FTSE Global Markets

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WHAT’S AT STAKE IN THE US PRESIDENTIAL RACE

I S S U E 8 3 • J U LY / A U G U S T 2 0 1 5

FTSE GLOBAL MARKETS I S S U E E I G H T Y T H R E E • J U LY / A U G U S T 2 0 1 5

Shari’a issuance hits a wall Managed funds: losing out to global macro?

Saudi taps the capital markets

Why is a strong dollar so important?

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EDITORIAL Francesca Carnevale, Editor T: +44 207680 5152; E: francesca@berlinguer.com David Simons, US Editor, E: DavidtSimons@gmail.com CORRESPONDENTS Lynn Strongin Dodds (Editor at Large); Ruth Hughes Liley (Trading Editor); Vanja Dragomanovich (Commodities); Neil O’Hara (US Securities Services); Mark Faithfull (Real Estate).

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e changed much of the content of this edition at the last minute to reflect what we think are some important developments in the global financial and investment segments. This has not been a benign summer by any means: but one which has upended the usual compote of economic drivers and which could signal systemic shifts in the credit outlook of one-time buoyant economies.

The impact of these shifts will be felt for some time and so we think it is important to review them and while it is perhaps too early to provide answers; we can at least make a stab at asking some important questions.

Technology and regulation are clearly the constant companions of any market shift right now. However writ large this year is the continuing appreciation of the US dollar and the impact that it is having on both industrial and stillemergent economies.

The impact of a too strong dollar is exacerbated as global demand continues to tank, with few signs of a smoothing ahead. Brazil, Russia and China each have their own well documented stories. The dollar has risen relative to currencies of these once leading lights as they struggle to cope with economic and financial fragility and in the case of Russia continuing political sanctions.

Less well known, but equally significant perhaps is turmoil in swing markets such as Saudi Arabia, which is also feeling the pinch of inclement economic weather. The government quietly tapped the capital markets, not once but twice in recent weeks. Most recently was an early August bond issue, worth $5.3bn, which was sold down mainly to Saudi financial institutions.

For novelty value alone the issues were picked up quickly and quietly. After all the last time Saudi Arabia had come to market was back in 2007. It plans to raise a further $18bn to help the government finance a growing budget deficit caused by its determination its to keep production levels high even as oil remains too cheap to mention. With sovereign debt is set to remain below 10% of GDP even if it does raise as much as $27bn over the next few months; but it does flag the case that not all is well in the Kingdom or anywhere else much for that matter.

Another thing: underlyings remain topsy-turvy. Both China and the eurozone are running trade surpluses ($500bn and $300bn respectively), unlike the US, so why the continual need to push down currency values? Monetary policy decisions in Europe aren’t helping, where the ECB’s substantial quantitative easing program is delineated more by the demands of the eurozone’s weakest members rather than its strongest. However, QE continues to boost the competitiveness of Germany even as if fails to ignite Italy, France and Greece.

Other countries too will begin to hurt as the currencies of two of the largest trading blocs continue to depreciate in value while their domestic demand is weak. Elsewhere, the dollar has also strengthened against the currencies of commodity exporters, such as Australia and Canada. For these countries, falling oil and commodity prices have triggered currency depreciations that are helping to shield growth and jobs from the effects of lower exports.

Until recently, US policymakers were not overly concerned about the dollar’s strength; but maybe the time is ripe for a rethink.

We are now in the run up to the US election and David Simons looks at the runners and riders and assesses their chances and policies. This is the most important presidential election for some years. The ability of the next US president to navigate the country across a range of divergent economic and political streams will to a great degree impact the evolution of the global markets for at least 20 years. Let’s hope the choice is a good one then.

ISSN: 1742-6650 Journalistic code set by the Munich Declaration.

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CONTENTS COVER STORY

4: It’s the story that overhangs almost every feature in this edition.

When will the US Federal Reserve start to tighten monetary policy.

However, given the accelerated volatility in the capital markets through July and August a near term rise could be detrimental. We explain how and why. .……………………..…………..............…………………………………………………

MARKET LEADER ARE INVESTORS REALLY SPOOKED BY EMERGING MARKETS RISK? Page 43 Photograph © aon168 Dollarphotoclub.com, supplied August 2015.

8: What’s at stake in the US presidential race?

OP-ED

12: Cooperation over competition as a driver of market efficiency

SPOTLIGHT

15: Why managed funds lose out to global macro allocations 16: Is the web wasted on investors?

19: ESMA publishes recommendations to EMIR Review

BELVEDERE

20: Defining a pro-risk stance in multi-asset portfolios

IN THE MARKETS

22: Shari’a issuance hits a wall: where’s the beef?

23: Overhauling Germany’s investment fund tax regime 25: The oil price dynamic of Iran’s return 28: The psychology of regulation: finding the right nudge

TRADING REPORT

30: Do we really need a universal cross-asset product identifier?

VANTAGE POINT

34: Interest rate cycles: lessons from history

COUNTRY REPORT

36: Qatar and LNG: defining new trading strategies 39: Kuwait’s revitalised infrastructure project market 41: Saudi Arabia’s new budget focus

ASSET ALLOCATION

43: Are emerging markets too speculative for words?

LEGAL LETTER

45: Why you should really know your representation rights

DATA PAGES

46: Market reports by FTSE Group Research

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measure it understand it apply it sĂZ ƌĞŵĂŝŶƐ Ăƚ ƚŚĞ ŚĞĂƌƚ ŽĨ ƌŝƐŬ ĞƐƟ ŵĂƟ ŽŶ ĨŽƌ ďĂŶŬƐ ĂŶĚ ĂƐƐĞƚ ŵĂŶĂŐĞƌƐ But a single VaR number is not the whole story D ƉƉůŝĐĂƟ ŽŶƐ Excerpt ĚĞůŝǀĞƌƐ͗ ^ŚŽƌƚͲƚĞƌŵ ĂŶĚ ůŽŶŐͲƚĞƌŵ sĂZ hƐĞƌ ĚĞĮ ŶĞĚ ƌŝƐŬ ĂƩ ƌŝďƵƟ ŽŶ ŽŵƉƌĞŚĞŶƐŝǀĞ ŝŶƐƚƌƵŵĞŶƚ ĐŽǀĞƌĂŐĞ ƌŽďƵƐƚ ƐƚĂƟ ƐƟ ĐĂů ŵŽĚĞů ĂƐLJ ŝŶƚĞŐƌĂƟ ŽŶ ŝŶƚŽ LJŽƵƌ ŝŶǀĞƐƚŵĞŶƚ ƉƌŽĐĞƐƐ

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COVER STORY – US DOLLAR RATE TRAJECTORY Janet L. Yellen, chair of the Board of Governors of the Federal Reserve System delivers an address to the Greater Providence Chamber of Commerce at their annual Economic Outlook Luncheon Friday, May 22, 2015, in Providence, R.I. (AP Photo/Stephan Savoia) Picture by: Stephan Savoia / AP/Press Association Images. Supplied August 2015

How to live with a rising dollar It’s a bugbear of a late summer. The China story has dominated the headlines as investor confidence weakens in the face of worrisome global growth projections. The VIX index had doubled in mid August, as the market response to a complicated mix of concerns over macro and market fundamentals, exacerbated by the recent exchange rate adjustment, was one of turmoil. Volumes were were also down over the summer, which didn’t help and consequently any directional trades had a more powerful effect. The Chinese government has intervened to keep prices from freefalling, but its (mainly) retail investors appear dogged in testing official resilience and the ability of the Chinese authorities to eat up its reserves to shore up its mainland stock markets. However, the real story of the summer is not stock markets but currencies. In that regard, there are important questions now about the valuation of the US dollar and its impact on global markets.

T

HE WORRY IS that markets will now witness a period of competitive devaluation in the hope of stimulating exports and economies. It tends to work when two or three countries do it. More and difficult times inevitably follow. Since the beginning of the year more than 20 countries have either reduced interest rates (which inevitably helps push down the currency values) or have introduced monetary easing (with essentially the same effect).

In August two players: one major, one minor opted to do the same with testing consequences for both. On August 11th China devalued the renminbi by 2% and a week later Kazakhstan took the decision

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to free float the tenge against the dollar.

“We remain convinced that the main reason for the devaluation is a first step in a very long process towards a free floating currency. This is a positive development, welcomed by the IMF, even though it causes volatility in the short term. We do not think that export competitiveness was an important factor behind the decision, even though the timing of the decision and recent economic data have led some analysts to believe that could be the main reason.

And at least some of the current sell-off in financial assets around the world is related to concerns about the health of the Chinese economy,” explains Markus

Svedberg, chief economist at East Capital.

The repercussions were immediate. The tenge lost 20% in value overnight and the Chinese mainland stock markets have lost all the gains they made since the start of this year and more. No one likes a bad business story and the devaluations only served to highlight the parlous state of the global economy eight years on from the 2007/2008 financial crash.

Steep losses across Asian markets look to continue the pain for emerging markets as a whole. Yet again, analysts say they are on the lookout for fresh stimulus from the government. While analysts and investors will be looking for fresh intervention from the Chinese government to

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“Few seasoned investors are discombobulated by this market volatility as see it rather as a gift.”

reverse this current rout, the reality is that without fresh investor inflows the government is on a losing wicket.

The other big issue right now is that the problem is no longer contained in Asia. UAE markets have also taken a battering of late. Falling demand for commodities from large emerging market buyers such as China, ultra-low and still weak oil prices, speculation that the US Federal Reserve will soon raise interest rates and what looks to be continued pressure on the value of emerging market currencies, is contributing to a general malaise. Moreover, price inflation has slowed and commodity prices continue to decline. Very few countries now show positive growth momentum; normally in these conditions we would expect a cut in rates or a fiscal boost: but who is in a condition to do that?

Things have not been much better in Brazil. The Ibovespa benchmark extended its slump since May 5th to almost 20% in mid-August as lender Itau Unibanco Holding SA and oil producer Petroleo Brasileiro SA shares failed to find traction.

As in China, traders have been pulling money from Brazil, this time over worries that President Dilma Rousseff will struggle to revive the economy, curb inflation and narrow the budget deficit as the country continues to be mired in political crisis. The real posted the secondbiggest decline among 16 global major currencies in mid August too.

Elsewhere, the benchmark Dubai Financial General Market Index is now than its 2015 starting point, and so is the Abu Dhabi stock market. The UAE is slightly better off than its GCC neighbours in that its economies are more diversified, with oil funding a maximum 60% of the Emirates’ combined budgets.

However, as crude oil has more than

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halved over the last year the region’s fortunes have changed. There’s no short term end in sight as the OPEC countries continue to ratchet up output. The upshot is that inventories are rising even as demand continues to fall.

Saudi Arabia has tapped the debt capital markets twice since mid-July, something it has not done since 2007 and Kuwait is now running a budget deficit as oil revenues, which account for 80% of its income has halved since the beginning of last year.

Emerging market equities have been among the most divested assets in recent months as weakening demand for commodities globally has taken a toll on countries, such as Brazil and Saudi Arabia, that rely on exports such as oil, gas, wheat and sugar to bolster economic growth.

The strong dollar is not helping. For flatlining emerging economies with a dollarbased credit system, a strong dollar just adds to the pain, as it weighs on debt payments and sucks money out of investment in growth. It could turn into a systemic problem, as emerging markets now account for just under 50% of world demand.

It seems that growth just below 7% for China, despite last year’s warnings by the government that it needed to take a fair bit of heat out of the economy, is just too poor for many investors, both on the mainland and outside. However, it might be that investors are increasingly worried that one, the government cannot sustain a program of propping up the stock market and two, that the country’s 7% growth target this year might not only be tough to achieve, but might be vastly over-stated.

A clear statement of intent from the Chinese authorities wouldn’t go amiss, as recent routs have taken place even as turnover has fallen on both the Shanghai and Shenzhen markets has fallen. So both state companies and many investors are clearly sitting on the sidelines to see what will emerge in terms of official policy.

Policies around credit easing could be on the cards; with additional announcements around municipal spending – but the country has to be careful that it is not storing up future problems in an effort to

stem its current challenges.

Although the problems are new, investors are still utilising time honoured allocation solutions. No surprise then that sovereign bonds, which have seen yields fall across the region, and gold have been the main targets of investors looking for safe havens.

Very few seasoned investors been discombobulated by recent market volatility.

“Significant drawdowns are part of the nature of equity investing and occur in most years. A drawdown of this size is not uncommon in years that ultimately deliver positive returns to investors.

While there are clear challenges in commodity markets and some emerging market economies, these are well defined and do not reflect a major deterioration of economic growth or corporate earnings in most of the developed world,” says David Stubbs, global market strategist at JP Morgan Asset Management.

Stubbs thinks the sell-off is creating opportunities for investors to buy quality assets at lower valuations.“Differentiating between regions and sectors primed for further growth and those that will struggle will be key for investors today and in coming years as the bull market continues to mature. The rally in safe-haven assets and currencies demonstrates once again of the importance of diversification as a tool of risk management,”he avers.

US rates Against that background, the US dollar has steadily gained in strength even as the Federal Reserve's key interest rate has been kept near zero since December 2008.

Although most analysts have discounted a rise in the dollar rate in September, the general belief is that barring a global financial meltdown, rates won’t rise until year end, though the argument for maintaining near zero rates is becoming increasingly thin. According to Svedberg, ”The recent volatility has reduced the expectations of a September lift-off. A delay of the hike would support sentiment and EM assets in the very short term, but we think that US interest rates will stay exceptionally low in any case and therefore believe that it is better to get the first hike out of the

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way. EM assets have already corrected massively and the lift-off could, somewhat counter-intuitively, mark the beginning of the end for the negative EM sentiment.”

His view is echoed by that of Arnaud Masset, market analyst at Swiss online banking firm Swissquote, who noted: “EUR/USD is having a breather after a mad run of more than 6%, bringing EUR/USD as high as 1.1714. The euro is currently stabilising around 1.1550. We expect the euro to hold ground against the dollar as the odds of a September rate hike have diminished considerably. Fed Lockhart, Federal Reserve Bank of Atlanta President, said he still expects a lift-off this year but moderated his language by adding that recent developments in China, together with the appreciation of the dollar and further decline of oil prices are clouding the US economic growth outlook. Investors are taking into account the latest available information and it appears that a rate hike in 2015 is not even guaranteed anymore.”

A rate rise likely this year?

Right now it continues to be a numbers game. The Fed's key interest rate has been kept near zero since December 2008, though following the July FMOC meeting Fed chair Janet Yellen indicated that a rate rise this year was increasingly likely. The US economy grew at an annualised pace of 2.3% in the three months to June, official figures have shown, which has buoyed policy makers. US growth has been boosted by increased consumer spending (Up 2.9% in the quarter) and cheaper fuel prices. The 2.3% annualised growth rate is equivalent to 0.6% growth quarter-on-quarter. However, this annualised growth rate is weaker than the 2.7% expected by economists and overall, the recovery has been slow.

The underlying story seems to be that while the US is clearly out of recession, the pace of growth remains weak by past recovery standards; the US Department of Commerce recently downgraded the 2011-2014 growth figures from 2.3% to 2%; underlying analysts concerns that all is not quite as it should be.

However, the US central bank remains

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focused on the US jobs market - which has seen the unemployment rate fall to 6%, which it does not deem to be sufficiently below the Fed’s target of 5.6% to warrant an increase in rates.

The central bank is more concerned about inflation numbers; which is still well below the central bank’s target of 2%. The FMOC noted continued downside risks should the dollar appreciate further even as commodity prices continue to decline.

The committee said it would continue to monitor inflation "closely, with almost all members indicating that they would need to see more evidence that economic growth was sufficiently strong and labour market conditions had firmed enough for them to feel reasonably confident that inflation would return to the committee's longerrun objective over the medium term".

Consumer prices rose by 0.1% in July, but in a wider context, were only 0.2% higher from a year ago. Core inflation, which does not take into account food and energy prices, also rose 0.1% in July, and was up 1.8%, just under the Fed’s target.

All this in combinations suggests the last third of the year will see something of a shifting landscape and the debate will move from when the Fed does lift rates to its overall tightening path. The Fed is unlikely to risk a dollar rise if it might have a negative impact on emerging markets, especially corporate borrowers that are exposed to the greenback. Should a rate rise happen (December seems to be the most popular month for most analysts right now) the likelihood is that the central bank will remain mindful of global conditions and ensure that rises are gradual and much less than 1%. That will put the focus on the next rate rise as that will be more indicative of the Fed’s medium term policy.

The issues weighing on any rise then are two-fold: those problems outside the US and still remaining problems within it. Oil prices are now seriously depressed and, added to the mix is the reality that inventories both in the United States and overseas are rising steadily. Given that prices are averaging around the $40 mark, it is bad news for those countries that are dependent on oil revenues. Among them

“The debate will move from when the Fed will raise rates to the trajectory of its overall tightening path”

is energy-rich Kazakhstan, the biggest economy of Central Asia, which has announced it is floating its currency, the tenge. It has affected importers too: Turkey continues under pressure, with the Turkish lira briefly touching a record low of TYR3.00/$1.00. The only caveat there is that the country is still at a political standstill and increasingly in thrall to the canny if sometimes quixotic rule of Recep Tayyip Erdogan. He has now called a snap election to at least bring some consistency of political purpose to the country’s fortunes.

For its part, the Fed’s Federal Open Market Committee's (FMOC) committee clearly recognised China as a potential problem, saying that a "material slowdown" in the Chinese economy could affect the US economic outlook.

