FT : Should AT&T buy Vodafone?

Should AT&T buy Vodafone? Link to article {http://on.ft.com/1eO4TCz}

Vodafone chief executive Vittorio Colao must be tired of being asked: “What exactly is AT&T doing?” For investors in the UK telecoms group, whether AT&T will mount a takeover bid is the only strategic question that matters, now that Vodafone has agreed the $130bn sale of its Verizon Wireless stake. AT&T shareholders are likewise intrigued by the US group’s very public interest in the European mobile telecoms market. Both Mr Colao and Randall Stephenson, his counterpart at AT&T, have been tight-lipped. AT&T has looked at options, according to people with knowledge of the group, even if detailed work is unlikely to begin until after Vodafone completes its Verizon stake sale next year. Mr Stephenson will need to weigh the pros and cons of what would be one of the biggest ever UK buyouts. Should AT&T buy Vodafone?

* The case for an AT&T bid for Vodafone Ready and waiting Vodafone’s full-year results in May are likely to show the biggest post-tax profit ever for a UK company, of up to £70bn according to Citi. Not a bad start for a company that would inevitably be portrayed as a work in progress should it be acquired.

AT&T wants to make transformational deals across Europe’s mobile markets. Vodafone fits the bill like no other – or at least no contender that could realistically be acquired given governments’ reluctance to allow the sale of national infrastructure owners such as Telefónica’s O2 or France Telecom’s Orange. There is no state or corporate poison pill within Vodafone. Indeed the company has made itself more attractive financially by recently consolidating £18bn of tax assets into its balance sheet. Management strategy is broadly aligned: both want to invest heavily in next-generation mobile networks to deliver high-speed internet connections.

Mr Colao already attempted a US merger less than a year ago when he tried to persuade Verizon to combine rather than buy the US business, and is not seen as philosophically opposed to a merger. “If somebody comes and says, ‘You have really beautiful assets,’ then I will agree,” Mr Colao told a conference last month. “We have beautiful assets.” The shareholder base has moved against those wishing to keep Vodafone independent, with US hedge funds betting on an AT&T merger displacing some European funds reluctant to own Verizon shares. Other shareholders may prefer a merger to the hard grind of an independent Vodafone making huge future investments.

* Sector shifts

The European economy is improving, and telecoms services will likewise recover as people become more comfortable with buying higher-priced mobile and broadband plans. Europe is only at the beginning of a shift to 4G networks that allow rapid mobile internet services. As Mr Stephenson noted in a speech where he described Europe as “fascinating right now”, mobile internet has not yet taken off as in the US. “If somebody were to invest aggressively in mobile broadband in Europe would the demographic not lead to the same type of result as in the United States? And I believe fundamentally, yes, it will.” Any deal would be part of a wider consolidation of the European telecoms market accelerated by money coming to the region from groups such as Liberty Global and Hutchison Whampoa. Regulations could also turn in favour of the sector, with recognition among Brussels lawmakers that the industry needs help to bolster investment, and the hope that competition authorities will allow consolidation in Germany. A favourable decision will be a game changer for the sector, which has long lobbied that regional strength would only result from mergers.

* Cowboys, Brits (and Ninjas)

Analysts say AT&T believes in the importance of scale – and consequently of increasing earnings per share through acquisitions. This makes sense to an extent, with larger telecoms groups winning buying power with equipment providers and wider customer reach, and enabling technology services and content deals. There is also an argument for geographical diversification at a time when the US market could slow down. The basic figures look sensible. “A straight acquisition of Vodafone at a 7 times earnings multiple could be accretive for AT&T with fair value accounting and a lot of help from tax assets,” say analysts at Bernstein. Financial markets would also be supportive of this strategy at a point when institutional funds are awash with investors’ cash that could be deployed in supporting a bid. AT&T would have little difficulty raising debt, meanwhile. Analysts also point to an “evangelical desire” to cure Europe of the sins of previous managements with some “American knowhow”. The cowboys, in the words of one analyst, are on their way. And if the Americans do not make their move fast, there is a growing belief among analysts of rival bid interest from Japan’s SoftBank.

