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    PREDICTIONS 2016 STAIRWAY TO HEAVEN, HIGHWAY TO HELL BREAKINGVIEWS


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    PREDICTIONS 2016 STAIRWAY TO HEAVEN, HIGHWAY TO HELL BREAKINGVIEWS


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    PREDICTIONS 2016 CONTENTS Introduction.............................................................................................. 4 The Thrill is Gone .................................................................................... 6  Fed liftoff will reinvigorate key market gauges  Two signs of M&A bacchanal’s last hurrah  U.S., Chinese unicorns will bolt in opposite ways  Arab sovereign wealth fund exodus just beginning  From Caterpillar an activist investor will hatch  Europe’s least bad option: ditch Schengen  Giants of central banking will be cut down to size  Argentina and Elliott give peace a chance in 2016  Quarterly reporting to get a major rethink  Recession probably awaits next White House chief Anticipation ..........................................................................................25  Disney awakens the financial power of the Force  Bank rule zealots will be forced to back down  Cheap batteries will give utilities electric shock  Virtual reality will spring to life in 2016  Rail mega-deal holds ticket to runaway M&A train  A (fake) bank CEO memo on plans to leave London  China will stop ignoring Facebook’s friend request  Capital squeeze will spark unicorn M&A orgy  London’s bankers should retrain as builders  Drought, not just of ideas, challenges Africa BREAKINGVIEWS


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    CONTENTS A Hard Rain’s A-Gonna Fall ................................................................. 43  Balance sheets will get more unbalanced in 2016  Global corporate profit is under serious threat  Volkswagen top brass will be up for the chop  Luxury groups could shrink their way to riches  Brazil crisis may have silver lining: Rule of law  The illusion of debt-fuelled earnings  Fund glut will send Asia’s buyout barons off-piste  Climate will supplant shale as top energy disruptor Won’t Get Fooled Again ..................................................................... 60  The Fed may be cutting rates again within a year  Oil will blow past $80 a barrel in 2016  Home economics cloud Clinton White House run  Numbers add up to HSBC leaving London  Annual reports offer front-page warnings  Global economy depends on more than India in 2016  Netflix will be recast from ally to villain  The Uber or Airbnb of finance will prove elusive  Global smartphone brands face mass extinction  Host Brazil may challenge for 2016 Olympics glory Acknowledgements .............................................................................. 76


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    PREDICTIONS 2016 INTRODUCTION It’s the end of the world as we know it – or at least as we’ve known it for the past seven years. The money for nothing that fueled government spending, emerging markets and the allure of risky financial assets will start going the way of disco in 2016 as the U.S. Federal Reserve raises interest rates. For nations and corporations with strong balance sheets, it could be a welcome shift – even a stairway to heaven. For overvalued businesses, profligate governments and high-yield markets, danger lies ahead – perhaps a highway to hell. That’s the theme of Reuters Breakingviews’ Predictions 2016, a collection of financial insight aimed at giving readers a jump on the year ahead. If the past is any indication, many of the pieces will be pitch-perfect. A year ago we said Deutsche Bank would oust its leaders and accounting fraud would become a top regulatory priority. Bingo. But we also forecast oil at $80 a barrel and a cooling mergers and acquisitions market. Right or wrong, our goal is to offer intelligent and provocative ideas in our typically pithy format. This year’s book is divided into four classic rock-inspired sections: The Thrill Is Gone, Anticipation, A Hard Rain’s A-Gonna Fall and Won’t Get Fooled Again. In the first category, we are doubling down on our view that mergers and acquisitions have peaked in America. Also look for oil-rich nations like Saudi Arabia to start raiding sovereign wealth funds to pay for social stability. Musician Robert Plant (R), lead singer of British rock band Led Zeppelin, performs during the 13th Mawazine World Rhythms International Music Festival in Rabat June 5, 2014. REUTERS/Youssef Boudlal BREAKINGVIEWS 4


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    INTRODUCTION A new U.S. president will take office just in time to battle the first recession since the financial crisis, and old-school interest rate indicators make a revival as the Fed raises rates again. Quarterly reporting will get a rethink – a prediction British insurer Legal & General just proved true. Activist investors will roam again and may move the earth under U.S. machinery maker Caterpillar. Many nations and companies will be judged on how well they anticipate challenges in the new monetary environment. Brazil’s economy will probably get worse before getting better, but the rule of law should help the nation emerge stronger from its crisis. China will allow Facebook to re-enter the Middle Kingdom, and entertainment juggernaut Walt Disney will rocket higher with the Star Wars franchise. Meanwhile, prudent banks will spend the year preparing thoroughly for Britain’s possible exit from the European Union. Tough times are ahead for the likes of Valeant Pharmaceuticals and other corporate rollups that padded profit with cheap money and financial engineering. The overall earnings of U.S. companies will take a hit from competition, disruption and tax policy after accounting for a historically high share of economic output. Elsewhere, big energy companies will scramble to account for decades of downplaying climate concerns. And lousy governance could force wrenching changes in the boardrooms of Volkswagen and Glencore. Anyone who vows not to get fooled again almost certainly will. A world hunkering down for more sub-$50 a barrel oil will breathe a sigh of relief as the price rises – wait for it – past $80. Media moguls who once considered Netflix an ally will come to view the video-streaming service as a villain, and companies will probably regret some of the self-aggrandizing titles they splashed on the covers of their annual reports. Even the Fed, having confidently raised interest rates, may wind up having to cut them again as 2016 draws to a close. We also have predictions about Prada, HSBC, Argentina and other topics. And if you want to know what country will bring home the most medals from this summer’s Olympics in Rio de Janeiro, check out our calculator. Prescient but imperfect, and with dated taste in music, we nonetheless promise to cover the coming year with the clarity, speed and insight that you expect. Join us now for a glimpse of the near future. Stick around to see how it all turns out. Reynolds Holding Law editor, Reuters Breakingviews Jan. 4, 2016 5


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    PREDICTIONS 2016 THE THRILL IS GONE FED LIFTOFF WILL REINVIGORATE KEY MARKET GAUGES BY RICHARD BEALES As the Federal Reserve starts exercising some atrophied muscles, traders will have to relearn their craft, too. The U.S. central bank is getting used to the idea of lifting rates above zero for the first time in seven years. That will reinvigorate some old-school market gauges. People used to watch fed funds futures, Eurodollar derivatives and a clutch of traded measures of inflation like hawks (or doves). These indicators are due fresh attention – even if their meaning has morphed. The Fed guessing game will intensify as traders make bets on what Chair Janet Yellen and her colleagues will do at each of 2016’s eight monetary policy meetings. Fed funds futures, nowadays helpfully analyzed on the CME’s FedWatch web pages, provide a market-implied trajectory for overnight interest rates in the near term. There are wrinkles in the post-financial crisis world, though. For instance, if the Fed sticks to a range for the fed funds rate rather than a specific level – the official target for seven years has been between zero and 0.25 percent – it makes the meaning of futures prices fuzzier because calculating implied probabilities of Fed moves requires assumptions about exact target rates. More broadly, financial markets have changed since before the financial crisis. Banks must hold more capital and they face other regulatory constraints, while central bank balance sheets have expanded dramatically – the Fed’s has swollen to $4.5 trillion from under $1 trillion in early 2008. Such effects could create new distortions relating to inventory levels, market liquidity and trading norms. That’s even more significant for other tools like overnight indexed swap (OIS) rates and Eurodollar futures. Using Eurodollar futures, for instance, to glean the market’s view of the longer- term path of Fed policy involves estimating the so-called basis, or gap, BREAKINGVIEWS 6


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    THE THRILL IS GONE Source: Factiva. REUTERS/Richard Beales and Katrina Hamlin 7