In a recent paper by Michele Mazzoleni at Research Affiliates suggests that emerging market countries should not look at a US rate rise with fear. “A better economic outlook and higher yields in the United States have been typically followed by stronger growth, rising risk appetite inflows in emerging economies, Mazzoleni writes.

He holds that historical evidence uncovers a significant relationship between capital market sentiment and emerging market currency returns. A strong dollar is not the cause of emerging market struggles he avers. “Quite the contrary, a strong dollar is the result of an adjustment process that historically has fed their economic recovery.”

He also thinks that emerging markets are a heterogeneous group of countries that over the years“have built significantly larger reserves and a domestic debt market. Hence the likelihood of observing widespread currency and banking crises has decreased.”

That’s all right then. n

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MARKET LEADER Donald Trump on the presidential stump, August 2015.

Trump has fired up the presidential election race with a mix of bold if not always politically correct policies and a sometimes confrontational delivery.Photograph © Daniel Raustadt/Dreamstime.com, supplied August 2015.

US presidential preview: what's at stake in 2016?

The US is back on the election trail once more. Who are the runners and riders? What are the battle lines between the parties this time around? Most of all, are Americans convinced the country is finally back on track--and will they vote accordingly? From Boston, Dave Simons reports.

A

NOTHER FOUR YEARS, another pack of Oval Office wannabees— some serious contenders, others likely to fold early on. There are plenty of them this time around: as of early August the GOP alone had some 17 different hats in the ring, making theirs the largest field of candidates for any single party ever.

Team Republican sports some familiar faces from past races, such as 2012 entrants Rick Perry of Texas and former Pennsylvania senator Rick Santorum (who managed a second-place primary finish four years ago) along with newcomers such as Florida's junior senator Marco Rubio and former governor (and one-time presumed frontrunner) Jeb Bush, plus New Jersey governor Chris Christie, outgoing Louisiana governor Bobby Jindal, as well as the party’s lone female contestant, former Hewlett-Packard CEO Carly

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Fiorina. However the most noteworthy entrant to date is New York’s voluble real-estate tycoon Donald Trump, whose surprisingly strong early showing has both puzzled pundits and infuriated GOP operatives.

It's a much thinner crowd over on the Democratic side: though the experts had all but conceded the nomination to Hillary Rodham Clinton even before she made her candidacy official last April, the former New York senator and Obama cabinet member currently has at least one viable challenger in the person of Vermont's ex-congressman and selfdescribed socialist Bernie Sanders, who has garnered some of the biggest and most enthusiastic crowds on the campaign trail (other Democratic contestants include former Rhode Island governor Lincoln Chafee, as well as Virginia's former senator Jim Webb).

Though in August the Obama administration leaked news that vice president Joe Biden could also seek the nomination.

If that is the case, then Clinton will have a run for her money.

It looks however, for now that the story is elsewhere. The first non-incumbent contest since the controversy filled election of 2000 is shaping up to be a crucial one for the GOP in particular. Not since the run of FDR-Truman has the Democratic party notched back-to-backto-back presidential wins; as of this moment, they are slight favorites to do so again (with most key polls showing a presumptive Clinton outgunning all Republican comers). While a stronger economic foundation would likely seal the deal, Democrats could have an ally in the GOP itself, whose neo-conservative fringe helped cost the party its one shot at ousting a vulnerable yet ultimately re-

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sourceful Barack Obama in 2012, and threatens to undo the fabric once more.

It's (still) the economy, stupid Financial matters aren't always the key determinant in an election year. It was, after all, the shadow of 9/11 that enabled George W. Bush to edge out John Kerry in 2004 despite a languishing stock market and lower GDP. However at this juncture the pollsters at Gallup see a "fairly typical" blend of issues for the upcoming race, with the economy on top and terrorism/foreign affairs ranking lower, or "about where they have been historically," according to Gallup. Research conducted in May supported these findings: more than 8-in10 voters believe the economy to be the most important factor leading up to the 2016 election.

"A healthy economy is fundamental to helping Americans achieve or maintain financial security, so it is not surprising that it usually ranks as the most important election issue for Americans in good economic times and bad," remarked Gallup in its report.

Although unemployment nearly 50% lower than in 2009, many Americans nonetheless feel less fiscally stable than those numbers would imply. Among the issues likely to hold sway come primary time is the broad chasm separating the country's top wage earners from the rest of the populace. Unlike the boom years of the last century which were more broadly beneficial, the start of the millennium has seen gains mainly confined to America's wealthiest individuals; by comparison, those earning $50,000 a year on average have actually watched their inflation-adjusted earnings fall below 2000 levels. Not surprisingly, Gallup found that 71% of Americans ranked dissatisfaction over income and wealth distribution as key to whom they will cast their vote in the upcoming election.

To end the Democrats’ winning streak, GOP operatives will have to prove themselves capable of tapping into the pulse of the electorate, something that has eluded them in the prior two presidential contests. In the wake of Obama's 2008 victory, GOP leaders devised a simplistic

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Vice President Joe Biden has not declared his candidacy: but should he run, he might upend Hillary Clinton’s ambitions for the presidency.Photograph © Palinchak/Dreamstime.com, supplied August 2015.

plan for taking back the White House: stonewall the president at every turn, even if it meant putting the country in harm's way. The midterms of 2010, which saw Democrats roundly pummelled for failing to immediately reverse the Bush era economic backslide, convinced GOP strategists their plan was working, though it came with a cost: for helping to engineer their victory, the Republican leadership awarded the right-leaning Tea Party movement a seat at the head table.

If the Tea Party's anti-Washington tone resonated with voters sceptical of Obamacare and other "big government" initiatives, its ranking members' unapologetically harsh views on a range of social and fiscal issues ultimately proved too much for even old-school Republicans, such as Arizona senator John McCain, who would later make plain his distaste for the group's often ruthless scare tactics (which, among other things, included a two-week government shutdown in late 2013).

Such political volatility sometimes has unintended consequences. Late in the 2012 campaign with Obama and Republican challenger Mitt Romney running neck-and-neck, a barrage of ill-timed conservative gaffes--among them Missouri senatorial challenger Todd Akin's claim that female victims of "legitimate rape" rarely become pregnant, helped turn what had been a whiskerthin race into a comfortable electoral-

college win for Obama.

Accordingly, many expected Romney's defeat to serve as a catalyst for a more moderate brand of Republican in 2016.

Nonetheless, after wresting control of the Senate from the Democrats last fall, an emboldened GOP is once again navigating hard to the right, creating a strange sense of deja vu all over again. Candidate Ted Cruz, for instance, made little attempt to sugar-coat his opinion of the Supreme Court's recent gay-marriage ruling for the benefit of the mainstream consumer, instead calling the decision one of the “darkest 24 hours” in U.S. history.

According to Harry Enten, senior political writer and analyst for polling aggregation website FiveThirtyEight, such comments not only serve to prolong the divisive effect of these issues, but could ultimately limit the party’s appeal in the general election by keeping individuals "from identifying with and potentially voting for the GOP." The polarization that has dominated Washington has led to a dearth of centrists on the Democratic side as well. The only true moderate in the current line-up, Vietnam war veteran and prolific author Jim Webb vehemently opposed George W Bush's war in Iraq yet also holds more hawkish views on issues such as gun control and immigration--the same broadmindedness that helped give Clinton-Gore a two-time plurality during the 1990s.

Such positions are now "verboten in the modern Democratic Party," insists Enten. Indeed, just as the GOP has plotted a more conservative course, those in the opposing party have moved in the other direction. Citing data from the University of Chicago's General Social Survey, Enten notes the continued decline of white moderates and conservatives as a percentage of self-identified Democrats.

"After Gore’s run in 2000, they have made up less than a plurality of all Democrats," says Enten. The upshot? "You simply cannot win a nomination by relying only on moderate and conservative white Democrats," maintains Enten.

Not that candidate Clinton isn't hip.

In contrast to the fence-straddling populism championed by her husband

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during his successful 1992 presidential bid, Clinton has already made clear her intentions to focus mainly on mobilizing strong supporters not only in traditional Democratic bastions such as the Northeast but also in vital swing states like Ohio, Michigan, Illinois and Florida.

Perhaps the most significant demographic shift heading into 2016 is the rapid rise in minority voters, the majority of whom were instrumental in Obama's twin victories in 2008 and 2012. In the once-reliably-red turned swing-state of Nevada, for example, white voters are expected to total only around 61 percent of the vote in the next election, down from nearly 69 percent in 2008, according to data from the Census Bureau and the States of Change: Demographics and Democracy Project.

Clinton, who polled well among Hispanic voters during her 2008 bid, stands to benefit the most from this sea change, notes FiveThirtyEight. At present Clinton's favourability ratings among black voters are nearly as high as Obama’s, and recent polling shows the former first lady carrying over 60 percent of non-white Democratic voters, compared to challenger Sanders' singledigit support within the same group.

"That’s very good news for Clinton given that non-whites now make up nearly a majority of the party," remarks FiveThirtyEight's Enten.

"Unless someone like Sanders can increase his appeal to non-white voters, or Webb is able to combine moderate/conservative whites with non-white voters, Clinton is likely to march to the nomination, just as Obama did."

Halo or hangover?

Citing a historical predisposition to close non-incumbent elections, Nate Silver, FiveThirtyEight founder and editor in chief, believes the odds of Clinton becoming the country's first female president are about evenly split at this point. Among the factors that could move the needle one way or the other, says Silver, is the near-term direction of the US economy--and, likely moving in lockstep, President Obama's approval ratings

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 5

Hillary Clinton has expected to carry the Democratic crown, but will her political ambitions be frustrated? Photograph © Jose Gil/Dreamstime.com, supplied August 2015.

down the homestretch.

"Clinton’s chances will be affected by Obama’s popularity as he exits office," affirms Silver. While there isn't always a direct correlation between an outgoing president's popularity and the fortunes of the party's incoming nominee--Richard Nixon, for instance, narrowly lost to John F. Kennedy in 1960, despite Dwight Eisenhower's 78 % favourable rating--it certainly bears watching, notes Silver, as Obama's final numbers could result in either a "halo" or "hangover" effect for the party’s nominee, depending on the mood of the electorate.

Should current trends continue, Obama could conceivably give his successor a substantial lift come election time. Toughing it out against one of the most partisan congressional throngs in history, Obama's seventh year has been unexpectedly bountiful, climaxing in late June with a succession of victories that went a long way towards securing his legacy. Just days after a rare bipartisan deal to fast-track authority for negotiating foreign trade agreements (made possible with the unlikely help of GOP foes John Boehner and Mitch McConnell), the Supreme Court handed down back-toback rulings that, in addition to making same-sex marriage legal in all 50 states, affirmed for a second time the constitutionality of Obama's signature Affordable Care Act. In response Obama's approval

rating hit 50%, its highest level in two years.

That will worry Hilary Clinton, should Obama throw his weight behind Biden.

"Fifteen or 20 years from now when we're writing about the Obama presidential legacy, this will be one of the weeks that we'll be talking about, when many of the issues that Obama put to the forefront were finally crystallised," commented Al Jazeera political contributor Jason Johnson.

While it is often difficult to make broad prognostications, with the parties more ideologically and fiscally divided than ever one can assume that a Democratic win a year from November would result in a continuation of the legislative oversight established under measures like DoddFrank, along with a more aggressive push for upper-income tax reform (which, given the existing Congress, has been something of a challenge for the sitting president). Should a Republican take the oath a year from January, it would likely portend a revival of the trickle-down/nonew-taxes economic standard that has come to define the GOP post-Reagan, as well as a comparatively hands-off approach to financial-market governance.

There's little doubt as to which side the Street will be rooting for: in a survey issued just prior to last fall's midterms, New York-based Convergex found that a scant 17% of financial-industry professionals approved of President Obama's job performance, while an overwhelming majority believed that equities would fare better under a GOP-led Congress (conveniently ignoring the S&P's nearly 200% rise since Obama took office).

Of course at this juncture a full-throttled recovery is hardly a foregone conclusion.

Last year's domestic GDP rose by an inflation-adjusted 2.4%--good, though not great, progress. Going forward, however, forecasts from groups such as the Economist Intelligence Unit (EIU), the European Commission (EC) and the International Monetary Fund (IMF) find real US growth inching higher to around 3% or more into 2016. Such strength would obviously bode well for the party in power, should these elements hold together over the next 15 months. n

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OP-ED Photograph © Unholyvault/Dreamstime.com, supplied August 2015.

Frenemies at the Gate A curious cultural shift is taking place when it comes to problem-solving in the financial services industry.

The sector is not renowned as a home for co-operation. Competition is intense, the stakes high, and individualism rewarded. Yet the industry has recently seen a marked increase in collaborative ventures.

The post-crisis environment, with regulations driving transparency, is encouraging firms to focus resource on areas where there is less competitive advantage, such as risk management or reporting. As a result, fierce rivals are beginning to buck the trend, putting aside their differences to mutualise solutions to problems regulatory, logistical and technical. Consortia, industry groups and open source projects abound. Joe Channer, chief executive officer at Delta Capita explains the dynamics.

O

NLY LAST MONTH, thirteen major banks announced joint backing for an effort to create a utility to reduce disputes over the margin used in swaps trading. Elsewhere, the world’s largest swaps dealers recently began talks on the creation of an open source model for calculating margin for bilateral derivatives transactions. Both moves are a direct response to new rules requiring dealers to post more margin in order to mitigate counterparty risk.

The proliferation of new multi-lateral trading facilities (MTFs) is another case in point. Take the Plato Partnership announced last year. A consortium of asset managers and broker dealers, the partnership is currently working to create a new, not for profit trading utility that is planning to launch a platform for large equity trades in anticipation of MiFID II, particularly Broker Crossing Network and dark pool reforms.

Present-day market challenges are clearly driving the shift. Alliances are most attractive when there is common, sizable challenge to be met, perhaps within a tight timeframe, and when there is limited or no competitive element to the solution.

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Moreover, as the examples above show, the volume and focus of regulation postcrisis is making these conditions increasingly prevalent.

From Basel to MiFID to AIFMD, firms are being forced to commit significant amounts of scarce resources into ‘hygiene factors’ – commoditised elements of the business where it is important to get things right, but where little commercial gain is to be had. Better to pool resources than for firms to replicate efforts via unwieldy in-house projects.

The increasing cost of meeting regulation, and challenging market conditions, are also conspiring to severely squeeze margins, which gives firms even less incentive (and ability) to pursue missioncritical-yet-non-competitive projects on a unilateral basis. The other contributing factor is the fast pace of technological change in the industry, destined to accelerate given the recent explosion of fintech innovation. Mass adoption of new technology often requires a collaborative element – for instance, around setting and agreeing standards.

It’s important to distinguish between different sorts of collaborative ventures,

as the risks and considerations vary. Most can be categorised along a spectrum (please see diagram: The spectrum of collaboration. On the far left of the spectrum sit ‘consortia’, of which Plato is a good example. These involve the creation of joint infrastructure to mutual advantage.

On the far right of the spectrum come ‘standards’, such as where the mass adoption of new technology requires a mutual agreeing of definitions and the creation of protocols to be effective. The recent announcement from SETL, which is looking to introduce blockchain technology to disrupt existing post-trade infrastructure, provides an example of the latter. As does the AltExchange Alliance’s ongoing project to define commonly accepted data standards for communication between limited and general partners within the private equity industry.

Marking collaboration Collaborative projects are far from straightforward. Troubled projects litter the sector’s history: indeed the latest swaps utility is designed as a replacement for an earlier, failed initiative. So what are the ingredients for success? Where a

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project sits on the above spectrum can make a difference to this answer. But regardless of its position there are few universal ingredients necessary for a successful endeavour, including: independent facilitation; a l egal framework and commercial commitment; well-managed participation and leadership The importance of having the project mediated and facilitated by a skilled (and neutral) third party cannot be overstated.

While the logic behind a joint venture might be straightforward, the reality of shepherding one to completion is anything but. Even when interests are aligned, it’s still a case of getting tens, maybe hundreds, of rivals to work together on what will likely be a highly complicated task.

The mediating party must – in addition to having the right level of industry expertise – possess a strong head for diplomacy, authority, pragmatism, as well as the capacity to spot and craft compromise. A good facilitator will at all times take care to be both attentive and sympathetic to the requirements of all those involved, even when they cannot all be met.

This third-party must also able to provide rapid access to the right skills and experience necessary to support the entire life-cycle of the consortium project.

Typically this can include setting up and delivering a Project Management Office, providing advisory services for corporate structuring, commercial negotiation, business case development, marketing, and delivery capability.

Importantly, and before any serious work is undertaken, a mediator can encourage participants to agree the scope, objectives and guiding principles of the project - no assumptions should ever be made here. These should be developed together with a well thought through collaborative business case and plan necessary to establish a realistic and clearly understood initial funding requirement.

Gaining early commercial commitment to pursue the project in accordance with these agreed guiding principles and objectives is often best achieved through a commercial Letter of Intent, which importantly should also commit an identified minimum investment to ensure the

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consortium is well-funded through to its next investment stage With the above commitment in place work can start on setting up a full legal corporate structure and commercial framework. It is imperative that all consortium members understand, from the outset, how their respective commercial interests are protected, how reserved matters will be handled and how decision making is achieved pari-passu. Without this in place, members will feel uncomfortable making hard decisions and the project will become protracted.

It is critical that the right people are involved in the project, in the right way, at the right time and with the right delegated authority to take decision for the firm they represent. A common misstep is to try and bring everyone to the table right at the start in an attempt to demonstrate wide collaboration from the get go. It is often much better to identify an initial core that can get the project going, and then pull a wider number of participants in as the project evolves. Failure to manage this will almost guarantee delays. That said, it is important that the consortium progresses steadily towards critical market representation to ensure fuller adoption.