* The case against a bid

Synergies and strategies

Some analysts question the extent of synergies from merging two businesses on different continents. They say AT&T already has sufficient scale and buying power with equipment makers, and larger telecom groups are not necessarily more profitable. Financially, Vodafone’s tax assets may not be useful unless the proudly American telecoms group relocates to Europe. Any repatriation of cash to the US may face tax hurdles. Vodafone is in the middle of a strategic diversification into fixed-line telecoms unlikely to be of interest to the mobile-focused AT&T. It is too late to reverse the acquisition of Kabel Deutschland in Germany, for example, while Vodafone is committed to fixed-line businesses in countries such as Italy and Portugal. Also questionable is how interested AT&T will be in Vodafone’s operations in India and Africa, as well as in Australia. There could be buyers such as América Móvil in India and Orange in Africa, however, while fixed-line businesses could interest Liberty Global. Even with possible disposals, Vodafone would not be bought cheaply – as the wily Mr Colao has made clear. AT&T will have to pay a premium to Vodafone shares already buoyed by M&A talk. Citi estimates a bid price of 290p, which equates to about £90bn for the whole of Vodafone after taking into account payouts to shareholders from the Verizon sale. Bernstein, meanwhile, prices a bid at between 240p-280p.

Here be Dragons!

Europe has been the undoing of many acquisitive international telecoms groups – most recently at América Móvil, which is nursing heavy losses after investments in KPN and Telekom Austria. This is not even the first time for AT&T, which worked with América Móvil on a failed buyout of Telecom Italia in 2007. AT&T could be wrong footed by the highly regulated markets of Europe at a time when the industry is arguing over reforms that will scrap roaming revenues. The lack of a single language or dominant regional authority undermines both marketing scale and organisational certainty, while AT&T’s management has already complained about local spectrum auctions that fracture the regional market. There is no certainty over consolidation rules. AT&T’s supply-side view of how to fix the European telecoms market could be wrong in the short term. Espirito Bank said last week that Europe’s mobile market was demand, rather than supply, constrained. Extra supply could therefore even undermine any nascent revenue recovery. The “build it and they will come” theory has yet to be proven for 4G mobile networks in Europe, even if there is evidence elsewhere in the world. The need for capital expenditure could drag down returns in the short term, with the danger that the £7bn earmarked for network expenditure by Vodafone is just the beginning of recurring costs. Any advantage from superior network investment could anyway be shortlived; telecoms companies tend to invest fastest when rivals are already doing so.

Defend the castle

Vodafone shareholders may vote to maintain the status quo given the prospect of a recovery in the company’s revenues. Financial performance should improve as regulated constraints on revenues from cuts to mobile termination rates and roaming charges fade and the economy improves. Vodafone may have sold its best business in the US, but the management has achieved a very good price and secured a considerable war chest to boost operations. Vodafone shareholders may want to see the outcome of the £7bn “project spring” plan to invest in rapid mobile data infrastructure and fixed-line broadband. And others may just want to see the company remain independent and UK-listed. Any latent nationalisation could be stimulated by politicians worried about the sale of one of the UK’s last global technology champions. Elsewhere in Europe, there are national security concerns about a US group buying its way into strong positions in markets such as Germany. Regulatory approval of the deal in all the many countries where vodafone operates could be arduous.

FT : Europe to unleash heavy rate-fixing fines

Brussels will unveil hefty fines as soon as Wednesday on global banks that allegedly formed cartels to rig two global interest rate benchmarks, in a settlement that is set to break European antitrust enforcement records. The latest crackdown on benchmark manipulation is expected to target up to 10 financial institutions. Some will admit wrongdoing while others will face formal charges alleging they colluded to fix Euribor, Yen Libor or both. The exact level of fines remains confidential, but the commission has warned some banks it is seeking combined fines of hundreds of millions of euros for those groups involved in both cartels.