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    PREDICTIONS 2016 between Libor and fed funds rates. Pre-crisis rules of thumb may prove way off. Fed-watchers will also eventually need to track inflation again. Statistical estimates, even those aiming to exclude energy costs, could be suppressed by recent low oil and commodity prices. Financial measures, like breakeven rates on U.S. Treasury inflation-protected securities or TIPS, may suffer from the same post-crisis market distortions. Traditional navigational instruments may still point in the right directions, but traders feeling out how they now relate to each other could cause a few market fender benders in the year to come. Published December 2015 TWO SIGNS OF M&A BACCHANAL’S LAST HURRAH BY ROB COX Pfizer’s $160 billion takeover of Allergan marked a few milestones in the mergers and acquisitions trade. It was the top deal of the year, exceeding Anheuser-Busch InBev’s purchase of SABMiller, and by some measures is the second biggest in history. The all-stock transaction also vaulted the total value of corporate dealmaking in 2015 beyond the record set in 2007, just before the financial crisis shuddered things to a halt. The pharmaceuticals union also printed another, more dubious superlative as one of the largest deals ever predicated on exploiting global tax loopholes. Without the ability for Pfizer, the larger of the two companies, to back its way into Allergan’s lower-tax Irish domicile, the maker of Viagra, Lyrica and other sweet-sounding compounds would have incinerated some $17 billion of shareholder treasure. That this high-water mark of M&A is justified by its tax workaround would be sign enough that the two-year boom of extraordinary corporate promiscuity is reaching its logical conclusion. Other, perhaps less perceptible, warning bells are clanging, too, which suggest companies are increasingly pursuing financial engineering to fix troubled core businesses, a trend that in previous booms has ended poorly for investors. BREAKINGVIEWS 8


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    THE THRILL IS GONE Spectators are silhouetted as they watch Italy’s fireworks during the 6th World Pyrotechnics Olympics in Manila Feb. 14, 2015. REUTERS/Romeo Ranoco The desire of companies to band together and reduce overlapping costs won’t diminish any time soon, particularly as the prospects for global economic growth look mediocre at best. Thanks to Pfizer’s combination with Allergan, the value of worldwide announced M&A reached $4.2 trillion in 2015, according to data compiled by Thomson Reuters, up from around $3.5 trillion in 2014, and surpassing the record achieved eight years earlier. Pfizer isn’t the first healthcare company to take advantage of a so-called inversion, wherein it merges with a rival based outside the United States to reduce the overall tax burden in ways that enhance the bottom line. Pfizer’s is, however, far and away the biggest on record: The drugmaker led by Ian Read is expected to save $1.7 billion in payments to the tax man by 2018, according to an analysis of the deal by my colleague Rob Cyran. What’s more, Pfizer’s inversion is larger than the previous 10 such deals in the industry combined. That includes the $66 billion merger with Actavis that created Allergan earlier in 2015. Together, those transactions add up to around $140 billion in value, Thomson Reuters data show. 9


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    PREDICTIONS 2016 At least Pfizer can justify the expenditure on Allergan using arithmetic, however illusory the savings may turn out to be if the U.S. government modifies its tax code in the next couple of years. A handful of smaller takeovers, unveiled in the days leading to Pfizer’s big one, are harder to fathom, and point to an anecdotal spate of distracted dealmaking that is often emblematic of a peak in the M&A business. Take the case of Urban Outfitters, the $2.9 billion apparel retailer, buying a pizza chain. Its acquisition of The Vetri Family group of restaurants is guided by the notion that Urban Outfitters, which also operates the Anthropologie brand, can increase foot traffic to its stores by selling customers food and beverages alongside scarves and underpants. According to Urban Outfitters Chief Executive Richard Hayne: “Spending on casual dining is expanding rapidly, and thus, we believe there is tremendous opportunity to expand the Pizzeria Vetri concept.” While consumers may be spending more on mozzarella than denim, it’s a clear instance of strategic shift for a fashion company in trouble. Urban Outfitters shares have lost more than a third of their value this year. Its third-quarter sales, released shortly after the pizza purchase, came in shy of what analysts had been expecting and its same-store sales barely budged from the year before. Pandora, the $3 billion music-streaming pioneer, is another example of a company reverting to M&A to stray beyond its challenged main operations. Like Urban Outfitters, the market has not been kind to Pandora shareholders, who are down some 20 percent on their investment year to date. It’s not usually a show of confidence, however, that the company has been buying assets in so-called “adjacent” businesses to its own. On the same day Urban Outfitters got into the pizza game, Pandora agreed to pay $75 million for some technology and intellectual property assets of Rdio, a rival service of sorts that filed for bankruptcy. The deal, coming after a profit-warning shocker and an earlier move into the “adjacency” of live music ticket sales with the $450 million purchase of Ticketfly, further unnerved shareholders. BREAKINGVIEWS 10


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    THE THRILL IS GONE Pandora’s boss Brian McAndrews described the deals as “defining the next chapter of Pandora’s growth story.” The implication, however, is that Pandora’s current chapter is over. ConAgra, meanwhile, has already started and ended a new phase within this very deal cycle. It disastrously tried to marry its branded consumer goods like Chef Boyardee with the white-label Ralcorp. Some two years after paying $5.1 billion for the business, it agreed in November to offload it to TreeHouse Foods for $2.7 billion. Earlier eras experienced similar adjacency calamities. Nokia got into mapping software with Navteq, paying $8.1 billion in 2007 and offloading it in 2015 for $5 billion less. In a previous boom, Germany’s Daimler spectacularly failed to combine its luxury car know-how with the mass- market Chrysler. And the AOL-Time Warner combo of that vintage still stands as the mother of all mission drifts. As such deals increasingly characterize the latest M&A bacchanal – along with those where clever financial structures overwhelm strategic logic – it presents strong evidence of a last hurrah. Published December 2015 U.S., CHINESE UNICORNS WILL BOLT IN OPPOSITE WAYS BY ROBYN MAK A fall in tech valuations may send U.S. and Chinese unicorns running in different directions. Several private Silicon Valley firms worth $1 billion or more have taken valuation hits once they are in the public eye. The same may be happening to one-horned beasts in the People’s Republic, only in private. Take Jack Dorsey’s U.S. online payments outfit, Square. The shares popped enthusiastically on the company’s stock market debut in November, but its market capitalization remains about a third below the $6 billion price tag implied by an earlier private funding round. Some unicorns that have yet to go public are already feeling the chill. Fidelity Investments, a prominent investor in late-stage private financings, recently marked down its holding in Snapchat by 25 percent from a headline valuation of $16 billion in May. 11


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    PREDICTIONS 2016 Source: CB Insights. REUTERS/Robyn Mak Super-unicorns such as Uber and Airbnb, valued at roughly $50 billion and $25 billion, respectively, on the strength of relatively small private fundraising exercises, can still tap Fidelity, T. Rowe Price and others for funds. These investors may be more cautious than they were, but it’s a more appealing option than an initial public offering with the risk of a very public drop in valuation. Of the four unicorns that have listed in 2015 only one, Shopify, floated at a mark higher than its last private price, according to data compiled by TechCrunch. Of the 14 that have gone public since 2011, half have traded down since their IPOs. Meanwhile the number of U.S. private-market unicorns continues to rise. China’s members of the club face skepticism, too, but in pre-IPO markets. Private equity and venture capital appetites have cooled since the stock market crashed in June, with investments for October hitting $2 billion – just a third of the previous month’s total, according to Zero2IPO research, and down 30 percent year-on-year. The slowdown probably helped prompt October’s $15 billion merger deal between two group-discount website unicorns, Meituan and Dianping. And U.S.-style late-stage funding from established institutions is hard to come by. BREAKINGVIEWS 12


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    THE THRILL IS GONE That means many of China’s startups may not have the option to stay private. They may not want to anyway, because public valuations are still high. The Nasdaq-style ChiNext board in Shenzhen trades at a whopping 80 times earnings and is up 80 percent this year. Regulators recently lifted an IPO ban, too. Funding scares will probably cause U.S. unicorns to shy away from IPOs, but the Chinese species may run towards them. Published December 2015 ARAB SOVEREIGN WEALTH FUND EXODUS JUST BEGINNING BY ANDY CRITCHLOW Oil-rich Gulf sheikhdoms are being forced to raid their sovereign wealth funds to shore up their budgets. With U.S. crude oil prices falling below $40 per barrel in December, they have no choice but to reach into these rainy- day savings. For now, they can hold on to some of their trophy assets, like strategic investments in Volkswagen or Barclays. But if crude prices keep tumbling, a fire sale will be hard to avoid. During the most recent energy boom, the six members of the Gulf Cooperation Council (GCC) – including Saudi Arabia, Qatar and Kuwait – amassed sovereign funds worth more than $2.3 trillion. These assets have traditionally comprised a mix of debt and other securities, in addition to influential stakes in some of the world’s biggest companies such as Glencore, VW and Barclays. Large chunks of this cash are now being repatriated back to the region to finance widening budget deficits, which this year are expected to be in the region of 13 percent of GDP in the GCC. Should oil prices average $56 per barrel next year, then GCC states would need to liquidate some $208 billion of their overseas assets, or just below 10 percent of their sovereign fund holdings, based on a Breakingviews analysis of their fiscal break-even costs. But if oil prices fall to $20 a barrel, as Goldman Sachs has warned, the GCC states may have to sell $494 billion worth of booty to make up the 13