Consortia require strong stewardship, so early appointment of a credible ‘CEO’ is advised. This will almost certainly shorten decision-making cycles, allow the project guiding principles to be upheld, and provide strong direction as well as a clear ambassador for the project. Appointing independent non-executives is advised for providing independent perspective and helping to manage deadlock situations.

In summary, a third-party facilitator should be able to ‘manage’ a project, moving it forward efficiently. All too often a group of rivals will attempt to go it alone.

This can leave a project lacking on all the above, partly due to the fact that these businesses will have plenty of their own dayto-day distractions and priorities, and partly because members will be uncomfortable with a competitor calling the shots.

The relative importance of these universals varies depending on where a project sits on the competitive spectrum.

Projects on the left-hand side of the spectrum – consortia – tend to be the most ‘political’, with the highest level of friction between collaborators in terms of project direction and outcome. These projects will typically touch on aspects of commercial advantage, which can make balancing the interests of various players very tricky. Here, the importance of a mediator with strong diplomatic skills and leadership is paramount.

By contrast, when it comes to defining standards or driving an industry utility there is often zero competitive advantage to be had, and all those around the table share a common goal. The challenge here is not about balancing interests but rather a logistical, technical one – how do we agree the standards as quickly as possible and drive mass adoption? Here, the mediator’s organisational, project management and consulting expertise come to the fore.

The type of venture also makes a difference to the positioning the mediator will need to do. The more competitive elements are involved, the more important it will be to allay fears that the project benefits some more than others, and emphasise the group benefits. Where competitive elements are absent (creation of standards) it is still important to position the venture as a genuine crossindustry push with real momentum behind it, as opposed to an optimisticbut-doomed suggestion from one corner of the market.

The direction of travel within the industry indicates that joint ventures within financial services are here to stay.

Regulators are on a mission to gain a much clearer, more detailed view of the market – and are encouraging the industry to work together to do so. At the same time, globalisation is continuing to drive market complexity. Put simply, the industry is growing up and going through a process of standardisation, while new technology will continue to disrupt. All of this is creating a perfect environment for consortia and alliances. There will be successes. There will be failures. Firms can do a lot to ensure that their projects fall into the former camp with the right assistance and approach. n

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SPOTLIGHT

CTA/managed funds lose out to global macro allocations According to Credit Suisse’s latest survey of the alternative asset allocation preferences of some 200 global institutional investors in hedge funds, the top three investment strategies favoured in the Americas was global macro (38%); event driven (47%) and equity long/short (54%). In EMEA meanwhile, global macro was the most popular allocation among institutional investors (54%), equity long/short (46%) and event driven (43%) while in APAC global macro (44%), multi-strategy (44%) and credit long/short (39%) predominated. The ability to capitalise on macroeconomic opportunities, such as an expected hike in US Fed interest rates, looks to underlie its popularity. However CTA/managed futures has declined in popularity among respondents.

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LOBAL MACRO STRATEGIES generally focus on financial instruments that are broad in scope and move based on systemic risk.

Systemic risk or market risk is not security specific. In general, portfolio managers who trade within the context of global macro strategies focus on currency strategies, interest rates strategies, and stock index strategies.

“One of the more notable developments from our annual survey conducted earlier this year is the marked increase in interest around multi-strategy funds, reflecting investor’s reaction to the fast changing investment environment we are experiencing at this time,” comments Robert Leonard, managing director and global head of capital services at Credit Suisse.

The investment objective of multistrategy hedge funds is to deliver consistently positive returns regardless of the directional movement in equity, interest rate or currency markets. In general, the risk profile of the multi-strategy classification is significantly lower than equity market risk. By definition, multi-strategy funds engage in a variety of investment strategies. The diversification benefits help to smooth returns, reduce volatility and decrease asset-class and single-strategy risks. Strategies adopted in a multistrategy fund may include convertible bond arbitrage, equity long/short, statistical arbitrage and merger arbitrage.

The survey also highlighted a decline in interest among institutional investors

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 5

in CTA/managed futures. According to Credit Suisse, increasing concerns about the Chinese economy appear to be a significant consideration in its lower ranking (9th this year, compared to third most sought after strategy through 2014).

Generally speaking, a CTA fund is a hedge fund that uses futures contracts to achieve its investment objective. These funds’ managers run different strategies using futures contracts, options on futures contracts and FX forwards. CTAs were initially commodity-focused but they now invest across all futures markets, e.g. commodities, equities and currencies.

The majority of CTAs are systematic traders or trend followers (roughly 2/3) with the ability to go long and short and to use leverage. Systematic strategies make use of computer programmes to interpret data and generate trades. These strategies attempt to capture large directional moves across diversified portfolios of markets.

Trend followers also tend be diversified across time frames. Systematic traders in particular are long volatility which means that returns are lumpy and the manager’s performance usually depends on a few very positive months. Meanwhile, discretionary strategies rely on a manager’s ability to effectively exploit chart patterns or divine global supply/demand imbalances from fundamental data. They apply advanced quantitative models which go beyond basic rules-based systems to forecast price direction or changes in volatility.

Managed futures traders lost 1.71% in

June according to the Barclay CTA Index compiled by BarclayHedge and reported in mid-July. The index remains up 0.05% year to date. “Trend reversals in equities, energy, and the US Dollar resulted in losses for 72% of the funds that have reported a June return as of today,” explains Sol Waksman, founder and president of BarclayHedge.

Seven of Barclay’s eight CTA indices had losses in June. The Diversified Traders Index dropped 2.48%, Systematic Traders lost 2.07%, Financial/Metals Traders were down 0.99%, and Currency Traders gave up 0.59%. The Agricultural Traders Index, up 1.15% in June, was the only managed futures sector with a gain.“Grain markets, which had been trending lower most of the year, bottomed in mid–June as traders began revising yield forecasts downward based on flooding concerns in the US Corn Belt,” says Waksman.

After six months in 2015, the Currency Traders Index is up 2.28%, Financial/Metals Traders have gained 2.26%, Agricultural Traders are up 1.38%, and Discretionary Traders have added 0.63%. The Diversified Traders Index is down 1.89% for the year, and Systematic Traders have lost 0.90%.

Meantime, the Barclay BTOP50 Index, which measures performance of the largest CTAs, dropped 4.38% in June. This is the largest monthly loss for the BTOP50 since January of 1991 when the Index declined 4.93%. The BTOP50 is down 3.16% at the end of two quarters in 2015. n

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SPOTLIGHT

Is the web often wasted on investors?

Emmett Kilduff, chief executive officer, Eagle Alpha, in a heartfelt polemic, writes that the volume of data produced online dwarfs all other sources. Every minute of every day Google receives four million search queries, YouTube users upload 72 hours of video, 204m of emails are sent, and Facebook users share 2.46m pieces of content. The pace of this data creation is only accelerating; a digital universe study by analyst firm IDC found that the total volume of information worldwide is now doubling around every 18 months.

Kilduff thinks that not enough of us are making money from the web: are you?

W

HILE THE VAST majority of this information is noise, signals can be extracted through proper use of data scientists, research analysts and technology.

Amazon, for example, makes $83,000 in online sales every minute. With the right people and tools, this treasure trove of consumer data can be turned into information about product sales, market trends and performance figures.

Despite the sheer scale of alternative information on offer, most online data goes unused by firms, who continue to rely on traditional sources for analysis.

However, the community is starting to wake up and some major firms have started to build out teams devoted to this purpose. Yet there is a long distance left to travel: research from IDC shows that 23% of the world’s digital information could be useful to investors. However, currently only three per cent is captured, and only a minute portion (0.5%) then analysed. This is a staggering gap. Like the energy in sunlight, the web is going to waste.

Much interest in the concept to date surrounds those looking to make a shortterm profit from market-moving news, which nowadays often breaks on social media first. While this sort of insight will always have its place, the buy-side’s bread and butter is long-term insight into fundamentals; many fund managers are paid to make investments across a two-tothree year, not two-to-three hour, timeframe. And it is here that the vast volume of non-conventional data online can really shine.

Let’s take the much-feted launch of Apple’s latest gizmo, the Apple Watch:

16

we were able to analyse over three million tweets related to the topic in order to select a sample of three thousand customers who had pre-ordered the device. We were then able to track and analyse what these three thousand customers were saying in order to glean a range of investment-relevant insight.

The analysis confirmed that the majority had received their watches earlier than expected, suggesting that Apple was following a worst-case-scenario strategy with regard to shipping dates.

The point of this data is not to supplant traditional analysis but to augment it. To take a macroeconomic example: the US labour market. A continued month-on-month fall in the volume of search terms such as ‘employment agencies’ and ‘job search’ may be a bullish indicator. Analysing the gap between job postings and job seekers on popular job sites such as Indeed.com can also shed valuable light, as can analysis of web traffic to those same sites – this analysis can then be extended to individual sectors and geographies. These measures are unlikely to be of much use taken alone, but taken together – and combined with conventional data and the requisite analysis – they can be used to form a far deeper and more comprehensive picture.

So why are we still in a situation where only 0.5% of web data is being used in this way by the buy-side? Neither the internet nor social media are ‘new’ anymore. There are a number of barriers to adoption. Compliance is one.

Actually, the biggest barriers are the expertise and tools required to sift through the noise in order to generate

meaningful insights. The web is a vast ocean of noise. And the process of turning this noise into insight is complex, involved and scientific.

For a start, it requires individuals with advanced data science and technology engineering expertise – not skillsets historically associated with research teams at investment firms. There’s also the fact that given the scale of data to be sifted through, web analysis requires the dedicated attention of a small army of research analysts to be truly effective. The increasing demand for data science skills is a major challenge facing the industry.

By 2018 the US will have a shortage of 190,000 data scientists, and 1.5m research analysts capable of identifying insights from this sort of data.

Even then, there are few tools available on the market today designed specifically to allow investment companies to perform the analysis. Various firms have started building out teams on a small, experimental scale, but the above factors mean that going full hog is cost-prohibitive. By contrast, those currently leading the field are smaller, specialist research houses with the expertise and resources to dedicate themselves to the full-time analysis of non-conventional online data. Rather than build out a full in-house solution, investment firms are partnering with these businesses to get what they need.

One day, the notion of factoring a mere 0.5% of the web’s data into investment decisions will be seen as nothing less than foolhardy. One day, robust analysis of the net will be par for the course, an expected minimum. For now, those firms with the nous to be first-movers will find themselves at a distinct advantage. n

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SPOTLIGHT

CPMI-IOSCO consults on UTI Harmonisation The Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) have today published for public comment a consultative report entitled Harmonisation of the Unique Transaction Identifier (UTI).

T

HE CONSULTATIVE REPORT focuses on the harmonised global UTI, whose purpose is to uniquely identify each OTC derivative transaction required by authorities to be reported to TRs. The final objective is to produce clear guidance as to UTI definition, format and usage that meets the needs of UTI users, is global in scale, and is jurisdictionagnostic, thus enabling the consistent global aggregation of OTC derivatives transaction data.

G20 Leaders agreed in 2009 that all over-the-counter (OTC) derivatives contracts should be reported to trade repositories (TRs) as part of their commitment to reform OTC derivatives markets in order to improve transparency, mitigate systemic risk and protect against market abuse.

Aggregation of the data reported across TRs, say regulators, is necessary to help ensure that authorities are able to obtain

a comprehensive view of the OTC derivatives market and activity. The 2012 CPSS-IOSCO report on OTC derivatives data reporting and aggregation requirements, the 2013 CPSS-IOSCO report on Authorities’ access to trade repository data and the 2014 FSB Feasibility study on approaches to aggregate OTC derivatives data provided the starting point for the harmonisation work on key OTC derivatives data elements for meaningful aggregation on a global basis.

Following the 2014 feasibility study, the FSB asked the CPMI and IOSCO to develop global guidance on the harmonisation of data elements reported to TRs

and important for the aggregation of data by authorities, including the UTI and Unique Product Identifiers (UPIs). This consultation is the first part of the response to the FSB mandate.

The report seeks general and specific comments and suggestions from responders by the end of September, to be sent to both the CPMI secretariat (cpmi@bis.org) and the IOSCO secretariat (uti@iosco.org).

Besides this consultative report, the CPMI and IOSCO will also be issuing a consultative report on the harmonisation of a first batch of key OTC derivatives data elements, other than UTIs and UPIs that are essential for meaningful aggregation of data on OTC derivatives transactions on a global basis. The CPMI and IOSCO also plan to issue consultative reports on global UPIs and on other batches of key data elements other than UTIs and UPIs in the coming months. n

Currency a key variable for corporate India says SGX India has provided portfolio investors diversified growth opportunities as it has continued to gradually integrate with the global economy. The Indian Rupee has increased its impact on India companies since the end of 2009, with India’s total world trade expanding by 80% to the end of 2014 reports SGX.

I

NDIA’S GDP GROWTH for Q1 2015 at 7.5% outstripped China’s 7.0%, placing India as the world’s fastest growing major economy. Earlier in the month the Reserve Bank of India (RBI) maintained India’s Cash Reserve Ratio at 4.00%, Repurchase Rate at 7.25% and Reverse Repo Rate at 6.25%. The last change made to the Cash Reserve Ratio was in early 2013, while the Repurchase Rates and Reverse Repo Rates have been reduced multiple times this year. The Repurchase Rate is the rate that RBI lends

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money to commercial banks and the Reverse Repo Rates is the rate at which the RBI borrows money from commercial banks.

One US dollar (USD) currently purchases 65.310 Indian rupees (INR) which is up from 60.684 level a year ago.

Annualised volatility of the INR on a rolling 120 day basis is currently 5.2%. In 2009 the value of India’s trade with the globe totalled $431.2bn which was 40% was composed of exports and 60% imports, hence India was a net importer to the value of approximately $84bn. In

2014, the value of India’s trade had gained 80% from the 2009 levels to $776.3bn.

Despite the rise of the USD/INR, India’s global trade composition in 2014 was similar to the 2009 composition, with 41% in exports and 59% in imports.

This integration has coincided with the moves of the MSCI India Index being less independent on the MSCI World Index - average correlations over the five years from the end of 2009 through to the end of 2014 were up 12 percentage points from the preceding 10 years. n

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SPOTLIGHT

EMIR Review: ESMA’s recommendations published The European Securities and Markets Authority (ESMA) has published four reports focused on how the European Markets Infrastructure Regulation (EMIR) framework has been functioning and providing input and recommendations to the European Commission’s (EC) EMIR Review.

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MIR IS A key component of the EU’s regulatory reform package in response to the financial crisis affecting many elements of OTC derivatives markets. While its implementation is still underway we recommend a number of changes, based on our experiences, to improve and streamline the regulatory and supervisory framework and to ensure that the objectives of stability and investor protection are met,”explains Steven Maijoor, ESMA chair.

The first report provides input to the EC’s consultation on the EMIR review with recommendations to amend the EMIR framework in a number of areas including the clearing obligation. In order to strengthen the EMIR framework and to better respond to changing market conditions, ESMA proposes amending EMIR in order to streamline the process for determining clearing obligations and to introduce tools allowing the suspension of the clearing obligation when certain market conditions arise. It also proposes removing the frontloading requirement; It also includes ESMA’s revised approach to the recognition of third-country CCPs, ESMA is proposing to rethink the entire equivalence and recognition process to increase its efficiency and effectiveness and to better respond to regulatory differences between third countries. ESMA proposes that the jurisdiction decision be governed

by Regulatory Technical Standards (RTS) and that any recognition process should also include additional risk-based considerations allowing it to deny or suspend the recognition of a third country CCP. A third element is ESMA’s plans to make changes to its supervisory and enforcement powers and procedures covering trade repositories, including increases in the level of fines, a broadening of the enforcement decisions available to ESMA, appropriate timeframes to consider applications in the registration process and clarifying TRs’ ob-

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ligations in relation to data quality and reconciliation and supervisory reporting.

Reports under Article 85 The second report is the first of three of the regulator’s reports issued under a specific article (Article 85) of EMIR. ESMA recommends removing the hedging criteria from EMIR and to use other measures to determine the systemic relevance of nonfinancial counterparties (NFCs), as this allows regulators to identify the few NFCs with the highest systemic importance while greatly simplifying the process and reduce the compliance costs for the majority of small and medium NFCs, which pose limited risks to the system overall.

Given that two of the key requirements applicable to NFCs include the clearing obligation and the exchange of collateral for uncleared trades, have not yet entered into force, ESMA says it is too early to analyse the consequences of those requirements on NFCs. ESMA suggests, when compared to financial counterparties, the systemic relevance of NFCs appears limited.

However, when the positions of NFCs are disaggregated (per asset class, per counterparty) the regulator says that data shows that NFCs are active and significant players mainly in the Commodity OTC derivatives market and, to a lesser extent, in the FX OTC derivatives market. It is shown that those active market players are not necessarily NFC above the clearing threshold (NFC+), as hedging transactions are not counted towards the clearing thresholds.

ESMA proposals relate to a better and simpler identification of NFC and a simplification of the framework applicable to NFCs; for example, by assessing the systemic importance of NFCs irrespective of the hedging/non-hedging nature of their trades, to ensure that the entities that qualify as NFCs are in effect the ones that pose the most significant risks to the system.

