Low, Lower, the Lowest

NIC Undergrad Review Volume 2 - Issue 1 FALL 2015

LOW LOWER THE LOWEST

NIC Undergrad Review Volume 2 - Issue 1

Contents 04

Welcoming Remarks

Looking Left and Right

Divergent Monetary Policy and Its Consequences

(Not so) Super Mario

Danger Ahead? Carl Icahn on the Fed

Imagine There’s No Hike

Should I Invest in the World I’m in? Or the One I Want?

Marchionne’s Way

On Trump and Boris Leading the West

Telecom Industry Calls for Consolidation

Reputational Economy

Real Estate: Today’s Ultimate Asset Class

Russia’s Gas and Oil: a Tale of Two Strategies

Power Games

"Lost! Lost! My Precious is Lost!"

Chinese Hard Landing?

The Perfect Storm

How to Hedge Against a Left-Wing Government in Portugal

The Team Afonso Borges Andrey Dmitriev Carlos Gonçalves Catarina Castela Diego Tremiterra Filipe Berjano Francisco Gonçalves Gonçalo Marques Joana Martins José Alberto Ferreira Inês Cunha Manuel Antunes

Manuel de Oliveira Manuel Vassalo Mariana Fernandes Mariana Ruivo Miguel Amaral Miguel Garção Miguel Moita de Deus Pedro Leão Pedro Filipe Rodrigues Sebastião Fernandes Tiago Louro Alves Tiago Reganha 3

NIC Undergrad Review Volume 2 - Issue 1

Welcoming Remarks As the Editor-in-Chief of the NIC Undergrad Review, it is truly a pleasure for me to join the Nova Investment Club Undergraduate Division in welcoming you to the first issue of this magazine’s second volume. As the first undergraduate student-run business magazine in Portugal, the Nova Undergrad Review is the culmination of our experience, dedication, and work. It is also our most ambitious project so far, both with regards to its content and international dimension. For this, we would like to give our warmest thanks to the Bocconi Students Investment Club for their collaboration. We hope this is the beginning of what will become a very fruitful partnership. Our goal is to provide insight and knowledge to the community at Nova. We want to engage students and promote dialogue on the most current and relevant topics – from business, economics, and finance to ethics, politics, and technology. Ultimately, we want to become one of the guiding lights of this community. Having studied in the United States in an education that is very much built around intensive extracurricular student participation, I know for a fact that this club embodies a step in the right direction. Not unlike other student activities, we want to help change students’ perspective of what constitutes the university experience. We want them to look past the curricula and identify the bigger picture. It is a picture of student initiative and cohesiveness, one which portrays an unwavering commitment to expanding and redefining our limits as students. It is an illusive quest of exploration and inquisitiveness – and it does not end. For this reason, I truly believe that the fact that this is the work of undergraduate students does not take away from the magazine in any way whatsoever. Everything has been set to the highest of standards. Such quality is a function of our belief in the extraordinary capacities of the student-body at Nova. Our students have demonstrated time and time again that they have the potential to magnificently follow any endeavor. As a club, this is precisely what we attempt to achieve day in and day out. As such, we cannot emphasize it more – namely, that we invite students at Nova to call upon us for whatever it is they need in their pursuit of excellence. This is both our most significant responsibility and our most fervent aspiration. Above all, I would like to acknowledge the team. Extremely talented, each one of them is a force of nature. They bring a novel voice to the club – but above all, they are my peers. Needless to say, I had the easy job as Editor-in-Chief. My peers’ sacrifice and their drive to make these issues their own was instrumental. It follows then that their passion is branded in each article. Last but most certainly not least: a word to our founding members. Thank you. Thank you for taking the time to create this unique platform for students at Nova. Thank you for caring, for lending us a helping hand in our times of need – for guiding us in our academic, professional, and social path. This, too, is yours.

Carlos Gonçalves

NIC Undergrad Review Volume 2 - Issue 1

Looking Left and Right Reviewing 2015 and Sizing 2016 Up

NIC-UD First-Year Students 2015, what a time to be alive! Oil goes bust, China slows down, M&A is through the roof and the Middle Eastern turmoil goes global. NIC Undergrad Review walks you through what was most interesting in this turbulent year.

Markets

In 2015, oil prices made the headlines once again. With plunging oil prices, now at a 7year low, many pundits expect it may take years before oil prices return to previous levels. It seems that even if US shale companies or OPEC were to reduce supply, the fact is that demand side problems would likely persist. With December 2016 WTI oil futures trading at around $46 a barrel, the Chinese economy slowing down, and Europe becoming more and more energyefficient, it is not clear if oil prices will rebound anytime soon. Tough times are likely to be ahead for oil-producing states such as Venezuela, Iran, Nigeria, Ecuador, Brazil and Russia. 2015 has also been a negative year for commodities, with major contracts posting 17% average declines. The Bloomberg Commodity Index, for example, which tracks prices of future contracts in 22 raw materials, posted a 22% homologous decline. The exception this year has been cotton, a market valued this year at $4.4bn and that rose 5.4% in 2015. Cotton was one of the four commodities whose price

increased in 2015 – along with cocoa (14%), sugar (5.7%) and orange juice (0.5%). American equities have also had an interesting year. Despite a hard hit in late August, which left many investors around the globe in a frenzy, the S&P 500 stood above the 2000 mark for almost all of 2015. The NASDAQ 100 exhibited steady growth, surpassing the all-time 4691.61 record from the year 2000. The Dow Jones Industrial Average, has roamed the 18000 mark, performed mediocrely relative to its growth rate figures from the past five years – exhibiting a clear slowdown. As far as Asia is concerned, July and August were critical for the Chinese economy. Chinese equities crashed approximately 60% during the Summer as the government tried to regulate the excessive levels of investment. The Communist Party couldn’t prevent the booming of the financial bubble by enacting measures to limit short selling, stopping any IPO’s and temporarily suspending the stock trade, what motivated fear and terror among investors, who turned to safer investing instruments as U.S. treasuries. Hence, Chinese stock market collapsed, with the Shanghai Composite and the Hang Seng plunging 8% on August 24th .

levels in 2015 during the beginnings of December. At the time of this article, M&A activity for 2015 is at an estimated $4.3tn, a value that, according to expectations, is supposed to land around the $4.7tn by end of 2015. Whatever happens in December, this year will go down as a golden one for M&A deals, as boardroom confidence, cheap debt financing and pressure to become as efficient as possible in a slow-growth economy has pushed towards mergers or takeovers. The desire to avoid taxes in 2015 has also been a main driver to many of these newly-merged companies, such as Pfizer Inc. and Allergan PLC, which had a roughly $160bn merger, the third largest M&A deal of all time (after America Online’s acquisition of Time Warner and Mannesmann’s purchase by Vodafone Airtouch, both by around $185bn). Other massive deals this year were the merger of Charter with Time Warner Cable, valued at $78.7bn, and Dell’s acquirement of EMC Corp. (for a valuation of $67bn). Overall, in 2015, we have seen nine transactions valued at over $50bn, and fifty-eight valued at $10 billion or more – two records that, again, have made 2015 one of the best years on record for M&A activity. By comparison, in 2014, only thirty-five of all deals made had a valuation over $5bn or more.

M&A activity also hit record 5

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A small note as well to the Goldman Sachs Group Inc. for its ranking as the top M&A adviser advising roughly on $1.6tn worth of deals during 2015.

Outside the Office

In 2015, we have also been witnesses to the truly global consequences of the conflict that has been escalating in the Middle East, particularly in Syria. In 2015, the militant and extremist jihadist group Daesh has seen its territory and influence expand but also shrink at times, as Russia and the US-led coalition intensified their bombings and as Syrian and Iraqi government forces and the Free Syrian Army gained ground. Also fighting on the ground are the Kurds, seeking to finally gain sovereignty, and the Al-Nusra Front, an Al-Qaeda affiliate. Though the war-torn region has been pushing waves of refugees towards Europe for some time now, media coverage on the issue only really intensified in 2015, sparking discussions after pictures of a drowning of a young Syrian boy. This has also sparked discussion of the problems and the fragility of the Schengen area and the European borders. Since the Daesh attacks in Paris, international authorities have come to talk more and more about a global anti-Daesh Coalition. These efforts are, according to the West, being frustrated by Putin’s decision of not abandoning Assad, an important ally to the Russians in a geopolitically crucial region. In the meantime, western powers 6

are coordinating bombings on Daesh positions.

the QE program until at least March 2017).

The Kremlin has been giving air support to the Syrian Army after a request from Assad. Russia has a different definition of “terrorist groups in Syria” and so it bombs not only Daesh targets, but also the Al-Nusra Front and some elements of the Syrian opposition. Russian bombings also intensified after Turkey shot down a Russian warplane on the Turkish-Syrian border. The Kremlin claims Turkish behavior is due to its oil smuggling from Syria in cooperation with Daesh. A controversial accusation since Turkey has no interest in having radical forces pushing refugees to their borders.

Besides the refugees and the struggle to achieve significant growth levels, the EU has had other problems on its hands during 2015. June and July were particularly chaotic – with the radical leftwing Syriza, which won the Greek elections in early 2015, defaulting on an IMF payment. This led to an intensified period of discussions and a national referendum to vote on a bailout package. To no avail, Syriza would be later forced to accept a harsher bailout package than the one it had voted to reject. Overall, 2015 was a shaky year for the European project – tensions with refugees, a sluggish economic growth and the rise of Eurosceptic and antiestablishment parties have damaged the European project.

In Europe, 2015 also saw the ECB’s “Single Supervisory Mechanism” be put into place. The year also kicked off with the ECB’s long-awaited QE program (€60bn a month) in the hopes that economic growth in Europe would pick up (which, as it turns out, has not been the case – insofar that the ECB just recently increased the duration of

Turning over to the U.S., Donald Trump has been making headlines during the Republican primaries for the US presidency. On the Democratic side, Hillary Clinton leads the polls.

“Rock or Bust”: 2015 was a crucial year for Eurozone, as ECB continued to use as many instruments as possible to reaffirm the strength of the Euro globally

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The geopolitical conflict in the Middle East will continue to intensify in 2016, forcing Syrians and Iraqis to leave their lands

Gun policy was also under debate, after a number of shootings throughout the year. In the economy, though the US had a rough start to 2015, contracting during the first quarter, the fact is that strong second and third quarter data on labor markets have led many to believe that Janet Yellen and the rest of the FOMC board members will finally raise interest rates during the upcoming meeting in December 2015. As the Year of the Monkey approaches, China’s economy is still waning as investment and

manufacturing have not adjusted yet to the lower levels in global demand. 2015, much like in Europe and in the US, was also a critical year for China. Besides the fact that in November, the Chinese currency was voted to be included in the IMF’s Special Drawing Right Basket, recognizing the extent of China’s progress over the last few decades in moving towards a more open and market-based economy, the fact is that volatility and uncertainty around slowing Chinese economic growth also defined China for the year of 2015, with financial markets sdfsdfsdfsdfsdfsdf

The Chinese “double-trouble”: investors fear the consequences of not only a slowdown in the economic growth pace but also an ageing population

having undergone a tumultuous summer as a result of the continuous injection of money into the stock market by a rising mid-class. The Chinese Government aggressively tried to control this crisis, with the People’s Bank of China cutting interest rates to a record low and devaluing the CNY, limiting short selling, etc. China’s crisis also implies demographics: the rapid ageing of population led not only to a decrease in the workforce for the first time since 2010, but also lead to a plunge in nativity rates. 2015 was also historical for China in this regards, as in October, the Communist Party abolished its one-child policy amid fears of the effects of changing demographics on a slowing economy. Outside the office, Volkswagen also made the headlines. In September, and for the wrong reasons – as it was revealed that special software had been installed in some 11 million Volkswagen diesel-powered vehicles designed to defeat 7

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emissions testing. A move to make cars seem cleaner for the environment than they actually were, ended up catalyzing an electric-car turn movement in the automotive industry.

those stocks that compose the three main American indices. This could result in a shift of attention to other asset classes, such as bonds or even commodities like gold or oil.