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    PREDICTIONS 2016 budgetary shortfalls based on forecast fiscal costs for their oil production in 2016. This is provided they maintain the lavish rates of public spending that the region’s populations have become accustomed to. At that rate of divestment these sheikhdoms – which pump about a fifth of the world’s oil – would almost drain their funds entirely by 2020. The Saudi Arabian Monetary Agency, which also acts as the country’s central bank, has already started to sell down some of its foreign assets, while money managers are reporting growing redemptions from other funds in the region. Gulf rulers have so far resisted any temptation to jettison their most treasured assets, which in many cases have granted them board seats atop some of the world’s leading companies. If oil keeps falling, even these investment jewels will come up for grabs. Published December 2015 FROM CATERPILLAR AN ACTIVIST BUTTERFLY MAY HATCH BY ROB COX Caterpillar, the $39 billion maker of machines that dig mines and lay asphalt, is ready for a metamorphosis. Daft deals hatched at the height of the commodities and Chinese investment booms have trashed the company’s stock and damaged the credibility of its management. An investor seeking change, potentially a breakup of the conglomerate, could play well on Wall Street, if not in Peoria. The company led by Chief Executive Doug Oberhelman emits the kind of pheromones that attract pushy investors like Nelson Peltz, whose Trian recently bought a stake in General Electric. Caterpillar has no single large shareholder, making it easy for an activist to creep into the capital structure and make a stink. Caterpillar’s executive team is also vulnerable. Five years ago, the company, based in Peoria, Illinois, struck its biggest acquisition since founder Benjamin Holt rolled out the first of his steam tractors capable of crawling, caterpillar-like, over soggy farmland. Just after taking charge of the BREAKINGVIEWS 14


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    THE THRILL IS GONE A Caterpillar excavator machine is seen at a work site in Detroit, Michigan Jan. 25, 2013. REUTERS/ Rebecca Cook company that has now employed him for 40 years, Oberhelman paid $8.6 billion for Bucyrus, which makes equipment used to mine raw materials like iron ore. The deal is fast becoming a case study in bad timing. A global commodities glut slammed Caterpillar’s new customer base, and shows no sign of relenting. Anglo American, for instance, initiated a restructuring that will cull 85,000 employees. Shares of the seven big London-listed miners have halved in value this year. Caterpillar’s own stock has shed a fifth of its value since acquiring Bucyrus. The S&P 500 Index, by comparison, has gained 72 percent over the same span. And Bucyrus’ main rival, Joy Global, has lost 84 percent of its market value, implying that Caterpillar has been dragged down by infesting its other world-class businesses with dangerous commodities. Though Caterpillar is best known for its earth-moving machinery, Credit Suisse notes that the company derives 39 percent of sales and 53 percent of profit from its energy and transportation business. That division manufactures turbines and other apparatus that compete with GE, whose shares have nearly doubled since Caterpillar bought Bucyrus. 15


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    PREDICTIONS 2016 Add it all up and Caterpillar may soon find itself exposed to a new investor eager to crack open the chrysalis in search of a butterfly. Published December 2015 EUROPE’S LEAST BAD OPTION: DITCH SCHENGEN BY NEIL UNMACK The least bad way to help Europe may be to dismantle Schengen. The 26-country free border zone is struggling to cope with refugees and security risks. Abolishing Schengen would be expensive, wouldn’t solve migration problems and would look like a U-turn on core European Union principles. Yet it might dampen the populism that threatens Europe’s economic integration. Like the euro, the Schengen zone that enables 400 million European citizens to travel without passports has proven incapable of coping with real-world pressures. Schengen made it easier for citizens to travel and A Syrian refugee cries while disembarking from a flooded raft on the Greek island of Lesbos, after crossing a part of the Aegean Sea from the Turkish coast, Oct. 20, 2015. REUTERS/Yannis Behrakis BREAKINGVIEWS 16


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    THE THRILL IS GONE trade. But it lacked a proper system for protecting external borders in Greece, Italy or Eastern Europe, or a system for rehousing asylum seekers. Its loose security arrangements look naïve in an era of homeland extremist attacks, like Paris on Nov. 13. And just like the euro, the ideal solution would be to have more Schengen, not less. That would mean policing external borders properly, sharing genuine asylum seekers equitably. It requires trust, cooperation and time. Instead, the region is going backwards: de facto, temporary borders are being erected, and there’s talk of ejecting countries that can’t observe Schengen rules. Abolishing or limiting Schengen would be damaging, but it is wrong to characterise it as a disaster for the European project. It would not impair European citizens’ rights to work or trade, nor stop them from holidaying. It would create costs to monitor borders and transport goods. The Dutch Association for Transport and Logistics puts the cost for Dutch hauliers at 600 million euros. Given that Dutch truckers make up about 7 percent of transports across the region, the cost could be just shy of 9 billion euros. Some form of rowback on Schengen may become inevitable if the migration crisis can’t be tackled. Yet it would have some benefits. Chief among them is addressing the populist rhetoric in France, the UK and Eastern Europe that sees any migration as a threat. British anti-Europeans, already outside of Schengen, may welcome signs that the region can police itself, and thereafter be more open to the other benefits of the union. Sure, showing one’s passport when crossing the EU is a drag, but worth it if the alternative is having no EU to cross in the first place. Published December 2015 GIANTS OF CENTRAL BANKING WILL BE CUT DOWN TO SIZE BY SWAHA PATTANAIK Central bankers were the next best thing to superheroes during the financial and euro zone crises. But after rescuing banks, markets and even countries, they have finally encountered their kryptonite: consumer prices. 17


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    PREDICTIONS 2016 Inflation has refused to materialise despite the most unorthodox efforts of the most influential rate-setters. U.S. Federal Reserve Chair Janet Yellen, European Central Bank President Mario Draghi and others in the Group of Seven industrial nations slashed policy rates to record lows and together bought financial assets worth more than $10 trillion – roughly equivalent to the combined currency reserves of all the world’s central banks. Economic activity has picked up but consumer prices are proving recalcitrant. G7 inflation averaged less than 0.2 percent in the first 10 months of 2015, OECD data shows. Worse still, central bankers’ power to bend markets to their will is waning, reducing their ability to weaken currencies and thus make imports more expensive. Draghi’s old nickname of Super Mario looked less apt after his Dec. 3 policy easing had the perverse effect of pushing the euro and bond yields up sharply rather than down. Time to deploy other policy levers. First, governments could start gently reversing half a decade of fiscal policy tightening. The mostly rich OECD countries will in 2015 run a structural deficit – that is, one which strips out the effect of economic swings – of 2.5 percent of potential GDP, the lowest in a decade and a half, the international organisation says. Voters’ austerity fatigue and circumstances such as Europe’s migrant crisis and security concerns all suggest some slippage ahead. Second, pay could do with rising faster. In 2014, real average wages in the OECD rose 0.2 percent, less than a fifth of the average annual increase seen between 2000 and 2007. Politicians are already thinking along these lines. Japanese Prime Minister Shinzo Abe plans to raise the national minimum wage by 3 percent each year from the next fiscal year, and the UK wage floor is due to rise more rapidly in the coming years. Even fiscal and wage measures might fail. Further falls in oil prices or a Chinese currency depreciation could counteract their inflationary impact. But that shouldn’t stop politicians from using what powers they have – especially now central bankers are proving helpless. Published December 2015 BREAKINGVIEWS 18


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    THE THRILL IS GONE ARGENTINA AND ELLIOTT GIVE PEACE A CHANCE IN 2016 BY REYNOLDS HOLDING AND MARTIN LANGFIELD Argentina and Elliott Management will finally give peace a chance in 2016. There may never be a better time for Latin America’s third-largest economy and Paul Singer’s hedge fund to end a 14-year standoff over defaulted bonds. New President Mauricio Macri needs access to global credit markets to implement his economic plan, and another defiant Peronist like predecessor Cristina Fernandez could take over if he fails. An Elliott affiliate has sought repayment of the bonds since Argentina’s 2001 default. It and other investors refused to swap them for discounted debt in 2005 and 2010, and in 2012 won a court order saying creditors that accepted the exchange could not be paid first. Argentina protested mightily, even appealing to the U.S. Supreme Court, but to no avail. Obstinance has come at a high price. The nation faces double-digit inflation, dwindling foreign reserves and a gaping fiscal deficit. The economy will grow just 0.4 percent in 2015 and shrink 0.7 percent in 2016, Argentina’s president-elect Mauricio Macri smiles during a news conference in Buenos Aires, Argentina, Nov. 23, 2015. REUTERS/Enrique Marcarian 19