In the third report, ESMA looks at procyclicality and recommends further specifying the rules for implementing the counter-cyclical tools adopted by CCPs for margins and collateral, including regular testing and transparency on the results to further improve their effectiveness. This report focuses on the efficiency of the procyclicality treatment measures provided by EMIR for the calculation of margining requirements, considering in particular the policies, procedures and methodologies adopted by the CCPs during their authorisation.

Variation margin requirements can be a source of procyclical effects, says ESMA, but will cover the current exposure of the CCP on the basis of realised (mark to market) or theoretical (mark to model) prices and will therefore reduce procyclicality effects on initial margins, as losses in an adverse market environment will be covered gradually over time reducing the potential 5 future exposure and the necessity of excessive initial margin calls.

ESMA says the initial margin requirements will cover the risk from potential future exposures based on current positions.

Thus, disruptive changes in the initial margin requirements may emerge as a result of sharp changes in the nominal exposures (positions), or changes in the short-term potential future volatility of prices.

The last report covers segregation and portability. ESMA says it has identified some differences in CCP practices in the implementation of the relevant provisions. In order to promote convergent practices and achieve a level playing field, it recommends introducing clarifications and more detailed requirements by RTS along with incentives related to margin period of risk depending on the safety of the chosen account structure. ESMA also proposes monitoring the take-up of the different types of account models to confirm adequacy and efficiency. n

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BELVEDERE COLUMN

Photograph © Jose Gil/Dreamstime.com, supplied August 2015.

EXPLAINING A PRO-RISK STANCE IN MULTI-ASSET PORTFOLIOS The month of July was a more turbulent time for investors than broad asset class performance numbers may suggest: while global equities as a whole ended the month roughly flat and major government bond yields moved only moderately lower, both asset classes saw significant intra-month swings.

Emerging market equities began to underperform in earnest and most commodity prices took another large leg down. Patrik Schöwitz, global strategist, multi-asset solutions at JP Morgan Asset Management explains the dynamics.

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HE US DOLLAR showed some renewed signs of strength and major yield curves began to flatten again. Developments were broadly consistent with our views of core investment drivers this year: a strengthening in developed market economies led by the US, counterbalanced by a still-difficult economic picture for emerging markets; the start of a monetary tightening cycle in the US in the second half of the year, with ongoing monetary easing across most of the rest of the world.

Events during the month did little to clarify the exact timing of the first US rate hike in more than nine years. Amid mixed progress for the US economy, the Federal Reserve’s (Fed’s) July policy statement nodded towards steady improvement in the labour market and further improvement in the housing market, while keeping the characterisation of consumer

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spending as “moderate.” But there were no changes to the Fed’s policy stance and it remained hedged on the timing of impending rate hikes.

In our view, the chance of a rate hike in September is roughly 60%, with the odds poised to be pushed heavily in one direction or the other by the July employment report due out in early August. A lower-than-expected employment cost index reading and GDP growth numbers released late in the month did little to resolve the interest rate call. A significant upward revision to first quarter growth was counterbalanced by slightly disappointing headline growth data for the second quarter; on the other hand, price gains were stronger than expected. In any case, the Fed has recently been strongly signalling that rates will rise in 2015, gradually quashing the chances of a 2016 initial hike. This should support the curve

flattening bias in our portfolios as that process unfolds.

The long-running Greek crisis came to a head in early July, with the country only narrowly avoiding exit from the euro area.

The deal eventually struck was stricter than what had gone before, making the passage of numerous economic reforms a precondition for even the start of negotiations on a third bailout package.

For now, the problem seems to have been kicked down the road yet again – as ever, the question is for how long.

Although the relatively harsh deal may actually bode well for the attitude of Greece’s creditors going forward, it leaves Greek domestic politics under considerable strain. Early elections could quickly bring the issue back into market focus.

This latest crisis round seems to have had limited economic impact outside Greece.

With the ECB standing ready to

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intervene, peripheral bond yields have remained contained and bank deposits rock solid. Early indications suggest some damage to European consumer confidence, but with business confidence unaffected. Thus our positive outlook for the European economy and risk assets over the medium term remains intact. In the near term we take a slightly more cautious view of European equities until we are convinced the deal in Greece will prove durable.

China: the epicentre of EM weakness The slump in Chinese equities that started in June continued to occupy headline space in July, but the market stabilised and the declines partly reversed early on in the month on the back of increasingly aggressive intervention by the authorities.

Volatility and weakness returned towards the end of the month and it remains to be seen whether further intervention will be required. The knock-on effect on the Chinese economy is unclear.

A relatively limited share of household wealth is invested in the stock market, so confidence effects may be the clearest transmission channel. Here the evidence so far is mixed. While consumer confidence seems unscathed, the latest Chinese purchasing managers index

(PMI) readings suggest renewed weakness following the stabilisation in hard economic activity data during the second quarter. Looking more broadly across EM, equity weakness was widespread in July. This reflected the ongoing litany of weak economic data, particularly from EM Asia and Brazil, as well as the impact of the approaching lift-off in US interest rates. The latter effect was also visible in renewed weakness of EM currencies against the US dollar and the continuing downdraft in EM growth-driven commodities. These developments further reinforce our negative stance on EM equities in our portfolios.

In our multi-asset solutions portfolios we maintain a pro-risk stance, but at a reduced level compared with the positioning after our most recent Strategy Summit, held in April. We have tactically lightened up our overweight position in equities in view of rising volatility as the US interest rate lift-off approaches, and as significant event risks are playing out in Greece and China. Consistent with this change we have reduced overall risk levels to below normal levels.

We maintain our long-standing conviction to be underweight emerging market equities in favour of overweight positions across developed equity

markets. Recent weakness across EM equites further strengthens our confidence in this position. Our medium-term view on global duration remains broadly constructive, as we see little risk of a rapid sell-off in duration in the coming months.

However, as we near the turn in US interest rates we have tactically neutralised this position. Our expectation for renewed flattening of yield curves - in the US in particular - remains in place and with bond markets now once again moving in that direction, we remain underweight the front end of the US curve, albeit in somewhat reduced size to account for the risk that the Fed postpones its rate hike to later in the year.

We continue to hold a positive medium-term view on credit, but our portfolios are neutrally positioned in high yield at the moment, given ongoing worries about liquidity and the fallout from low oil prices. In currencies, our views are largely unchanged – we are positive on the US dollar, although we expect that the focus of its strength is likely to keep shifting towards emerging and commodity currencies. We maintain a negative stance on the commodity complex, driven by subdued demand from emerging economies and robust commodity supply growth. n

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IN THE MARKETS

Shari’a issuance volumes down this year Sukuk issuance in July stood near $1.2bn, however over the year to the end of July overall issuance volume looks to be down around 20% as corporations pull in their borrowing horns; meanwhile sovereign sukuk issuance is down 38% year to date, while quasi sovereign issuance is down by a notable 78%. Corporate issuance now dominates, with 64% of new Shari’a compliant issues in July originating from the corporate sector. What’s the beef with Islamic compliant debt markets?

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OLLOWING AN ACTIVE market in 2013 and something of a damp squib last year, issuance volumes in 2015 look to be much lower this year.

Standard & Poor’s foresees the global sukuk market heading toward a correction this year after Bank Negara Malaysia (BNM), one of the largest issuers of sukuk worldwide, stopped issuing earlier this year. “In the first half of 2015, BNM’s pullback saw total sukuk issuance drop by 42.5% compared with the same period a year earlier,” says S&P global head of Islamic finance Mohamed Damak. “In 2014, BNM alone issued about $45bn (MYR171.6bn of sukuk out of a total issuance of $116.4bn,” he explains.

Some of the reason for the pull-back appears to be the make-up of investors in the central bank’s securities. “Part of the reason behind BNM’s decision was that its sukuk were subscribed to by a broad array of investors, preventing them from reaching their intended end-users (primarily Malaysian Islamic banks for liquidity management purposes),”he says.

As a result, BNM decided to switch to other instruments restricted to banks, explains Damak.

Weak oil prices, challenging external funding conditions due to the expected Federal Reserve interest rate hike, and uncertainties over Greece through much of this year and more recently enhanced volatility in both emerging and advanced stock markets have undoubtedly raised the bar for sukuk issuers to generate funds in core sukuk markets. It is also threatening medium term systemic changes in the sukuk market per se.

Worldwide volume of sukuk issuance performed in line with its expectations with total issuance dropping by only

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10.7%, confirming says the ratings agency that the impact of falling oil prices on recurring government spending and investment projects in core markets, Gulf Cooperation Council [GCC] countries and Malaysia, was limited in the first half of 2015. Meantime, Fitch Ratings says in a recent report that total new bonds and sukuk (with a maturity of more than 18 months) from the GCC, Malaysia, Indonesia, Turkey, Singapore, Pakistan, Sri Lanka, and Taiwan (GCC+7) declined 27% in the first half of this year from a year ago. Bonds were down 30% and sukuk by 16%. In the second quarter of this year sukuk accounted for only 20% of total new issuance, marginally up from 18% in 2Q14.

GCC sukuk and bond issuance declined 25% year on year says Fitch.

Loans (Islamic and conventional syndicated loans) in the GCC+7 issuers were down 7% in 2Q15. However, Islamic finance deals were up 47% year on year in 1H15 and accounted for 13% of total new loans. Islamic finance deals share in 2Q15 increased 9.5%, which was lower than in 1Q15 at 16.5%, but still above the last few years' average of 7%.

S&P thinks the effect of lower oil prices on sukuk issuance in 2016 remains uncertain. Much will depend on whether there is a recovery in oil prices or whether governments in core markets decide to reprioritise their spending and avoid continuing using their reserves and tap the capital markets more aggressively to finance their spending; neither of which is likely this year.

Strong sovereign and financial institution (FI) sukuk issuance was a feature of the first half of this year, notably the Republic of Indonesia, which issued a

$2bn 10-year wakala sukuk. The transaction was the largest single-tranche US dollar sukuk issue in Asia to date.

Among the brighter moments in the segment has been the periodic testing of Islamic bonds by non-traditional issuers, such as Hong Kong Sukuk 2015, a special purpose vehicle established in the jurisdiction by the Hong Kong government.

At the end of May the government sold down a $1bn sukuk, which was listed in Hong Kong, Nasdaq Dubai and Bursa Malaysia, was oversubscribed, with orders totalling $2bn from 49 institutional investors, including central banks and now ubiquitous sovereign wealth funds.

Middle Eastern buyers bought up as much as 42% of the issue, with only 15% coming from Europe. The five-year bond was priced at 1.894%, which is lower than last year’s issue and is 35 basis points over five-year US Treasuries.

The Aa1 rating assigned to the Trust Certificates is at the same level as the long-term local-currency and foreigncurrency issuer ratings of Hong Kong, as the sukuk certificate holders are effectively exposed to Hong Kong's senior unsecured credit risk and not the performance risk of the underlying assets relating to the certificates, says Moody’s, which rated the issue.

The FI structure has traditionally been a feature of bank issues. This year Dubai Islamic Bank and Noor Bank set a pace of sorts, each with an issue worth $750m.

Corporates however, continued to be relatively quiet in terms of issuance. In 2Q15 the total sukuk issuance volume rated by Fitch grew 7.2% to $48.3bn, with sovereigns standing at 39% and corporates at 34%, followed by FI accounting for 27%. n

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IN THE MARKETS Photograph © Saniphoto/Dreamstime.com, supplied August 2015.

Germany looks to overhaul its investment fund tax regime In late July, Germany’s Bundesfinanzministerium (the Ministry of Finance) issued a draft bill on the reform of fund taxation. It involves a significant revision of Germany’s investment fund tax regime and abolishes the 95% participation exemption for gains from portfolio shareholdings. If the Bill is passed into law, it will come into effect at the beginning of 2018. Here’s a brief outline of the main points in the bill.

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URRENT TAX RULES in Germany separate the regime for taxing investment in funds and the regime for investment funds or entities. The draft bill brings the two regimes together and all investment funds and their investors will come under the Investment Tax Act. All UCITs and alternative investment funds (AIFs) fall under the Act, together with single investor funds and non-commercial corporate bodies that are not subject or exempt from taxation, such as, corporate investors and family trusts.

However holding companies, and special purpose securitisation vehicles do not appear to be included in the investment fund designation under the Act, including those entities that are not subject to the German Capital Investment Code (KAGB). Moreover, German or foreign funds that take the legal form of partnerships, unless they qualify as UCITS or pension scheme funds Altersvorsorgevermögensfonds) are also exempt. The distinction between retail/mutual funds and special funds is also maintained under the draft bill.

The draft bill has two notable elements.

The first is the abolition of transparent

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taxation and introduction of a non-transparent taxation system based on the separate taxation of investment funds and investors for all types of investment funds (UCITS and AIF including single investor funds) regardless of their legal form, with the exception of partnerships. Partnerships are only within the scope of application if they qualify as a UCITS pursuant to section 1 of the German Investment Act (KAGB) or if their business objective serves the purpose of pension asset pooling.

The second is the abolition of tax reporting requirements for investment funds. In particular, the requirement to publish so-called deemed distributed income (DDI) and other German tax figures in the Federal Gazette (Bundesanzeiger), which was considered to be burdensome and costly by many fund managers.

All German investment funds that fall under the Act will be subject to corporate income tax at 15% plus a 5.5% so-called solidarity surcharge. Tax will be levied on dividends on unlisted and listed German equities; fees for and manufactured dividend payments under securities lending and repo transactions related to German equities; income and capital gains

from German real estate and all other German source income, such as income from hybrid instruments, but not capital gains from equities, bonds or derivatives.

The tax on German source income is introduced in order to establish a level playing field for German and non-German funds and to comply with European law.

There are no substantial changes however to the taxation of AIF-partnerships. Transparent taxation applies on the basis of the general income tax principles; provided that the AIF qualifies as assetmanaging partnership, it is neither subject to income tax nor to trade tax. An exemption is also available for an investment fund that has qualifying investors such as tax-exempt German charities.

Moreover, German special funds can elect a full transparent treatment in relation to German dividends and compensation payments, in which case they will be directly allocated to the investors on a pro-rata basis and taxed in accordance with the tax status of the relevant investor.

In general, German investment funds will only be exempt from German trade tax provided that the objective business purpose of the entity is limited to passive investment

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activities and the active management of the entity’s assets is excluded. By way of contrast, German special funds will generally be exempt from German trade tax (however, the qualification as special fund always requires a passive activity).

Retail funds will see some significant changes under the Act, but in comparison special funds will only be subject to a few changes. Under the current regime, the investor base has to be limited to not more than 100 investors, which are not private individuals, in order to qualify as a Special Fund. However, the Act provides that a special fund must meet each of eight specific conditions (these conditions currently have to be fulfilled by all investment funds, incl. special funds). Moreover, the Draft Bill contains certain (anti-abuse) provisions which prevent private individuals from investing in Special Funds via tax transparent partnerships that are themselves regarded as institutional investors.

Investors in special funds will be taxed on any distributions from the funds; any deemed distributed income; and any

capital gains from the disposal of units in the funds. Corporate and business investors in special funds will also have to pay tax on the above-mentioned earnings (and again the application of the 95% participation exemption and the partial income taxation regime is explicitly excluded). Under currently applicable laws, only 5% of the capital gains from the disposal of equities are taxable for corporate income and trade tax at the level of a corporate shareholder. This 95% participation exemption applies – unlike the exemption for dividends – irrespective of a minimum shareholding.

For private individual investors all earnings from special funds will no longer benefit from the 25%-flat tax but be subjected to the individual progressive tax rate. The other important proposed change is the abolishment of the 95% participation exemption for gains from portfolio shareholdings.

The new bill has particular resonance for single investor funds, as it is likely, say commentators that under the bill in future they will be liable for higher taxes on their

investment as single investors may lose the benefit of the current tax regime’s 95% participation exemption.

In addition to the reform of investment taxation, the draft law contains the previously announced abolishment of the preferential treatment of capital gains from portfolio shareholdings (that is, holdings of under 10%) for corporate tax purposes. This new legislation is expected to apply for the first time to capital gains realised after the 31st December 2017.

Until then the preferential tax treatment under the current regime will continue to be available.

In line with the rules for portfolio dividends, the Draft Bill provides for a full taxation of capital gains if the corporate shareholder holds less than 10% of the share capital on 1 January of the relevant year. Accordingly, capital losses from portfolio shareholdings can only be offset against dividends and capital gains from portfolio shareholdings (in other words they shall be ring-fenced). The interaction of this ring-fencing with hedging from a tax perspective is likely to be problematic. n

€109BN FLOWS INTO GERMAN FUNDS IN FIRST HALF THIS YEAR Germany’s fund industry attracted net inflows of €109bn in the first half of this year, with total fund flows in 2015 set to double over the same period last year, says the German Investment Funds Association (BVI).

Spezialfonds and retail funds contributing just under €70bn and approximately €43bn, respectively. Total assets managed in Germany increased by almost 8% to €2.6bn over the period N BALANCE, INVESTORS withdrew over €4bn from assets outside investment funds even as assets under management grew by almost 8% to around €2.6trn between January and July. The assets managed by fund companies in Spezialfonds touched €1.3trn, while assets under management in retail funds stand at €877bn and those held outside investment funds amount to €377bn. The BVI says Spezialfonds were the most popular vehicle, attracting almost €70bn in net inflows, while mutual funds attracted €43bn.

Multi-asset gained in popularity as an allocation, attracting a net inflow of €23.8bn in the first half of 2015. Among multiasset funds, investors focussed increasingly on funds with a higher equity exposure, which doubled their net new assets by €7bn. Balanced multi-asset funds attracted net/net inflows of €9.7bn while funds with an emphasis on fixed income attracted net new inflows of €9.7bn.

