits have revived, wages are increasing and capex is increasing. Consumers are tentatively spending more, and individual investors have rediscovered some of their animal spirits. Corporate management has been pressed to put more emphasis on efficient capital management, especially since the real return on cash is deeply negative. And the government is now encouraging a wholesale portfolio shift for public pensions into equities and foreign assets. There is a long way to go. But equity valuations are still compelling in absolute and relative terms. If there was ever a time to back Japan, this is it. Japanese lesson: future perfect? Konzept 3637 China and South Korea—lessons from a setting sun The first and foremost principle of new banking regulation is now clear: taxpayers must not be subordinated to bank creditors. Hence contingent convertible (CoCo) bonds came into the world by regulatory fiat to contribute to the solution of the “too big to fail” problem. These instruments behave like ordinary bonds most of the time but may take a greater hit than equity if the issuing bank falls into distress. Together with a statutory resolution framework that allows for the bail-in of general creditors, CoCos help prevent the most egregious transgression when dealing with failing banks – a public sector bail-out. Michal Jezek, Jean-Paul Calamaro The contours of CoCo land Konzept 38Konzept39 In that respect it should be welcome news that CoCos have become such a prominent asset class in a relatively short span of time. Yield-starved investors flock to them in search of returns, and issuers like CoCos because they allow the building up of regulatory capital far below the cost of equity. Is there a catch? This article provides an overview of the asset class and summarises the findings of our proprietary CoCo pricing framework. CoCos are bonds structured to absorb losses on a going-concern basis by converting to equity or by being written down. This happens when a bank’s capital ratio falls below a contractually specified trigger level or when the authorities determine that the bank is not viable. While this may sound simple enough, CoCos are in fact highly complex securities. There are four main reasons for this. The first problem is that a bank’s capital ratio is not observable very frequently. Typically capital ratios are updated only quarterly when results are reported. Some CoCos may even have multiple triggers related to different measures of capital, although extra triggers are usually less likely to matter. Second, the CoCo feature can be added to bonds issued at various points in the bank’s capital structure. Normally, these are traditional capital securities: Tier 1 bonds, which are perpetual instruments with discretionary coupons, and Tier 2 bonds, which have a maturity date, mandatory coupons and rank senior to Tier 1 instruments in insolvency. Third, CoCos may have a high trigger (typically 7.0 per cent) or a low trigger (typically 5.125 per cent). Fourth, there are various trigger types. Some CoCos convert to equity, others have full or partial principal write- down. Write-down may be permanent or temporary, with the latter allowing for discretionary write-up. If they are so complicated, why bother? CoCo bonds were created largely as part of the global overhaul of banking regulations (Basel III) in the aftermath of the financial crisis. Before the crisis, regulators and investors had relied on subordinated hybrid securities (now known as “old-style” hybrids) to act as going-concern capital and absorb losses in times of distress. Those securities, however, proved woefully inadequate in the crisis, and the public sector had to come to the rescue of failing institutions. Thus came about new hybrid securities – additional Tier 1 (AT1) CoCos. Unlike old-style Tier 1s, AT1s provide loss absorption via both principal conversion or write-down and discretionary coupons. Additionally, banks in some jurisdictions, such as the UK or Switzerland, issued Tier 2 CoCos for domestic regulatory purposes. In most of Europe, however, banks have no incentive to do so. Thus, AT1 instruments, which are firmly embedded in Basel III regulations, will come to dominate the European CoCo market. That said, relative to other types of bank debt the CoCo market is still small. At the end of the third quarter of 2014 there were over €50bn of Tier 1 and €25bn of Tier 2 CoCos issued by Western European banks. This compares with over €1tn of covered bonds, €3tn of senior unsecured bonds, €300bn of plain vanilla Tier 2 bonds and €160bn of old-style Tier 1 bonds. However, the future growth of the CoCo market is predetermined by regulators. During the Basel III phase-out period from the start of 2014 to the end of 2021, grandfathered old-style Tier 1s will be gradually replaced with AT1s. Hence the AT1 market gathered pace in recent quarters as regulators finally provided clarity about eligibility requirements and ruled on the tax deductibility of interest. After the summer hiatus, AT1 issuance restarted in September with Santander, UniCredit, Credit Agricole, HSBC and Nordea deals. The latter two provided a further boost to the asset class. This is because new issuers entered the market, allowing for greater diversification, and the bonds were rated investment grade for the first time, thus attracting a new class of investors. The ultimate size of the AT1 market is expected to exceed €200bn, growing by about €30bn a year. Still, the broad investor community remains polarised in its views of CoCos given their novelty and complexity. While many investors are driven away from this asset class by its potentially disastrous pay-off, many others are rather indiscriminately attracted by its high yield and perceived unlikely downside. Which view is right? Neither, as it happens. The pricing of CoCos is ultimately about differentiating between various tail risks and thus requires a valuation methodology that properly accounts for all the diverse features of these securities. A good place to start when pricing CoCos is to ask – are they closer to credit or equity? The short answer is that they are (hybrid) credit instruments with equity-like behaviour in distress. Thus, a balanced assessment of the mixed risks is needed. On the one hand, some fixed-income investors stay on the sidelines because they see CoCos as equity rather than debt. Such perceptions erect a fairly artificial barrier to entry since in the age of the bail-in investors may end up owning equity anyway, even if they buy a plain vanilla bond. On the other hand, there is a reason why caution is advised with respect to this new asset class. The market is yet to be tested with a CoCo being triggered or even just trading close to its trigger. The complexity of the instrument combined with low frequency of capital ratio reporting could give rise to stressed market conditions with challenging mark-to-market volatility. A mere worry that such an event is imminent could make the market overreact. Another pricing issue specific to AT1 CoCos is the non- payment of coupons. In the new regulatory environment this presents a far greater risk than was the case for old-style Tier 1 bonds. Banks that operate inside regulatory capital buffers face restrictions on distributions. In fact some buffers specific CoCos are in fact highly complex securities The broad investor community remains polarised in its views of CoCos Konzept 4041 The contours of CoCo land to individual banks (so-called “Pillar II”) are generally not even disclosed, thus presenting an extra layer of uncertainty for investors. As Basel III capital buffers grow from transitional to fully loaded levels, this risk of coupon skipping will increase. If history is any guide investors seem to underestimate the magnitude of losses that banks incur with each crisis. One only needs to look back at the previous decade to see that bank losses can mount up rapidly and exceed the current buffers to CoCo triggers. This often happens unexpectedly, allowing