The decision will be announced by Joaquín Almunia, the EU competition commissioner, will add to the escalating costs of a scandal that has rocked the financial sector. The multi-bank deal will also provide a more comprehensive account of alleged collusion between traders at different institutions, people familiar with the settlements said.

Each of the two cases – one focused on the Yen Libor and the other on Libor’s European sister benchmark – involve around half a dozen banks or brokers, the people said. Most banks involved – including Royal Bank of Scotland, Deutsche Bank, Société Générale and Citi – have been discussing a settlement that would see them fined for attempting to act in concert to rig the benchmarks and profit from related interest rate derivatives. Barclays will avoid a fine for Euribor manipulation while UBS will not be fined for Yen Libor because they alerted EU officials to the illegal practices. But both banks will admit wrongdoing, a move that could still leave them vulnerable to private damages claims in the courts. Some banks – JPMorgan, HSBC and Crédit Agricole – have been involved in the talks but were last month balking at signing a joint Euribor settlement. Banks that hold out are expected to face formal charges that could pave the way for fines at a later stage. Interdealer broker ICAP is not part of the joint settlement. The announcement will be an unwelcome reminder of past sins for an industry still struggling to cope with a series of scandals ranging from mis-selling of mortgage-backed securities and consumer products to alleged manipulation of foreign exchange benchmarks. The European Commission decision is to be formally adopted by the college of commissioners on Wednesday, according to the meeting agenda. The exact level of fines remains confidential and it not even known by the banks involved. But the commission warned some banks that it is seeking a fine of as much as €800m each for groups involved in both cartels. The range of fines for the individual banks will vary significantly and depends on a mix of culpability and leniency for co-operation. Once the investigation is complete and all banks are fined, the penalty is expected to break antitrust records in Europe; to date the highest combined EU fine for a cartel is around €1.5bn. One person familiar with the case said the fines for Yen Libor are expected to be significantly smaller than the penalties for Euribor manipulation. There are EU guidelines for calculating cartel fines but the rules have never been applied to markets in financial instruments. The commission can impose a maximum penalty equivalent to 10 per cent of a company’s global turnover for each cartel it is found to be involved with. Four banks – Barclays, RBS, UBS, Rabobank – and broker ICAP have already paid a total of $3.5bn in fines to settle with regulators around for world for Libor-related abuses. However, the EU antitrust authorities have not been party to those deals and for three years pursued their own investigation relating to breaches of antitrust law. A third EU cartel probe into alleged Swiss franc Libor abuses is still in progress. Unlike US antitrust regulators, Brussels will not settle with individual cartel members and it only concludes cases simultaneously with all or most of the companies involved. Those banks refusing to settle would face formal charges – a so-called statement of objections – that could eventually lead to an antitrust ruling and a fine. The main incentive to settle under EU rules is the 10 per cent reduction in fines and a shorter and less detailed charge sheet against the cartel, which limits the potential for private damages claims. Those holding out have the opportunity to fight the charges in commission-organised hearings and eventually to appeal against any decision in the courts. All the banks and the commission declined to comment.

>>> Infostrada may attract bid from Vodafone

Infostrada may attract bid from Vodafone

Infostrada, the Italian Internet and telecoms company, could attract a bid from Vodafone, the listed UK mobile phone group, Italian language daily Il Sole 24 Ore reported. The report cited financial sources

The report said that Vodafone sees Infostrada as an alternative investment to Fastweb, the listed Italian telecoms group controlled by Swisscom. The report said that Vodafone considers Swisscom's asking price too high.

The report noted that Infostrada is controlled by Wind, the Italian telecoms group, which is in turn is controlled by the Russian telecoms group Vimpelcom.