On July 14, the New Horizons spacecraft, launched nine years earlier, made its closest approach to Pluto and its flock of five moons while taking the highest quality images of the planet ever.

In the Middle-East, even top area scholars and analysts find it hard to predict how the situation will develop. Even though, there is the possibility that in 2016 the conflict will intensify, as tensions between Russia and Turkey develop and the Syrian Army gains momentum. We believe that Daesh will lose more territory as foreign bombings intensify. No matter what route the conflict in Syria and Iraq takes, the human calamity is likely to persist for the upcoming year of 2016. For this reason, a reduction in the flow of refugees is not expected, although coordinated efforts with Turkey might induce a slight reduction of this inflow. We also anticipate that the anti-immigration feeling will most likely not fade, as rightwing parties gain influence and Europe becomes further polarized on the issue.

Finally, in November, the World Health Organization declared at last that the outbreak of the Ebola epidemic in Liberia was over, after more than a year.

The NIC-UD Oracle 2016 is likely to spell trouble for oil and the rest of commodities â&#x20AC;&#x201C; as a stronger dollar, lower oil prices, trouble in Emerging Markets and a slowing Chinese Economy (the main driver of growth in commodities for the last decade) prove to be a dangerous concoction. After the 2015 M&A galore, some industry watchers point to idiosyncrasies of some of these deals to inject a note of caution, and warn that the current pace may not be sustainable. With the diverging monetary policies and the fed hiking rates soon, it will be interesting to observe how global sales of corporate debt affect M&A activity. Regarding 2016, there is skepticism towards the growth of the global stock markets, mainly because American indices have climbed higher than anticipated, raising red flags for investors, who may become fearful of investing in 8

In 2016, expect higher borrowing costs, as the Fed is likely to start the process of gradually raising the federal funds rate during its December meeting, with Fed fund futures pricing a 84% probability of a rate hike still in 2015 and a 40% probability that US rates reach 0.75% by mid-2016. On the other hand, the ECB bond-buying program is to continue at least until March 2017, showing that low inflation is here to stay (at least for the short term â&#x20AC;&#x201C; despite the fact that the ECB holds a 1% forecast for HICP-measured inflation by the end of 2016). The monetary policy divergence

between the two sides of the Atlantic is bound to mark 2016. Note, however, that a strong dollar is not necessarily good for US, as it might induce disinflationary trends. On the other hand, Euro to Pound rate is expected to hit low levels in early 2016 (0.67, as DBâ&#x20AC;&#x2122;s estimations point). Shifting towards technology, we see 3D-printing becoming the next thing in 2016 after a strong year for 3D-printers. Moreover, new devices from HTC Vive and Oculus Rift (a Facebook-owned venture) will leave tech enthusiasts hyped as they come out in the first quarter. Increased automation in the automotive industry is also predictable for the next year as Apple is rumored to enter the competition following Google and Tesla. Finally, SpaceX's massive Falcon Heavy rocket is set to launch in Spring 2016. The company plans to recover the stage one rocket boosters by landing them back on Earth after launch, a possible breakthrough for space exploration. At NIC UD, though none of us are truth seers, and though it is certainly most unwise to predict what the future will bring, it has been an interesting exercise to try and foresee what 2016 will have to offer. We want to thank our readers for this opportunity, and hope they enjoy the rest the other articles in this publication.

Now back to you, Yellen 9

NIC Undergrad Review Volume 2 - Issue 1

Divergent Monetary Policy and Its Consequences BoE and Fed vs BoJ and ECB

Filipe Berjano and Tiago Alves The world economy has been quite slow to recover from the Great Recession. Having recently achieved robust labor market statistics, the UK and the US are the exceptions. Both countries have witnessed considerable and stable economic growth since 2014 – the year in which the Fed ended its QE program. Similar to the Fed’s likely experiment with a December rate rise, the BoE has also begun to unwind its QE program, projecting a rate rise in the near future. As the UK and the US prepare to tighten monetary policy, the BoJ and the ECB are doing precisely the opposite due to low growth and inflation. In fact, the BoJ increased the dimension of its QE in October 2014 as the country struggled with a stagnant

economy. In the Eurozone, as risks of deflation doomed large, ECB President Mario Draghi imposed a large scale bond buying program worth €60bn per month until September 2016. Whereas both the Fed and the BoE started their stimulus programs shortly after the fall of Lehman Brothers, their European and Japanese counterparts only begun similar processes much later. This can be partially explained by the difference in mandates of each central bank. Namely, the Fed is expected to keep stable prices and full employment, whereas the others are focused mainly on keeping inflation below a set target. Since 2012, Japanese monetary policy has also been deeply influenced by Prime Minister Shinzō Abe’s economic policy of strong

government stimulus. This program consists of very low interest rates, high public investment financed by budget deficits, correction of excessive currency appreciation, and monetary easing through extensive bond buying programs. With regards to economic growth, countries that started QE earlier have had a greater and faster recovery. The effects of QE were most notable in short-term and long-term government bond yields, as well as in overall stock market rallies. From an economic perspective, central banks have had a difficult time trying to stimulate inflation, mainly due to the sharp fall of commodity prices that begun in 2014 – particularly in the case of oil, which is currently near a seven-year low. The coexistence of monetary

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policies – specifically of tightening in the US and the UK and of easing in Europe and Japan – has caused great appreciation of the USD and the GBP against the EUR and the JPY. The strong USD has impacted commodity prices and is one of the reasons for the continued maintenance of low rates. Moreover, a rate hike in the US would further strengthen the USD, hurting US exports. On the other hand, low commodity prices and weak currencies are positive news to both the Eurozone and Japan, which have seized the opportunity for a decrease in imports and a much-needed boost in exports.. Independently of the specific macroeconomic priorities of each central bank, its main purpose is to position their respective economies at a sustainable equilibrium with the help of monetary policy. However, the effects on currencies and

emerging markets have to be taken into consideration in this context of diverging policy marked by the Fed and the BoE on one hand and the ECB and BoJ on other hand. Given the policy scope, it must be – at the very least – acknowledged that communication and discussion of concerns and policy choice are important tools for central banks, enabling effective forward guidance with the capacity of mitigating adverse outcomes and spurring desired results. Given the USD dominance in world trade and financial markets, US monetary policy has worldwide consequences involving risk premiums, volatility, and credit. The Fed’s QE provoked large capital inflows from the US to emerging economies, leading to the appreciation of their currencies and a decline in their exports. Now the tables have

turned. A hike in interest rates by the Fed could result in further appreciation of the USD against most currencies present in emerging markets. This phenomenon would aggravate their current situation; after all, a significant number of companies, governments, and institutions hold USD denominated debt. These agents would see their debt burden increase as their currencies depreciate. Emerging economies account for more than half of the world’s GDP in purchasing power parity terms. As such, the slowdown in emerging markets is one of the reasons why the ECB has been probing the prospect of boosting its QE program. However, the Fed is resolutely considering a rate rise. Although the US economy has consistently displayed some strength, a rate increase could negatively impact global demand.

NIC Undergrad Review Volume 2 - Issue 1

(Not so) Super Mario Draghi’s Recent Fall from Grace

Afonso Borges

How I miss Christmas before university life and January exams. Not a worry in the world. All the time in the world to play Super Mario Bros. Of course, I can name some activities more deserving of your time. Yet, Super Mario Bros is worth mentioning because it aids the understanding of one of the most important events of this holiday season: monetary policy. For those of you who are not familiar with the game, here is how it goes. Little Mario is minding his own business until he finds a mushroom. Little Mario eats said mushroom and becomes Big Mario. This Mario was Mario Draghi in January 2015 as he announced the QE program for the Eurozone. And so, life goes on. Big Mario comes across a turtle. Big Mario is hit by said turtle and becomes Little Mario 12

again. This Mario was Mario Draghi in December 2015 as he announced that the ECB was cutting its deposit rate to -0.3% as well as extending its QE program until March 2017 “or even beyond." You might say that this view has an unnecessarily long image and that December announcements sure sound more like a mushroom than a turtle. Not so fast. While the ECB's policies announced in early December represent an even more accommodative monetary policy, they fell below what the market was expecting and had priced in. As a consequence, on the day of the central bank's policy announcements, the EUR was up 3% against other major currencies, European stocks sold off 3% and yields on European and even American bond yields

increased – meaning prices went down. To understand how expectations work, imagine that last Christmas your ever-so-generous uncle, aware of your interest in the subject, gave you a yearly subscription to The Economist. So far, you have enjoyed KAL's cartoon and felt flattered by the looks your colleagues threw your way as you held the magazine. The big difference, however, is that this year you will not be impressed by a repetition of last year's gift. Sure, you would not mind another year of the magazine, but your uncle – being ever-so-generous – could have thrown in a yearly subscription to Netflix as well. Similarly, as Uncle Draghi tried to replicate January’s recipe, Nephew Market said "not cool.”

NIC Undergrad Review Volume 2 - Issue 1

Danger Ahead? Carl Icahn on the Fed There’s a Monster in the Closet

Francisco Gonçalves and Mariana Ruivo As an activist investor, Carl Icahn is the sort of individual who is used to shaking up management and having his say. After a philosophy degree in Princeton and an unsuccessful run at medical school, Mr. Icahn is one of the most revered figures in Wall Street. Often taking substantial – including controlling – positions in individual companies, Mr. Icahn and his affiliated companies own businesses in a wide range of industries, such as telecommunications, real estate, industrial services, oil refining, transportation and manufacturing. What does Mr. Icahn have to say about the Fed? In a recent video, published in his website and entitled “Danger Ahead: A Message from Carl Icahn,” the activist investor was critical of FOMC’s decision not to raise the federal funds rate on September 17. The decision to raise or not raise the federal funds rate is certainly a controversial one. Taking into consideration the crash that hit the US in the housing market and banking sector between 2007 and 2009, as well as the global contagion of the financial crisis in part due to the securitization complexities in financial markets, the Fed – then led by Ben Bernanke – resorted to a variety of monetary policy tools to prevent the US economy from collapsing.