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    PREDICTIONS 2016 the International Monetary Fund forecast in October. A settlement with the holdouts, owed up to $15 billion, could reopen sources of foreign capital and help reboot growth. A resolution is far less urgent for Elliott, considering its total sovereign debt holdings are a tiny fraction of its more than $27 billion of assets under management. Yet the expense of battling for repayment is mounting, and the firm is eager for a return on its investment. Fernandez called the holdout bondholders “vultures.” But just before his Dec. 10 inauguration, Macri sent an emissary to meet the court-appointed mediator in the dispute. Though the shape of any deal is unclear, it would surely exceed the less than 30 cents on the dollar offered in the 2010 exchange. The trick for Macri will be getting any deal through a left-leaning Congress, where he might be able to bargain with, among others, pragmatic Peronists not loyal to Fernandez. If the new president can’t fix the economy, his administration could quickly founder. A far less amenable counterparty might then succeed him – maybe even Fernandez herself, who could try to return in 2019. That alone should persuade Elliott and Argentina that further stalemate is pointless. Published December 2015 QUARTERLY REPORTING TO GET A MAJOR RETHINK BY ROB COX Quarterly capitalism has become a four-letter word. From BlackRock boss Larry Fink to American Democratic presidential contender Hillary Clinton, critics of the overweening desire to hit the numbers every three months, common among both investors and managers of publicly traded companies, see a fundamental flaw in today’s system. But words are cheap. For the system to change, significant players have to make the first move. That may happen in the year ahead. BREAKINGVIEWS 20


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    THE THRILL IS GONE Corporate executives have long railed against the treadmill of reporting their guts out every three months. They say it’s a waste of time, costs money, and is a distraction from the more important tasks of setting strategy and running a business. They moan that it creates unnecessary and unhelpful swings in stock prices and debt funding costs and, most damaging of all, hinders longer-term planning. Defenders of the practice do not say they need news flow to trade, or that trading is fun and profitable. They talk about transparency. Stock-market investors who have regular glimpses into corporate finances are better placed to judge the progress of strategy, assess the efficacy of management and gauge product cycles. The ultimate investors – widows, retirees, teachers and billionaires – gain from the knowledge. This logic has led to mandatory quarterly reports for companies with securities regulated by the U.S. Securities and Exchange Commission. For the last three decades, the instinct to tell more, and more frequently, has gone global. Laurence Fink, chairman and CEO of BlackRock, gestures at the session “The Global Economic Outlook” in the Swiss mountain resort of Davos Jan. 24, 2015. REUTERS/Ruben Sprich 21


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    PREDICTIONS 2016 Germany’s Deutsche Boerse requires companies to provide detailed statements every quarter. Even where such regularity of reporting is no longer required – as in the United Kingdom since 2014 – it is still the convention. But the trend may be reversing. This past summer, UK insurer Legal & General’s $1 trillion investment-management arm nudged the debate forward when it wrote a letter to the top 350 companies on the London Stock Exchange urging them to consider dropping quarterly reporting. “Reducing the time spent on reporting that adds little to the business,” Legal & General Investment Management Chief Executive Mark Zinkula wrote, “can lead to more articulation of business strategies, market dynamics and innovation drivers, which are linked to key metrics that drive business performance and long-term shareholder value.” While lots of stewards of other people’s money agree in principle, in practice many still worry that any company that only gives its investors a look into the sausage factory every six months will be stigmatized in the markets. Classically, this would manifest itself as a valuation discount to peers. It’s worth noting that Legal & General itself still provides interim management statements every quarter. The world’s largest public fund managers and insurers could help change habits by firmly stepping off the quarterly treadmill, at least where the law currently allows. After all, shareholders set the theoretical transparency discount by deciding what shares to purchase and at what price. Ultimately, these human beings determine valuations. If the custodians of trillions of dollars of assets decide what’s good for the goose (ending quarterly reporting by the parent) is also good for the gander (the portfolio managers they employ) then other companies in other industries can follow suit. Ten of the largest listed investment managers – including BlackRock, Allianz, State Street and Bank of New York – oversee some $10 trillion of wealth. There will be resistance. Not every investor buys the argument that quarterly reporting is a bad thing. It may help avoid problems earlier, BREAKINGVIEWS 22


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    THE THRILL IS GONE before they fester – giving shareholders time to get out or press CEOs to fix matters more rapidly. And businesses in technology, retailing, consumer goods and media probably move too swiftly for six-month updates to be sufficient. The quarterly-financial-industrial complex won’t like a big shift, either. Stock exchanges like Deutsche Boerse and Nasdaq benefit from companies reporting twice as often in a given year, as it bolsters trading volumes and fills their faster-growing “market data” business pipelines. More frequent corporate dispatches are arguably better for the news and information business, too, including Breakingviews parent Thomson Reuters. It even benefits Warren Buffett, who has often lamented short- termism in the investing world. Berkshire Hathaway owns Business Wire, which would see its volume of earnings reports cut if the world moved to report twice a year. It will take a brave and big investment manager to get beyond these entrenched interests and sustained effort will be needed to modify rules requiring disclosure four times a year. But if the signals from fund managers with the most at stake are genuine, expect their corporate parents to lead the way in the not so distant future. Published November 2015 RECESSION PROBABLY AWAITS NEXT WHITE HOUSE CHIEF BY DANIEL INDIVIGLIO More than just a nice desk in the Oval Office awaits the next U.S. president. Whoever wins the campaign will probably contend with an economic recession, no matter what the Federal Reserve does with interest rates. The great downturn ended six years ago, longer than it traditionally takes for another slowdown to hit. Given the sluggish recovery, another peak could be years off. But unless modern records are shattered, today’s White House contenders will need to brace for a crisis. 23


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    THE THRILL IS GONE before they fester – giving shareholders time to get out or press CEOs to fix matters more rapidly. And businesses in technology, retailing, consumer goods and media probably move too swiftly for six-month updates to be sufficient. The quarterly-financial-industrial complex won’t like a big shift, either. Stock exchanges like Deutsche Boerse and Nasdaq benefit from companies reporting twice as often in a given year, as it bolsters trading volumes and fills their faster-growing “market data” business pipelines. More frequent corporate dispatches are arguably better for the news and information business, too, including Breakingviews parent Thomson Reuters. It even benefits Warren Buffett, who has often lamented short- termism in the investing world. Berkshire Hathaway owns Business Wire, which would see its volume of earnings reports cut if the world moved to report twice a year. It will take a brave and big investment manager to get beyond these entrenched interests and sustained effort will be needed to modify rules requiring disclosure four times a year. But if the signals from fund managers with the most at stake are genuine, expect their corporate parents to lead the way in the not so distant future. Published November 2015 RECESSION PROBABLY AWAITS NEXT WHITE HOUSE CHIEF BY DANIEL INDIVIGLIO More than just a nice desk in the Oval Office awaits the next U.S. president. Whoever wins the campaign will probably contend with an economic recession, no matter what the Federal Reserve does with interest rates. The great downturn ended six years ago, longer than it traditionally takes for another slowdown to hit. Given the sluggish recovery, another peak could be years off. But unless modern records are shattered, today’s White House contenders will need to brace for a crisis. 23


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    PREDICTIONS 2016 Since the Great Depression, the average period between the end of one American recession and the start of another has been about five years. By that metric, the economy is currently operating on borrowed time. It has been more than a year longer than that average since the slowdown that accompanied the global financial crisis ended in June 2009. Of course, this time around it might just take a little more time than usual to rebound. The United States enjoyed 10 recession-free years from early 1991 through early 2001. That’s the longest uninterrupted period of prosperity in 150 years of record-keeping. That means unless this is another historically unprecedented moment, another recession will arrive by June 2019. True, most economists don’t see an imminent slowdown. They expect the Fed to eventually begin to raise interest rates in response to the economy’s strength and its ability to weather tighter monetary policy. As Goldman Sachs explained in a research note, the unusually slow recovery implies a longer-than-usual cycle. The bank does not forecast a recession for 2016, the last full year that Barack Obama will occupy the White House. If correct, that makes any slowdown a problem for, take your pick: President Donald Trump, Carly Fiorina, Bernie Sanders, Hillary Clinton, etc. If it starts early enough in the 45th president’s first term, the commander in chief might be able to place the blame at Obama’s doorstep. But every time since World War Two that an American president faced a recession that began after his first year, he failed to win re-election. Presidents don’t deserve all the blame for the unavoidable cycles of developed economies. That doesn’t stop voters from thinking otherwise. Moreover, if the next boss happens to be Jeb Bush, a recession on his watch would mark the fourth in a row to have begun under a member of his immediate family. He and his rivals need to brace for the inevitable. Published September 2015 BREAKINGVIEWS 24