Il Sole 24 Ore

(BFW) Tethys Petroleum Says No Hydrocarbons in Kazakhstani Well Dexa

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Tethys Petroleum Says No Hydrocarbons in Kazakhstani Well Dexa 2013-12-04 07:16:58.989 GMT

By Benjamin Dow Dec. 4 (Bloomberg) -- Doto well being prepared for testing. * Kalypso well stimulation, testing to commence mid-Dec. * Co. says new well on Kul-Bas contract area to be drilled in 1H 2014

Link to statement:{NSN MX9SS03V2801 <go>} Link to Company News:{TPL CN <Equity> CN <GO>}

For Related News and Information: First Word scrolling panel: {FIRST<GO>} First Word newswire: {NH BFW<GO>}

To contact the editor responsible for this story: Benjamin Dow at +7-495-771-7735 or bdow2@bloomberg.net

>>> What to look at today

US MArket Closed lower with cyclical sectors leading on tyhe downside...Energy was on the only sector up on oil move on news Opec might curb output in 2014...VIX @ 14.55 +2.25%...Brazil -1.75%...Shanghai Composite was the lone index to trade higher, with other markets tracking softer US sentiment. MOFCOM spokesperson said to have announced plans for as many as 18 new free-trade zones, while finalizing 12 free-trade agreements with ASEAN, Singapore, Pakistan, New Zealand, Chile, Peru, Costa Rica, Iceland and Switzerland, Hong Kong, Macau and Taiwan. Commerce Min still in negotiations on 6 agreements: South Korea, Gulf Cooperation Council, Australia and Norway FTA...Shanghai +1.11%... BOJ board member Sato noting that while further policy easing cannot be ruled out, the magnitude of April 2013 launch of QE would be hard to replicate; Does not see need for a preemptive easing if the impact of sales tax hike is temporary. Nikkei225-2.17%

Eur$1.3578 S&P Fut +0.15% European fut+0.2%

Keep an eye on : - AC FP : Accor Raised to Buy at UBS, Sees Better Revpar in Next 2 Yrs - CS FP : AXA CEO Says Company in Line With Mid-Term Plan - AVV LN : Aveva Offers Buying Opportunity; M&A May Loom, Berenberg Says - BMPS IM : Foundation Mulls Paschi Stake Sale Before Dec. 27 Vote: Sole - CLS1 GY : Celesio investor Elliott aims to boost stake, exert influence  - EAD FP : EADS to Compete in NATO Missile Defense System Tender, Welt Says - EKTAB SS : Elekta 2Q Op. Profit, Sales Miss Ests; Keeps FY Forecast - GLPG BB : Galapagos Says Phase 1 Results Positive for GLPG1205 - INGA NA : ING Top Restructuring Stock Among Europe Banks, Nomura Says - SIE GY : Siemens to Deliver Trains as Early as This Month: Sueddeutsche - UCG IM : Avoid Popular, UniCredit a Better Trade, Macquarie Says - VOD LN : Vodafone May Be Looking at Italian Assets: Sole

>>> Brokers Upgrades & Downgrades

Up

*ACCOR RAISED TO BUY VS NEUTRAL AT UBS *AVEVA RAISED TO BUY VS HOLD AT BERENBERG *COLRUYT RAISED TO NEUTRAL VS UNDERPERFORM AT MACQUARIE *DAILY MAIL & GENERAL TRUST RAISED FROM REDUCE AT NOMURA *OPHIR ENERGY RAISED TO HOLD VS SELL AT LIBERUM *PEUGEOT ADDED T0 CONVICTION BUY LIST AT GOLDMAN *RENAULT RAISED TO NEUTRAL VS SELL AT GOLDMAN *SEVERSTAL RAISED TO OVERWEIGHT VS NEUTRAL AT JPMORGAN

Down

*BANK ZACHODNI CUT TO HOLD VS BUY AT DEUTSCHE BANK *CAMPARI CUT TO NEUTRAL VS OVERWEIGHT AT JPMORGAN *GENMAB RESUMED SELL AT GOLDMAN, PT DKR175 *MBANK CUT TO HOLD VS BUY AT DEUTSCHE BANK *MMK CUT TO NEUTRAL VS OVERWEIGHT AT JPMORGAN *PEKAO CUT TO HOLD VS BUY AT DEUTSCHE BANK *RECKITT BENCKISER CUT TO SELL VS BUY AT UBS *RTL CUT TO NEUTRAL VS BUY AT NOMURA *UBM CUT TO NEUTRAL VS BUY AT NOMURA