Balanced funds were preferred by retail investors as they ploughed €23.8bn into the segment. Equity funds have also

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been popular, with inflows of some €7bn, though they were pipped by balanced funds which attracted €9.7bn over the period, while bond-oriented funds brought in €7.2bn. With combined assets totalling €207bn, balanced funds are the second-largest group among retail funds. Since mid-year 2014, their market share has grown from 21% to 24%.

Manufacturing companies and industrial foundations looked to have intensified their investments in Spezialfonds With combined assets totalling some €780bn, insurance companies and retirement benefit schemes are the largest investor groups within the Spezialfonds segment, accounting for a share of just under 60%. Manufacturing companies and industrial foundations in particular have significantly increased in importance for new business. During the first half of 2015, they entrusted Spezialfonds with fresh money to the tune of some €15bn net, raising their share in new inflows to 21%, compared to 4% for the full year 2014. Spezialfonds are managing €225bn for manufacturing companies and industrial foundations. n

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IN THE MARKETS Photograph © Jukuraesamurai/Dreamstime.com, supplied August 2015.

Will Iran coming out of the cold change the oil price dynamic?

There’s a strong fractal quality in today’s oil corporate sector news as Graham Spooner, investment research analyst at The Share Centre, was touting Tullow Oil today as offering contrarian investors exposure to any longer term oil price recovery. The basis of his view? “Despite declining profits in the first half of the year, this morning Tullow Oil reported an encouraging trading update with production increasing 4% on the same period last year.” It is a clear paradigm for what is happening at the macro level, with production outstripping demand by a growing country mile. As if that wasn’t enough there’s a strong possibility that after many years in the sanctions freezebox, Iran could be coming out of the cold and add 800,000 barrels a day of oil into the global supply mix. Can the oil sector cope with additional supply? Who will be the winners and the losers in the next round of inevitable market constriction that must accompany sustained over-supply? Also, what’s the long term impact on oil prices?

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ULLOW OIL HAS felt the pain of the plunge in the price of oil, as revenue fell by 38% to $800m. The company has taken steps to offset this and is targeting cost saving in the coming year. We feel positive about the good progress reported in its West African projects, where guidance for the remainder of the year has increased to 66,000 – 70,000 barrels of oil per day.

Looking forward for investors, exploration projects in East Africa have also shown

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good results and are supported by the governments in Kenya and Uganda,”says Spooner. “We currently recommend Tullow Oil as a ‘buy’ for contrarian investors, willing to accept a higher level of risk. The stock is highly geared to the oil price, and will benefit from any longer term recovery.”

Given the confluence of trends and influences on today’s oil price you would have to be a contrarian investor to believe that in the short term oil prices will

recover. Earlier this month, the market had expected the Organisation of Petroleum Exporting Countries (OPEC) to reduce output. In the event, the pressure group decided to maintain production at current levels.

As Cyril Benier, manager of the AXA WF Framlington Junior Energy fund, the recent slump in oil prices is directly due to supply side constraints. “The majority of OPEC countries are close to full capacity, except for Iran and Iraq, making

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the markets increasingly nervous about Iran’s potential role in future global energy supply.”

Benier’s view is predicated on the understanding that if the United States and Iran sign an agreement on the Iranian nuclear development programme, Iran will return to the crude oil export market in force, thereby putting more downward pressure on barrel prices in the short term.

Despite the macro trends bearing down on oil, producers outside the United States look to have decided to pump oil as hard as possible or run the risk of the asset being left in the ground for good. It is an interesting trend, given that it looks to be flying in the face of some paradigm shifting developments in the energy market. Saudi Arabia appears to have already adopted the approach of maximising production before it is too late. It is already pumping 10.3m barrels a day, a 30-year-high. This could be increased to as much as 12.3m a barrel, according to the International Energy Agency (IEA); on the basis that if it is a depreciating resource, it might be efficacious to produce it as fast as possible.

That might be a chimera says Benier, as his long term historical analysis of oil production shows that it has decreased by as much as 40% over a 15 year period; and the market share of production cartels, OPEC in essence, is down 30% compared with 15 years ago. “OPEC’s position is sustainable because many of its producers are low cost exploiters, typically $40 per barrel (Saudi crude exploitation costs are even cheaper); however, compared to the North American producers the cost of new production capacity is much higher,”explains Benier.

While there are any number of seismic tremors in the oil landscape, the reality is that climate change issues are not one of them. While the leaders of the G7 group of nations recently made a commitment to cut greenhouse gases by 40%-70% by 2050 from their 2010 levels, along with phasing-out all fossil fuel emissions by the end of the century; ultimately, this decision will have little impact on oil prices. As Benier notes: “Oil demand is essentially driven by transportation trends; it is not driven by energy consid-

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erations, which is more gas and coal and as car consumption has become more efficient in advanced economies, demand has slowed, even in the historically seasonal periods such as summer, when more people are on the roads. However, longer term, especially in emerging markets, there will be a clear growth in demand as more people buy and use cars.

Overall, demand from the transportation sector is rising between 1% and 1.5% a year and I see no reason for this trend to change in the near term.”

The strongest seismic shifts in the market are in the North American production belt; and the story here is one of two halves. In Canada, according to the Canadian Association of Petroleum Producers, companies plan to increase output by 156,000 barrels a day each year until 2020, despite the downward pressure on oil prices.

In the US however, where shale oil production represents, according to Benier, some 5m barrels a day (around 5% of global crude output and three times the global crude oil excess supply). Production in the US looks to be more attuned to the market and producers have shown immense flexibility and willingness to cut production when required. Benier says in part that this is due to the nature of US shale oil production, where exploiters work to a shorter production cycle and where the well depreciation rate is very high (typically, outside the US the cycle is much longer, ranging between two and three years).

Even so, according to a recent EIA report, the United States is forecast to remain the world’s top source of oil supply growth until 2020. In the coming months says Benier, oil prices will likely react to “the various adjustments in the supply side, whereas demand growth remains steady.”

In practical terms he expects prices to remain in a corridor between $55 and $70 (West Texas Intermediate pricing: WTI) per barrel over the foreseeable future.

Like Spooner, Benier believes that the key to investing in oil companies is opting for those that have actively worked on costs and capex reduction to improve cash

flow generation and where the downside risk is lower. “At current oil price levels, E&P companies are working to cut costs, improve cash flow and maintain or reduce debt levels,” says Benier. “In this context, companies that are exposed to structural themes around efficiency and productivity gains should outperform the rest of the energy sector.”

He also thinks that being overweight US unconventional drilling provides an opportunity “to benefit in the short term from the margin recovery story and in the long run, from oil production growth.”

Iran’s growth windfall The Tehran government expects to achieve GDP growth of 5% next year as a premium for emerging from US-led sanctions. Moreover, despite flailing oil prices, growth this year is also expected to touch 3%.

Iran will benefit from both having its frozen overseas assets released, which will help the country offset its budget deficit and add to its stock of foreign currency reserves (currently around $100bn).

Iranian assets overseas are various estimated to be worth between $30bn and $50bn. Moreover, kept away from the capital markets by sanctions, the government insists it has relatively very little debt, with some analysts suggesting it ranges anywhere between 17% and 25% of GDP. So far successive governments have been relatively unwilling to disclose the country’s exact financial status.

All in all, Iran has, rather ironically, been relatively protected from the current turmoil seeping through emerging markets as the Iranian economy is not yet linked to the global capital markets.

Moreover, while potentially a significant oil exporters, until now oil revenue has only contributed 30% to the government’s overall budget.

Nonetheless, the country faces important challenges; not least the modernisation of its pensions system and internal financial markets. The question is how readily the government will now respond to the opportunities presented by the end of sanctions and open up the country to foreign finance and investment.n

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IN THE MARKETS

The psychology of regulation: the right nudge As we steadily approach the 10-year anniversary of the financial crash, there can be no doubt that it has transformed the regulatory culture and environment that firms inhabit. On one level this means most firms now find themselves far more heavily regulated than before. The desire among authorities to ‘fix’ the causes of the crash – as well as improve transparency and minimize risk more generally – has inspired pages and pages of new rules and controls, such as the comprehensive ‘Dodd-Frank’ (Wall Street Reform and Consumer Protection) Act, writes Bill Mulligan, CEO, Cordium US and Cordium Software at Cordium, who explains how alternative investment funds have been impacted by change.

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T ISN’T JUST about the volume of new rules. The way and extent to which these rules are enforced is also changing. Alternative funds are coming under unprecedented scrutiny from an increasingly proactive SEC. The numbers illustrate the extent to which the Regulator is on the warpath: in 2013 the Enforcement Division of the SEC opened up 908 investigations (a 12 per cent increase on the year before) and obtained 574 formal orders of investigations (up 20 per cent over the same period). It is estimated that in today’s environment a whopping one in twelve firms will face action at some point. And fines are have reached record highs. This isn’t some covert operation; to quote the SEC’s Mary

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Jo White verbatim, “We are casting our nets wider, and using nets with smaller spaces, paying attention to violations and violators regardless of size… we will be in more places than ever before.”

It would be wrong to interpret this as a reaction to increased wrongdoing or a fall in standards within industry. No such trend exists. On the contrary it reflects a fundamental shift in the Regulator’s attitude and role. Whereas enforcement and investigation used to be ‘last resort’ measures in cases of clear wrongdoing, they are now increasingly being used as broad regulatory and investigative tools.

How should firms respond? Well, the traditional answers apply now as much as they ever have: firms should work to

ensure they fully understand what is required of them, and review their internal compliance processes to ensure they are robust and fit for purpose (an external audit is often of tremendous use here). Education will also always be key: ensuring that staff at all relevant levels within the firm understand SEC rules on suitability, and so on.

However, in a new environment with zero room for error, it might also benefit firms to start to think about compliance within a relatively new dimension – that of convenience.

Nudge theory In recent years, ‘nudge theory’ has risen to prominence within various social,

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political, and economic fields. The root idea is that humans are deep down creatures of habit and convenience, and that ‘anti-social’ (or otherwise suboptimal) individual behaviour are often triggered (or at least made more prevalent) by the ‘right’ option being too difficult or unobvious, rather than an active malice or intention to do the ‘wrong’ thing. Its broad conclusion is that ‘making the right thing as easy as possible’ is a crucial ingredient in effecting a culture of compliance, equally important to – if not more important than – threats, education or moralising.

The philosophy has been embraced by both the US and UK Governments as a new means of achieving social behavioural change. In the US, Obama appointed Cass Sunstein – a vocal proponent of the theory – as administrator of the Office of Information and Regulatory Affairs. This newfound popularity at the top is in part due to financial constraints Governments have found themselves in since the crash: ‘nudges’ are perceived to generally be less costly and drastic than authoritarian alternatives. For instance, encouraging shops to put fruit at eye level is a ‘nudge’ as opposed to simply banning junk food.

Other prominent examples of this theory in action include the recent innovation whereby banks are encouraged to put ‘donate to charity’ buttons on ATMs. This makes donating to charity very easy and something you have to consciously choose not to do, rather than actively put in effort to do. The switch from opt-in to opt-out regimes for organ donation is another example. There is a large number of people who would be happy for their organs to be donated, but would simply never get around to filling out a form to say so. The opt-out approach demonstrably increases organ donation rates without forcing people against their will.

The theory is very applicable to the world of regulatory compliance, and provides a new way for firms to think about their culture of compliance. The stereotypical image of a compliance breach is the sensational act of wrongdoing – intentional fraud, and so on. But

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in fact the vast majority of compliance breaches are unintentional – the result of something not being filed quite right, a process being forgotten or a detail missed. This truth is reflected in the SEC’s change of stance – these are precisely the sort of ‘housekeeping’ infractions they are now going after full throttle. Yet nudge theory would suggest that in this case the most effective way of creating a culture of compliance is not stricter rules, penalties, or even endless education (though these will remain important). Instead, the most effective way of creating a culture of compliance is to make acts of compliance (filling in this form, following that process) as convenient, simple, and easy as possible for the individual concerned – and for it to slot as seamlessly as possible into their day-to-day habits and schedule.

The role of technology Modern technology is one obvious way of achieving this. Even the most wellmeaning employee or firm is more likely to fall short of compliance standards if doing so involves a major distraction from the day-to-day work, and involves substantial additional time and effort (such as having to fill out long and arduous

forms). By contrast, if the process can be largely automated behind the scenes (without taking up the time or brainpower of the employee in question) and be made into something unobtrusive that takes two minutes (such as pressing a few buttons on a screen), compliance will improve – it’s just human nature!

A similar effect can be observed via recent technological innovations in other industries. iTunes, Spotify and the world of music provides a neat example. The industry went through a difficult period during the transition away from physical discs to downloadable music; a struggling business model failed to adapt to new ways of consuming and listening to music.

A piracy epidemic emerged. Innovations in the world of online music downloading and streaming however – the latest and greatest being Spotify – have reversed this trend. This is largely because it is now very convenient to access and download a wide range of high quality music – how you want and when you want – with just the press of a few buttons. Most people don’t want to pirate, and are happy to pay money for music: convenience was the missing ingredient, made possible by technological innovation.

This is why leading compliance consultancies – whose business model has in the past been built squarely around expert human advice – are investing heavily in technology, and to some extent transitioning to being tech companies themselves. A range of software solutions designed to make compliance convenient and easy – from self-updating calendars prompting users with regard to important regulatory deadlines through to algorithms that run client information against international watch lists – are starting to come to market.

None of this is to suggest that the old pillars of financial compliance – human expertise, appropriate deterrence, educational initiatives, and so on – are on their way out. These will always have an important role to play. But nudge theory and the rise of smart technology promise a new front and new tools with which to fight the good fight, in a world where the dangers of non-compliance have never been greater. n

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TRADING REPORT Do we need a cross-asset universal product identifier?

Covering the entire spectrum of asset classes and financial services, from loans and credit cards to derivatives and bond positions, a Universal Product Identifier (UPI) will enable a holistic approach to identifying all trades and positions, including capital calculations, reporting, clearing mandates and booking rules. While such an idea sounds great in theory, historical attempts at achieving global agreement have fallen short, even within a sub sector of the industry. Peter Meechan, Jim Bennett and Pauline Tykochinsky of Sapient Global Markets examine the feasibility of universal product codes; ponder whether the industry is ready to come together to create them; and discuss what a potential solution might look like.

Photograph © fablok/dollarphotoclub.com, supplied August 2015.

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URING THE PAST few years, firms have had to deal with a series of global regulatory changes, including the Dodd-Frank Wall Street Reform Act in the US; along with European Market Infrastructure Regulation (EMIR), Markets in Financial Instruments Directive (MiFID) and Regulation (MiFIR) in Europe; and reporting and clearing requirements in Asia.

These have resulted in numerous international regulatory bodies enforcing a series of new regulations for various jurisdictions, such as the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) (US), European Commission (EC) and European Securities and Markets Authority (ESMA) (Europe), Swiss Financial Market Supervisory Authority (FINMA) (Switzerland), Federal Financial Supervisory Authority (BaFin) (Germany), Financial Advisory Committee (FAC) (China), etc., to ensure transparency of trading activities and reduce systemic risk.

A key area of change has been in the over-the-counter (OTC) derivatives space where new mandates that involved realtime trade reporting and mandatory clearing highlighted a major problem for all firms—product identification.

Many of the regulations are tied to individual product types. For example, some products need to be reported to the CFTC, whereas others need to be reported to the SEC; some products must be cleared with a central counterparty, whereas others can remain bilateral. The problem lies in the

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loans and mortgages. It is an issue that runs across asset classes for functions that need to include all of a firm’s positions but treat them differently based upon product type. A key example of this is with capital treatment, whereby calculations need to be treated differently based upon product but aggregated across all of the firm’s positions.

definition of the products.

The nature of the OTC derivatives industry means that many products have evolved over time to become highly customized for individual client needs and there is little standardization across firms as to how a product is defined or named.

What one firm calls product ABC, another may call DEF. Making matters worse is that the regulator may call the same product XYZ. Anyone who has worked on implementing the new Dodd-Frank rules will have experienced the difficulty of deciding which rules applied to which trades and positions and how such trades needed to be classified when reporting.

While the problem may have been brought to light by the implementation of rules for OTC derivatives, it also exists within a range of asset classes, including

A universal product identifier The ideal solution to this problem would be a standardised way of referencing each product, based upon a set of differentiating attributes that are understood by both the industry and global regulators. Standardized identification exists today in other asset classes, such as the International Securities Identification Number (ISIN) for bonds, commercial paper (CP) and warrants.

Could such an identifier also work for areas that have historically resisted standardisation and could disparate areas of the industry come together to utilize a single standard?

There are many types of problems a Universal Product Identifier (UPI) could address. The complexity of the UPI could differ depending upon which use cases were included. Each type of market participant has a different level of interest in solving for each problem, so a consensus needs to be reached Another challenge in categorizing some asset classes is the requirement for dynamic classification that is triggered by a recent security event. For example, some

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regulatory disclosures require a more granular classification of loan products driven not only by the initial contract agreement but also by certain subsequent life cycle events.

These could include default on payments; some operational specifics in booking the product, such as held-tomaturity versus available for sale; operation loss events; and certain risk metrics, such as fair market value (FMV), etc. Similarly, commodities options require information about the last tradable date to assess exposure and capital requirements.

With certain credit products (for example, credit indexes), the regulatory treatment of the product changes based upon the number of names at time of execution. Therefore, a product traded one day could be reportable to the CFTC, and the same product traded a week later could be reportable to the SEC. One way to address this is to limit the hierarchy of the product to data points that are fixed and leave dynamic items to the transaction. This would make for a simplified product taxonomy, but adds an additional set of criteria to be used in regulatory determination. As such, it does not solve the entire problem.