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    CHANGING ANTICIPATION TIMES ANTICIPATION DISNEY AWAKENS THE FINANCIAL POWER OF THE FORCE BY JENNIFER SABA AND ANTONY CURRIE Walt Disney is about to awaken the financial power of the Force. The media conglomerate appeared to have fallen for a hokey religion when it paid $4 billion for Star Wars maker Lucasfilm in 2012. Now, as it prepares to unleash the first of six new movies in the space saga, it may be on track to more than triple its money. Advance ticket sales for “The Force Awakens” smashed records even before its Dec. 18 opening. That gives the movie a good shot at displacing “Avatar” as the top-grossing movie of all time. The 2009 hit pulled in $2.8 billion in global box-office revenue, according to Rentrack data. People dressed as Storm Trooper characters from Star Wars waiting to purchase toys in advance of the film “Star Wars: The Force Awakens” in Times Square in New York, Sept. 3, 2015. REUTERS/Carlo Allegri 25


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    PREDICTIONS 2016 As with “Avatar” before it, debuting in December avoids the glut of wannabe-blockbuster movies that usually come out in early summer. So no Jedi mind trick should be required to persuade moviegoers to shun other flicks in favor of the continuing adventures of Luke Skywalker, Han Solo and Princess (now General) Leia Organa – along with new characters. Assume the film directed by J.J. Abrams rings up a more conservative $2 billion in worldwide ticket sales – a Breakingviews estimate that takes the average box-office receipts of the top 10 movies released around Christmastime. Factor in production and marketing costs as well as theater revenue splits, and pre-tax profit would be about $700 million. Meanwhile, revenue from licensing and the oodles of toys, action figures, books, clothing and other items that will carry the Star Wars mark could hit $500 million over the next year, according to Macquarie’s Force-enhanced gaze into the future. Apply Disney’s consumer-product operating margin of 40 percent, and that adds another $200 million of operating earnings. Home entertainment and video streaming may yield another $300 million. Tally it up and Disney could squirrel away $1.2 billion before tax in the next 12 months – and that doesn’t factor in any revenue from amusement parks, TV spinoffs and the like. It’s unlikely to do as well on the five movies to follow – past Star Wars sequels brought in, on average, 25 percent less. On that basis, and after handing over 30 percent to the Republic of Uncle Sam, the company run by Bob Iger could earn an average of $669 million in each of the next six years. On Disney’s current stock market multiple of around 20 times 2016 earnings, Lucasfilm would be worth $13.3 billion. That may be insignificant next to the power of the Force, but it’s a payoff even Jabba the Hutt would be happy with. Published December 2015 BREAKINGVIEWS 26


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    ANTICIPATION BANK RULE ZEALOTS WILL BE FORCED TO BACK DOWN BY DOMINIC ELLIOTT Bank capital hawks are about to bump up against the realities of politics. Basel-based standard setters are due to finalise capital adequacy reforms that banks call Basel IV over the next 12 months. The catch is that these tweaks to the pre-existing Basel III framework conflict with European policymakers’ growth plans. Basel IV is needed to harmonise assessments of credit, trading and legal risks. European banks’ measurements of their risk-weighted assets – a key determinant of their capital requirements – are suspect, insofar as they sometimes produce low results and differ by jurisdiction. U.S. peers, by contrast, typically carry fuller risk-weightings on their balance sheets: they lend less to corporations and offload lower-risk mortgages to government-sponsored enterprises. The full implementation of Basel IV may take several years. But the key question is whether European lenders, once it does kick in, will need to maintain their key common equity Tier 1 ratios at the current level of about 12 percent of RWAs. Source: Barclays research, Reuters Breakingviews. REUTERS/Dominic Elliott 27


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    PREDICTIONS 2016 Bank of England Governor Mark Carney’s answer to that question, for the UK at least, is no. Though he backs greater harmonisation in measuring asset riskiness, Carney argues that the UK regulator already forces banks to hold capital in anticipation of RWA reforms. So UK banks will only need to exceed a 9.5 percent common equity Tier 1 ratio under Basel IV and they won’t need new capital. Euro zone politicians and regulators could follow Carney’s lead. European Central Bank President Mario Draghi is keen to jumpstart Europe’s securitisation market, but Basel IV could raise the relevant capital requirements by 2.2 times, according to an ISDA-led lobbying group. European politicians care more about improving the euro area’s anemic growth rate, which the International Monetary Fund puts at just 1.7 percent in 2016. Brussels will want a slight uptick in lending to continue. So Basel IV will be in its sights, given Barclays analysts reckon it could knock 2.2 percentage points off lenders’ common equity Tier 1 ratios. European financial services commissioner Jonathan Hill has already commissioned a review of the net effect on economic growth of various post-crisis rule changes. Its conclusion may be that Basel IV should either result in lower capital requirements, or be substantially watered down. Published December 2015 CHEAP BATTERIES WILL GIVE UTILITIES ELECTRIC SHOCK BY KATRINA HAMLIN Power suppliers have long enjoyed a natural monopoly. But the arrival of budget batteries coupled with cheaper solar power will allow a growing number of consumers to pull the plug on old-fashioned electricity networks in 2016 and beyond. Solar panel prices have already plummeted, and batteries look set to follow in the near future as manufacturers hone new technologies and ramp up production. Tesla says it can slash the cost of its own batteries by more than a third with a bigger, better factory. That’s plausible: costs dropped BREAKINGVIEWS 28


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    ANTICIPATION by 14 percent on average every year between 2007 and 2014. Broker CLSA reckons they will tumble by a further 70 percent over the next five years. The prospect of being able to generate, store and manage their own power may prompt some customers to leave the grid. In parts of developing economies where electricity has yet to arrive, power networks may not be needed. More than a fifth of India’s population does not have access to electricity. Rather than waiting for infrastructure to expand, Prime Minister Narendra Modi’s government is offering a 30 percent subsidy to encourage homeowners to use solar to become self-sufficient. Energy companies’ initial responses to this potentially existential crisis have ranged from denial to defensiveness. Doing nothing is not a great option, but actively resisting the shift is worse. In Australia, industry lobbyists initially tried to fight special subsidies for renewable energy and raise fees for homes with solar panels. Though such bullying tactics will burn solar homeowners in the short term, it only encourages them to seek ways to harvest and hoard their own energy. Some power companies have decided to embrace change. Australian utilities AGL Energy and Origin Energy now sell solar panel and battery sets to their own customers. Though there’s a risk the move will dim demand for conventional electricity, the bet is that clients will stay connected to the grid in order to sell their extra volts back to the utilities. In that case, the grid will survive as an exchange where energy is traded between large and small producers and consumers. Others would be wise to heed their example and take action. Battery power is about to deliver an electric shock to the old system. Utilities will have to see the sunny side if they are to survive. Published December 2015 29


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    PREDICTIONS 2016 VIRTUAL REALITY WILL SPRING TO LIFE IN 2016 BY QUENTIN WEBB Newly launched headsets from Facebook, HTC, Sony and others will help turn the immersive artificial environments of virtual reality into what could soon become a $10-billion-a-year commercial reality. For decades the dream of VR has remained unfulfilled. Nintendo’s 1995 “Virtual Boy” console, for example, was an infamous flop, complete with red-and-black wireframe graphics. Later equipment often made users nauseated, as eyes and body received conflicting information. But advances in processing power now make for far smoother, more compelling experiences in VR and augmented reality, its less intense cousin. Tech giants and venture capitalists reckon the duo may become the next big computing platform after mobile. Investors have poured some $4 billion into AR and VR firms since 2010, PitchBook says. This should start bearing fruit in the first half of 2016, as HTC’s Vive, Facebook’s Oculus Rift, and Sony’s PS VR headsets go on sale. Samsung’s A visitor plays a game on a PlayStation VR at the Paris Games Week, a trade fair for video games in Paris, France, Oct. 28, 2015. REUTERS/Benoit Tessier BREAKINGVIEWS 30