little time to take action that would prevent capital ratios from falling below a critical level. Recently, for example, SNS Bank provides a telling story of how swift such deterioration can be. SNS Bank reported a Core Tier 1 ratio of 9.6 per cent in the second quarter of 2012, stating “EBA capital shortfall SNS Bank NV fully addressed” [sic]. Half a year later, however, the bank was nationalised. Equity holders and subordinated creditors were expropriated, recovering nothing on their investments. Let the CoCo buyer beware. Another crucial element to pricing CoCos is the trigger level. This is a critical feature of these securities. Together with the trigger type (conversion, temporary write-down or permanent write-down), the level determines the risk of losing your principal. However, some qualifications are needed. While high-strike CoCos should nearly always trigger before the bank reaches the point of non-viability, low-strike CoCos are considered “close” to the point of non-viability and hence will sometimes fail to trigger before resolution is imposed. In that case, CoCos will be treated as if they were plain vanilla bonds in a bail-in. The effective trigger is thus higher than the low stated trigger. In short, the difference between high-trigger and low-trigger CoCos in practice is less than the distance of the triggers might suggest. Thus with so many different characteristics it is important to compare apples with apples when pricing CoCos. Valuations must consider the diversity of features as well as the above caveats. Our own approach prices CoCos based on the pricing of vanilla subordinated bonds, the trigger level, trigger type and the bank’s (contingent) capital structure. It also allows the extraction of market beliefs from prevailing prices, such as the implied expected value of shares upon conversion. This information is useful in making valuation judgements. Such a framework also helps explain the relationship between CoCo and equity prices by showing how fair CoCo pricing changes with the trigger level. In the extreme, a permanent write-down structure is fully subordinated to equity in distress and so the triggering (effectively debt write-off) translates into a windfall profit for shareholders. The closer the trigger is to the current capital ratio, the higher the chance of such a wealth transfer from CoCo investors to equity investors. At very high trigger levels, the fair CoCo bond What is more, if history is any guide investors seem to underestimate the magnitude of losses that banks incur with each crisis. One only needs to look back at the previous decade to see that bank losses can mount up rapidly and exceed the current buffers to CoCo triggers. Investors seem to underestimate the magnitude of losses A permanent write- down structure is fully subordinated to equity Konzept 4243 The contours of CoCo land At the macro level, AT1s recently underwent a sell-off of nearly 1.7 percentage points in yield terms from early June’s lows. This widening has only partly retraced. Arguably, the repricing has brought the asset class to a healthier state. As expected, the long-awaited Asset Quality Review and Stress Test have finally introduced greater transparency and comparability into European banking, removing some uncertainty weighing on bank credit investors. The AT1 market is sending a clear message to issuers – the cost of contingent capital is far below the cost of equity. Given the long-run cost of equity of around 12 per cent, the cost of AT1 capital is currently more than five percentage points lower. Unlike dividends, AT1 coupons are tax deductible and so AT1s become even more attractive after tax. Thus, filling the required AT1 capital bucket with higher-grade equity capital may be legitimate but comes at a hefty price. The optimal bank capital structure includes AT1s, and that will drive CoCo market development. If you are interested in more details, please go to gmr.db.com or contact us for our in-depth report “dbCoCo: A New Strategy and Valuation Framework for CoCo Bonds”. yield might well exceed the cost of equity. Equity absorbs losses before CoCos but this reverses once the capital ratio falls below a critical level. With CoCos, the traditional creditor-shareholder pecking order is no longer ironclad. And in some cases this might extend to cash distributions as well. Under Basel III, AT1 coupons must be fully discretionary and so-called dividend pushers (obligation to pay coupons if dividends are paid) are disallowed. In the European Union, unlike for example Switzerland, the same applies to so-called dividend stoppers (obligation not to pay dividends if coupons are not paid). While banks may state it is their current intention to respect capital structure hierarchy when making distributions, they must make clear that the policy may change at any time at their discretion. Thus, AT1 holders could become subordinated to equity holders when it comes to payouts. Issuers’ reputational concerns are AT1 investors’ best (and only) friend if dividend stoppers are not present. Do investors fully understand the risks around CoCos and are they prepared to bear potential losses? In some areas regulators have decided to pre-empt a potential misunderstanding. For example, the UK Financial Conduct Authority designated CoCos as “highly complex” and imposed a temporary 12-month ban on their distribution in the mass retail market. Thus, financial firms can now distribute CoCos only to professional, institutional and sophisticated or high net worth retail investors. The Danish regulator has taken similar steps. In social and political terms, (direct) retail investor pain is hardest to bear. Remember the upheaval when haircuts had to be imposed on retail investors into Bankia’s subordinated bonds? Considering all the above, are markets pricing CoCos correctly? Our framework suggests that there is currently not enough discrimination between CoCos based on their specifications and capital structures of their issuers. More specifically, some high-trigger, permanent write-down, Tier 2 bonds look significantly overpriced. Investors underestimate the principal loss risk of these aggressive structures, apparently taking false comfort in their Tier 2 designation. In addition, CoCo spread curves are too flat and should steepen. This phenomenon is largely a reflection of the current “reach-for-yield” environment. Also note that major Swiss banks have built up large CoCo buffers to comply with the national regulatory regime. The pricing of their subordinated vanilla credit does not fully reflect the enhanced protection these CoCo buffers now provide. Are markets pricing CoCos correctly? Konzept 4445 The contours of CoCo land Progress in computer technology has been so rapid that many feel it is a new world. Germany’s Chancellor Merkel famously referred to the internet as terra incognita (Neuland) earlier this year when confronted with the Snowden revelations. There is a widespread belief that new technologies pose new threats. That belief is wrong. Alexander Düring Cyber insecurity Konzept 46Konzept47 According to legend, famous mid-20th century bank robber Willie Sutton explained that he robbed banks “because that is where the money is”. If Slick Willie were around today he would be breaking into computers because that is where the money is now. Likewise, Francis Walsingham (1532-1590), spymaster to Elizabeth I, would not today be opening and decoding other people’s letters. He would be breaking into their computers because that is where the information is. Theft and espionage are not new. Every person and every organisation have had to protect themselves from these risks for a long time. One morning around 20 years ago a German bank branch was robbed. The thieves only took bags of bank statements. But in doing so they obtained the home addresses and bank balances of clients in an expensive part of Berlin. That kind of information is valuable because it takes the guesswork out of housebreaking. Today, such