To keep the economy afloat and preserve price stability, the FOMC, which is in charge of setting monetary policy in the US, began lowering the federal funds rate on September 2007 to 4.75%, effectively changing the interest accrued by commercial banks when these borrow from the excess reserves kept in regional federal reserves to meet their daily capital requirements. The federal funds rate proceeded to decline over the span of one year, hitting the 0% and 0.25% ultra-low range in December 2008. It has stayed there ever since. Much like the Fed announced in May 2013 that it would began tapering the ongoing bond-buying program – a practice which came to a final halt in October 2014 after having added more than $3.5tn to the Fed's balance sheet – now many agree that the time has come to end this prolonged era of near-zero rates. With the US economy nearing full employment levels and amidst some signs that productivity and wage growth might finally pick up, the intuition is that an overheating jobs market can spur a pickup in inflation and wages. Given the Fed’s mandate over price level stability, many pundits and investors are now positioning the economy for a rate hike as well as subsequent increases to the costs of borrowing. In fact, according to the CME Group’s “Fed Watch Tool,” market sentiment suggests an 83.3%

chance that the FOMC may come to increase the fed funds rate in their next meeting in December 2015 to 0.50%. In “Danger Ahead,” Mr. Icahn directly relays to audiences his apprehensions on the US economy. Chief among these are the consequences to the Fed’s refusal to reign in its loose monetary policy. Along with pulling the US out of the crisis, Mr. Icahn is quick to denounce the negative effects low rates have had in flooding markets with cheap and easy credit. With global sales of corporate bonds eclipsing the $2tn mark for the fourth consecutive year, he argues that “middle-class investors” have been pushed into the market for the so-called “highyield” bonds (otherwise known as “junk” bonds). However, near-zero rates have created other problems, with many American chief executives, according to the activist investor, borrowing and using “financial engineering” to artificially prop up earnings (and therefore stock prices) via acquisitions and equity buybacks. Global sales of corporate bonds are not financing capital expenditure and new machinery to make the economy more productive. Mr. Icahn, a self-proclaimed follower of the Benjamin Graham’s investment methodology, is troubled because 13

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he no longer believes that companies’ fundamentals are being reflected in earning figures. In short, Mr. Icahn is a strong proponent of a rate rise and a staunch critic of the Fed for having opted out of such an operation – which begs an interesting question: what could possibly justify a rate hike in the FOMC’s December meeting? Carl Icahn’s reasoning is compelling and clear: low interest rates breed asset bubbles. If the economy is not becoming more productive, and if unemployment figures are already nearing full employment levels, then perhaps Mr. Icahn is right to say that easy credit is doing more for companies’ earnings and stock prices than it is for consumers and job creation. However, there are also nontrivial cases to be made against the rate hike. One of the stronger ones lies in the fact that the Fed has been optimistic concerning the US economy’s ability to reach the mandated 2% inflation rate target. This worry has been echoed by Fed Governor Daniel Tarullo, who expressed his concerns that expectations for 14

inflation are still near-historic lows. Other concerns include the impact of diverging monetary policies and a stronger USD, both domestically (as US exports get hurt and US-based firms operating across the globe mount further losses) as well as internationally (USDdenominated debts become harder to pay off, particularly in emerging markets). Yet, another argument – and probably the most caricature of them all – is the worry that “zombie companies” (companies that have been kept barely alive by the current, historical period of low rates) may start filling for bankruptcy soon after a rate hike. The extent of the effect of these “zombies” on the economy’s productivity and employment levels, however, remains unclear. Some argue that this may bolster the economy, as competition forces bad business out of the picture and frees up labor and resources for more successful enterprises. Is Carl Icahn right? Maybe. Data, particularly with regards to US unemployment figures, has been positive. Then again, markets could react in a multitude of ways

come December if the FOMC does decide to raise rates. After all, data on the labor participation rate, underemployment, and the growth of the US manufacturing sectors is not very attractive. In fact, the manufacturing sector is currently contracting. Ha-Joon Chang, author of the bestseller 23 Things They Don’t Tell You About Capitalism, wrote that “contrary to what professional economists will typically tell you, economics is not a science (...) [for] all economic theories have underlying political and ethical assumptions, which make it impossible to prove them right or wrong in the way we can with theories in physics or chemistry.” Ultimately, when rates do rise, it will be more important for economists to have had discussions on the various scenarios that might emerge – including their consequences, both domestic and international. Anyone that promises something different – even if they do go by the name of Carl Icahn – is someone to watch out for.

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Imagine There’s No Hike Betting Against the Odds

José Alberto Ferreira and Mariana Fernandes We live in a prolonged era of unconventional monetary policy. Since 2008 for the Fed and 2014 for the ECB, QE programs have increasingly become the norm as interest rates matured past their effectiveness. Monetary policymakers have gone beyond their traditional scope, applying extraordinary instruments – including QE – whose results were not entirely foreseeable. When the FOMC gathered in October, many expected a rate rise due to signs of economic recovery – the first in almost a decade. In the EU and the US, however, inflation remains anemic. In fact, the the 2% annual target is not likely to be met before the end of the decade. Although it did not occur in October, the expectation of a rate hike in December by the Fed continues to be widespread. Indeed, several analysts believe that – seven years after the beginning of the Great Recession – banks, firms, and households are now ready for such a hike. Others, however, conclude that near-zero interest rates should remain. Early this year, federal funds futures, which can be used to place bets on interest rate moves, indicated an overwhelming 99% probability of a rate hike; two months ago, however, the likelihood of a hike was below 50%. As such, analysts, economists, and policymakers

have been obliged to consider the case in which the Fed does not raise the federal funds rate in December. Ultimately, this operation is not such a consensual idea – which begs a question that goes against the odds: what if rates do not increase? Those who are contrary to a rate hike, particularly in the US, base their views on the slow wage growth that has accompanied the decrease in the unemployment rate (namely a seven-year low of 5% as of October), arguing that wage-driven inflation is losing its significance. After all, low unemployment traditionally pushes inflation up. In other words, the economy is witnessing a nearly inflation-free recovery. Moreover, if rates were to increase too soon, low inflation could possibly shift into deflation – a nightmare that Japan knows all too well (the BoJ has been practicing near-zero rates for nearly two decades). Deflation encourages households to postpone consumption, negatively pressuring the economy and bringing about rate cuts or unconventional monetary policy. As of recently, companies’ revenues have not met expectations, as proven by the most recent modest earnings season. Furthermore, this outcome is masked by successive bouts of cost-cutting measures.

Moreover, commercial banks’ net interest margins have reached significantly low values that are battering their stock value. J.P. Morgan estimates, for instance, that a 100 basis-point rise in rates would increase its net interest income by $2.8bn per year. Recent evidence from both the EU and the US demonstrates the far-reaching effects of sustaining low interest rates for long periods of time. Primarily, low interest rates encourage borrowing and therefore investment. However, this positive outcome can lead to deflationary pressures once there exists a shortage of demand or excess of supply – as the recent US oil boom has exemplified. Keeping rates low also leads to an increase in buybacks through cheap borrowed debt, which not only masks equity valuations in this era of low earnings, but also affects long-term profitability. After all, liquidity is not necessarily being invested into CAPEX or R&D. In fact, corporate bond and loan issuance in the US is approaching a twodecade high of $1tn. Low rates also affect asset allocation. Investors turn to fixedincome bonds with longer maturities as they grow more sensitive to increases in interest rates (e.g. 10-year government bonds). However, this has an impact on all sorts of assets, including real 15

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estate. House prices in the UK, for example, are at a historic high even though the availability of houses for sale has been decreasing. This is a result of owners prioritizing rent as source of cash return in midst of cheap credit that is driving prices up. Emerging markets also suffer in a deflationary environment as demand for commodities is continuously pushed downwards, driving investors away. Lastly, another aspect of the drawn-out rate policy regards pension fund and longer, fixedincome financing. The lower the interest, the more companies commit to these funds. Their resources, therefore, are not applied to production – a concern pointed out by the OECD in 2011. Switching gears to the bigger picture, a scenario without a rate hike implies that monetary policy is not yet normalized and, therefore, the economy is not 16

ready to start a new tightening cycle. Ultimately, both the ECB and the Fed pursue inflation targets; so, given the level of low inflation, it is not unfathomable that some economists believe that the time for a rate rise has yet to come. It is a discussion, then, that focuses on the timing rather than on the substance of such an operation. Overall, central banks seem to be searching for positive news to put forward rate hikes. They are doing everything in their reach to normalize monetary policy.

policy. Now more than ever, and despite the consensus on the long-term damaging consequences of low interest rates, the “intricate economic and financial linkages in our global economy” – as Janet Yellen puts it – requires central banks to be bolder and more creative. For how much longer can the world economy sustain near-zero rates? Are central banks waiting for the right time or the right tool? One way or another, one thing is for sure: “business as usual” is no more for central banks.

Insights

NIC Undergrad Review Volume 2 - Issue 1

Should I Invest in the World I'm in? Or the One I Want? An Intuitive Approach to a Well-Reasoned Dilemma

Afonso Borges

UBS’s recent “Life’s Questions” ad campaign gathered an array of question marks that it thinks its clients might come across throughout their lifetime – only to conclude that “for some of life's questions, you're not alone” and that “together we can find an answer.” One of those questions could not be more relevant, which is precisely why I will be addressing it in this article. “Socially Responsible Investment” (SRI) is not a new trend. According to the ever-soresourceful Wikipedia, it may date back to 1758 when a religious society in Philadelphia prohibited its members from participating in the slave trade. Throughout time, the concept has evolved, in one form or another, to exclude investments in products such as guns, liquor, and tobacco in the 18th century. Moreover, it began addressing issues related to 18

gender equality as well as labor and civil rights in the 1960s. More recently, the scope of the concept has been shrinking, having increasingly become synonymous with environmentally sustainable projects. In the last few years, the term SRI has been replaced by ESG, which stands for “Environmental, Social and Governance.” According to the Morgan Stanley Institute for Sustainable Investing, Millennials are the demographic cohort that is currently most interested in ESG Investment. By April 2015, almost 1400 asset-management firms with an aggregate of $60tn in AUM have signed the United Nations’ “Principles for Responsible Investment.” While making the case for ESG Investment, I have often come across a misconception among investors that I have sought to

address by proving it wrong. Namely, this is the notion that “sin stocks” tend to outperform the overall market. Hampus Adamsson and Andreas G. F. Hoepner have recently published a paper called “The ‘Price of Sin’ Aversion: Ivory Tower Illusion or Real Investable Alpha?” in which they claim that previous research on this topic had ignored the simple fact that “small beats large.” They also concluded that when accounting for the differences in market cap with value-weighted portfolios, sin stocks “do not exhibit any significant outperformance” and gambling stocks actually underperform. Notwithstanding, the argument I want to make is not about returns. Instead, it concerns human morality.