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    ANTICIPATION low-end Gear VR is already out, while Microsoft is working on the HoloLens visor. Developers like Japan’s Bandai Namco, Capcom and Square Enix are preparing games in genres from horror to romance. As usual, early adopters will be gamers and gadget enthusiasts. Wider adoption will require vaulting a couple of hurdles: that no one looks good wearing a clunky VR headset poses a marketing challenge; and the hardware needs apps with broader appeal. But that should come. There are many potential uses: students could attend distant lectures; fans could sit front row at sold-out concerts; architects could walk the halls of unbuilt buildings; and so on. The initial financial impact will be modest, but this could ramp up quickly. Nomura analysts estimate sales of home-based VR kits will be sub-$2 billion in 2016, largely in hardware. By 2020 that could be $10.4 billion, with 45 percent in software. Major beneficiaries will include programming houses and hardware specialists like Nvidia, the graphics chipmaker. Among the bigger players, success in VR would be a big boost for HTC, whose handset business is ailing, and help cement Sony’s dominance in console gaming. It would also vindicate Facebook boss Mark Zuckerberg’s bold, $2 billion bet on Oculus. The tech industry could be about to change reality again. Published December 2015 RAIL MEGA-DEAL HOLDS TICKET TO RUNAWAY M&A TRAIN BY JEFFREY GOLDFARB The runaway mergers and acquisitions train is barreling into its third year. Global merger volume in 2015 shattered the $4.1 trillion annual record set in 2007. As measured against worldwide GDP, the rate nearly doubled to more than 6 percent in just two years. To understand why this level of activity could stay on track for a while longer, look at North America’s railroad mega-deal. 31


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    PREDICTIONS 2016 Canadian Pacific in mid-November disclosed a $28 billion offer to buy U.S. peer Norfolk Southern. The Calgary-based railway operator is grappling with low growth. Its revenue is projected to increase by just 2.4 percent in 2015 compared with almost 8 percent for each of the last two years. It’s not alone: S&P 500 Index constituents suffered a collective third-quarter sales drop of 3.9 percent, according to FactSet. That stark reality will be a motivating force for mergers. The shareholder roster at Canadian Pacific offers more insight. Its biggest investor was hedge fund billionaire Bill Ackman’s Pershing Square. He originally unveiled a stake in late 2011 when the company’s stock was trading at about $60. It more than tripled in three years before sinking back to around $130. Activist investors like Ackman have doubled their funds to some $130 billion in two years and piled into nearly every industry. Their pushiness will drive plenty more deals like Canadian Pacific’s. Further consider the nature of the rail bid. It involves a Canadian company stalking an American one. Cross-border transactions tend to pick up as merger momentum gathers steam. About 44 percent of deal volume in 2007 included a buyer and seller from different countries, according to Thomson Reuters data. In 2015, it was about a third, suggesting there may be capacity for more. Source: Thomson Reuters, IMF GDP figures. REUTERS/Jeffrey Goldfarb, Rob Cox BREAKINGVIEWS 32


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    ANTICIPATION Similarly, Canadian Pacific’s offer was unsolicited. Such aggressive approaches, including ones eventually withdrawn, accounted for 15 percent of M&A in 2007 compared with about 14 percent in 2015. Lofty valuations could make targets more demanding and eager suitors increasingly frustrated. Finally, the rail tie-up is messy. That tends to be a hallmark of deals near the end of an M&A boom. Merger partners become harder to find, testing competition limits or leading to mission drift. Norfolk Southern rejected its rival’s overtures on Dec. 4 in part because it suspected the combination wouldn’t be approved by regulators. Don’t expect that to stop many other buyers just like Canadian Pacific from trying. Published December 2015 A (FAKE) BANK CEO MEMO ON PLANS TO LEAVE LONDON BY ROB COX The following is a fictional memo from the office of the chief executive of a big American bank to employees sent on the occasion of the British referendum on European Union membership: Dear colleagues, You are by now aware of the British electorate’s vote last night to leave the European Union. While we had hoped for a different outcome given our considerable investments in the United Kingdom, we have been preparing for this possibility for the past two years. Fortunately, we are in a position to act quickly. Thanks to the work done by our “Brexit Task Force,” which we formed in late 2015, we have architected a cross-platform contingency plan that will see many of the functions now performed by the London-based broker- dealer migrate to regional EU centers. While this transition will not be simple, and there will be some employee dislocation, we expect clients will not notice a significant difference. 33


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    PREDICTIONS 2016 In the past 12 months, the company has invested $50 million in scenario planning related to the referendum. As part of that process, we have effectively routed nearly 85 percent of the bank’s retail and commercial lending activities through our Dublin-based banking subsidiary. Our facilities management team has procured options on additional office space in preparation. Front-office customers will be served from our Client Performance Hubs in Frankfurt and Madrid. Support and administrative functionality will gravitate towards our Center of Compliance Excellence in Gdynia. Overall, we expect to migrate less than 20 percent of our current operational workforce in the UK, numbering about 5,600 people in total, over the coming two years. Many of you have asked why we did not campaign harder for Britain to stay in the EU given the investments we have made in the City of London over the past few decades. The short answer is that we felt the optics of a large Wall Street bank visibly trying to sway opinion would backfire. The financial services industry is still rebuilding public trust after the 2008 crisis. We had hoped that Prime Minister David Cameron’s efforts to renegotiate the terms of Britain’s membership in the EU would bear fruit. Unfortunately, the numerous attacks perpetrated in many European cities in recent months by supporters of the so-called Islamic State have weakened the domestic political positions of German Chancellor Angela Merkel and other counterparties critical to the reform process. I appreciate your patience as we work towards a new, dynamic operating structure for the bank in Europe. The Brexit Task Force will be toiling diligently to identify which positions in London may be transferred to the continent on a going-forward basis, and to plan for the effect of lifting the financial transactions tax, and the cap on banking bonuses for UK-based employees. BREAKINGVIEWS 34


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    ANTICIPATION In the meantime, I urge you to continue your dedication to serving our customers and to upholding the value principles of the bank. Britain’s participation in the EU may draw to a close, but business continues as normal. Sincerely, Bank CEO Published December 2015 CHINA WILL STOP IGNORING FACEBOOK’S FRIEND REQUEST BY ROBYN MAK China will “friend” Facebook again in 2016. Chinese censors blocked access to the $300 billion social network barely a year after it launched there in June 2008. Yet founder Mark Zuckerberg is going to great lengths to leap the Great Firewall. Rivals have shown that foreign groups can play by local rules. A 3D plastic representation of the Facebook logo is seen in front of displayed cables in this illustration in Zenica, Bosnia and Herzegovina May 13, 2015. REUTERS/Dado Ruvic 35


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    PREDICTIONS 2016 Even though China’s 668 million web users can’t access Facebook, the Silicon Valley company says the People’s Republic is one of its largest advertising markets as Chinese businesses eyeing overseas markets target Facebook’s 1 billion daily active users. That’s significant as ads brought in more than 95 percent of the company’s $4.5 billion in revenue in the three months to September. Now Zuckerberg is eager to connect his social network to the world’s largest internet population. The 31-year old CEO hosted a meeting with China’s internet policy chief in 2014 and met with visiting President Xi Jinping in October. The hoodie-clad founder is also learning to speak Mandarin. None of this will necessarily sway Chinese bureaucrats. Yet there are signs that relations with U.S. tech groups are thawing, provided the latter bend to local rules. Jobs networking site LinkedIn, for instance, censors certain content on its Chinese site, while note-taking app Evernote has disabled a note-sharing feature on its Chinese service. Both store local data in China as well. These strategies are paying off: LinkedIn already had around 4 million mainland users when it formally launched its Chinese service in February 2014. Now it has 10 million. What might a Chinese Facebook look like? Posts deemed too sensitive from accounts in China would be blocked in the country, while censors could also filter content from abroad. If this proved too complicated, Facebook could even opt to launch a separate service, such as an event planning app, to test the waters. Finding a local partner would help to seal the deal. Google, which retreated from the People’s Republic five years ago over censorship concerns, will introduce a Chinese app store in 2016, Reuters reported on Nov. 20. A partnership with local smartphone maker Huawei, which makes Google’s handsets, should give it a boost. Facebook could persuade another domestic manufacturer like Xiaomi to pre-install its app on Chinese phones. Re-entry would only be the beginning as Facebook would face a fierce fight with local networks like Tencent’s ubiquitous WeChat. Zuckerberg will need all the Chinese friends he can get. Published December 2015 BREAKINGVIEWS 36