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Key to deciding upon the use cases is to determine the scope across asset classes, i.e., can a UPI provide solutions across OTC derivatives or across all areas? A crossindustry sector UPI would certainly help when calculating capital, but implementing such a solution across areas that already have their own IDs (for example, securities) raises its own set of problems.

Solving across all asset classes is a lofty goal, but one that can be achieved.

However, it is better to start with one area—such as OTC derivatives which has the most diverse set of products and the most pressing need from a regulatory perspective—and then expand to other areas.

This means that when any solution is being designed, the end goal (one of true universal acceptance across asset classes) needs to be considered.

This way, the solution can be extended rather than redesigned during each phase and some level of input would be required from all sectors at all stages of design and implementation. If a particular industry sector solves the problem in isolation, they will have a difficult time trying to force their design on an industry sector that already has some form of identifier.

The final prerequisite is involvement from the regulators. It is pretty clear that most of

the use cases revolve around the regulatory treatment of trades and positions. The UPI will only be effective if the regulators that decide upon the treatment are using the same taxonomy to make their determinations. Therefore, their endorsement is as critical as industry acceptance.

Towards a solution When it comes to UPI issuance, there are three basic ways that it can be handled.

UPIs are only issued by a centralised issuing entity. Product details (the defined set of attributes) are sent to the entity by either industry bodies such as ISDA and a new ID is published. This has the advantage of ensuring that there is no duplication of products but requires that a product taxonomy be fully defined prior to UPIs being issued. And, it means that either new products would be traded without a UPI or a method of assigning temporary UPIs must be defined.

UPIs are sold in batches to organisations that may create new products (for example swap dealers). The organisation assigns the UPIs themselves and returns the assigned UPI with product attributes to the issuing organization for validation and distribution. This has the advantage of providing dealers with the ability to

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create on-the-fly custom products and trade them with a UPI. The disadvantage is that other firms could assign their own UPIs to identical products, causing product duplication.

Similar to option 2, UPIs are assigned by the dealers first trading the product.

However, instead of a batch of numbers being purchased and later assigned, the numbers could be generated and assigned by the initiating dealers using an algorithm that ensures uniqueness. An example of this would be including a code that is unique to the dealer.

Whichever method of implementation is chosen, the industry needs some form of market utility (or group of utilities) that would be responsible for distributing UPI information on behalf of the issuing entities.

Diagram 1 depicts how a centralised UPI utility (or series of utilities) could be used by the industry to generate UPIs and act as a UPI look up service, working alongside the regulators.

Defining a new format for a universal code in one sector of the industry and

then trying to get another established sector to adopt it would be extremely difficult. However, there is little need to do this. There is no reason that each sector cannot maintain its own format and even generate and distribute its own identifiers, as long as each sector has identifiers that do not match those used by a different sector, or establishes an easy method of understanding which sector the identifier comes from by the format, or provides a centralised report of all identifiers across all industry sectors In other words, organisations generating the identifiers need to work together.

UPI funding Funding for a UPI utility or service would depend upon the method used to generate and distribute each UPI. If it is up to dealer firms to assign UPIs to products that they themselves create, they could purchase blocks of blank UPIs, in a similar manner to how a grocery producer buys a block of UPCs (bar codes).

However, if a centralized UPI-generating

organization creates and assigns all UPIs, they would need to charge users of the service either a monthly fee or a transaction cost for retrieving UPI data.

Conclusion A UPI has long been thought of as an unattainable goal within the OTC derivatives industry and other non-standardized industry sectors. However, as regulations increase in these areas and become more product specific, the benefits of a UPI become more apparent. A key focus of much of the recent regulatory reform has been the standardisation across asset classes. The move towards electronic trading and growth of straight-through processing (STP), market utilities and clearing demands this. A UPI would not only provide a catalyst to standardization but standardization would itself benefit from the introduction of a UPI, producing a self-improving circle.

For the UPI to be successful, industry leaders need to first agree upon the problems that are being solved and the regulators need to be on board. n

Global identifiers: how easy is the route to full market transparency?

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n July, US Commodity Futures Trading Commission (CFTC) issued an order to continue the transition to a global system of legal entity identification (LEI) and that it had extended the designation of the utility operated by DTCC-SWIFT as the provider of legal entity identifiers under the regulator’s swap data recordkeeping and reporting rules. DTCC-SWIFT’s initial designation was made by a Commission order back in July 2012 for a two-year term. At the time the order was issued, the Commission was already participating in an international process to establish a global LEI system, into which the legal entity identifier to be used to comply with Commission requirements was expected to transition.

The order essentially extends DTCC-SWIFT’s designation for an additional year, while the global LEI system becomes fully operational. Registered entities and swap counterparties can comply with the Commission’s swap data recordkeeping and reporting rules by using legal entity identifiers issued by DTCCSWIFT, or any other pre-Local Operating Unit (pre-LOU) that

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has been endorsed by the Regulatory Oversight Committee (ROC) of the global LEI system as being globally acceptable.

The DTCC-SWIFT utility is now known to the public as the Global Markets Entity Identifier (GMEI) utility.

In a Meet the Market even in New York earlier in the summer, David Strongin, executive director of the Global Financial Markets Association noted that the only way for the global LEI system to be 100% effective was universal adoption. The market remains, almost five years on, with only piecemeal acceptance or even acknowledgement of the initiative. “If half the world uses the LEI and the other half does not, then we’ll end up right where we are today. It is now up to regulators to move the LEI forward by mandating its use in their home regions. Encouragingly, the EU is rolling out the LEI broadly through provisions in MiFID and EMIR. Authorities in the US have taken initial steps at implementing LEI reporting in swaps reporting rules. Others, including Canada, Australia and Hong Kong, have also embraced the concept,” notes Strongin. n

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VANTAGE POINT Photograph © Kathleen Hughes, Managing Director, Goldman Sachs Asset Management

Interest rate cycles: lessons from history Market dynamics over the summer continue to bring into focus whether the US Federal Reserve Bank will raise interest rates. It is not a question of whether the Fed will raise rates, but when. At various junctures in this edition we have looked at the impact of rate rises. In her regular column for the magazine Kathleen Hughes, managing director of Goldman Sachs Asset Management looks at how equities and fixed income have performed around rate hikes historically and what these trends mean today.

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EARLY A DECADE has passed since investors have witnessed a rising rate environment. Even then, the last go-round was short-lived. In reality, investors have not grappled with persistent interest rate gains for more than 30 years.

Amid what many market watchers suspect could be the twilight of a prolonged secular bond bull market, the issue now is whether little-noticed but important relationships between asset prices and interest rates may come to the fore.

How should investors broach the subject of rising interest rates? Examining the history of asset class performance during periods of rate gains is one useful starting point. Insights from the historical record include shifts in rate regimes have often moved with speed—surprising both the market and the Federal Reserve Bank. Historically, global equity prices have often rallied in both the run-up to policy ratehike cycles and in the year following the onset of rate increases—with the health of the economy a key consideration; Moreover, in the United States, largecap equities have frequently staged a short-term dip as investors assess the change in environment, but these episodes have frequently proven to be buying opportunities. History also shows that diversified bond portfolios have often

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turned positive within a period of a few years even amid rising interest rates.

While there is no perfect historical precedent for the Fed’s extraordinary post-crisis monetary policy, there is precedent of equity market performance amid rising interest rates. Equities have advanced in the majority of recent historical examples. In the last 32 policy-rate hike cycles globally, local equity markets gained a median 12% in the 12 months leading up to the start of the new rate cycle. A similar pattern emerges from the same sample of global cycles after the onset of a new rate regime, with the median equity market rising 10% in the year following the initial hike.

Even though the prospect of rising rates after a period of extraordinary monetary policy may give some investors pause, the generally held theory behind the coexistence of rising rates with rising stocks is quite simple: benign economic environments. If the broader economy is expanding, higher rates may simply reflect the rising pace of economic activity. Economic expansion has historically been an underpinning of corporate earnings growth, which is often identified as a driver of long-term stock returns.

Investors’ rising-rate concerns often

center on fixed income, where bond math shows that rising rates mean falling prices. But math also suggests that bond maturity matters. Historically, the ability of a diversified fixed income portfolio to roll into newer, higher-yielding bonds has helped blunt some of the impact of rising rates.

In the 1994 rate cycle, for instance, the Barclays US Aggregate Bond Index fell 2.2% one year after the Fed raised interest rates. The decline did not persist indefinitely. The same index posted an 18% gain in the three years following the rate hike. In 1999 and 2004, the Index also gained over one- and three-year postrate-hike time frames.

While the persistence of the current low interest rate environment underscores the challenges faced by any wouldbe predictor of rate increases, the historical record may offer some consolation for those who watch the subject with concern. Most significantly, equity market performance has tended in most cases to be positive when the tide of interest rates turns. While bond portfolios understandably remain a focal point for rate considerations, long-term allocations historically have weathered rising rates to a greater degree than the climate of public debate today may suggest. n

JUNE-AUGUST 2014 • FTSE GLOBAL MARKETS

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1115 BROADWAY NEW YORK, NY 10010 sta@securitytraders.org

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COUNTRY REPORT - QATAR

Photograph © Jevgenijs Sulins/Dreamstime.com, supplied August 2015.

Qatar’s LNG: trading places Until last year, Qatar fair dominated the narrow world of LNG. Having consistently controlled a tad over a third of the global market (by comparison, Saudi Arabia barely has 10% of the global oil market). It led in gas liquefaction; its output helped influence prices and its long term offtake contracts were the envy of other producers. Now Qatar has to make some tough choices as aggressive and rising producers such as Australia, the United States have thrown down a competitive gauntlet. Qatar’s once cosy world is not cosy anymore. Can it rise to the challenges it will inevitably face over the coming decade?

Until recently investment in LNG was based on the conceit of sustained and rising demand across the globe.

Producers have had good reason for this confidence. LNG demand in Asia, says a recent ANZ research paper, is expected to increase by at least 40% to touch 230m tonnes a year; mostly driven by demand from China and India. The bank also suggests that LNG has a solid long-term outlook, though supply will rise faster than demand in the medium-term.

Exporting countries, buoyed by long term gas offtake contracts would often provide cradle to grave logistical support to buyers, even to funding the building of specially built terminals that turned

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condensate back into gas, and thereby (went the logic) securing their own export pipelines over the long term. Qatar was an early innovator. The country was instrumental in helping develop the global LNG logistical infrastructure and also secured its dominance in a highly specialised market.

Qatar now faces two problems: one, increased competition from other producers and two, variable demand from once predictable importers.

The country has clearly given ground to new projects in North America and Australia, whose imminent export terminals could add as much as 110m tonnes of capacity to the global mix in

the next few years; and there is more to come. Similar projects in Russia, Indonesia, Malaysia and across Africa, once they come on stream will increase output by at least a third on today’s totals.

The International Gas Union (IGU) thinks output will rise to 423.7m tonnes by 2020, compared with 301.2m tonnes in 2014.

Qatar has then had to cope with a severe contraction in its US market (because of the country’s oil shale boom).

It thought it had successfully transferred supplies to large import markets, such as Japan, India and South Korea; all of which are highly dependent on LNG imports.

Qatar’s LNG accounts for 80% of all LNG exports to Asia.

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Japan is Qatar’s largest market followed by South Korea and India.

Qatar also enjoyed something of a risk premium following the 2011 nuclear accident at Fukushima, following an earthquake and which encouraged the country to shut down its nuclear capacity in entirety. Because of the surge in Japanese demand, Qatar was commanding prices north of $17/mmBtu, and which at one point touched $20.50/mmBtu even as prices in the US were at a rock bottom $3/mmBtu. It seemed that Qatar’s expectation that global demand for LNG would rise and rise was a no-brainer. Fast forward five years and the good times no longer roll.

Changes in demand, capacity issues and market pricing dynamics are combining to eat into Qatar’s historic dominance and it is feeling the effects already. Reuters reported that independent LNG consultant Andy Flower estimates Qatar's exports to Asia in the first half of the year fell by around 2.7m tonnes.

China exemplifies the trend. Qatar supplied China with 7.16m tons of LNG last year, the International Group of Liquefied Natural Gas Importers data shows. Moreover, Qatar signed contracts back in 2008 to sell a total of 5m tons of LNG a year to China National Offshore Oil Corporation and PetroChina. Negotiations to supply an additional seven million tons a year haven’t yet yielded results and it looks like volumes have crashed by as much as 40% overall this year, compared with 2014.

That’s because China, like other buyers is rethinking its buying strategy. China has capacity to regasify 38.5m tonnes of LNG a year, with an additional 40.9m of capacity either under construction or approved to come on stream by 2018, according to recent Reuters’ data.

However, China's capacity utilisation was 51% last year, down from 59% in 2013, according to the IGU. The country’s imports of LNG this year are expected to touch 20m tonnes, leaving the country with substantial spare capacity. It is not alone. Japan, which is the largest single importer of LNG, with a regasification capacity of 190m tonnes

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a year had a utilisation rate of only 47% last year. Moreover, the IGU says that global regasification utilisation was only 33% last year. Elsewhere, India has imported 30% less liquefied natural gas (LNG) than it is supposed to under a long-term deal with Qatar as a slide in spot prices has cut demand from local buyers; . Moreover, local press reports suggest that the Indian government is looking to reduce imports further.

Reflecting these seemingly systemic changes in demand. Asian spot LNG prices LNG-AS are hovering at about $8.10/$8.20 per million British thermal units, down around 20% since the start of this year and are as much as 60% off their peak of $20.50 in February last year.

The problem for Qatar and other long term suppliers is that in many instances spot prices are now cheaper than those under importers’ long term offtake agreements and naturally, buyers are increasingly unwilling to pay unnecessarily higher prices.

Japan in particularly is caught by the difference. Pricing of LNG under its longterm deal is linked to the previous 12month Japan Crude Cocktail (JCC), including caps and floors based on average JCC prices of the past 60 months.

In the past, importers were willing to accept long term pricing schedules as it reduced volatility and helped with long term planning, as prices were relatively constant. However, now that market volatility has reduced prices substantially what looked to be an important budgetary tool now feels cumbersome.

Asian buyers still pay extra for gas.

However, as Japan gradually restarts its nuclear reactors, the supply-demand balance will shift further. There are also other market changes in play. New suppliers look to prefer to break the traditional linkage of LNG prices to oil, and to base them on US and European markers instead.

Competitive forces Qatar for three decades has been living it large as the world’s dominant supplier of LNG. However, by 2020 Australia will, at current investment rates, be the world’s

largest supplier, according to a recent QNB research paper, against Qatar’s 77m output. The US is also building capacity (by an estimated 50m tonnes a year) and Canada is on the same track.

Russia is also looking to be a global supplier, in particular to Asian markets.

It signed a major deal in May this year with China which will inevitably bite into the market share that other LNG producers have enjoyed with the country.

The agreement covers as much as 38bn cubic meters of gas annually over 30 years through a yet-to-be-built pipeline in a deal that looks to both substantially diversify its sources of LNG. The long terms implications for a sea-based supplier such as Qatar are clear; it will have to become increasingly competitive in prices to maintain market share.

There are also some left field suppliers ready to join the global gloop; though the likelihood of them being global supplies in the near to medium term are pretty negligible.

Among them Nigeria, Mozambique and Tanzania, which recently announced giant gas finds.

Nigeria’s LNG projects, including the Train 7 and Olokola projects do not appear to have advanced in recent years, largely because of the government’s inability to get to grips with the long expected Petroleum Industry Bill.

The mechanics of Qatar LNG supply Most of Qatar’s output comes from its North Field, which has ample reserves – enough for another 216 years at current output levels. Exploration for deeper reservoirs beneath the North Field has yielded little that is commercial so far and following a moratorium on exploration announced a decade ago, current gas projects focus on domestic power upgrades and petrochemical diversification. Accounting for 55% of the country’s gross domestic product (GDP), Qatar’s economy heavily relies on its energy sector with most of its revenue generated from selling LNG. Its state-owned enterprise, Qatar Petroleum (QP) and its subsidiaries run much of Qatar’s oil and gas industry. QP has 14 LNG trains with a total production

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capacity of 77 MTPA, and RasGas and Qatargas operate seven LNG trains each.

The Qatargas consortium includes QP, Total, ExxonMobil, Mitsui, Marubeni, ConocoPhillips and Shell, while QP and ExxonMobil own RasGas. Qatar still has a competitive advantage in that, like Saudi with oil, it has one of the lowest production costs in the world.

Qatar’s natural gas and LNG can be produced at about $2 per million British thermal units as opposed to the $8-$12 prices found in the United States, Australia, and East Africa. With annual sales in excess of $180bn, LNG is a rather nice little earner for the peninsula state.

It also commands a virtual navy of LNG carriers, called the Al Rekayyat, run

by Royal Dutch Shell. The extent of the fleet effectively raises a barrier to entry to new suppliers. Natural gas, when chilled to minus 260 degrees, turns into a liquid that takes up only a fraction of its former volume. The process allows huge quantities of fuel to be pumped onto ships and dispatched around the world. Some carriers are over 1,000 feet long and can carry about 217 thousand cubic meters of LNG, equivalent to carrying around $30m-$40m worth of gas in one ship.

Additionally, the country has secured substantial volumes of valuable byproduct petroleum liquids. QNB says it has enough gas reserves to maintain current rates of production for the next

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138 years. However, gas reserves in Qatar fell 0.6% in 2014 as a result of extraction policies and a state-imposed ban on further gas exploration and development in Qatar’s North Field, where most of its reserves are located.