PT Change

*BUNZL PT RAISED TO 1,260P VS 1,070P AT CANTOR; KEPT AT SELL *Geox PT Raised to EU2.2 vs EU1.3 at Mediobanca *INDESIT PT RAISED TO EU12.7 VS EU8 AT KEPLER CHEUVREUX *MEDIASET PT CUT TO EU3.5 VS EU3.65 AT NOMURA; KEPT AT NEUTRAL *Monte Paschi PT Cut 8% to EU0.11 at Exane; Kept at Underperform *SWEDISH ORPHAN RESUMED SELL AT GOLDMAN, PT SKR60 *UBI PT RAISED TO EU4.7 VS EU3.4 AT UBS; KEPT AT NEUTRAL *WACKER CHEMIE PT RAISED TO EU95 VS EU81 AT UBS, STAYS BUY

Initiation

*GENMAB RESUMED SELL AT GOLDMAN, PT DKR175 *MORPHOSYS RATED NEW NEUTRAL AT GOLDMAN, PT EU61 *NETCARE, LIFE HEALTHCARE RATED NEW BUY AT DEUTSCHE BANK *SWEDISH ORPHAN RESUMED SELL AT GOLDMAN, PT SKR60

Country Sector Call

* Sector -Bernstein Lists Luxury Goods Cos. Most Likely to Raise Divs. * Stock *PEUGEOT ADDED T0 CONVICTION BUY LIST AT GOLDMAN

>>>Asian update

Asian Market Update: AUD hits 3-month lows following soft Q3 GDP; Shanghai rallies on reports of more FTZ/FTAs

***Observations/Insights*** - Shanghai Composite was the lone index to trade higher, with other markets tracking softer US sentiment. MOFCOM spokesperson said to have announced plans for as many as 18 new free-trade zones, while finalizing 12 free-trade agreements with ASEAN, Singapore, Pakistan, New Zealand, Chile, Peru, Costa Rica, Iceland and Switzerland, Hong Kong, Macau and Taiwan. Commerce Min still in negotiations on 6 agreements: South Korea, Gulf Cooperation Council, Australia and Norway FTA. - BOJ board member Sato noting that while further policy easing cannot be ruled out, the magnitude of April 2013 launch of QE would be hard to replicate; Does not see need for a preemptive easing if the impact of sales tax hike is temporary. Nikkei225 is the laggard, having fallen by over 2% in the morning session on sudden reversal in recent yen weakness. - Australia Q3 GDP misses estimates on q/q and y/y; 2.3% annual print marks lowest level since Q4 of 2011; Terms of trade component particularly weak at -3.3% vs +0.1% prior as China demand for raw materials slow. Despite the selloff in AUD, some of the analysts were quick to dismiss the data, pointing to more recent evidence of improvement in Q4.

***Economic Data*** - (AU) AUSTRALIA Q3 GDP Q/Q: 0.6% V 0.7%E; Y/Y: 2.3% V 2.6%E (lowest reading since Q4 2011) - (AU) AUSTRALIA NOV AIG PERFORMANCE OF SERVICES INDEX: 48.9 V 47.9 PRIOR (8-month high) - (CN) CHINA NOV HSBC/MARKIT SERVICES PMI: 52.5 V 52.6 PRIOR (22nd month of expansions) - (HK) HONG KONG NOV HSBC/MARKIT PMI: 52.1 V 50.1 PRIOR (highest since Jan) - (IN) INDIA NOV HSBC/MARKIT SERVICES PMI: 47.2 V 47.1 PRIOR (5th consecutive contraction) - (NZ) NEW ZEALAND Q3 VALUE OF ALL BUILDINGS Q/Q: 1.4% V 4.8%E - (KR) SOUTH KOREA NOV FOREIGN RESERVES: $345B V $343B PRIOR - (UK) UK NOV BRC SHOP PRICES INDEX Y/Y: -0.3% V -0.5% PRIOR (7th month of decline)