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    ANTICIPATION CAPITAL SQUEEZE WILL SPARK UNICORN M&A ORGY BY ROBERT CYRAN A capital squeeze may stimulate an orgy among unicorns. Plentiful money has detached valuations on many hot private tech firms from reality. There are 144 of these private companies worth $1 billion or more, according to CB Insights. Curiously, about a third are valued at $1 billion on the dot. As capital becomes more expensive in 2016, selling to rivals or mating with other unicorns will become appealing. Few of these young companies are cash-flow positive, so most will need capital infusions to survive. That spigot is slowly dwindling. Fidelity Investments recently marked down the value of its Snapchat and Zenefits holdings, and BlackRock slashed the value of its Dropbox stake. If massive asset managers pull back, private firms will be dependent on tinier venture capital outfits, which may be more demanding in their terms. Even hardened angel investors are becoming skeptical. Marc Benioff, Salesforce.com’s founder, says he will no longer invest in unicorns because they have “manipulated private markets to obtain these values.” Going public is an option. American technology firms’ proceeds from initial stock sales so far this year are $6.1 billion – a fifth the amount they raised last year, according to Thomson Reuters data. Global trends are similar. Claims that remaining private allow founders to retain a long-term focus look suspect. Super-powered voting stock allows insiders to treat public companies as their fiefdoms. But the stretched private valuations make it harder for unicorns to go public. Insiders do not want the ignominy of a so- called down round. Floating at a reduced price also creates the impression something has gone wrong. That can make it difficult to lure customers and talented engineers. M&A may be a better option. Two of China’s private taxi apps, Didi and Kuaidi, combined in February to gain scale against Uber, and the combined valuation ballooned. Didi Kuaidi recently invested $100 million in U.S. based Lyft. Lyft could seek shelter from Uber by selling itself to Didi Kuaidi or partner Hertz. 37


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    PREDICTIONS 2016 Other unicorns that have run into trouble could also find comfort in the arms of bigger, more mature rivals. Benefits manager Zenefits might make a nice target for Workday or ADP. It’s easy to see how cloud-storage firm Dropbox might drop nicely into the portfolio of Microsoft. Insiders may not wish to sell at public market valuations. Tacking on a change of control premium would help narrow this gap. And a lack of cash flow and scarcer private capital may eventually force their hands. Published December 2015 LONDON’S BANKERS SHOULD RETRAIN AS BUILDERS BY GEORGE HAY Here are two predictions about the UK labour market for 2016. Banks with swollen cost bases and anemic growth will lay off tens of thousands of people. And chronic skills shortage will stop the country from building the houses it needs to offset rising prices. In an ideal world, that means that bankers ought to think about becoming builders. Banks have a problem that isn’t going away. Expenses are too high for returns to exceed costs of equity, especially because once-proud fixed income divisions now have to hold lashings of capital. Almost every bank has launched multi-year cost-reduction programs: HSBC is cutting up to 25,000 jobs by 2017, Standard Chartered plans 15,000 by 2018, while Barclays said in 2014 it would aim for 19,000 by end-2016. In sum, these three plus Lloyds Banking Group and Deutsche Bank will lay off 77,000 staff, with over a third likely to be in the UK. British homebuilding has the opposite problem. The sector has lost 300,000 workers since 2008 as builders retrained away from a denuded sector. At the very least, it needs to build 80,000 houses a year above the 141,000 it managed in 2014 to keep pace with household formation, according to consultant Arcadis. With the average home having required 1.5 workers annually to get built, that implies Britain needs to find at least 120,000 new house builders. BREAKINGVIEWS 38


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    ANTICIPATION It’s sadly unlikely that sharp-suited corporate financiers will suddenly opt for a life of hod-carrying. But the culture clash between life on a construction site and that of a fixed-income trading floor, where the deepest cuts are occurring, may not be so great. This may even apply to pay: the deficit of bricklayers is sufficiently extreme for skilled tradesmen to be able to demand annual incomes of over 60,000 pounds. By way of comparison, the average compensation for Barclays’ 132,300 employees in 2014 was just over 67,000 pounds, although those facing the chop may be towards the higher end of the scale. Were the UK government minded to bring house prices back under control, it would probably have to publicly fund most of the extra houses needed. That could provide the delicious irony of masters of the universe becoming salaried employees of the state. But if any financial types fancy a pivot into something undeniably socially useful, they should head sitewards. Published December 2015 DROUGHT, NOT JUST OF IDEAS, CHALLENGES AFRICA BY ROB COX On Oct. 18, Zambian President Edgar Lungu called off soccer games and closed bars and restaurants for a day of national prayer. “I personally believe that since we humbled ourselves and cried out to God, the Lord has heard our cry,” Lungu told the 15 million people of the landlocked African nation. Sadly for Zambians, God heard things differently. Lungu implored his people to pray for the national currency, the kwacha. Having dropped by nearly half since he took over in January – almost perfectly tracking the sliding price of his country’s chief export, copper – Zambia needed some divine intervention. Since imploring his people to genuflect, the kwacha has fallen another 14 percent. Zambia is a cautionary reminder of how quickly the prospects for growth and prosperity can shift, especially in Sub-Saharan Africa. A year ago, Zambia was expected to lead its neighbors in boosting economic output. In 39


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    PREDICTIONS 2016 June of last year, the World Bank forecast Zambia’s gross domestic product would be nearly 7 percent greater by the end of 2015. The country even warranted a shout-out in our Breakingviews 2015 Predictions book. As it stands, the country will be lucky to expand by more than 5 percent by the end of the year. While that’s certainly better than, say, Italy, it needs to grow far faster to pull Zambians out of poverty. Gross domestic product per capita in Zambia is below $2,000, or just an eighteenth of Italy’s. It’s a similar story from Accra to Zululand. While the World Bank calculates that Sub-Saharan Africa’s GDP growth has been faster than the developing world’s average, excluding China, since the 2008 financial crisis, progress is threatened on too many fronts. Just a few of them are of domestic manufacture. While bad economic thinking and corruption are still rampant in much of Africa, Mother Nature, alongside myriad problems in the rest of the world, is set to take an unusually high toll. Zambia and its neighbors Botswana and South Africa account for about a quarter of Sub-Saharan Africa’s GDP. The oil spigot that is Nigeria comes in for about a third. The nations on the southern tip carry considerable weight in determining the region’s growth picture. So a potentially devastating water shortage there comes at a terrible moment. Water is needed to grow food for people and animals. It’s also critical to the mining industry – not simply as a raw material used in the process of extraction, but to generate energy. Zambia gets nearly all of its electricity from three major dams, including one at the usually glorious, now dry, Victoria Falls. As a result, copper production has slowed just as the metal’s price has dropped. Many mining operations are only managing to stay open by using generators powered by expensive, imported diesel fuel. All of this comes as the mining and energy business globally is reeling from the crash of the commodities super-cycle. Mines are closing and jobs are being cut across the industry. South African platinum producer Lonmin, which traces its roots back to British imperialist Cecil Rhodes, just detailed a bankruptcy-avoidance plan that sees it shedding some 6,000 jobs. BREAKINGVIEWS 40


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    ANTICIPATION Meantime, the effect of sparse rainfall is leading to rising food prices. The National Agricultural Marketing Council of South Africa reported a 4.1 percent increase in basic food prices in the year to July. “This could have a negative impact on household food security in South Africa, affecting the affordability of selected staple foods (bread) as well as various food items making a contribution to dietary diversity,” the council warned. This sort of inflation is particularly worrying in poor nations where the percentage of wages dedicated to sustenance can be higher than 40 percent of household income. The rising cost of putting food on the table threatens to further erode social stability in South Africa. Recent protests, some of which have turned violent, over university tuition would pale in comparison to riots by the poor in the cities and the townships fueled by empty stomachs. As if Planet Earth weren’t dealing parts of Africa a bad enough hand, the Federal Reserve’s prospective tightening of interest rates is sucking capital away from riskier nations, and an actual increase is likely to continue the trend. The financial pressure has manifested itself starkly in currencies like the South African rand, which is down 22 percent in 2015, along with Zambia’s kwacha. Cheaper currencies add to the cost of importing food. A woman fetches drinking water from a well along a dry Chemumvuri river near Gokwe, Zimbabwe, May 20, 2015. REUTERS/Philimon Bulawayo 41