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Some of the richest people in modern-day society are also some of its greatest philanthropists. The “Giving Pledge,” an initiative started by Warren Buffett and Bill Gates, has recently seen the addition of Mark Zuckerberg and Priscilla Chan to their list of 138 individuals or billionaire couples that have committed to giving away the majority of their wealth to philanthropy. While this is a remarkable contribution, it is arguably easier for a billionaire to give away a large proportion of his or her wealth than it is for the average Joe or Jane to give away anything at all. After all, doing so might very well compromise his or her safety net. Moreover, philanthropic schemes by the ultra-rich often entail some form of tax benefits – as pointed out by DealBook’s Jesse Eisinger. On December 3, Mr. Eisinger wrote: “Mark Zuckerberg did not donate $45 billion to charity. You may have heard that, but that was wrong. Here’s what happened

instead: Mr. Zuckerberg created an investment vehicle.” Controversy aside, it is generally believed that allocating funds to humanitarian causes is a nice thing to do. At one point or another, I hope we will all look at our wealth and wonder how much of it we should give away. Other relevant questions that emerge when considering the issue of donating wealth include the specific causes that deserve the funds that we have worked so hard to earn, as well as the point in time in which we should start giving it away. As for the causes, one must find something he or she can relate to. This is something that I cannot help you with; however, I do hope to convince you that if you indeed have the desire and the capability to donate a portion of your wealth at some point, now is the best time to do so. The most common explanation I have heard as to why one should

postpone his or her donation scheme is that wealth has been increasing at a high rate over the years. Thus, it follows that if one was to wait one more year, the amount one would be able to give away – both in nominal and in real terms – would be higher than it would have been otherwise. Although this logic can very well be true for business-owners, entrepreneur, and investors alike, there exists a missing piece. While wealth tends to grow over time, the other side of the coin is that the necessities of those in need also grow over time – and, most importantly, that the latter arguable compounds faster than the former. Unfortunately, I do not have statistical evidence for such a statement. Yet, it seems intuitive enough that the sooner we address urgent issues such as global warming and rising inequality of opportunities, the greater the benefits we will be able to reap.

NIC Undergrad Review Volume 2 - Issue 1

Marchionne’s Way Deciphering the Method to His Madness

Diego Tremiterra

The Fiat brand needs no introduction. Founded in 1899 by Giovanni Agnelli, it quickly grew to gain a control of 87% of the Italian market in 1925. After WWII, Giovanni’s grandson, Gianni, developed an international expansion plan supported by the boom in global demand for cars. Having all the competencies and instruments to become a worldwide success, the Italian carmaker somehow failed to become an established brand and started facing tough challenges in the beginning of the twenty-first century. As a result, Sergio Marchionne was hired in 2004. He was the fifth CEO in three years and Fiat was losing money since 2000, seeming destined to insolvency. Marchionne decided to step in and take charge; this is the story of what later became one of the most significant carmakers in the world. As soon as he joined the company, Marchionne spotted several faults with Fiat’s leadership management. 20

Consequently, he began rounds of layoffs in order to promote young and risk-taking talent. With a renewed team, reinforced technology and a more efficient production process, Marchionne brought to the market the Fiat Cinquecento in 18 months, beating the previous four-y ear benchmark to put a car in the streets. This car model was a massive success; in fact, high demand caused Fiat to ramp up production by 60% in the first year. Between 2004 and 2008, Marchionne increased net revenues from €46.7bn to €59.5bn (+27.5%), while increasing profit margin from 0.2% to 5.4%. Everything was en route – until the automotive industry was hit by the Great Recession, bringing about the toughest years ever for the industry: 2008 and 2009. In fact, a good year for the American segment of this industry is sales of 15 million units; by 2009, however, Americans bought only around 10 million units (-33.3%). Nevertheless, Marchionne had to reach the critical and sustainable mass of over 6 million vehicles

sold per year. To materialize this priority, Marchionne looked to Chrysler as the most favorable strategic alliance. Moreover, with its 50,000 employee base, Chrysler in the US was leaking cash and lacking consumer love. Therefore, Marchionne made a deal with the US government (which at the time was predominantly preoccupied with the US job outlook): 20% of Chrysler plus a $6bn high yield loan (19.7% interest) to be paid back in 2017. With Chrysler, Marchionne adopted the same strategy he employed at Fiat: no more of grumpy high-ranking managers and a focus on young and creative minds. He brought in 26 such leaders that would speak directly to him, strongly improving the decision-m aking process. As a result, Chrysler, under Marchionne’s management, repaid the loan in 2011, six years before the due date. On January 2, 2014, Fiat secured the remaining 41,5% stake of Chrysler for $4.35bn – a merger that proved to generate significant synergies: Chrysler was

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a considerable player in SUV, mini-vans, and light trucks, whereas Fiat’s strengths lied in smaller and more fuel-efficient cars. That was the moment when the current seventh biggest automaker in the world was born: Fiat Chrysler Automobiles (FCA). As of today, FCA has a five-year corporate strategy that forecasts a sales volume growth of more than 50%, while reducing debt (from anywhere between $0.5 to $1bn by 2018) and investing €48bn in between 2013 and 2018. Ideally, the plan is to grow FCA’s position in fast growing and high-margin markets. The restructuring of the Chrysler’s brand enhances the exposure to growth markets. In North America, it will give up its attempt to position itself in the luxury market segment. Dodge’s mission will be to focus on muscle cars (even if that means a dip in volumes), whereas Jeep will pursue product penetration production in growth markets. The Ferrari spin-off followed by

its IPO was the first step in growing FCA’s high-margin exposure. Marchionne did so to get financing, so that he could increase production from 7,000 models to 10,000 per year. But the method to the madness does not end there. The revival of the Alfa Romeo is also underway; in fact, over 200 engineers have been secretly working in the last two years on how to revitalize Alfa Romeo’s brand equity, along with the powerful and seductive brand narrative it enjoyed in the 60s. With that, they are attempting a change in the type of drive from front-wheel to rearwheel; the objective is to return to drivers the old-but-solid-gold experience, thus more fearfully targeting BMW’s and MercedesBenz’s market coverage. The automaker also has a wide expansion plan for the US, in which it plans to leverage Chrysler’s existing distribution channels. The automotive industry will be facing many challenges: increased capital requirements, new emissions and safety regulations,

and increased consumer’s demand for car connectivity and autonomy. Nevertheless, Marchionne is exceptionally aware of that, as he showed in his “Confessions of a Capital Junkie” presentation. At heart, Marchionne is a mix of the modern and straightforward CEO with touch of investment banking. Precisely because of this, he has managed one of the most successful turnarounds in history and is currently pursuing an ambitious (outrageous for some) strategy which, if successful, will knock it out of the park and blow everyone’s mind. Including mine.

Did You Know? Another important response to the Great Recession was the demerger of Fiat Industrial, so that Marchionne could focus on growth and consolidation opportunities. This operation would come as a consequence of different earning cycles, as well as volatility and capital requirements between automotive and the industrial manufacturing processes.

NIC Undergrad Review Volume 2 - Issue 1

On Trump and Boris Leading the West A Hypothetical Exercise

Inês Cunha and Miguel Garção What if the West was lead by two showmen? Though the chances for this to happen may not appear to be great, it actually might be possible in a matter of months or years. Having similar physical characteristics, both Boris Johnson and Donald Trump are known for speaking their mind. Donald Trump, an American tycoon, is running for President of the US in the 2016 elections and has consistently been the frontrunner for the Republican Party in the last months. Boris Johnson, the mayor of London since 2008 and a Member of Parliament since 2015, is seen as the people’s choice to be the next leader of the Conservative Party. Therefore, he is a potential candidate as the next Prime Minister of the UK – after all, David Cameron has ruled out serving a third term at Downing Street, thus triggering a leadership contest ahead of 2020. Despite having refused this idea and also failed to directly pursue support, Boris currently has substantial backing within the Conservative Party. However, not all is alike. Perhaps most significantly, Boris has had extensive experience a public servant; on the other hand, Trump has no such political experience. He has never been elected to any form of political office – and paradoxically enough, that is precisely one of his campaign’s unique selling points. Moreover, the 22

businessman is said to be worth $4bn – needless to say, not everyone can compete with such a level of wealth. With regards to personality, whereas Trump – rarely described as open-minded or intellectual – clearly exploits his wealth to catch votes, Boris is an Oxford-educated and sophisticated thinker who comes across as charming and tolerant. People like Boris and they laugh with him, regardless of whether or not they agree with his idea. His behavior and interpersonal skills contributes to his likeability – and unlike Trump, who either does not comprehend social boundaries or simply does not care for them, Boris usually understands how to walk between the fine line of political correctness. Indeed, Trump is notorious for how often he indults individuals and communities (his most recent scandal involves mockery of a disable reporter). Obviously, such

behavior heavily influences the public’s perception of Trump as arrogant and crass. By contrast, when Boris insulted the city of Liverpool by criticizing its grief over the kidnapping and decapitation of Ken Bigley, he later apologized. Ultimately, some people have said that Boris is a genius pretending to be an idiot. Well-humored, he believes in social justice and contrast. On the other hand, Trump's "rich loudmouth" personality is, in fact, much closer to the real Donald Trump – and this makes the businessman exponentially more confrontational. Regardless, the likelihood of Boris’ and Trump’s political prominence has never been more realistic. As such, it is time for a hypothetic exercise: what would actually happen if these two charismatic showmen were to lead two of the West’s most significant economies?

NIC Undergrad Review Volume 2 - Issue 1

When it comes to foreign policy, Donald Trump has said he would “absolutely” withdraw refugees’ passports, shut down mosques, and ban Muslims from entering the US in order to fight Daesh. He has justified such aggressive policies by claiming, for instance, that he saw Muslims cheering the 9/11 attacks in Atlantic City, New Jersey (despite the lack of evidence and credible reports). Boris, in deep contrast, firmly believes that the “jihadi madness” is rejected by the great majority of Muslims. His answer to Daesh is considerably softer: “we need to be able to monitor these vipers nursed at the breast of the British state: their movements, their communications, and sometimes we need to be able to separate them from others who could aid and abet their plans.” Both of these showmen have a strong view on immigration. Trump wants to build a wall on the Mexican border and deport 11 million undocumented immigrants. The feasibility of such measures, however, is doubtful to say the least; more so, the US economy, in particular industries that are dependent on cheap immigrant labor, would be negatively affected – particularly with regards to its job outlook. Boris, on the other hand, has stated that while he is not against immigration as long as immigrants work and pay taxes, he is against the EU’s excessive influence on this matter. In short, Boris is demanding significant changes in its immigration policy. Still with regards to EU reform, another objective is to decrease EU business regulations. These conditions are all vital for Boris if

the UK is to remain in the EU. However, he still believes that it is best for the UK to remain in the EU – which is not to say that, as Boris has previously stated, that a Brexit is not inevitable. After all, with the Greek government-debt crisis, the price of getting out of the EU has never been lower. More controversially, Boris is excessively conservative with regards to gender equality and women’s rights, having previously stated that women “have got to find men to marry” in universities. As such, it would be unwise to expect any sort of progress related to the gender gap and protection for women in the workplace. Financial services and business would theoretically benefit with both figures if most of their ideas were achieved. Trump’s tax plan, which includes getting rid of corporate taxes, would make US businesses more competitive and improve the economy in the shortterm; however, Trump has failed to clearly mention how he would compensate such measure. After all, an increase in the deficit and the budget debt is expected to occur in any situation in which tax revenues decrease, ceteris paribus. Eventually, the market might not be a fan of this scenario since no investor would keep investing in a country that is deliberately driving towards a fiscal cliff. Moreover, the Trump’s 20% tax on imports would be a violation of nearly all the US’ trade laws and treaties. No matter how skilled a negotiator Trump is, it would be tough for him – if not impossible – to overcome these policies’ illegality.