***Fixed Income/Commodities/Currencies*** - (JP) BOJ offers to buy ¥200B in 1-3yr JGBs, ¥300B in 3-5yr JGBs, and ¥200B in JGBs with maturity over 10-yr - (AU) Australia MoF (AOFM) sells A$800M in 2.75% 2022 Bonds; avg yield: 4.1615%; bid-to-cover: 2.25x

- (US) API PETROLEUM INVENTORIES: CRUDE: -12.4M (first draw in 10 weeks) v 0Me - GLD: SPDR Gold Trust ETF daily holdings fall 1.8 tonnes to 841.4 tonnes (lowest since Jan 2009) - SLV: iShares Silver Trust ETF daily holdings fall to 10,304 tonnes (lowest level since 10,284 on Jul 23rd) from 10,309 tonnes - (CN) China Statistics Bureau: China pork price +0.7% in late Nov

- USD/CNY: (CN) PBoC sets yuan mid point at 6.1300 v 6.1352 prior setting (record high setting for Yuan)

- AUD is down sharply across the board following weaker than expected Australia Q3 GDP, which is also weighing on NZD against USD and other currencies. AUD/USD fell over 1% below $0.9050 at its worst level - a 3-month low - while AUD/JPY tumbled as low as ¥92.50, down about 120pips from opening highs. NZD/USD reversed 4 consecutive rising sessions to fall over 60pips below $0.8180 and NZD/JPY was down 70pip at ¥83.70. USD/JPY pair largely traded sideways around ¥102.50, backing away from overnight highs amid a massively one-sided yen-short positioning in the markets. EUR/USD traded in a narrow 15-pip range around $1.3590, with traders eyeing Thursday's ECB policy decision.

***Speakers/Political/In the Papers*** - (CN) China Ministry of Commerce (MOFCOM) spokesman Yao: China targets to set up as many as 18 free-trade zones - financial press - (CN) China politburo holds conference on economic work for 2014, reiterates key areas of reform; To issue urbanization plan in 2014 - Xinhua - (CN) Moody's: China banking system outlook stable but with some challenges - (CN) Citigroup: Shanghai Composite may rise 26% in 2014 above 2,800 - (CN) China Ministry of Commerce (MOFCOM) spokesperson Shen Danyang: US has exaggerated the scale of dumping of Chinese products

- (JP) Japan govt, companies said to be planning total stimulus of ¥18.6T - Japanese press - (JP) BOJ Board member Sato: The domestic economy is recovering moderately; there is no need to ease preemptively if economic impact of sales tax hike temporary

- (AU) Australia Treasurer Hockey: Govt GDP forecasts will not be achieved - (AU) RBS strategist: Q3 GDP is "ancient history"; RBA knows that Q4 has improved and rates are likely to remain on hold for some time - (AU) Moody's analyst: Latest GDP data shows Australian economy is underperforming; Seen some positive developments since end of Sept - SMH

***Equities*** Market Snapshot (as of 04:30 GMT): - Nikkei225 -1.7%, S&P/ASX +0.4%, Kospi -0.7%, Shanghai Composite +1.3%, Hang Seng -0.4%, Dec S&P500 +0.1% at 1,793, Feb gold -0.1% at $1,220, Jan crude oil +1.2% at $97.2/brl

US markets: - CCXI: Announces Positive Top-Line CCX168 Phase II Data in ANCA-Associated Renal Vasculitis; +9.6% afterhours - SAEX: Announces $40M of New Project Awards (NOTE: Q4 Rev est $76M), Including First Contract in Brazil, along with Achievement of Key Milestone; +9.2% afterhours - JCP: Reports Thanksgiving weekend SSS +10.1% y/y; +3.4% afterhours - LEN: Prevails in Defamation and Extortion Case Against Marsch; Jury Awards $1B in Damages; +0.5% afterhours