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    PREDICTIONS 2016 Some African own-goals make matters worse. As foreign direct investment is already drying up, Nigeria recently meted out a whopping $5.2 billion fine on the South African mobile phone operator MTN for failing to deactivate 5.2 million unregistered phones. By almost any measure, the punishment was disproportionate to the crime, and is double what MTN is expected to earn this year. Moves like this, and South African President Jacob Zuma’s lackluster economic stewardship, make it harder to attract foreign capital to the region. Rising food and energy costs may be a function of climate, or God. Sliding commodity prices and currencies owe more to the slowdown in China and the monetary policy of foreign central banks. Throw them together with Africa’s perennial corruption and mismanagement, and it’s hard to see a particularly bright spot on the continent in the coming year. Published November 2015 BREAKINGVIEWS 42


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    A HARD RAIN’S A-GONNA FALL A HARD RAIN’S A-GONNA FALL BALANCE SHEETS WILL GET MORE UNBALANCED IN 2016 BY JOHN FOLEY The lesson that too much debt is dangerous has sunk in. But for many companies, the corollary proposition, that too little cash is a killer, seemingly hasn’t. If there’s one thing investors ought to remember heading into the eighth year since the financial crisis, it’s that without healthy cash flows, balance sheets won’t stay balanced for long. Trading house Glencore is a prime example. As commodity prices continued to plunge in 2015, its net debt of $27 billion, which investors had previously tolerated, started to look scary. The shares went into freefall. As cash flows dwindled, so did the amount of debt investors would stomach, forcing boss Ivan Glasenberg to hack the dividend, sell assets, cut production and reduce borrowings to $18 billion. Weak commodities will wreak more havoc, but rising U.S. interest rates could make matters worse. That’s especially true for emerging markets, which have loaded up on U.S. dollar debt. A currency mismatch is one factor weighing on Brazilian oil major Petrobras. Non-bank borrowings in U.S. dollars had reached $2.3 trillion in developing countries by the end of June, according to the Bank for International Settlements. Mexican, Indonesian and South African borrowers have all doubled their dollar debts since 2009. Europe has its own toxic cocktail, of stubbornly low inflation and poor consumer demand. Yet some companies are still casual about cash. One in four companies in the Euro Stoxx 600 index outside of banking and energy spent more on operations, capital expenditure and dividends than they made in the past 12 months, according to Eikon data. British grocers Tesco and J Sainsbury, telecoms group Vodafone and carmaker Daimler have all spent beyond their means for three consecutive years, as have numerous oil and energy groups. For some, dividends and investment will be vulnerable. 43


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    PREDICTIONS 2016 Who, if anyone, has learned their lessons? That would be the United States. Outside of resources and finance, the ratio of U.S. corporate net debt to EBITDA is now only slightly above the 20-year average of 1.6 times, according to Credit Suisse. Brazil, by contrast is 4.5 times. Only about 17 percent of these U.S. companies are spending more cash than they make. For once, America has something to teach the world about leverage. When the reckoning comes, cash-rich companies and private equity firms will be in a position to sweep in and acquire assets on the cheap. More likely than not, they’ll come with American accents. Published December 2015 GLOBAL CORPORATE PROFIT IS UNDER SERIOUS THREAT BY RICHARD BEALES Quarterly capitalists should gird themselves for disappointment. With post- tax earnings running around 10 percent of national income, according to the Bureau of Economic Analysis, U.S. companies are close to a peak of profitability not seen since at least the late 1960s. High levels of corporate Source: Bureau of Economic Analysis, Breakingviews calculations. REUTERS/Richard Beales BREAKINGVIEWS 44


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    A HARD RAIN’S A-GONNA FALL profit are a global phenomenon, too. Competition, disruption and tax policy – not to mention weaker growth – are set to change all that. Worldwide, net income after interest and taxes increased fivefold between 1980 and 2013, according to a study published in September by the McKinsey Global Institute, not far short of doubling as a share of global GDP to 7.6 percent. The consultancy’s think tank foresees competitive pressure on margins from emerging markets like China. Fast-growing companies are starting to go global, and their tendency to be controlled by government or family interests may mean they can accept lower profitability in the short term than Western multinationals whose investors watch quarterly earnings closely. Meanwhile, though the profit pie has grown, gains have gone disproportionately to technology and other idea-driven sectors at the expense of traditional industry. That trend could continue, with even today’s biggest tech firms – the likes of Apple and Alphabet (formerly Google) – themselves potentially vulnerable to upstarts wielding new ideas. The MGI also notes that the scope to cut costs, for example the outsourcing of production to China by Apple and others, could be bottoming out. Borrowing costs, which have lingered at historic lows thanks to the world’s central bankers, also look set to rise. Slackening economic expansion is another factor. One consequence, the collapse in oil prices, is largely responsible for a plunge in the U.S. energy sector’s profit. As a result, analysts predict that overall S&P 500 Index earnings for 2015 will be a hair lower than in 2014, according to S&P Capital IQ’s tally on Dec. 16. They remain relatively optimistic, though, forecasting 8 percent growth in S&P 500 profit for 2016. That sounds bullish. Companies face other headwinds, including tax policy. The recent furor over tax-reducing mergers by U.S. companies – notably drugmaker Pfizer’s $160 billion deal with Allergan – is just one instance of authorities questioning whether businesses pay enough to governments. Investors who have gotten used to earnings ratcheting higher every quarter may want to reset their expectations. Published December 2015 45


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    PREDICTIONS 2016 VOLKSWAGEN TOP BRASS WILL BE UP FOR THE CHOP BY OLAF STORBECK Volkswagen’s chairman and chief executive are both new to their roles. But in the coming months the German carmaker faces both multibillion-euro fines as a result of cheating on its diesel emissions as well as a scathing external report on its governance. These will shine a spotlight on leaving long-term insiders in charge. Matthias Mueller, who took over as CEO after the emissions scandal cost Martin Winterkorn his seat at the wheel, is a VW lifer and former Porsche boss. Hans Dieter Poetsch, meanwhile, spent 12 years as finance chief before becoming chairman. There’s some justification for appointing one of them: steering the overly complex vehicle that is Volkswagen through an existential crisis arguably requires detailed knowledge of its inner workings. Installing both of them, though, seems tin eared. Of the two, Poetsch looks the more exposed. Ferdinand Piech is pictured during a welcoming ceremony at the plant of German carmaker Volkswagen in Wolfsburg April 23, 2012. REUTERS/Fabian Bimmer BREAKINGVIEWS 46


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    A HARD RAIN’S A-GONNA FALL First, he’s a confidant of Ferdinand Piech, the towering patriarch of the Porsche family, VW’s controlling shareholder. Piech spent 22 years as boss and then as chairman of Volkswagen until being forced out in a power struggle in April 2015. He started the empire building and created the internal fiefdoms and sclerotic culture that worsened under Winterkorn. Poetsch is also, thanks to having held a seat on the executive board as finance director, one of those who can be held legally responsible for any company misconduct in the emissions scandal. And he is central to a key legal issue: whether the 17-day delay in September in informing investors about its emission woes after admitting cheating to U.S regulators can be justified. All this puts Poetsch in a difficult position to start with for many of the tasks he will have to carry out as chairman. These include assuaging the anger of American regulators, lawmakers and VW shareholders. His role is likely to get even trickier as scandal-related costs mount: the 8.7 billion euros the company has so far set aside do not cover any fines; and the U.S. Environmental Protection Agency alone could impose a penalty of up to $18 billion. Meanwhile, U.S. law firm Jones Day’s investigation into the inner workings of the scandal will probably unmask the carmaker’s rotten internal culture as well as whatever role Poetsch played. Appointing an independent chairman in 2015 would have been a smart move. In 2016, it will become a necessity. Published December 2015 LUXURY GROUPS COULD SHRINK THEIR WAY TO RICHES BY CAROL RYAN Less is more. But apparently luxury companies don’t feel that applies to their swollen store networks. Labels like Prada and LVMH have spent a decade expanding rapidly to meet emerging market demand. Slowing sales and overexposure suggest it’s time to go the other way. While cutting back will be painful, it could spur higher luxury valuations. 47

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