After London’s financial sector having contributed to one of the UK’s biggest crash and slowest economic recovery, Boris has declared that inequality is essential to fostering "the spirit of envy" and has even hailed greed as a "valuable spur to economic activity." Hence, it is unwise to expect any further form of business or market restriction from Boris’ political platform – even if markets may come to doubt the security and stability of an economy where free rein is given. Leaving all scandals aside, it is possible to say that both Boris Johnson and Donald Trump are incredibly charismatic and enthusiastic. However, this is not a sufficient condition for being the leader of a country – particularly given the fact that both of these showmen are a bit short on ideas. Again, we resort to a (perhaps more significant) hypothetical exercise: can we imagine a world in which Boris Johnson or Donald Trump have access to nuclear codes?

NIC Undergrad Review Volume 2 - Issue 1

Telecom Industry Calls for Consolidation Threats and Opportunities in the Italian Market

Bocconi Students Investment Club (BSIC) We all know the strong changes that Internet has brought to our everyday lives; in fact, the way people are connected and communicate has changed dramatically over the past years. Phone calls and standard text messages are increasingly becoming less popular as alternative communication services and apps like WhatsApp or Messenger take over. Customers’ demand has changed and supply has had to adapt, such that these new trends have strongly affected telecom markets all over the world, including the Italian one. The Telecom (Tlc) market accounted for €34bn in 2014, which represents around 2% of the Italian GDP, almost equally split between fixed and mobile telephony. In order to understand the drivers of the rapid decline in telecommunication prices in recent years, it is useful to analyze how the revenue decomposition of Tlc companies has changed in the recent past. Revenues coming from voice telephony have been declining rapidly, while the ones coming from data traffic have been increasing but not enough to offset the declining path of the voice revenues. The dynamic is quite similar both for mobile and fixed telephony. Among fixed telecom services, it is possible to see a significant decline in voice revenues due to

the reduction in rates and the progressive shift of voice traffic to mobile. Many of the fixed operators have dealt with this new challenge by offering more integrated services, replacing voice services with more value added content that is more online based. For what concerns mobile telecom, revenues from traditional service components as voice and messaging, heavily impacted by the strong competition of online telecom apps, continued to decline in the recent years. On the other hand, Mobile Broadband has been growing and, although yet unable to offset the drop in revenues from traditional services, it represents the main strategic and business opportunity for the mobile Tlc industry. In other words, Tlc companies have had to move away from their extremely profitable voice and messages services, cutting prices and slushing margins – while entering a new, more competitive and lesser profitable market, namely traffic data, to keep generating revenues. With such a difficult environment for organic growth, it is not surprising that the main industry players are trying to sustain margins by realizing cost synergies also through mergers and acquisitions. In August 2015, the parent companies of the third and the

fourth largest mobile operators in Italy, VimpelCom Ltd. (Wind) and CK Hutchison Holdings Ltd. (3 Italia), announced the agreement to form a 50/50 joint-venture, which will become the major player of mobile telecommunication industry with a market share of 33.5% in terms of customers, followed by Telecom Italia (32.3%) and Vodafone Italy (27%). The new company is expected to generate €6.4bn of revenues and an operating profit of more than €2bn and will be run by Maximo Ibarra, currently the CEO of Wind. Hutchinson’s move needs to be contextualized in its overall strategy: the company already acquired other mobile carriers in Ireland, Austria and the UK, trying to become one of the major players of the European mobile telecommunications industry. Given the substantial reduction of players involved in the market, the deal is subject to the approval

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of the European Competition Authority, expected to release a judgment about the feasibility of the deal within May 2016. Even though the same commission has recently rejected the merger between the second and the third Danish mobile operators, there is optimism about the final decision as the number of significant players in the Italian market will eventually be three and not two, as there would have been in the Danish market. The deal will have two major implications for the market. Firstly, it is expected to generate an overall amount of €5bn of synergies, mainly driven by operating cost savings and reduction of the capital expenditure. This would allow the new operator to be more aggressive in terms of pricing, trying to further increase its customer market share. The second important point is that the merger could be the first step towards a broader consolidation of the industry in terms of potential convergence between mobile and fixed telephony. In other European markets the consolidation has led the players to offer more integrated services

including mobile, fixed telephony and, in some cases, even pay-perview TV services. In the past couple months, a lot of attention has been built around Telecom Italia. The company has been facing many problems ever since its privatization in 1997, and is now dealing with the consequences of the recent financial crisis and recession. With a steadily declining EBITDA over the last 5 years, Telecom Italia is one of the best examples an European company with good profitability prospects, but which is still in trouble due to its incapability to overcome the obstacles of the Great Recession. That is, Telecom Italia is currently cheap; it needs both fresh capital injections and an internal reorganization. This makes it an interesting target for strategic and financial acquirers looking to buy low and restructure the company, namely Vivendi and Xavier Niel. Vivendi SA is a Paris-based multinational company operating in the content and media sector, focusing primarily on digital entertainment. The company acquired its first stake in Telecom Italia as a result of a deal with

Telefonica SA, then increased its holdings to almost 20% through purchases made in recent months. Vivendi has recently asked to add 4 of its highest executives to Telecom Italia’s board. The proposal would increase the company’s influence on Telecom Italia’s governance, and must be interpreted in light of an Italian provision that obliges any acquirer who has exceeded the 25% ownership threshold to make a bid on all of a target’s shares. It is likely that Vivendi wants to avoid the risky and expensive full takeover offer, and is looking for alternative paths to gain control. Telecom Italia’s infrastructure and customer base could strategically justify the acquisition, though the shadow of an opportunistic investment is just around the corner. Vivendi’s objective could be to secure a good stake now in order to be a player in the future, under the perspective of further consolidation in the European telecom industry.

NIC Undergrad Review Volume 2 - Issue 1

Reputational Economy #rate4rate #rate4costumer

Gonçalo Marques and Manuel Antunes The same way credit rating agencies appeared during when economic development demanded a reliable third party opinion on the credit risk of a firm, today’s society demands a reliable third party opinion for almost everything. Credit rating agencies appeared when the economic expansion in the US spread the businesses to new areas in the country, increasing the trading distance. At the time, companies needed someone who knew the companies they were trading with to rate them, in order to decide whether or not to lend them money. Investors were not dealing with lending among a community they knew anymore. The first firms appearing in the market with a similar goal as credit agencies were the mercantile rating agencies, who rated the ability to pay of merchants and published it in guides. This was back in 1837. The same need for a reliable rating boomed in another market since the second half of the twentieth century – the tourism market. When travelling around it was easy not to find the best restaurant in town, nor the best hotel. If you did not know a person who had gone to that same destination, it was likely you would buy a travel guide before you go in order to plan your trip. Today, the tourism market is much bigger, the world is much more global, and the connection 26

between people has increased. Large rating companies became more and more popular, and the experience of each of us is now much more important for businesses – consumers are now the new rating specialists. This change in roles made businesses more cautious of the service they were providing. The impact of an unhappy costumer is now much bigger than the impact that a close group of friends had before. Quoting Joshua Klein’s Reputation Economics book: “your network is worth more than your net worth.” In the end, who benefits the most out of this transparency is definitely the costumer, who can make wiser choices more easily based on the market’s opinion instead of the opinion of a couple of friends, or a travel guide author. For some businesses, the development of such a subindustry became as important as the product the are offering. From the eBay seller who we need to rely on, to the hostel one of us is picking for Spring Break and the café we are looking for to have brunch; in all of these cases we will be looking for its online reviews. We want to know others’ experiences before we have ours. Restaurants, bars, hotels, online sellers, job-seeking websites – we would not be the same without this simple and efficient way of

getting to know people’s insight on the various existing businesses and their services. The sharing economy is one in which the reputational economy reaches its climax. One of the most interesting characteristics of this form of economy is that it is marked by an economic development of one of the most natural human acts: the act of sharing. At the same time, we will need to trust, and such trust will only come from others’ previous experiences of our product, which effectively shapes our reputation. Businesses like Airbnb, Uber (in its pop version), car- and bikesharing apps, and P2P lending would not be as successful as they are without such a system. The importance of one’s reputation is such that we need to be aware of how powerful this weapon is. After all, “once something goes online, it will never go offline.” This article was sparked by the authors finding themselves searching online for the best ice-cream shop in their hometown. They wanted a gelato.

NIC Undergrad Review Volume 2 - Issue 1

Real State: Today’s Ultimate Asset Class Keeping the Money at Home, but Not Under the Mattress

Manuel de Oliveira and Pedro Leão

Amid the low level of interest rates we have seen during the last couple of years, bonds have become a less attractive investment. Together with QE and other macroeconomic factors that originated a couple of strong bullish years on equity investments, this spurred the investors’ attention towards stocks. However, more recently, as expectations of an interest rate rise by the Fed increase, stocks are not looking that attractive anymore. Concerns have been raised, one of them related to US exports and its consequences on companies’ profits for the next year, which can hurt stock prices. It is now time to look at some alternative investments, which brings us to real estate. It is defined as “property comprised of land and the buildings on it” – this being an oversimplified explanation for something that is actually not simple at all. Thus, we hope to shed some light on real estate as an investment, which is much more than just buying a home. Real estate as a part of an investment portfolio can

be segmented in two major categories. First, there are income producing investments, such as offices, retail, industrial and leased residential, which, when leased, all produce income, in the form of a rent. This is extremely positive as a form of investment since not only are you able to get a steady, regular income out of it (like a bond), but you are also exposed to capital appreciation and a propensity to fluctuation in value like with a stock. Secondly, there are non-income-producing investments, such as houses, vacation properties or vacant commercial buildings. These work the same way with the exception of the rent component – this means that all the return the investor hopes to attain must come as a result of capital appreciation. Like all other forms of investment, real estate has its own benefits and shortcomings. Obvious upsides of investing in real estate (more specifically income generating properties) are that it can be a great way of substituting the most common fixed income instruments, with higher net cash flows during the holding period. 27