information would be obtained through phishing (see box). But one thing the internet has changed is that there are new lines of attack. A thief might come into your house through your door or through the window. That has been the case for centuries. Nowadays he might also come through the Heartbleed bug (see box) via what you thought was a secure connection. Computer technology has also shifted the cost-benefit ratio of theft. Robbing a bank in Willie Sutton’s day involved weapons, maps, masks and getaway cars. Today it can be done more cheaply from a thief’s own home. Also, more data is held in electronic form so breaking into a corporate database yields more information. Theft has therefore become more economically attractive than it used to be. However, this is a quantitative shift, not a qualitative change. What should we do about cyber-crime? The first step towards security is to realise that there is a threat. Most people assume that someone wants to steal their wallet. Fewer people seem to assume that someone might want to access their photos on iCloud. The “it won’t happen to me” school of risk management is the single biggest risk factor for technology infrastructure. When accounts are broken into, unsecure passwords and pins are the most likely cause. Phishing and spear-phishing are tricks that con artists of the Willie Sutton vintage would recognise. The Stuxnet worm (see box) deployed against Iranian enrichment plants may have been technologically advanced but the basic strategy was invented by Odysseus at the siege of Troy: persuade gullible individuals to grab what they think is a cute freebie. The standard assumption for managing cyber attacks should be to assume that you will be attacked, and that the attack will be successful. Knowing that all your data can be stolen and misused helps you concentrate on important questions. They are: — What is my data worth to me? — What and how much data do I need to keep? — If I have to keep data, does it have to be in a place that has a link to the internet? — How much of a loss is data destruction versus data becoming public? The only way to secure data permanently is to destroy it (indeed, the same is true for physical property). Deciding how much data to keep in the first place is therefore the most crucial choice in data protection. Even when data is stored for a long time, it may not have to be accessible quickly. Data on a tape library is slower to access and therefore safer than data on a hard drive. Data on a tape on a shelf in a strong-room is safer than data in a tape library. Human weaknesses aside, the risks on the internet fall into a few distinct groups: Some locks look sturdy but can be broken easily due to a design fault. Early bike locks made from super-hard steel could be shattered easily when cooled down using a standard icing spray. The Heartbleed and Shellshock bugs were the equivalent design failures in technology. It is extremely hard for normal users of technology, including large institutions, to be aware of all the potential flaws in all the software that is being used. The only remedy is to reduce the amount of data that is accessible (regular deletion exercises where possible, use of tape libraries, etc). Break- ins can sometimes be detected through the use of honey traps (made famous by Clifford Stoll in 1986 to catch hacker Markus Hess – see box), but this is not a game that a large organisation can win. Any big company will have so much interesting data that an intruder will have trouble finding the honey trap among all the real honeycombs. Even the best locks on the front door are useless when the back door is left open. As well as openings due to technical flaws a corporation may have other entry points that are accessible to outsiders. The definition of open in this context is connected to the definition of outsiders. A microwave radio connection is open to everyone within the beam range. A physical telephone line is open to everyone with the inclination to get into a cable tunnel. A submarine data cable is probably open only to state actors. For all practical purposes, the internet is open, if sometimes only due to technical flaws in network infrastructure. Open networks can be secured by closing them where possible, and using them as little as possible. Physical separation of important data from open networks is the only reliable protection. Preventing legitimate users from opening networks, for example via BYOD (see box), is an important corollary. Flawed technology Open networks Konzept 4849 Cyber insecurity Your house will be safer from intruders if you lock internal doors. Although costly to implement, it is useful to design internal connectivity along the lines of “form follows function”. Not every machine needs to be able to access every other machine using every possible protocol. Locking down access with internal firewalls adds to the security provided by logins, encryption and the like. Because internal firewalls are only as good as the router software is safe, it is important to back them up with restricted physical cabling where possible. Leaving ten credit cards lying around the house means that the theft of any one threatens your bank account. Unlike physical items, data can be copied without degradation. This sometimes creates the temptation to hold multiple copies of the same data in different places. But because each of these places is at risk of being attacked, multiplying storage places means multiplying attack risks. This is the core risk of cloud computing. Data in the cloud is replicated across multiple systems, sometimes maintained by different entities. Failure to protect the data in any one place will expose it. Because multiple entities are involved, defence strategies and attack vectors are more likely to be uncorrelated so the risk of exposure scales almost linearly. Big Data in the cloud would seem to contradict all these ideas. It does not have to. Yes, keep big data repositories, but keep them away from the front office and have one-way feeds into them. Keep communication lines in and out of these repositories narrow and tightly controlled. Yes, use cloud technology but isolate the cloud from other systems. In theory, encryption is the solution to communication over open networks. In practice, the picture is more complex. True end-to-end encryption is rare and runs into legal obstacles in some jurisdictions. Most encryption setups are therefore vulnerable at some point along the information chain, be it on mail servers, terminal connections and so on. Note that even encrypted information transfers may reveal important metadata, like sender or receiver, or subject lines or filenames. Even the timing of a data transmission can provide clues: the time zones of senders, for example, or the correlation of messages with political events. Furthermore, so-called side channel attacks (see box) can recover encrypted information from seemingly unrelated data such as the power consumed in decrypting it. Excess connectivity Excess replication In theory, encryption is the solution to communication over open networks. In practice, the picture is more complex. Konzept 50 51 Cyber insecurity BYOD (Bring your own device): Firms allowing employees to use their own personal devices for work purposes. Heartbleed bug Implementation error discovered in the OpenSSL library, a very common implementation of the secure sockets layer security protocol. Honey trap A machine that is designed to attract and trace a hacker, using supposedly interesting data as bait. One-time pad Cypher code that is used only once, thus evading attacks based on statistical analysis. Phishing Obtaining confidential information through deceit such as fake emails or websites. Shellshock Bug discovered in the bash command line interpreter commonly used in various UNIX systems including the Mac OS operating system. Side-channel attack Attack of a supposedly secure communication using information other than the communication itself (for instance, using