As systemic changes flow through the LNG market, Qatar is potentially at a tipping point and in need of a bold and consistent strategy that will cement its leading position in a rather fluid market.

Time for a strategy is now as it now has to start renegotiating its offtake agreements.

In terms of Asia, its principal long term agreements start to come to an end in the early 2020s. As many as ten Qatari contracts with Japanese buyers come to an end in 2021, and substantial supply contracts with South Korea end in 2023. However, if current pricing remains a chronic feature of the markets, as with India, Qatar may be pressured to act sooner.

There are signs that the country is beginning to work with trading houses, though its LNG majors RasGas and QatarGas, in carving out new business deals through short term contracts or tenders. In recent weeks, transactions have been announced with Egypt, Jordan and Pakistan. Exports have also increased to Eastern Mediterranean buyers including Israel. Compared to the size of the long term Asian deals, this is still short change, nonetheless sales to Jordan and Egypt have risen by 0.4m tonnes so far this year, while exports to Europe look

to have risen by 2.5m tonnes.

The new markets being chased by Qatar are now without their own issues.

Negotiations with Pakistan over an estimated $21bn deal are dragging out as the country’s independent power producing firms look to be stalling in providing bank guarantees to cover the purchase of gas supply. Qatargas is also looking for security guarantees as local press continues to highlight the problem of gas theft, particularly in the KhyberPakhtunkhwa districts. The IPPs are being asked to provide standby letters of credit worth between $20m and $60m as well as a letter of credit covering one month’s worth of gas utilisation, worth up to $30m. The deal has been dragging on since February, when Pakistan jumped the gun and announced the deal was live.

The pricing on the Pakistan deal is said to be competitive at a price cheaper than India’s long term offtake contract. The deal has been highly nuanced as the US had ‘encouraged’ Pakistan to sign with Qatar rather than Iran, which at the time was still subject to sanctions. As a deal to lift Iran out of sanctions, the Pakistan government has felt less ‘energised’ to make a quick decision on the deal.

As this issue went to press, news emerged that Qatar had agreed with PetroChina to shift delivery volumes under an existing 25 year offtake contract towards the peak demand winter period. It is a major concession to the Chinese and seems to fit into Qatar's newfound pattern of adapting market requirements to hold onto its share of the prized Asian market. The deal only extends to this winter, but could be renewed when PetroChina and Qatar discuss their delivery programme for 2016 later this year.

The moral seems to be that Qatari LNG will continue to be very profitable, but prices will decline and it won’t be able to be the world’s swing producer or strategic player anymore. The question then is whether the country has the nous and the will to fight its corner in a changing world. Any change in strategy will perforce concentrate on market share as well as price. n

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GCC OUTLOOK: KUWAIT Photograph © Cornelius20/Dreamstime.com, supplied August 2015.

Kuwait’s revitalised infrastructure project market The roll out of the Kuwait’s five year development plan (2015-2020) looks to have been revitalised in the summer after something of a hiatus in the first half of the year. Despite low oil prices, and a substantial projected drop in state revenues over the 2015/2016 financial period, Kuwait’s capital goods project market looks once more to be gaining traction. In recent weeks a new refinery project and an extension to Kuwait City’s airport were signed, in deals worth a combined KWD5.2bn (approximately $17.3bn). As of the beginning of August, the country looks to be generating some KWD71bn (around $234bn) of capital goods projects over the coming half decade.

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FTER A NOTABLE slowdown beginning in the last quarter of 2014, Kuwait has ratcheted up its investment in infrastructure. It looks like over $47bn worth of capital projects will be finalised this year, almost double that of last year (when spending on infrastructure touched $25bn). The total value of Kuwait’s projects market (planned and active projects) is estimated to be in the region of KWD71bn as of the beginning of August and that figure will likely rise by year end.

Some of the projects awarded so far this year include the Lower Fars Heavy Oil Field Development – Phase 1; the

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Fifth Gas and Condensate Train at Mina Al Ahmadi Refinery, Sabah Al Salem University – Colleges of Social Science, Shari’a and Law and Administration Facilities Buildings, and the New Equate Headquarters.

The question is whether the near round of projects will do enough to help the country diversify its revenue streams, improve bureaucracy and regulation of companies, encourage private sector investment in both infrastructure and the corporate sector, and reduce its dependence on imported, cheap labour. Systemic economic and cultural shifts in the

country are required to achieve this, not least creating legislation that positively encourages foreign investment inflows into both the stock market and private corporate sector.

In recognition of some of these themes, the government notes that an important feature of this new round of investment is the inclusion of public private partnerships (PPP) in the project finance mix.

Last year a new law to regulate all PPPs was enacted, which the government hoped would spur private sector in Kuwait’s capital goods market. Under the law, the Partnerships Technical Bureau

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(PTB) was supplanted by the Kuwait Authority for Partnership Projects (KAPP), an independent government body that manages PPP projects. Under the PPP model, Kuwait is hoping to award the KWD442m Umm Al-Hayman Wastewater Treatment Plant in the fourth quarter of this year.

Kuwait has also revived the Metro and National Railroad projects, though no award is expected before 2016.

Additionally, the recently established Kuwait Authority for Partnership Projects (KAPP) is scheduled to roll out several power generation projects over this year and next. This will include desalination plants at Al-Zour North: Phase 2 and AlKhiran IWPPs by 2016 and the AlAbdaliya Integrated Solar Combined Cycle (ISCC) Power Plant (CSP).

More than KWD6.5b in oil and gas contracts are now expected to be signed this year, with packages 1-5 of the New Refinery project (Al-Zour), worth KD3.4 bn, dominating recent award mandates.

When finished, the refinery will be the largest in the GCC, processing as much as 615,000 barrels per day (b/d), essentially doubling Kuwait’s current refining capacity.

Bidding for the phases of the Al-Zour scheme opened in March; however many of the first round of bids came in well above budget. Project sponsor, stateowned Kuwait National Petroleum Company (KNPC) was compelled to put the projects on hold while it applied for an increase of KWD871m in budget spend. Following approval, project mandates for all five elements of the project were awarded in July and August to the lowest bidders in the March bidding round.

Tecnicas Reunidas/Sinopec/Hanwha, submitted the lowest bid of KWD1.1bn in the original bidding round for the first processing plant in the scheme. Fluor Corporation/HHI/Daewoo Engineering submitted two low winning bids: one worth KWD832m for a second processing plant and a further KWD 987m to construct utilities and offsite facilities for the scheme.

Hyundai E&C submitted the lowest bid, worth KWD 454m for the construction of marine facilities, the fifth element in the

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scheme; and finally, KNPC officials awarded the KWD475mcontract for tankage (the fourth element) to lowest bidder Italian firm Saipem earlier this month.

Also in July, Kuwait Oil Company, KOC, awarded a KWD222m ($733m) contract to UK-based Petrofac to develop a liquid transport system from a number of oil wells to gathering centres 29, 30, and 31 which are currently under development. The three gathering centres will help crude production capacity in Kuwait’s northern oil fields.

KOC also announced that it is planning a fourth gathering center (32) to be tendered in 2016.

The government announced in midAugust that it had awarded the contract to build a new terminal at Kuwait International Airport to the same consortium that had an earlier more-expensive bid dismissed. Turkey’s Limak Construction and local construction firm Kharafi National won the deal after bidding $4.34bn for the work – KWD74m dinars cheaper than the offer it submitted in November last year.

As with the Al-Zour project, a final decision on a project mandate was delayed when the lowest bid KWD1.38bn

by Limak Construction came in above the sponsor’s original KWD1bn budget. The Ministry of Public Works (MPW) asked the Central Tenders Committee (CTC) to cancel the tender until it could deliberate any change in the technical specifications and budget. The CTC announced in midAugust that the Limak-Kharafi consortium had submitted the lowest bid during the re-tendering process.

The Directorate General for Civil Aviation (DGCA), responsible for the airport, is also moving ahead with other projects. The deadline for prequalification for the KWD150m Passenger-Support Building is past. The shortlist of qualified companies is due in October, says a report on the Kuwaiti project market by NBK issued in August. “The project is designed to be a quick fix to relieve traffic pressure on the existing terminal. The DGCA is also looking to tender the KWD148m Runway & Parallel Taxiways Package. The tender is due to be issued in Q3,”says the bank.

In another project given the green light

over the summer, Kuwait’s Ministry of Public Works awarded local contractor Mushrif Trading & Contracting a KWD82m contract to develop a 40kmr road linking Mina Abdulla to Wafra.

Budgeted spend Kuwait’s National Assembly in early July approved the government’s spending for financial year 2015/2016. The revenue of state institutions is estimated at KWD12.2bn over the period (40% down on the previous year), with KWD1.2bn allotted to the Future Generations Fund.

Projected expenditure over the period was estimated at KWD19.17bn with the balance of expenses covered from the country’s reserve fund. Oil revenue accounts for 88% of the country’s total revenue.

Oil revenue is estimated at KD 10,598,900,000 over the period, some 44% lower than the previous fiscal year. This estimate is based on the $45 price of oil per barrel, and an exchange rate of 290 fils for a dollar and Kuwait’s quota in OPEC of some 2,700,000 barrels per day.

The projected budget deficit will most likely decrease considering the 2% increase in the selling price of Kuwaiti oil and the exchange rate of the dollar against the dinar.

However, the deficit will remain as long as the oil price is less than the equilibrium point in the budget — $77 dollars, after deducting the allotment for the Future Generations Fund.

Oil production costs meantime are projected at KWD2.48bn and the cost of production per barrel is estimated at KWD2.515. The non-oil revenue is projected at KWD1, 26bn, signifying a 15% increase compared to the previous fiscal year, though the assembly suggested that this might have been overstated.

The figures reflect a difficult situation for the government, even as it has reaffirmed its commitment to continue to invest in the country’s future. For some years the country has been painfully aware of the need to diversify away from its dependence on oil revenues; but continues to invest massively in the sector. Will this latest investment round signify real change? n

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SAUDI ARABIA – BOND ISSUANCE Photograph © Alexander Bakanov/Dreamstime.com, supplied August 2015.

Saudi Arabia’s new budget focus At a time when Saudi Arabia continues to pump out oil as demand falls and inventories rise, it has now turned to the capital markets to help prop up budget spend as export revenues and reserves fall. Saudi Arabia has tapped the capital markets twice in the last six weeks: the first involved some SAR15bn ($4bn) in seven and ten year bonds; followed by a SAR20bn issue. The issues were sold down rapidly in the local banking market, but while ratings agencies and investors remained quite sanguine about the bonds, it signals a new direction in Saudi economic affairs.

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ARKETS AND RATINGS agencies had expected the sovereign to tap the capital markets over the summer to help cover revenue shortfalls. The bonds were sold locally, rather than in the international capital markets, a move that some analysts say points to substantial liquidity in the Saudi banking sector.

Continued pressure on oil prices, added to Saudi Arabia’s current infrastructure spending plans suggests that the country’s budget deficit could rise to 15% of GDP. The Saudi economy is heavily dependent on oil, which accounts for 90% of fiscal revenues, 80% of current account revenues and 40% of the gross domestic product.

Gulf Council Cooperation (GCC) state stocks per se extended their decline in late August amid a global rout and as

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Brent crude fell below $45 per barrel for the first time since 2009. The slide in Brent to the lowest in more than six years is piling pressure on Gulf countries, which rely on oil income to fund government spending. The six-nation Gulf Cooperation Council is home to about 30 percent of the world’s proven crude reserves.

Until late July Saudi Arabia had been drawing down on its foreign reserves to sustain government spending. This time last year the Saudi Arabian Monetary Authority reported that reserves stood at $746bn; now Moody’s estimates they have fallen to $675bn. “We expect additional bond issuances on a monthly basis through the end of this year,”says Steven Hess, a Moody’s vice president. “Various media reports suggest the Kingdom could issue a further SAR20bn per month

through the rest of this year, which would bring the total issuance to SAR115bn or about 4.7% of our projected GDP for 2015, bringing total government debt to 6.4% of GDP this year. This would cover about 32% of our projected fiscal deficit for 2015, which is about 15% of GDP.” The IMF is more bearish, believing that a central government fiscal deficit will be nearer 19.5% this year, and while the deficit will decline in 2016 and beyond as one-off spending ends and large investment projects are completed, it will remain high over the medium-term. That’s because, says the agency, GDP growth is projected to slow to 2.8% this year, and then further to 2.4% in 2016 as government spending begins to adjust to the lower oil price environment. Over the medium-term, growth is expected to be around 3%. Inflation is

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SAUDI ARABIA – BOND ISSUANCE likely to remain subdued.

In February Saudi Arabia’s Council of Ministers endorsed a budget worth SAR860bn, with education allocated some 25% of total spending, healthcare 19% including funding for three new hospitals, three blood banks, and many primary care and specialist clinics across the country; transport and infrastructure taking 7.3%, water 7%, municipal services 5%.

The general belief is that Saudi Arabia is constrained to maintain current spending levels by growing social unrest among a growing population, much of it under 25, that cannot understand why the benefits of the last 25 years have not necessarily trickled down through Saudi society. It is a sensitive time too, as the country struggles to balance its sympathy with Islamic radicalisation and its uneasiness at the more extreme elements, such as the rise of Daesh and unrest in neighbouring Yemen, where it is leading a military coalition against the Iran-backed Houthis.

It is clear that the country has yet to articulate a consistent policy both internally and externally. In a July report, the IMF noted that the decline in oil prices “has increased the importance of structural reforms to switch the focus of growth away from the public sector and toward the private sector. With unemployment of nationals still high and the working-age population growing strongly, the government is continuing to focus on reforms that aim to increase the employment of nationals in the private sector and diversify the economy away from its reliance on oil”.

The IMF says it is looking for measures from the sovereign that include comprehensive energy price reforms, firm control of the public sector wage bill, greater efficiency in public sector investment, and an expansion of non-oil revenues, including by introducing a VAT and a land tax.

However, each year, the government does not explain what it does with as much as 36% of its annual budget spending. Some of this goes on defence and security. In recent years, the country has ramped up its military spending, investing billions of dollars into building and upgrading its arsenal amid growing

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unrest in the region. Even so, an equally significant portion also seems to be allocated to Al Saud family members. Not even the IMF talks about what the government does with more than one third of its spending.

While the governing elite looks to find consensus over policy, the administration has begun to make some cosmetic changes in an effort to show willingness to live within its means. The grandiose Madinah mosque development has been downsized.

Moreover, it has signalled that while it has raised crude oil production to 10.6m barrels a day since June, it is unlikely it will raise output further. However, the reality is that it is vain attempt to hold back the tide of market shifts. Iran will likely come on stream as a modest, though sizeable mainstream supplier next year, adding an additional 1m barrels a day to the mix (though that is something of a chimera as India has soaked up Iranian output for some years now and will continue to do the same going forward). So very little change there most likely. The real problem is that America, once Saudi’s main buyer now has more oil than it uses and continues to add its already large oil reserves at depots such as Cushing, Oklahoma.

Despite the rout in GCC equity markets, analysts are looking at change in the Saudi universe as a largely positive development.

“The most exciting development in the EM/FM universe, outside of the possible China A share market inclusion, is the potential presented by the opening up of the equity market in Saudi Arabia,” says

Jan Dehn, head of research at Ashmore Investment Management.

“The country opened its $500bn equity markets to Qualified Foreign Investors [from mid-June this year]. In the run up to the event, Saudi markets had performed exceptionally well. At one stage the Saudi markets were amongst the top three best performing markets globally. While the exuberance of local investors hoping for big foreign inflows may have been misplaced in the short term, in the long term, once the market access process is refined, this would be too formidable a market to ignore,”he adds.

The opening up of the market was not the cornucopia everyone expected. In part that is due to the conservatism of the Saudi’s. Market regulator, the Capital Markets Authority, looks to be keen to prevent any speculative money coming into the country. Consequently, it restricted trading to institutions and professionals with $5bn (£3.2bn) under management, and a five-year track record.

Moreover, foreign investors are still not allowed to take controlling stakes in Saudi Arabian companies, with the maximum holding of any single investor in a given company limited to 5%. The combined holding of all qualified foreign investors in any company is limited to 20%.

There are other niggles: among them, explains Dehn, is an onerous registration process, understanding the new independent custody model and practical issues of managing a pre-funded market (T+0 settlements). “Index providers have been cautious as to when and where (emerging market, or frontier market) the market would be included in indices. However, given the size, scale and liquidity of the Saudi market, it would not be far-fetched to see the market categorised in the EM indices category,”he thinks.

“The sovereign's re-entry into the bond market will also promote financial market deepening. A sovereign issuance will provide a benchmark for other entities that may want to borrow from capital markets, which would promote financial sector development and diversification away from overreliance on the banking sector,” says Moody’s Hess. n

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ASSET ALLOCATION Photograph © Naruto4836 /Dreamstime.com, supplied August 2015.

Emerging markets rout: A market out of fashion? or irrational speculation?

It is probably an understatement to suggest that August was a testing month for emerging markets.

Irrespective of the drivers of the recent route the sheer extent of market volatility in recent weeks only served to question the commitment of investors to segment as an allocation choice. Should emerging markets be worried that it is indicative of a lasting directional change?

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ARLIER THIS YEAR signs were it might be a tough year for the segment. After all, they face a basket full of challenges: sanctions against Russia, weaker commodities prices (bad for Brazil); China’s slowing economy, a strengthening US dollar (up at least 12% over the last ten months); and weak demand from Europe are all in the mix.