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In spite of real estate’s attractiveness right now, it carries clear disadvantages. Most people may not have either the capital to make an investment like that or do not have the time and skills required to manage their investments. Although the upside of having a property is that you can actively manage it and therefore have some control over its market price (unlike stocks or bonds), the downside is that you are most likely going to have unexpected management costs from time to time, which can trim down your net profits. Either way, there are still some ways you can invest in real estate with smaller amounts of money and little time. A Real Estate Investment Trust (REIT) is a company that owns or finances income-producing real estate. REITs provide investors with all types of regular income streams, diversification and long-term capital appreciation, providing investors without much capital the opportunity to invest and still be exposed to the real estate market. To qualify as a REIT, a company must comply with several requirements. Firstly, it must invest at least 75% of its total assets in real estate and derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Also a REIT must pay at least 90% of its taxable income in the form of shareholder dividends each year. Next, the company must be an entity that is taxable as a corporation, is managed by a board of directors or trustees, and has a minimum of 100 shareholders, in which no more than 50% of its shares held by five or fewer individuals. Given this, it is easy to understand why investing in a REIT will give you the possibility of getting exposed to a various different types of real estate properties 28

by buying units of the trust rather than buying the whole property. This enables investors to obtain fixed income through dividend payments, as well as capital gains if the investor decides to sell his or her units later at a higher price. Additionally, if you are looking for a diversification opportunity, some REIT ETFs – such as Vanguard REIT ETF (VNQ), iShares U.S. Real Estate ETF (IYR), and iShares Cohen & Steers REIT ETF (ICF) – can be good options. After all, these give you exposure to a broader range of REITs instead, combining stakes in the commercial, industrial, residential and office sectors. Just keep in mind that they are more focused in the US real estate market, which currently may very well not be the most attractive geographical segment. Some interesting REITs to look for are the ones that contain on their portfolio big exposure to industrial buildings rented to industrial and manufacturing companies that depend heavily on exportations and can profit from a stronger dollar and weaker home currency competitive advantage, stimulating a growth in the industry and driving rent and building prices up. Key factors in these type of investments are location (specially in terms of accessibility to roads and ports) and facilities’ conditions (in terms of structure, space, accessibility by big vehicles, inside or outside space and refrigeration). Unfortunately, there are not many REITs that fit into this category and some of them are in already overpriced markets. With regards to this type of investment in such an industry, especially in the case where it is taken as an individual investment and not as a REIT, information asymmetry can have a huge impact on profits. That is a way in which you can have the type of advantage over professionals. That is what Peter Lynch used to refer to and emphasize so often in an investor’s quest to achieve big profits (even if in this case we are not addressing stocks). Of course, this investment strategy is not available to everyoneunless one were to leverage her or himself, a move which also has some advantages in a low rate environment. Another advantage is the possibility of getting the upside of capital gains of stocks, at the time of property resale. Besides, it is a great way of diversifying your portfolio and reduce risk given that

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that historically house prices are independent of bonds and stock markets variations. As a matter of fact, the lower interest rates are, the better it is for those seeking to buy a house. This happens because mortgage loan rates walk hand-inhand with interest rates, and unless you are able to pay for the house upfront, taking a mortgage loan can be a problem if you cannot afford the extra interest. Moreover, usually one of the greatest issues with getting a bank loan is the amount of interest you pay during the first installments â&#x20AC;&#x201C; after all, when you look at it, a large subset of the money you pay goes towards the interest payment and not the principal repayment due, which remains almost the same. If interest rates are low, you will pay a smaller percentage of your instalment as interest and a bigger portion as reimbursement, which means you will be able to pay down your debt quicker and therefore pay a low nominal value (not percentage) of interest on your next installments. Even if the rates go up in the future (as they most likely will,

particularly for the US), your principal due is already smaller and the impact of the rate raise is thus reduced. An example: if you borrow $175,000 for 30 years, your principal and interest payment will only be $835 per month, with a 4% fixed interest rate. Now consider the impact of an interest rate increase of 2% on a mortgage loan. Borrow $175,000 for 30 years at a 6% interest rate and your payment balloons to $1,049 â&#x20AC;&#x201C; a staggering 26% increase in your loan payment. Overall, regardless of the type of investor you are and given that your investments are realized correctly, you can definitely benefit from the low rate environment right now when it comes to buying a property. Be aware, however: some markets in the US and EU (especially the UK) have repeatedly been labeled as overpriced, so make sure you do your homework beforehand.

House Price Index 300

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Itâ&#x20AC;&#x2122;s raining oil. What else? 30

NIC Undergrad Review Volume 2 - Issue 1

Russia’s Gas and Oil: a Tale of Two Strategies Running from (and Towards) Interdependence?

Andrey Dmitriev and Pedro Filipe Rodrigues Russia holds a strategic position in global energy markets as a major competitor in gas, oil and coal. Not only is the energy sector the great provider of revenues for the government, but it is also one of the reasons why Russia can once again cope in terms of geopolitics with Europe or even the US. The environment of low energy prices and economic sanctions in Russia has created additional pressure to the sector during one of its most important stages of the last decades and may delay the long-term “Energy Strategy” adopted by its government. Russia-EU relations are much centered on the supply of gas to western markets. As such, the Russian gas industry is a major power-projecting tool even more than the oil industry, regardless of its sizeable contribution to government revenues.

Better energy efficiency would allow higher domestic savings and more gas available to reach other markets. Nevertheless, Western economic sanctions and the recent plunge of oil prices have proved to be quite a blow to its gas sector. The sanctions have restricted many energy projects from getting much-needed financing from the West, while low oil prices – which also affect gas due to LTC’s oilindexed-prices - have restricted Russia’s self-financing capacity. Over the past two years, Russia has increasingly looked eastward, mostly to China, both for investment and as a new market for its gas. The Chinese market, which has the potential to match the European market, is looking to decrease its coal use for energy- generating purposes and sees gas as a less pollutant sdfssdfsd

substitute. Furthermore, at the current location where most of the gas is extracted, the Nadym Pur Tazov district of Western Siberia, production is expected to drop from 500bcm currently to 333bcm in 2035. This poses one of Russia’s current major challenges: substituting its old gas fields and building new exploration facilities in times of financial hardship. For example, one project which aims to diversify gas exports and compensate for decrease of production in traditional areas is the Yamal LNG, a $27bn jointproject between Novatek, France’s multinational Total, China’s CNPC and The Silk Road Fund. An LNG plant in the Arctic may be a strategic step for Russia, given that the Northern

As a geopolitical weapon, Russian gas has been used to mediate relations with Europe, especially in the context of Russia’s largest energy company, Gazprom. These two regions have an energetic interdependence in which the EU depends on Russian supply – 30% of all imported gas – and Russia depends on European demand – which accounts for 50% of Gazprom’s revenues, which corresponds to one-third of its gas. Such imbalance results partly from the Russian chronic problem of inefficient resource utilization.

NIC Undergrad Review Volume 2 - Issue 1

passage goes mostly through Russian territorial waters and there would be no need for transport infrastructure. Moreover, icebreakers may ship liquefied natural gas (LNG) to almost anywhere in the world, allowing Russia to reach new markets. However, even though this LNG plant is to be operating by 2017, $17.5bn are still necessary to complete the project, mostly due to the absence of longterm funding due to sanctions and some reluctance from the Chinese that is fueled by its current slowdown, as well as the possibility that Australia might be a cheaper source of LNG. In the context of oil, Russia holds a prime position in global markets, as it provides one-eight of the total volume. About 75% of Russian oil – both crude and refined – is allocated to the international market and accounts for 40% of the Russian government revenues. Russia supports a two-way strategy for its oil exports, with Europe consuming the bulk of it due to the geographic proximity and the pipeline linkages with Russian producers However, its product is being increasingly shifted to Asia, particularly China and India. As stated in its “Energy Strategy,” its goal is to double exports to Asia by 2035. Regardless of its newfound objective, the western market is a cash cow for Russia, accounting for 80% of total exports – especially to Germany, the Netherlands, Poland and Belarus. However, as Russian companies struggle to meet the targets for Asia, a part of western oil has 32

been redirected towards the ESPO pipeline network. This is more lucrative due to the higher premium of the ESPO blend over the Urals blend, which is the medium-heavy sour crude exported to Europe. Recent estimates indicated that by 2035 both markets may be on par, with Russia shifting most of its Siberian production towards its eastern provinces, and signing long-term “loan-for-oil” contracts with China – currently until 2038 – to secure financing to support this sharp transition within Russian oil market. This strategy clearly indicates that Russia is trying to dodge competition from the Middle East and that, rather than using oil for geopolitics, it is more concerned with increasing the security of demand for its oil and diversifying its exports. With regards to its refined products, Russia is expected to continue to compete in western markets, supplying around 90% of its demand. However, competition will shift from quantity to quality, as the exports of higher quality fuels such as ULSD are expected to increase

over fuel oil. The strategy is to take advantage of Europe’s diminishing refining capacity and to acquire stakes in European refineries at bargain prices, as some companies are selling assets at low prices due to refineries’ high exit costs. Indeed, Russian companies seem more willing to upgrade European refineries and supply them with cheap oil than to build new ones in Russia. By providing huge tax breaks to oil companies, President Vladimir Putin is pointing to the mineral riches of Russian eastern provinces as the country’s “national priority of the century.” While doing everything within its reach to promote ESPO to a benchmark crude, low oil prices and western sanctions have limited the access to foreign technology. This has forced Putin’s hand as he has finally opted to support the development of Russian technology. However, even if Russia succeeds with its oil strategy as it did in the past, turning all forces to the eastern market may ultimately create the same type of dependence that Russia is running from in Europe.

NIC Undergrad Review Volume 2 - Issue 1

Power Games An Energy Tug-of-War

Diego Tremiterra

Everyone knows how dependent we are on oil. The second half of 2014 showed us how volatile the oil market can be, with Brent plunging from $114 on June 20 to $48 on January 23 – such a drop is usually seen in Disney World’s rollercoasters, not in financial markets. Historically, though, this drop is not as impressive as others: just look at the period of time between 2008 and 2009, when oil prices dropped from $147 to $32. Regardless, many reasons could explain such a phenomenon. At first sight, it might be interpreted as a consequence of continued (or even increased, in the case of Saudi Arabia) production from OPEC to protect their market share from increasingly cheaper extraction prices of shale oil in the US. As supply increases, ceteris paribus, oil prices fall, hurting the US shale producers with their higher break-even point at around

$60 (see the oil extraction cost estimates displayed below). On the other hand, we could also find a more structural and deeper explanation. Jeff Currie, global head of Commodities Research at Goldman Sachs, believes that what brought the current oil price to around $40 is much more than just power games. First of all, it is a supply issue, which is more complicated than just OPEC’s strategies. Shale technology is reshaping the industry, structurally changing the oil extraction process from capex intensive to variable-cost intensive, turning oil production into a “manufacturing process.” As Mr. Curries explains, “nowadays, extracting shale oil is like producing paper clips.” With current technologies, shale capacity can be increased,

modified or even cut in around 30 days. That is mind-blowing, especially when compared to the old mechanism, in which oilrigs would pump oil for ten years and changing capacity was considered to be a massive headache. This structural change has increased competition and caught the attention of investors, who consider shale oil an interesting investment due to the “short” payback period and how rapidly it can adapt to fluctuations in prices. The increased interest led to renewed investment and, therefore, increased production in the US, bringing 3.8mn bpd of incremental oil supply to the market from 2011 to 2014. Secondly, we have the issue of demand. Historically, the BRICs used to be the base-load demand. For instance, countries like Brazil and China used to represent a guarantee for oil demand while 33