laser measurements of window vibrations to recover the sound of a conversation inside a building). Spear-phishing Phishing attacks targeted at specific firms or individuals using information about the target obtained earlier. Stuxnet Worm discovered in Iranian centrifuge plants. Worse still, codes are breakable. Side channel attacks typically require close physical proximity, but encryption may be broken anywhere if the codes are weaker than believed. Very few people on earth can truly claim to understand all aspects of code security. While there are encryption methods like one-time pads (see box) that are absolutely safe, they are not practical because they require as much information on a secure separate channel as the information going along the encrypted line. There have been suggestions that several pseudo-random number generators (the poor man’s one-time pad) have been deliberately compromised at the behest of governments. While most people would be unable to exploit the vulnerabilities thus created, it is not a safe assumption that all who can are government-related actors. Encryption should therefore not be assumed to be completely safe. There is no perfect safety of information assets. The best start to preventing data from getting stolen is to assume that it will be. Before data is copied, assume that the copy will be compromised – is the convenience of that copy worth the risk? If data is kept, assume it will be stolen – is it worth keeping that data around? If data is easily accessible to insiders it will be easier to access to thieves – is the easy access really necessary? Keeping data secure is no different from securing cash. Carry just what you need and lock the rest in a safe. Tech terms Konzept 5253 Cyber insecurity A year ago former US Treasury Secretary Larry Summers floated the possibility that the US economy could enter so-called secular stagnation. Since then the term has entered the vocabulary of economists and market participants. Yet there remains much disagreement over whether America has entered secular stagnation. Representing opposing views on the topic, Dominic Konstam , head of US rates strategy, and Torsten Slok , chief international economist, agreed to debate secular stagnation in early October. Alan Ruskin , co-head of FX research, was in the chair. The big debate—secular stagnation Konzept 54Konzept55 Alan: Secular stagnation means a lot of different things to different people. What does it mean to you? Torsten: My sense is that people think growth of around two per cent in the US means the economy is suffering from secular stagnation. The problem with this rule of thumb is that growth has indeed been around two per cent, but potential growth has only been around 1.6 per cent in recent years. So, growth is low and definitely less than the three per cent where it was before the crisis. But two per cent is still enough growth to lower the unemployment rate. It’s not stagnation. Dominic: I think there is a little more to it, and people like Larry Summers are still trying to define it themselves. But my sense is that secular stagnation is best defined as a situation in which you need more and more monetary stimulus to maintain a constant level of growth. That easing then feeds imbalances that create a financial crisis, such as in Asia in 1997, in Russia in 1998 and in the housing market in 2007-08. But the monetary stimulus interventions in leading up to those crises didn’t actually change the underlying average growth rate of the economy much. So secular stagnation is a dangerous state that needs ever- increasing monetary stimulus that at best maintains growth, whilst significantly increasing the risk of a financial crisis. Alan: So do you think that growth will be lower than the past? Torsten: Well, there is a modest downward trend in the labour supply thanks to demographics. But what is underappreciated is that the other components that drive GDP growth, namely capital and productivity, could offset this negative contribution. Productivity growth being low forever is not my forecast, nor is it the Congressional Budget Office’s nor the Social Security Administration’s, nor the Fed’s. If anything, they all see a rebound in productivity. Growth has been low of late because we had a huge crisis. Cleaning up the banking sector takes a long time, cleaning up the housing market takes a long time, and cleaning up the household sector takes a long time. Already, housing looks a lot better. We have fewer foreclosures, fewer distressed sales and fewer short sales. Likewise consumer balance sheets look a lot better because asset prices have gone up, partly thanks to the Fed and most importantly because house prices have rebounded. Now that these components and sectors of the economy are more in balance, we will start to see growth accelerate. Dominic: I think there are important issues with the growth story. We all agree that labour force growth is very low. But I am not sure this is so relevant to the secular stagnation debate, since it will also lead to lower demand growth and hence be inflation-neutral. I think the issue is more on the productivity front, where we have become less productive through time. It could be we are less technically innovative or that there is a lack of confidence restraining investment. And obviously there are a lot of external drags. Average productivity growth since 1972 has been about 1.5 per cent. Since the crisis, we are running at one per cent and recently running less than that. We are well below even disappointing trend growth. That may well be due to a hangover from the de-leveraging shock. I agree with Torsten that this will improve. But even if investment increases by 10 per cent annually, it does not look like productivity growth will go much above where the CBO currently has a trend, which is between 1.7 and 2.0 per cent. So we still have an uninspiring story. And if you then layer on an inflation target at two per cent that we assume the Fed is going to meet, we are left with a relatively uninspiring nominal growth story. After getting used to nominal growth rates well above four percent in the past, will the economy adjust well to lower nominal rates? I don’t think so, and that’s the issue. Alan: OK, then let me ask where the equilibrium real interest rate should be. Torsten: Clients think that secular stagnation equates to rates being low forever. But because the labour market is getting tighter, if the unemployment rate is falling we are getting closer to full capacity. At some point we will cut through full capacity and see inflation. So the challenge to those who believe in secular stagnation is whether we can see inflation with low growth. I would say yes, and therefore rates will not be low forever. Still, I would assume that the neutral fed funds rate is now close to 3.5 per cent, while it used to be more like 4.5 per cent. Dominic: I’ll shade that lower, say 2.5 to 3.0 per cent. What needs to be taken into account is the underlying labor force: is it growing or shrinking? Think of a country like Japan. They end up having a lower neutral rate because of their employment dynamics compared to countries with similar inflation and unemployment levels. The Cleveland Fed published a paper in February that showed how the Fed reacts to employment growth itself. The funds rate tends to be higher when employment growth is strong rather than weak. Thus looking ahead, unless productivity is zooming when we hit full employment, jobs growth should slow down to say a hundred thousand, possibly even less. And all else being equal, policymakers will think there’s full employment Konzept 5657 The big debate—secular stagnation and that inflation has hit the target, but that jobs growth is still only 100,000. I strongly feel that in that state the Fed will be comfortable with a lower funds rate than when we had jobs growth running at 200,000. Alan: Dominic, can you tackle what you hinted at earlier, which was Larry Summer’s idea that we are building up