IIF’s August portfolio alert noted that EM flows fell to a year-to-date low of $4.5bn in the month as concerns about China sparked global market jitters. The sell-off intensified in late August and on Black Monday, August 24th touched the same magnitude as outflows on September 17th back in 2008, when Lehman’s bankruptcy triggers a global sell off.

It has been a longer story however with net non-resident inflows into emerging markets tracked by IIF

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averaging less than $3bn a month, compared to an average of $22bn over the last five years.

On a regional basis, IIF says EM Asia has seen the sharpest retrenchment in over the last two years and EM Europe experienced a seventh consecutive month of outflows.

Investors also have legitimate cause for concern. Since the 2007-2008 financial crisis, emerging markets have been on a credit binge, fuelled by ultra-low US interest rates that sent lenders looking farther afield for better returns. Over the six years through September 2014, private credit to the non-financial sectors of major developing countries almost tripled, to $4.3trn, according to the Bank for International Settlements, which are mainly denominated in (now) expensive dollars.

Moreover, average price to earnings ratios on Shanghai’s main board may

have dropped in the recent rout from a high of 22 to 15, but this is still way ahead of ratios this time last year when they hovered around a more acceptable 10.

Together these considerations have resulted in some significant blocks of capital flight. It has though been a year long, rather than summer trend.

Turkey/India: two inflection points Turkey, India, Indonesia, Brazil, and South Africa’s equity markets in particular have reported steady outflows since the start of the year. Clearly, it is hot money that is moving out over concerns that asset bubbles have built up, that emerging market economic growth is now slowing and that political risks are rising.

Like many leading emerging markets, the Indian equity market has underperformed in the last few months. Everyone has their own story, but in India’s particular

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case, this is due to rising concerns over subdued growth in the earnings of local corporations, the possibility of a delayed revival in economic activity, unseasonal rains and a weak monsoon for this year.

In Turkey meantime accelerating inflation and the inability of the central bank to respond by raising rates because of pressure from the president’s office to keep interest rates low is impacting the local-currency bond market adversely.

President Erdogan’s decision in late August to call elections to snap the country out of its torpor hit a bump as markets continued to tank.

According to Moody’s latest credit report, Erdogan’s gamble may not resolve the political impasse. The most likely outcome is a multi-party coalition, whose inherent instability would in the ratings agency’s view result in “additional elections before the nominal end of the parliamentary term in 2019. It would be challenging for the government to implement growth-enhancing structural reform measures and maintain strong fiscal and monetary policy anchors in a fragile political environment”.

The issue for Turkey, like all emerging markets caught in the current global gloop is that investors not only look for growth but also continual market reform.

Given the current fragile global environment, that won’t be too high on any incoming government’s priorities.

GDP growth will likely fall to 2.5% this year from 2.9% in 2014, a view that Moody’s says is supported by the country’s August consumer confidence index, which, at 62.4%, was at its lowest level in six years.

Unemployment rose 10.2% in May 2015 from 9.9% the month before. Moreover, despite the continued low oil prices, the lira’s weakness has kept inflation high (6.8% in the 12 months to July.

Nervy investor sentiment has raised government borrowing costs with 10-year government bond yields at 9.34% in July from 6.96% in January this year.

More systemic shifts in play The two countries typify some of the individual considerations (markets still in need of reform and markets that are

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hostage to political fortunes) that look to be weighing heavily on investors seeking a safe haven for their assets. However, there are more systemic shifts in play.

Western banks also look to be pulling back their exposure to emerging markets, particularly in those markets where profits have been hard to find. Lending to emerging market borrowers has (as a result) been an early casualty of the shift.

According to recent estimates from the BIS, the outstanding stock of cross-border lending into developing nations decreased by about $80bn in the last three months of 2014 -- the largest quarterly withdrawal in more than five years.

According to Bloomberg, the outflow from China, at $51bn, was the largest in nominal terms, followed by Russia, with $19bn. Measured as a share of gross domestic product, cross-border lending declined the most in Malaysia, followed

by Angola.

There have been the obvious high profile moves; among them HSBC’s accelerating a plan to break from key emerging markets, in a renewed effort to become “simpler and smaller”. HSBC Holdings Plc is among global lenders facing pressure to exit underperforming businesses, particularly in Asia, where few foreign banks have achieved stellar financial success.

The case should not be over-stated, as any pull-back by western banks creates opportunities for either local banks to fill in the gap and assert themselves at home; or upcoming western banks with international pretensions to build their brands abroad.

There are also philosophical/theoretical questions to answer. Asset prices have been distorted by many years of ultra-low interest rates. Emerging markets looked to be the answer, but the massive inflows of money into these economies inflated local real estate prices and pushed up stock values. With so much money now exiting the segment, the question is: will it lead to financial instability at a delicate time in international relations? Moreover, what will be the long term effect of ultra-low interest rates on both developed and emerging economies – not much

thinking has been articulated around these questions.

The danger is that leading emerging economies such as Turkey start pushing up interest rates to help prevent the exit of capital too quickly. Then there is the contagion effect of others following suit and speculators benefiting from that nasty cycle. That’s because, as we all know, economics 101, once you start raising interest rates by too much it damages the value of longer term assets.

The other issue to keep in mind is the oft stated reluctance of the US Federal Reserve to raise rates. Most expect the first rise to be registered in the early autumn; though others think any rise will be much later in the year. The events of the summer are likely to keep any US rate rise later rather than sooner this year.

For now the focus is more on Chinese monetary policy, with investors looking for signs of easing to help support the still fragile mainland stock markets; with some analysts looking for a reduction in the central bank’s reserve requirement.

What is clear that the immediate casualty of current market volatility is the new issues market. For their part credit markets have been sluggish through most of August, with issuers and traders paying close attention to equity market volatility.

Equally, the investment equation is not simplistic. Successful investing is about picking the right sweet spot. AXA Investment Managers (AXA IM), recently launched its WF Asian Short Duration Bonds. AXA IM says the fund’s investment approach is not tied to a benchmark and instead takes a total return approach to investing, focusing selectively on high yield and investment grade credits with a short duration.

“Against a backdrop of favourable demographics and longer term structural factors, Asia remains an important driver for global economic growth over the longer term. In the near term, we believe that it will continue to stand out for its higher yielding environment, as well as being a net oil importer and beneficiary of lower oil prices,”says Jim Veneau, head of fixed income at AXA IM and lead manager on the fund. n

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LEGAL LETTER

SFO compelled interviews : legal representation rights This article considers the recent decision in The Queen on the Application of Jason Lord, Paul Reynolds, Justin Mayger v Director of the Serious Fraud Office [2015] EWHC 865 (Admin). It looks at the High Court's ruling to refuse permission to judicially review the decision of the Serious Fraud Office to prevent three senior employees from being accompanied by the external legal representative of their employer at a section 2 compelled interview. Abdulali Jiwaji and Rory Spillman of Signature Litigation take us through process and the implications for witnesses.

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HE HIGH COURT has refused permission to judicially review the decision of the Serious Fraud Office (SFO) to refuse to permit three senior employees to be accompanied by the external legal representative of their employer at a s.2 compelled interview.

Whether the SFO is willing to permit a legal representative to attend a compelled interview is dependent on whether the proposed legal representative's presence may be considered to be potentially prejudicial to the SFO's investigation.

GlaxoSmithKline plc (GSK) has been and is the subject of a number of investigations in multiple jurisdictions with respect to alleged bribery and corruption.

On May 27th 2014 the SFO announced that it had opened a criminal investigation into the commercial practices of GSK and its subsidiaries. As part of its investigation the SFO served notices on three senior individuals within GSK to attend compelled interviews pursuant to Section 2 of the Criminal Justice Act 1987. Section 2 provides the Director of the SFO with certain investigatory powers, including the power to compel an individual to attend an interview and answer questions.

There was no suggestion that these individuals were suspects: they were being interviewed as witnesses in order to further the SFO's investigation. The three individuals in question confirmed their attendance and advised the SFO that they wished to be accompanied by a legal representative.

Each individual had retained the same law firm representing GSK with respect to the investigation. The SFO initially opposed the three individuals being accompanied

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by any legal representative. However, during the course of correspondence the SFO agreed to allow the individuals to be accompanied by legal representatives, but refused to allow this to be the legal representatives of GSK. The three individuals brought an application for permission to judicially review the decision of the SFO on the following grounds: the SFO had breached the common law right of an individual to be accompanied by a legal representative of his/her choice; the SFO had acted contrary to its own policy; and the decision was irrational.

In refusing permission the High Court found that the grounds were unarguable.

Although there is a general right at common law to consult privately with a solicitor when detained in custody, there is no common law right to be accompanied by a solicitor at a Section 2 interview.

Nothing in the Act conferred any such right upon an interviewee and it would be for Parliament to create such a right.

The SFO's policy, as evidenced in its Operational Handbook, is to permit the attendance of legal representatives at Section 2 interviews on the condition that their attendance does not unduly delay or in any way prejudice the investigation and the legal representative understands their role, which is different to that of a PACE interview.

The written policy of the SFO goes further and indicates that it is not always appropriate to allow solicitors acting for companies to be present when an employee is being interviewed as there may be a conflict of interests between the

employer and the employee.

The SFO was entitled to take the view that there was a real risk of its investigation being prejudiced by the presence of the legal representative. Such prejudice included the risk that the legal representative would be under a professional obligation to report back to the employer and, as a result, may interfere with the candour in which the interviews are normally conducted, hindering the SFO's chances of obtaining relevant information. The SFO did not have to prove that an actual conflict existed.

However, there was no restriction on the interviewees seeking the advice of GSK's legal representatives before the interviews and reporting back to GSK and its legal representatives after the interview. Further the individuals were free to retain and instruct any other solicitors to act for them with respect to the interview.

The Court also confirmed that arguments invoking the European Convention of Human Rights did not take the matter further in circumstances where the interviewee being interviewed pursuant to Section.2 has not been arrested or detained.

The Court was careful to indicate that its findings were only with respect to the circumstances of this particular case. The SFO's objection to the presence of a legal representative will, at least according to its own written policy, need to be considered on a case by case basis. The SFO's Operational Handbook is currently under revision, and it will be interesting to see how the SFO, and indeed other investigators, approach this area going forward. n

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MARKET DATA BY FTSE RESEARCH

ASSET CLASS RETURNS 1M% EQUITIES (FTSE) (TR, Local) FTSE All-World USA Japan UK Asia Pacific ex Japan Europe ex UK Emerging

12M%

-2.9 -1.9 -2.8

8.8 7.3 32.2 0.7 3.4 11.2 8.2

-6.3 -4.1 -4.3 -2.1

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

-46.1

-1.1 -1.5

-11.7 -18.3 -31.4

-4.2 0.3

GOVERNMENT BONDS (FTSE) (TR, Local) US (7-10 y) UK (7-10 y) Germany (7-10 y) France(7-10 y) Italy(7-10 y)

-1.5 -1.6 -1.7 -2.6 -3.0

3.6 6.8 4.8 4.3 4.9

-2.6 -2.0

4.8 1.8

CORPORATE BONDS (FTSE) (TR, Local) UK BBB Euro BBB FX - TRADE WEIGHTED USD GBP EUR JPY

-1.2

19.2 5.8

1.8 -10.6 -10.0

0.1 0.6

-10

-5

0

5

-75

-50

-25

0

25

50

EQUITY MARKET TOTAL RETURNS (LOCAL CURRENCY BASIS) Regions 1M local ccy (TR) -1.9 -2.1

Japan Developed USA Europe ex UK FTSE All-World UK Asia Pacific ex Japan Emerging BRIC -6.3

-7

Regions 12M local ccy (TR)

-4.1 -4.3

-6

-5

-4

-3

32.2

Japan BRIC Europe ex UK Emerging FTSE All-World Developed USA Asia Pacific ex Japan UK

-2.8 -2.9 -2.9 -3.0

-2

-1

0

11.4 11.2 8.9 8.8 8.2 7.3 3.4 0.7

0

10

Developed 1M local ccy (TR) Japan Italy Belgium/Lux Netherlands Finland Switzerland Denmark Developed USA Sweden UK France Norway Australia Israel Germany Hong Kong Spain Canada Korea -6.3 Singapore -6.5

-7

-2.8 -2.9 -2.9 -3.0 -3.0 -3.4 -3.6 -3.7 -3.7 -4.0 -4.0 -4.1 -4.1 -4.2 -4.9 -5.2

-6

-5

-4

-3

-2

-1

0

-10

Emerging 1M local ccy (TR) Indonesia India Mexico Taiwan Thailand Emerging China Malaysia Brazil Russia South Africa

0.8 0.7 0.5 -0.6 -1.5 -2.1 -2.5 -2.7 -5.3 -6.2

-6

-4

-2

0

2

40

32.2 29.1 28.9 23.7 19.3 16.5 15.3 12.6 12.2 8.9 8.5 7.9 7.3 5.4 5.1 4.1 1.6 0.7 0.4

0

10

20

30

40

Emerging 12M local ccy (TR) China India Taiwan Emerging South Africa Mexico Indonesia Thailand Brazil Malaysia Russia

2.1

-8

30

Developed 12M local ccy (TR) Japan Denmark Belgium/Lux Netherlands Israel Sweden Finland Germany France Developed Hong Kong Italy USA Australia Switzerland Canada Spain UK Singapore Norway -2.1 Korea -4.5

-1.6 -1.9 -2.1

20

4

28.1 12.5 12.1 8.2 7.1 6.8 2.7 2.6 0.1 -8.3 -27.4

-40 -30 -20 -10

0

10

20

30

40

Source: FTSE Monthly Markets Brief. Data as at the end of June 2015.

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J U LY / A U G U S T 2 0 1 5 • F T S E G L O B A L M A R K E T S

Test_Layout.qxp_. 28/08/2015 08:49 Page 47

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World Japan Europe ex UK

USU Emerging

UK

Global Sectors Relative to FTSE All-World Basic Materials Consumer Services Technology

Oil & Gas Health Care Financials 120

Asia Pacific ex-Japan

120

Consumer Goods Industrials Telecommunications Utilities

110

110

100 100 90 90 80 80 Jun 2013

Oct 2013

Feb 2014

Jun 2014

Oct 2014

Feb 2015

Jun 2015

70 Jun 2013

Oct 2013

Feb 2014

Jun 2014

Oct 2014

Feb 2015

Jun 2015

BOND MARKET RETURNS 1M%

12M%

FTSE GOVERNMENT BONDS (TR, Local) US (7-10 y)

-1.5

UK (7-10 y)

3.6

-1.6

Ger (7-10 y)

6.8

-1.7

4.8

Japan (7-10 y)

1.8

-0.3

France (7-10 y)

-2.6

Italy (7-10 y)

4.3

-3.0

4.9

FTSE CORPORATE BONDS (TR, Local) UK (7-10 y)

-2.2

Euro (7-10 y)

6.2

-3.3

3.1

UK BBB

-2.6

4.8

Euro BBB

1.8

-2.0

UK Non Financial

-2.4

Euro Non Financial

6.6 2.3

-2.0

FTSE INFLATION-LINKED BONDS (TR, Local) UK (7-10)

4.9

-1.0

-3.5

-3

-2.5

-2

-1.5

-1

-0.5

0

0

1

2

3

4

5

6

7

8

BOND MARKET DYNAMICS – YIELDS AND SPREADS Government Bond Yields (7-10 yr)

Corporate Bond Yields

US

Japan

UK

Ger

France

Italy

U UK BBB

6.00

Euro BBB

6.00

5.00 5.00 4.00 3.00

4.00

2.00

3.00

1.00 2.00

0.00 -1.00 Jun 2012

Dec 2012

Jun 2013

Dec 2013

Jun 2014

Dec 2014

Jun 2015

1.00 Jun 2010

Jun 2011

Jun 2012

Jun 2013

Jun 2014

Jun 2015

Source: FTSE Monthly Markets Brief. Data as at the end of June 2015.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 5

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MARKET DATA BY FTSE RESEARCH

COMPARING BOND AND EQUITY TOTAL RETURNS FTSE UK Bond vs. FTSE UK 12M (TR) FTSE UK Bond

FTSE US Bond vs. FTSE US 12M (TR)

FTSE UK

FTSE US Bond

110

115

105

110

100

105

95

100

90 Jun 2014

Sep 2014

Dec 2014

Mar 2015

95 Jun 2014

Jun 2015

FTSE UK Bond vs. FTSE UK 5Y (TR) FTSE UK Bond

FTSE US

Sep 2014

Dec 2014

Mar 2015

Jun 2015

FTSE US Bond vs. FTSE US 5Y (TR)

FTSE UK

FTSE US Bond

180

FTSE US

240 220

160

200 180

140

160 120

140 120

100 100 80 Jun 2010

80 Jun 2010

Jun 2011

Jun 2012

Jun 2013

Jun 2014

1M% FTSE UK Index

Jun 2015

3M%

Jun 2012

FTSE USA Index

-6

-4

-2

-3

-2

123.0

-0.5

19.9

-1.1

0

59.6

1.5

-1.7

-0.8

FTSE USA Bond

0.9

-1

0

Jun 2015

5Y%

0.3

-0.9

Jun 2014

1.8

-1.9

FTSE UK Bond

Jun 2013

6M%

-2.4

-6.3

-8

Jun 2011

1

-1

0

1

17.4

2

0

50

100

Source: FTSE Monthly Markets Brief. Data as at the end of June 2015.

48

J U LY / A U G U S T 2 0 1 5 • F T S E G L O B A L M A R K E T S

150

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