NIC Undergrad Review Volume 2 - Issue 1

the US was seen as the margin of adjustment, meaning that oil prices would spike or plunge dependent upon demand in North America. What we witness nowadays is the exact opposite. With the US ever closer to achieving energetic independence, they are now base-load demand, whereas the BRICs and similar countries are the margin of adjustment. This means that oil prices will fluctuate dependent on demand in countries like China or Brazil. If we track the economic performance of such countries in the last year, we can easily verify that poor growth is translated into lower oil demand, increasing the gap between global consumption and production. Overall, it is more of a supply than a demand story. As prices averaged $50 in the last year, this means that shale in the US has been running at a loss. How have they been able to survive? Easy: with the help of debt. As of October 2015, the amount of debt held by US oil and gas producers had skyrocketed to $170bn, more than double the amount of debt that existed five years ago. Moreover, the Fed is expected to hike rates; this will result in higher interests on both debt and inventory, shortening the life span for loss-making oil producers. Winter is coming for some producers around the world; this explains why we have seen large companies cutting costs and reducing their output, as the low price environment does not suggest a rebound, at the very least in the short-medium term. For instance, both BP and Chevron have been cutting 34

massive amounts of jobs to desperately try to decrease costs and maintain current dividends. By next year, the US government expects output to decline to an average of 8.6mn bpd, down from an average of 9.3m bpd in 2015. Consequences of low prices are being felt globally, with forecast for non-OPEC production to decrease by 500,000 barrels a day in 2016 (according to IEA research), the biggest cut in the last 24 years. Goldman Sachs has gone as far as to estimate that, if OPEC production continues to grow and non-OPEC demand stays resilient, then we might see prices as low as $20 a barrel. The dynamics of the past year point to an overall change in the oil market. Even though OPEC seems to be winning the duel against shale producers, it is far away from having the pricemaking power it once had. The shale revolution brought less volatility to the oil market, flattening the supply curve and effectively reducing OPECâ&#x20AC;&#x2122;s market power. Historically, OPEC has always increased or decreased production in order to lower or spike prices, respectively. As the supply curve flattens, however, this strategy will increasingly become more inefficient as prices do not fluctuate as much. To add insult to injury, shale is not the only threat to the OPEC dictatorship. Alternative sources of energies are becoming increasingly relevant, playing a global role in the energy market. World biofuel production has doubled to over 1.2mn bpd since 2006. Wind power has grown, in

oil-equivalent terms, to 2mn bpd in 2013 (having doubled since 2008). Solar power had grown from 20,000 bpd of oil-equivalent energy to 400,000 in the same period of time. Going forward, albeit cheap shale gas prices might create a difficult environment for renewables, we will still manage to witness an increasingly more diversified combination of energy sources. Furthermore, gas turbines could hedge the intermittency of renewables: Mr. Curries states that, in the foreseeable future, electricity production will be led by natural gas, wind, and solar power, while transportation means will primarily rely upon electricity, natural gas, and oil. At the end of the day, we ar e witnessing a world which is slowly becoming less dependent on oil. With the support of technology, mor e diversified sources of energy are becoming available to the consu mer, threatening oil producers and, mos t of all, OP ECâ&#x20AC;&#x2122;s future stream of revenues.

NIC Undergrad Review Volume 2 - Issue 1

"Lost! Lost! My Precious is Lost!" Gold in an Era of Low Rates, Inflation and Growth

Catarina Castela and Miguel Moita de Deus

Unless you have been really distracted lately, you have probably heard that the price of gold has been quite low these past months. In fact, it has been on a steady free-fall since the 2011 record-high price of $1,921.17. This week’s price was $1,072.6. But how has such a decrease happened in the first place and why has it continued? We must first understand why gold is so important, from a historical and evolutionary point of view. No: this article is not an exploratory piece on the Californian gold rush or the Spanish hunt for El Dorado. It is, instead, our attempt to (hopefully) shed some light on why gold still and always will be a thing. Until WW1, many countries had in place the (in)famous gold standard, which gave citizens and companies the possibility of converting paper notes into gold coins or bar. After the war, however, the USD began to be increasingly used by the rest of the world as a reserve currency; this was the beginning of the end of the gold standard’s role in our society. Gold only really regained its shine in the twentieth and twenty-first century when investors started the purchase of this commodity not only as a way to hedge against inflation and other economic calamities, but also for speculative purposes. Since gold was not as influenced by said factors, this move

enabled investors to minimize their wealth loss during recessions. Although global markets are an ever-changing phenomenon, this strategy of “cheating” the volatility of currency by purchasing gold is still up and running – that is precisely why this shiny metal is still so important in today’s economy. So, again, why has gold been on such a downtrend? For starters, gold prices – not unlike the great majority of goods and services – are ultimately a function of its demand. Moreover, its supply changes slowly; after all, it takes at least ten years or more to convert a gold deposit into a producing mine. It follows then that if prices are down, then demand has been decreasing. The justification for such a statement lies with the low value of inflation, the stronger USD, and the upward trend in the US economy. In 2008, the IMF went as far as to estimate that 40% to 50% of gold price shifts since 2002 were related to USD moves. As of recently, the USD has been appreciating relative to other currencies; moreover, as it is still used as a reserve currency throughout the world, demand for gold has logically decreased, as gold plays the role of an alternative investment source 35

NIC Undergrad Review Volume 2 - Issue 1

that conserves the investor’s wealth. Moreover, the increasing USD shrinks the relative value of other currencies, consequently pushing the demand down. In an era where US inflation has been rock-bottom, now stuck at a seven-year record low rate of 0.2%, demand for gold has also been showing weak signs. Why? Well, investors do not need to shield themselves from the fall in the value of paper currency in terms of the goods and services it can buy. Usually and paradoxically, inflation level below the Fed’s 2% target rate discourages rate hikes, which should constitute positive news for gold. Currently, however, even at the current level of inflation, there is a wide expectation of a rate hike in the FOMC’s December meeting. This is another reason that explains why gold has become so cheap these days. Unlike equities or bonds, gold does not generate any type of return or dividend income. After the Great Recession, when yields from other assets were low and there existed an associated high risk, investors felt at ease with parking their money on gold. After all, the shiny metal provided a safe haven for those who wanted to keep their assets’ value. Currently, however, most financial products are offering higher yields for lower risk due to the overall world economic recovery; as such, investors are increasingly shifting their focus to assets such as stocks, bonds, and futures – thus leaving gold to a darker and more unpolished future. What does the future hold for gold? Has economic recovery and subsequent growth established the dawn of a new era of cheap gold? Although no one can say for sure, some factors can help investors understand and perhaps have a glimpse of what the future might hold. One of them is the probable Fed rate rise in December, which will effectively control inflation but will not bid well for gold, for the reasons previously mentioned. Another indicator of the (not so) glittering metal is the actual intrinsic value of the product. A study from two National Bureau of Economic Research researchers, namely Claude Erb and Campbell Harvey, suggests that the fair value of gold amounts to $825 an ounce and that “$350 an ounce is the 36

downside risk to the price of gold given the existence of a golden constant framework, a prior low real price of gold and the current level of the U.S. Consumer Price Index.” All in all, it is (fairly) certain that every time the economy is worse off or the USD is weak, gold becomes investors’ crying shoulder regardless of how long it has been neglected. At the end of the day, the world population is concerned with economic growth, not gold. In the short-medium term, it seems the scenario will improve. Nevertheless, the precious commodity still and always will have considerable influence in world markets and in the global economy. Unlike what is prophesized in fairytales, however, one asset will not rule them all – at least that has been the case with gold.

Next stop: economic slowdown

NIC Undergrad Review Volume 2 - Issue 1

Chinese Hard Landing? Implications for Global Markets and International Trade

Miguel Amaral and Tiago Reganha

Long gone are the days in which China’s double-digit economic growth was taken for granted. China is now facing the impact of over-investment in basic economic sectors, over-borrowing, and the strength of the CNY. However, despite the lack of confidence that followed China’s stock market crash, its impact on China’s downturn has been largely overestimated. Currently experiencing a period

of great transition, rather than a financial crisis, China now has more housing space per capita than Spain – which is notorious for its major housing bubble. The basic industries sector, financed by over-b orrowing from local governments to boost real estate and infrastructure construction, is now in decline and being partially replaced by the service, consumption, and information technology sectors. In fact, steel, cement, and electricity sectors have experienced negative growth

since since only early2015. 2015.Since Sincethen, only the electricity sector has rebounded. More importantly, one must look at the big picture in order to realize how the situation at hand – both positive and negative in nature – is affecting the world’s economy, trade, and financial markets. As this scenario evolves, China’s trading patterns will fail to materialize as negatively as it is expected. For instance, several analysts have reported that China’s imports have declined this year, which is a half-truth. In fact, although the decline did occur, the actual decline in volume is less significant than the decline in the value of the imports. After all, China is a major importer of primary and raw materials, as well as agricultural products – all of which have seen significant price drops recently. The same logic explains the decrease in China’s exports to the EU in which the consecutive devaluation of the CNY is to blaa

NIC Undergrad Review Volume 2 - Issue 1

blame, with a 25% gain on the EUR in just a year. In fact, it is likely that the volume of exports is actually still rising. The biggest indicators of China’s transition is its trade surplus and ratio of trade surplus to GDP – which inversed the trends of previous years and will likely stay between 5.5 and 6% of the GDP for 2015 – and new booming sectors, including e-commerce. While China has been the market leader for a while, only now are we seeing their distribution systems, information technology, and logistics services leaping ahead and replacing old and inefficient practices previously in place. The competitive ecommerce space, coupled with the decrease in imports of energy and raw materials, is pushing the prices down, causing deflation and one of the causes for the lowering of the GDP. One of the main causes of the overestimation of the impact of China’s downturn is the

misconception that the country is a major force of global growth. Its trade and current account balance proves that its capacity to promote growth outside its borders is somewhat limited. Ultimately, the major negative implications of this downturn will fall upon the countries that heavily depend on China in the context of trading, such as Mongolia and Sierra Leone. Both of these countries have a trade dependency of 90%, followed by African countries that export oil and raw materials, as well as Australia and Brazil. Surprisingly, Europe, China’s leading export market, will hardly be affected as most EU countries’ trade with China is below 5%. Nevertheless, an exception should be made for indebted countries, whose burden will be heightened by the deflationary trend. Overall, China’s slowdown and price deflation will have the most negative impact on world’s producers of energy and raw materials; on the other hand, it will have a positive impact for

importing countries. Europe, which does not produce primary materials nor has large export activity with China, will in fact benefit from China’s hard landing: the global downward trend in the prices of basic materials will benefit Europe’s importers while the price drop of Chinese goods will increase the profit margins of European business – as well as improve the general public’s living standards. Either way, China’s economic transition will face several obstacles. In particular, the negative sentiment of economic agents has the capacity of trampling such a move towards a larger role of private investment and consumption – this has been the case since the tumble of the Chinese stock market in August. Finally, the constant uncertainty and lack of clarity regarding the direction of government policy is also very damaging, including its refusal to make major structural changes and the incessant monetary policy alteration.