additional financial instability that will impair growth? Dominic: Going out of your way to repair balance sheets in principle sets you up for normalisation of things like labour market slack. But because there is a tendency to expect potential growth not to improve anytime soon, greater monetary accommodation is a given. At the same time, we are hard-wired for much higher nominal growth; just look at all the unfunded liabilities in the system. So people are hoping for nominal returns that are significantly higher than what a 3.5 to 4.0 per cent nominal potential growth rate can deliver, and they consequently take more risk. The 2000s are a great example, when not only US but also overseas investors loved US collateralised debt obligations because they were desperate to get higher nominal returns to compensate for their own problems. That in itself exacerbated monetary accommodation and fuelled the next crisis. Alan: Which raises the question, is there a bond bubble? Dominic: There is one in credit. You can look at the rally in high yield bonds and say that it’s gone way too far given that the probability of a growth slowdown has increased. But because volatility is still low, thanks to Fed-induced complacency, investors have gone into what we call the enhanced carry trade, whether it is taking on more credit risk, selling volatility or being in a roll-down trade of some kind. This creates a problem if volatility comes back or the Fed raises rates, as it will create a credit event. That may not be a full-blown financial crisis, because banks are in better shape now, but it will be a problem for investors. It’s another concern raised by the secular stagnation thesis. Alan: Torsten, do you subscribe to this view? Torsten: Absolutely, there are plenty of signs that risk appetite has gone too far in the carry trade or the hunt for yield. If you look at where credit spreads have been and where they are today, you quickly conclude that they are much tighter than historical averages, for both high yield and investment grade. This means that either a credit event or the Fed proceeding with rate hikes would probably widen spreads due to today’s extreme investor positioning. That said, rate normalisation should be no hurdle to other risky assets and equities if the process is managed quite well. Alan: Earlier you brought up Japan. Is Japan the secular stagnation poster child? And what about Europe? Dominic: Japan definitely had stagnation issues. But if you think about the stimulus that creates a financial crisis, Japan never had a sufficient one, so it’s not the same. I think Europe is going down the same road as Japan. The ECB is doing the quantitative easing thing. If it is really proper QE in the end, and it really does raise asset prices, then Europe could have a similar problem as the US. But my guess is that they’re not going to achieve the same monetary expansion as the US or more recently Japan. Therefore the bubble effects would be limited. They are more likely to end up relying on negative interest rates to drive down the currency and indirectly thereby support growth. Alan: Is there much of what Dominic just said that you disagree with? Torsten: Not really. This is a rather unique situation. The US is actually recovering and about to hike rates next year while the rest of the world is, if anything, slowing down – both in the Chinese case and in Europe, whereas Japan is just wobbling. For many years we have been used to business being synchronised, but now it looks like the US will be the main engine again. Alan: There’s more agreement than I thought. Thank you both. Konzept 5859 The big debate—secular stagnation Thus further on, along the outer edge of that seventh circle, all alone I went, to where the melancholy people sat. Out of their eyes their woe was bursting forth; first here, then there, they helped them with their hands, now from the flames, now from the heated soil. Not otherwise do dogs in summer-time, now with their paws, now with their muzzles, whene’er by flees, or flies, or gadflies bitten. When on the face of some I set mine eyes, on whom the woeful fire is falling there, I knew not one of them; but I perceived that from the neck of each there hung a pouch, which had a certain color and design, wherewith their eyes appeared to feed themselves. Oliver Harvey Divine Comedy: Inferno, XVII, by Dante. Financiers in literature— written down Konzept 60Konzept61 So were usurers condemned by Dante to the seventh circle of hell, scorched by a soft rain of fire, eyes fixed downwards to the heavy coins hung round their necks. This melancholy image provides a good starting point for a discussion of financiers’ literary reputation. Dante dumps the money lenders in the same ditch as sodomites and blasphemers. This idea stemmed from Aristotle who held that money had an intrinsic value and that the charging of interest was therefore an outrage against nature. The language the Greek philosopher employed when arguing against it, (“...and this term usury, which means the birth of money from money, is applied to the breeding of money, because the offspring resembles the past...”), hints disconcertingly at sexual malpractice. 1 The association of finance with the fabricated and freakish is an enduring literary conceit. As wealth was (and still is) believed to be the product of honest labour alone, so profits from money itself must be a kind of trick. As Harold James has noted, how else can metal be turned to food or ugly old men marry beautiful young women? 2 In Anthony Trollope’s novel The Way We Live Now , the shady financier Melmotte holds a ball to embellish his new social status. Evidence of his alchemistic capacities is abundant in Trollope’s description of the occasion: “The house had been so arranged that it was impossible to know where you were, when once in it. The hall was a paradise. The staircase was fairyland. The lobbies were grottoes rich with ferns.” Of course, the imagery of bankers as conjurors is firmly entrenched in the popular consciousness. Commentators warn against the dark arts of finance, while the public wonders at the wizards of Wall Street. One of the most prominent internet memes accompanying the US Federal Reserve’s quantitative easing program was Ben Bernanke’s portrayal as the Wizard of Oz. The metaphor has also been embraced by practitioners themselves, an example being George Soros’s rather self-congratulatory title to his investment thesis, The Alchemy of Finance . In recent years, life has increasingly imitated art. The apotheosis was the run up to the recent financial crisis, in which the industry apparently plunged full tilt into the business of illusion. The construction of synthetic credit derivatives, the magicking away of credit risk by complex equations and the vast outstripping of real global output by financial assets all appear to validate the Aristotelian critique. As for the protagonists, most seem to have vanished in a puff of smoke. In literature, wizardry and magic have always been closely associated with a challenge to order and stability. The financial scandals of the late 19th and early 20th centuries provided a rich seam of material for writers concerned with rapid social and economic change. Financiers were an obvious target because they represented a usurping of the old social hierarchy. In his poem cycle, The Cantos , Ezra Pound represents finance as a practice that obscenely inverts the cosmic order: …with usura, sin against nature, Is thy bread ever more of stale rags Is thy bread dry as paper... They have brought whores for Eleusis Corpses are set to banquet At behest of usura. Canto XLV (1937) 19th century novels featuring financial scandals have themselves been seen as attempts to hold the moral failings of the declining European nobility to account. 3 The aristocrats in Friedrich Spielhagen’s Sturmflut (1876) find themselves ruined by unscrupulous foreign bankers, a consequence of their fecklessness and greed. One hundred years earlier a disillusioned nobleman had asked the great 18th century writer Samuel Johnson what had happened to the gallantry of the English aristocracy. “It is gone into the city to make a fortune,” Dr Johnson replied. 4 More recently, Sebastian Faulks used a hedge fund manager, John Veals, to illuminate the venality of London society in his post-Lehman novel A Week in December (2009). By chance, the banking scandals of the early 1870s coincided with the increasing prominence of social Darwinist theories. Just as the paternalistic ideals of the nobility were fading, so there would be little to protect the masses against the swirling economic currents of the age. It did not take a leap of literary imagination to put bankers at the top of the food chain. This is evident in the opening of Theodore Dreiser’s novel The Financier (1912), where the protagonist and future speculator is struck by an epiphany outside a fishmonger’s: “Lobsters lived on squid and other things. What lived on lobsters? Men, of course! Sure, that was it! And what lived on men? ... Was it other men?” 5 But the idea of bankers fixing it against the ordinary Joe was not a Victorian invention. In 15th century Florence, Cosimo de Medici aroused hostility as his lending became increasingly indispensible to the overstretched city state. Machiavelli complained that “he helps everyone with his money, and not only private individuals but the state, and not only Florentines...” 6 1 Politics, by Aristotle. 2 The Literary Financier in The American Scholar, Vol. 60, No. 2, 1991 by Harold James. 3 The Literary Financier in The American Scholar, Vol. 60, No. 2, 1991 by Harold James. 4 City of London: The History by David Kynaston, (1994–2001). 5 Quoted in The Literary Financier. 6 A Most Delicate Invention, London Review of Books, by Tim Parks, (2011). Konzept 6263 Financiers in literature—written down Similarly, John Pierpont Morgan found himself the subject of public opprobrium after bailing out the US banking system in the Panic of 1907. Upton Sinclair’s novel The Money Changers (1908) attacked the shadowy deals and criminal activity that lay behind the crisis. The racy style and worldly cynicism of the novel makes it an early ancestor of The Wolf of Wall Street . Literary attitudes to banker conspiracies were bound up with anti-Semitism. In the early 20th century, GK Chesterton, Hilaire Belloc, Ezra Pound and Rudyard Kipling all associated high finance with Jewish malfeasance. In 1913 Rufus Isaacs, the first Marquess of Reading and only the second practising Jew ever to serve in the Cabinet, was targeted by Kipling for his alleged role in the Marconi scandal. Benjamin Disraeli, a British prime minister, author and Jew, had probably not helped calm the paranoia by creating the character Sidonia in his 1844 political novel, Coningsby . A sort of Victorian Professor Xavier, the Jewish Sidonia benevolently steers the political events of the day from the shadows. He is thought to be based on the founder of the banking dynasty Nathan Rothschild, and on Disraeli himself. Of course, the most famous banker in all literature is a Jew. William Shakespeare’s Shylock is considered to be the singularly most unpleasant creation in an extensive list of late medieval Jewish villains, and has cast a long shadow ever since. Critics have excused Shakespeare on the basis that Shylock is less racial portrait, more moral indictment of a hated economic practice. 7 Indeed, this is precisely the order of importance in which Shylock organizes his prejudices against Antonio: I hate him for he is a Christian; / but more, for that in low simplicity / he lends out money gratis and brings down / the rate of usance here with us in Venice. The Merchant of Venice, Act I, Scene III The Jewish association with finance was historical fact, not literary invention. In Luke, Jesus teaches Christians to “do good and lend, hoping for nothing in return,” and no Biblical image represented more providential bite than the expulsion of the money changers from the Temple in Jerusalem. Christians practiced usury on pain of their souls and often their freedom. The theology was advanced by Saint Jerome, who considered the practice of finance so singularly pernicious that it could be used as a weapon against one’s enemies, which led to the questionable military tactic of Christians bankrolling the Saracens during the Crusades. 8 Yet even in the Middle Ages moral outrage rubbed along uncomfortably with the economic convenience of credit. This contradiction became more acute as the European economy expanded. Financiers were a necessary evil to build cathedrals, fight wars or underpin international trade. There followed imaginative attempts to distinguish between permissible commercial activity and damnable usury. 9 An early solution was to use the newly invented letter of exchange to hide interest bearing loans as foreign exchange transactions. Eventually there was grudging acceptance of the link between credit risk and need for lenders to charge their borrowers – the word “interest” itself derives from the Latin “intereo” or “to be lost”. What guilt remained is reflected in the multiplicity of religious commissions from repentant bankers, of which the most exquisite example is probably the Arena Chapel in Padua. Enrico Scrovegni commissioned Giotto to decorate the interior in order to atone for the sins of his banker father (also damned by Dante), and this shady past is hinted at by the prominent place Giotto attached to the pay-off of Judas in the fresco cycle. But bankers not only patronised artists, they bred them. The English poet Thomas Gray was born to a money scrivener while the Pre-Raphaelites owed their founder, John Ruskin, to an overworked city clerk. Perhaps the best known literary product of the City was TS Eliot who was an employee of Lloyds Bank for eight years. He described his job in a way that many in the industry might still recognise: “Not that I know anything about banking, but the business is so huge that I don’t suppose more than half a dozen men in the bank know more than their own little corner of it.” 10 For writers, moral imperative and practical necessity can be unhappy bedfellows. Art is fundamentally a product of a bourgeois society because it requires an audience not always distracted by the grubby realities of fulfilling basic material needs. In this sense, a surplus of capital is a necessary condition for the privileged space in which writers work. The literary critic Cyril Connolly recognized poverty as one of his “enemies of promise,” while some writers have displayed financial acumen that jars with their public persona. William Wordsworth speculated in real estate, stocks and bonds and even dabbled in personal loans. 11 Others have found retreating from the state of nature more appealing. “If everyone had spent their time writing about Donne then we shouldn’t have gone off the Gold Standard,” despaired Virginia Woolf in the 1930s. 12 With their immortal souls condemned, bankers might be forgiven for consoling themselves with earthly pleasures. This has certainly been the case in cinema. From Gordon Gekko to Jordon Belfort (even in Trading Places Dan Ackroyd and Eddie Murphy end up on a yacht), the devil gets all the best tunes. But the razzmatazz of Wall Street has cast no spell over literature. In Tom Wolfe’s 7 E.g. Usury in The Merchant of Venice, in Modern Philology, Vol. 33, No. 1, by John Draper. 8 Medieval usury and the commercialization of feudal bonds, by Shael Herman, (1993). 9 The Morality of Moneylending, in The Objective Standard, by Yaron Brook, (2011). 10 City of London: The History by David Kynaston, (1994–2001). 11 Wallace W. Douglas, Wordsworth as Business Man, PMLA, Vol. 63, No. 2 (1948). 