NIC Undergrad Review Volume 2 - Issue 1

The Perfect Storm Recession, Political Stability, and Commodity Pain in Brazil

Manuel Vassalo and Sebastião Fernandes

Back in 2010, Brazil’s economy grew three times faster than that of the US. As millions of Brazilians moved from poverty towards the middle class, President Luiz da Silva had an 83% approval rating. As a member of the BRIC, a term coined by economist Jim O'Neill, Brazil and its peers – that is, Russian, India, and China – were supposed to establish a new economic order through fruitful growth rates. For a while this seemed to be the case as each country grew exceptionally at the same time that commodities and energy exports were booming. Then, Brazil was the world’s seventh largest economy. Since 2013, however, Brazil has been the weakest link. In her first term, President Dilma Rousseff enjoyed weak growth rates, averaging 2% per year between 40

2010 and 2014 – a value considered low relative to Brazil’s average growth rate of 3.5% between 2002 and 2008. Despite low growth, global demand for Brazil’s soybeans, iron ore, and oil were quickly increasing. Inflation was soaring (6.4% in 2014, which is well above the mandated 4.5% target) due to loose monetary and fiscal policy, and a decreasing trend in the unemployment rate took place, from 7.2% in 2010 to 4.3% in 2014. For Brazil, the tables turned in 2015; indeed, the Brazilian economy has shrunk 2.6% in the last year, which is by far the worst contraction in the past 25 years. Moreover, the country is struggling with a rising four-y ear high unemployment rate and a currency that has lost 25% of its value against the USD. Since last

year, imports have fallen about 12% and the stock market is down 20%. As expected, President Rousseff is having a difficult time with approval ratings of about 8%, the lowest since 1992 when Brazil’s President Fernando de Mello was impeached. Brazil’s economic failures are best explained through the current Chinese economic slowdown and transition, the massive corruption scandal involving Petrobras (Brazil’s largest oil company), and low commodity prices. Exports to China boomed over the last decade. As of lately, however, China’s attempt to transition towards a consumer-led economy that is less dependent on investment and manufacturing has severely affected its trade activity with Brazil.

NIC Undergrad Review Volume 2 - Issue 1

Moreover, given that commodities represent a big part of its GDP, the falling commodity prices – coupled with the depreciation of the BRL – have decreased the value captured by Brazilian exports, even though the export volume has, in fact, increased. Corruption in Brazil is not a new phenomenon. With Petrobras, the issue at heart is the size of the scandal: as of early 2015, the company’s scheme had moved $2bn just in bribes. In July, the police arrested executives from Electrobras – Brazil’s largest electric utilities company – with charges related to the latter scandal. Overall, this proved to be a deadly blow to business confidence, as investment fell nearly 12%. As it occurred in much of the emerging market, several Brazilian companies took advantage of the Fed’s monetary policy to finance their operations, thus racking up their USD-

denominated debt. Coupled with the USD rally, the devaluation of BRL has made debt repayment even more expensive – an effect that has effectively countered the long-term notion of competitive export strength in the face of a lower-value currency that augments exports’ attractiveness in the global market and encourages domestic consumption. Some people believe that trouble in developing economies may affect the US because most of the investment growth in the global economy since the financial crisis has been driven by the emerging world. At the end of the day, however, the US is not helping at all. It is not just China causing Brazil a headache abroad. Things can get worse this very year. If the hike in US interest rates is to take place, investors may increasingly tend to pull their cash out of emerging markets like Brazil.

Ultimately, Brazil is paying for mistakes it made during its boom years. Its central bank lowered interest rates in 2011, triggering inflation which is now rising by double digits. Marcos Troyjo, an associate professor of international affairs at Columbia University and an expert on Brazil’s economy, has brilliantly framed the Brazilian reality: “If you think about a whole stretch of history from 2010 to 2018, which is almost a decade, Brazil’s going to experience very little growth, if any growth at all. It’s sort of a reproduction of what we lived through in the 1980s, a time that economics books called the ‘Lost Decade.’ So we are going to have another Lost Decade.”

NIC Undergrad Review Volume 2 - Issue 1

How to Hedge Against a Left-Wing Government in Portugal Stability Might Not Be in the Mood from Now On

Gonçalo Marques and Manuel Antunes

As the Left rises, the Right falls. Some will win and some will lose. How to be within the segment of individuals who will not report losses by the end of the year? As a left wing government rose to power on the November 24, longterm perspectives for the Portuguese recovery diminish. The coalition led by António Costa aims to encourage real economy, particularly by stimulating households’ consumption, neglecting the Budgetary Stability Pact. With the end of a cycle of four years fully dedicated to achieve the goals established by troika, some effects of the past strategy of retraction will be lost immediately. Maybe because of some dreamlike ideas and promises that could drive Portugal back to a crisis situation, investor’s may, at a first glance link a left-wing government to uncertainty and instability. The memory of the 42

legacy of the past Socialists Party (PS) government might not be helping its reputation among investors. PSI 20 Index, the Portuguese main stock exchange, has not registered a defined trend since the national elections of the 4th of October, but faced a lot of volatility, registering several gains and losses since that date. The two things to note in this period for this index are (1) a solid gain the week before and after the elections [10,6% in total] possibly due to the rise of the right-wing coalition in the election polls, and its consequent win and (2) a decent loss [-7,56%] the period before and after the Portuguese right-wing government (PaF coalition) fell. Unfortunately, both situations end up being inconclusive, in the sense that the other European indexes, FTSE 100, DAX, CAC 40 and in particular the Spanish IBEX and the Italian FTSEMIB, followed the same path for those periods. What one can note is that Short

term (2Y) Portuguese Government Bonds behaved slightly better than its Spanish and Italian peers the days after the Portuguese elections (October 4), and were more volatile after the fall of the PaF coalition. In longer maturities, despite the consistent fall in Portuguese yields after the new government took office, no big divergences from its peers have been registered. So far “uncertain” is the only adjective to describe such investor’s behaviour. The billion-dollar question is if a left-wing Portuguese government is a threat or not to the economic recovery and budget reorganisation that has been seen recently – GDP growth of 0,9% in 2014, 1,7% in 2015 and 1,9% in 2016; 2,2% growth of private consumption in 2014 and of 2,2% and 1,7% predicted for 2015 and 2016; -0,3% decrease in Government spending in 2014,

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predicted to continue1 through next periods2. Back to the main topic of this article, facing somewhat of a shortage of flavor on the Bond market during this past periods, a short position in this market would make sense for someone bearish on the Portuguese market - someone expecting a big downturn in the Portuguese economic recovery or expecting a downgrade of the Portuguese Bonds investment grade, this time by DBRS leaving Portuguese bonds out of the ECB bondbuying plan. Unfortunately there are no ETFs tracking the small Portuguese bond market, which would make this short hedging solution a bit more difficult to create, since short selling is not easy to achieve as a private investor.

Did You Know? PT GVMT bonds are not junk – at least according to DBRS. Considering the uncertainty over the Portuguese market is here to stay, and consequentially volatility won’t be over soon, depending on how bullish or bearish we are, it would be interesting to analyze some derivatives covering this market. Focusing our analysis in the options market, we have available in the Easynext Lisbon longer maturities (03/2016 and 3 06/2016) for strike prices closer to today’s spot4 price of the PSI20 Index, rather than strike prices further from todays spot.

Knowing the importance of the time to maturity on the value of an option, we considered a longer maturity would provide us better chances to hedge against a more volatile market. Also, expecting higher volatility of the market in a future moment of political uncertainty – another change in government – it would be interesting to hold an option that would cover the date of the closest possible parliament elections – after the election of a President. A bearish investor on the Portuguese market could opt for a put option out of the money (OTM) 5 with a lower strike price than the spot price today. A bullish investor would look for a call option with a higher strike than the spot today. Both, taking uncertainty of the Portuguese stock market as granted for the months to come, would look for options with strike prices that would let the option pretty much OTM, and with longer times to maturity, in order to benefit the most of the possible volatility of the market in the longest period possible. Both strategies would be very risky, due to the exposure only towards a fall or rise in the price of the index, but with the longer time to maturity, and the high expected volatility, it is feasible to believe the changes in the underlying spot price will strongly affect the option prices. This effect will be stronger the further the maturity date. An investor who does solely believe in the volatility of the market, with no strong position on the direction of the Portuguese stock exchange, would prefer to structure its position in such a

way that would neutralize the effect of a price increase vs a price decrease of the underlying, exclusively benefiting of the price change in absolute value, in other words, benefiting from the volatility. The option combination that would allow this position would be combining a put option with strike of 5000 and a call option for the strike of 5200 and same maturity. This combination is called a Long Strangle. Some other option strategies could be considered, as seen in the graph below, but considering short selling is not accessible to everyone, the Long Strangle would be the most suitable investment solution for this situation. The pay-off structures represented were computed for prices registered on November 26 at around 19h00. The maturity of the Straddle is 06/2016 and the maturity for the Strangle is 12/2015. From the figure one can conclude small changes in the spot price of the underlying from three months average approximately 5200/5250 - can lead to positive pay-offs.

This year’s Government expenditure ended up being greater than expected due to the unsuccessful sale of Nova Banco, but this will, sooner or later, no longer represent a weight in the Government Balance Sheet; 2 Data from BANCO DE PORTUGAL • Economic Bulletin • October 2015; 3 Price set today at which we agreed to trade the underlying at the maturity date; 4 Current price of the underlying; 5 When the spot price is far the price enough to make a profit (when spot>strike, for a call, when strike<spot, for a put). 1

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Long Strangle 1400 1200 1000 800 600 400 200 0 -200 -400 4000

4200

4400

4600

4800

Call

5000

5200

5400

Put

As far as the XXI Government Program is concerned, the minimum wage, labor market and taxes will be the main priorities for the next legislature. In fact, the coalition plans primarily to return the cuts in the salary of Public Function at a pace of 25% in the first quarter, 50% in the second, 75% in the third and 100% in the last quarter, starting from January 2016, with the purpose of giving back the purchasing power lost. At the same time, it will proceed to a phased increase in the minimum wage of €95 until 2019, with the salary moving upwards to € 530 in 2016, € 557 in 2018, € 580 and to € 600 in 2019. Furthermore, pensioners will benefit directly since the Retirement Supplement will be restored to public sector workers. Pensions will also suffer a new update on January 2016, the first since 2009. Regarding direct taxation, not only the surtax over IRS, but also the Extraordinary Contribution of Solidarity (CES) will decrease by half, which will additionally contribute to a rise in the wage effectively received at the end of the month and consequently in the power purchase. 44

5600

5800

6000

6200

6400

Long Stragle

Consumers will not be the only ones to take the advantage of a left-wing government. The coalition led by the Socialist Party (PS) targets to reinvent the tax system for companies. In Portugal, the sustainability of companies is a long-lasting problem. The Portuguese business framework is composed in its majority by micro sized enterprises, with 89% of the companies having business volumes under €2m and 10 workers or less. Enterprises that employ over 250 employees, which represent 0.3% of the total framework, are responsible for 43% of the total sales volume generated in 2014. The new government is planning to implement a long-lasting ideal of incentives to the settlement of new companies, easing the lagging process. Due to this specific type of business framework, and the small number of listed companies, it is hard to tell a certain trend among the consumer goods companies’ stocks - the ones most exposed to available income increases. At the same time, these same companies will face greater employee costs, which will

possibly penalize them in a shorter run, until the actual increase in available income is translated into an increase in revenue. The one sector one can say will clearly benefit are the restaurants and bars, who will see its VAT decrease by 10% in 2016, the new government says. The will of every single measure has an almost certain positive impact in the economy in a very short term. The problem is to manage all that assuring the budget constraints and the international agreements. That is something hard to believe for everyone, including investors. That being said, the reason for the uncertainty in the future are the doubts regarding the achievement of better deficit levels and the adjustment of the public finances, when several expansionist economic measures are put in practice. The past tells us that when those targets are not met, Portuguese people available income and the Portuguese economy will be punished once again.

EVEN LOWER?