12 City of London: The History by David Kynaston, (1994–2001). Konzept 6465 Financiers in literature—written down The Bonfire of the Vanities (1987), Sherman McCoy lives in a New York apartment that “ignites flames of greed and covetousness,” drives a $48,000 Mercedes and takes cabs to work, (unlike his lawyer father who goes by subway). It is not long, however, before McCoy’s world is punctured. The title of Wolfe’s book itself harks back to the puritanical counter-reaction that brought low the bankers of the Florentine republic. Perhaps worse, writers have tended to paint the business of finance as dreary and grey. In The Beautiful and Damned (1922), by F Scott Fitzgerald, the dashing heir Anthony Patch leads a dissolute life dedicated to pleasure and aestheticism. Yet Patch can barely tolerate a week in the Wall Street office he is sent to work in. For Fitzgerald, the money men offered no glamorous world of sharp suits and flowing champagne, but an unpromising existence of salaried obscurity. Nor have bankers been romanticised like some great industrialists. Perhaps the most coruscating portrayal of all belongs to TS Eliot, who describes the horror of the daily commute: Unreal City Under the brown fog of a winter dawn, A crowd flowed over London Bridge, so many, I had not thought death had undone so many. Sighs, short and infrequent, were exhaled, And each man fixed his eyes before his feet. Flowed up the hill and down King William Street To where Saint Mary Woolnoth kept the hours With a dead sound on the final stroke of nine. The Waste Land (1922) In literature, as in other spheres, bankers could use some redemption. But it is difficult to see where from. It is striking how cursorily the subject of finance has been treated by writers since the crisis, particularly given that by necessity the public have become more attuned to the language of economic debate and coda of markets. Perhaps it is the suspicion that it was not only the bankers with their snouts in the trough pre-2008. In any case, bankers will probably just get on with it. And maybe this in itself may be the object of some grudging admiration from the literary world. In the words of Lucy Snowe in Charlotte Brontë’s novel, Villette (1853): I have seen the West End, the parks, the fine squares, but I love the City far better. The City seems so much more in earnest: its business, its rush, its roar, are such serious things, sights and sounds. The city is getting its living – the West End but enjoying its pleasure. At the West End you may be amused, but in the City you are deeply excited. 13 13 Ibid. Columns 68 Book review—The Birth of Korean Cool 69 Ideas lab—secrets of investment success 70 Conference spy—oil and gas 71 Banking at the box office 6667 KonzeptKonzept The rise and fall of pop culture movements can often seem unpredictable and capricious. In her book The Birth of Korean Cool , Korean American journalist Euny Hong shows how the nation rose out of poverty to become one of the wealthiest and trendiest nations in Asia. But the global reach of “K-Cool” is neither miracle nor accident. Ms Hong asserts that the development of Hallyu or Korean wave – a name that covers K-pop, Korean dramas, movies, games etc – bears some similarity to the rise of South Korea’s heavy industry, which benefited from state sponsored cheap funding and technology transfers. Moreover, as with heavy industry, the South Korean government imposed market discipline by prompting Hallyu to compete globally. In turn, Hallyu has not only increased export revenues for South Korea, it has also helped to improve the national brand. Hallyu naturally owes much to the hard work and passion of the artistic talents involved. Ms Hong describes how Korean youths are “used to intense sadomasochistic academic pressure, extreme discipline, constant criticism and zero sleep.” Behind the scenes, however, it is driven by the financial and managerial commitment of the entertainment industry – most of the K-pop stars today were trained and prepped for years before they were presented to the public – as well as by the government’s support. The government’s role was particularly instrumental in Hallyu’s overseas expansion. Ms Hong describes how a diplomat smuggled a K-drama to be aired in Hong Kong, while more recently a government official organised flash mobs in France, demanding a K-pop concert. The timing was right for the rise of content makers, including Hallyu. As Ms Hong points out the Asian crisis of 1998 prompted the South Korean government to turn to the technology and content industries. As a result of public investment, South Korea is now one of the most wired countries on earth and is about to launch the fastest wireless network, 5G. The internet in turn has allowed easy distribution and popularisation of Hallyu. The rapid rise of the emerging market middle class was an extraordinary opportunity for growth. Both Taiwan and South Korea benefited from the rise of China’s consumers, but when it comes to cultural and personal services exports Korea’s are 3.5 times Taiwan’s, and its travel and visitor numbers are about 1.5 times those of Taiwan. Having said that, a much bigger part owes its thanks to the gaming industry, exports of which are estimated to be at least 10 times that of K-pop content, putting South Korea in the top five of the global game industry, with about six per cent market share. While the government’s focus on the creative sector dates back to the Asian crisis, it was also sought out more recently as a means to correct the nation’s “image problem.” With K-dramas, South Korea’s image is now far removed from that dictated by old Western TV shows like MASH. During the last administration, a Presidential Council on Nation Branding took the government’s efforts to another level, increasing financial and technical support to developing countries, dispatching services volunteers abroad and promoting exchange and research programs. While the council is no more, the Ministry of Culture, Sports and Tourism and the Ministry of Foreign Affairs, among others, have intensified such efforts. While at times it seems rather disorganised, there is a concerted effort to restore and celebrate South Korean culture. Meanwhile, the Park administration also created and mandated the Ministry of Science, ICT and Future Planning to generate new sources of economic growth from the creative industries. In the 19th century Korea was labeled the hermit kingdom. However, modern South Korea is anything but closed, introverted or static. While the country may be accused of being too unpredictable, its willingness to change and reinvent itself may save South Korea from being left behind. Book review— The Birth of Korean Cool Juliana Lee Just over a year ago the db Ideas Lab series was launched, where speakers from academia and beyond were invited to speak at Deutsche Bank on diverse topics. There were many talks about investing that provided insights on how to improve performance. This article briefly summarises the following lectures: Keynes the investor Dr David Chambers, University of Cambridge, 22 November, 2013 Risk Management 2.0: demystifying the Black Swan Professor Rama Cont, Imperial College London, 24 January, 2014 Corporate Social Responsibility – doing well by doing good Professor Alex Edmans, London Business School, 31 January, 2014 What are the ingredients of hedge fund ‘alpha’? Dr Melvyn Teo, Singapore Management University, 1 September, 2014 Value and momentum investing: A flow perspective Professor Dimitri Vayanos, London School of Economics, 5 September, 2014 John Maynard Keynes, who many regard as the first truly global macro investor, in some ways embodied the best (and worst) traits of a successful money manager. His investment style was dissected by Dr Chambers, an expert on the subject. He described how Keynes’s investment career spanning the 1920s to the 1940s could be split in two halves. Early on Keynes traded too much, explained Dr Chambers, attempting to buy low and sell high with a broad portfolio. His performance was poor. But eventually Keynes switched to a buy-and-hold approach with concentrated bets on a few companies. This new style saw him outperform the market for much of the 1930s and 1940s. By the end of his life Keynes’s personal financial investments were worth £15m at today’s prices. Underlying his success was an obsession with data and research. He was also an innovator in allocating his portfolio significantly to equities – decades before it became fashionable. Indeed, the importance of access to information was echoed in Dr Melvyn Teo’s lecture. He described how hedge funds that are based in, or share, the cultural background of the geography in which they invest typically outperform funds that do not. As for what companies to invest in, Professor Alex Edmans said that companies that treat their employees well as measured by Fortune magazine’s annual “Best Companies To Work For” tended to subsequently outperform their peers by two to three per cent a year. Finally, Professor Rama Cont from Imperial and Professor Dimitri Vayanos from the London School of Economics separately spoke of the non-macro factors that need to be incorporated in an investment process. Professor Cont showed that incorporating feedback loops – say the leverage ratios of banks – into risk models would more closely match the reality of a much higher frequency of “extreme” events that conventional models would otherwise miss. On a related note, Professor Vayanos showed that tracking fund flows would allow investors to better predict which markets would trend and revert back to fair value. Knowing funds are suffering outflows would also allow investors to detect which seemingly uncorrelated assets would start to move together if that fund held those assets. Intense focus, a heavy use of data and research as well as a holistic approach to understanding the success of companies appear to be the key features of successful stock picking. Meanwhile, attentiveness to the likely reaction function of market players, whether through regulatory requirements or fund redemptions, is the key to managing risk. Ideas lab—secrets of investment success Bilal Hafeez Konzept69 Konzept 68 Trading Corporate Raider M&A Broking Bank Solvency Asset Management Retail Exploration: The tone from both conferences was positive in spite of a quadrupling in discovery costs per barrel since 2004. Interestingly oil prices were not mentioned once with regard to exploration. Costs are up because unconventional resources are now the main growth driver for half of the industry. Meanwhile conventional exploration is harder too – for example 70 per cent of new discovery volumes over the past two years were deepwater. While pricing has trailed complexity at least companies are finding hydrocarbons. Sure, the 18bn conventional barrels discovered last year were a third down on decade averages. But the big drop in discoveries has come from national oil companies. The non government sector is performing close to its long term par of 15bn per year. Oil services: Again the mood was upbeat despite demand worries, lower oil prices, logistical challenges in the US, Russia sanctions and less activity in Iraq and Libya. Companies see no end to the on-shore bonanza in America. Smaller discoveries and faster decline rates mean more rigs per unit of production. Baker Hughes spoke of the prevailing paranoia among exploration and production companies that someone else has the latest piece of kit. New technologies such as dissolving plugs mean better prices. Meanwhile offshore rigs are also becoming high-tech to cope with high-pressure, high-temperature deepwater drilling. The trouble is offshore demand is being met with a quarter jump in rig supply by 2017. As for Russia? “That market won’t come back in my lifetime” said one executive. US shale: This year the US is expected to drill about a hundred times more shale wells than the rest of the world combined. But executives worry “there is no new Eagle Fords out there” and about rising costs. With the best wells dug and steep decline rates, many drillers have a “brute force mentality”. For example, single blasts can now require a million pounds of sand. Additional infrastructure cost means exceeding the cost of capital is rare. The “most elegant” drillers expect high marginal cost players to quit. Indeed everyone is pumping and hoping they outlast the next guy. No wonder a few E&P companies suggested that it may be “cooler” to be off-shore again. Value versus volume: Oil companies are under pressure to stop spending and boost payouts. But the presentations from smaller, unconventional players did not seem heavy on restraint. For chastened majors, however, there is massive scope for capex reductions – a quarter of planned projects will generate sub- 15 per cent returns – but cuts will dent volumes given that expensive, unconventional production is where the action is. Hence the problem for investors is that even if the world’s major oil companies ditched all future projects with an estimated internal rate of return below 15 per cent, upstream free cash flows start declining again after 2021. Majors have to keep finding the stuff and hope that better technology and execution can boost returns instead. Life in UK upstream yet: Is the term North Sea Oil contradictory or literal? Certainly exploration success in recent years is poor. But off-shore UK remains a top ten location for capex worldwide. On the one hand it is a good thing in that elevated oil prices have spurred investment in high-pressure, high-temperature drilling – well capex has doubled as a proportion of total spend since 2011. On the other hand spending also reflects the fact that projects are a fifth over budget on average. Indeed, a third of new projects do not generate 15 per cent returns, even after incentives. For brown field projects, however, returns remain good on a global basis. Conference spy— oil and gas Stuart Kirk Notes from the dbAccess Global Oil and Gas Conference and the Deutsche Bank Energy Conference Banking at the box office Finance sectors on the big screen Highest grossing finance-related films ($m) • Pretty Woman • Trading Places • The Pursuit of Happyness • Die Hard • Working Girl 330 220 200 170 130 Konzept 70Konzept71 The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively “Deutsche Bank”). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report. Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law In August 2009, Deutsche Bank instituted a new policy whereby analysts may choose not to set or maintain a target price of certain issuers under coverage with a Hold rating. In particular, this will typically occur for “Hold” rated stocks having a market cap smaller than most other companies in its sector or region. We believe that such policy will allow us to make best use of our resources. Please visit our website at http://gm.db.com to determine the target price of any stock. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor’s currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors’ own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the “Characteristics and Risks of Standardized Options,” at http://www.theocc.com/components/ docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document. The risk of loss in futures trading and options, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures and options trading, losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor’s home jurisdiction. In the U.S. this report is approved and/ or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/ or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001), and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank’s prior written consent. Please cite source when quoting. Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analysts about the subject issuer and the securities of the issuer. In addition, the undersigned lead analysts have not and will not receive any compensation for providing a specific recommendation or view in this report: John Tierney, Mark Clark, Tim Race, Richard Parkes, James Malcolm, Alexander Düring, Sanjeev Sanyal, Bilal Hafeez, Stuart Kirk, Jean-Paul Calamaro, Michal Jezek, Oliver Harvey, Juliana Lee, Alan Ruskin, Dominic Konstam, Torsten Slok. Konzept 72