- OVTI: Reports Q2 $0.60 v $0.43e, R$397.2M v $392Me; -12.7% afterhours - AMBI: Plans not to submit NDA for accelerated approval of quizartinib based on the Phase 2 and 2b clinical trial data; -22.7% afterhours

Notable movers by sector: - Consumer discretionary: Dentsu Inc 4324.JP -2.2% (Jiji cuts stake); Cochlear Ltd COH.AU +1.0% (receives FDA clearance); Sydney Airport SYD.AU -5.3% (traffic results) - Industrials: Token Corp 1766.JP -4.2% (H1 results); Kia Motors 000270.KR +1.1% (Nov US sales); First Tractor 38.HK +2.5%, Stanley Fertilizer 002588.CN +5.6%, Shandong Kingenta Ecological Engineering 002470.CN +6.4% (China politburo issues plan on modern agriculture development); CPI Yuanda Environmental-Protection Group Co Ltd 600292.CN +2.4%, Beijing SPC Environment Protection Tech 002573.CN +1.4%, Fujian Longking Co Ltd 600388.CN +2.8% (Eastern China reports smog; China politburo issues plan on green, low-carbon development); China COSCO 601919.CN +5.0%, China Shipping Development 600026.CN +10.0%, China Shipping Container 601866.CN +9.9% (China politburo issues plan to promote marine economy related constructions); Shanghai Port 600018.CN +10.0%, Shanghai Waigaoqiao FTZ 600648.CN +10.0%, Shanghai Lujiazui Finance & Trade Zone Development 600663.CN +10.0%, Shanghai Material Trading 600822.CN +10.0% (China comments on free trade zone trials) - Materials: Ningxia Qinglong Pipes Industry Co Ltd 002457.CN +10.0% (private banking plans) - Financials: Emperor Capital Group Ltd 717.HK +7.6% (FY13 results)

(Barron's) Pimco's Bill Gross: What's Keeping Me Up at Night

Pimco's Bill Gross: What's Keeping Me Up at Night

Pimco's founder praises Vanguard's index approach and asks "where might our future mistakes be hiding?"

I've always liked [Vanguard founder] Jack Bogle, although I've never met him. He's got heart, but as he's probably joked a thousand times by now, it's someone else's; a 1996 transplant being the LOL explanation.

He's also got a lot of investment common sense, recognizing decades ago that investment managers in composite couldn't outperform the market; in fact, their alpha would be negative after fees and transaction costs were factored in. His early business model at Vanguard promoting index funds was a mystery to me for at least a few of my beginning years at PIMCO.

Why would most investors be content with just average performance, I wondered? The answer is certainly now obvious; an investor should want the highest performance for the least amount of risk, and for almost all measurable asset classes, index funds and many ETFs have done a better job than almost all active managers primarily because of lower fees.

The "almost all" caveat is the reason I can write so freely and with such high praise for Vanguard. I am, after all, supposed to be promoting PIMCO in these Investment Outlooks, and PIMCO is a $2 trillion active manager with lots of long-term consistent alpha. Jack marvels about what he himself labeled in a recent Morningstar interview the "PIMCO effect."

To paraphrase his interview, he spoke to index managers beating almost all active managers, but then "there was the PIMCO effect." We at PIMCO thank him for that with a "back atcha, Jack!" There's actually a place for both of our firms and investment philosophies in this age of high finance. If Bogle's concept of indexing was metaphorically similar to finding a cure for the cancerous devastation of high fees, then perhaps PIMCO's approach could be similar to mapping the investment genome and using it to produce consistently high alpha. There's room for each of these investment laboratories.

I will admit that there are other active management labs as well that are worthy of not only recognition, but investor confidence and dollars. I have nothing but the highest of praise for Bridgewater's Ray Dalio and GMO's Jeremy Grantham and their staffs. Their voluminous thoughts occupy a special corner of my desk library. Each has a distinctly different approach to active management – Dalio's focusing on a levering/delevering template and Grantham's on a historical reversion to the mean for most asset classes.

Neither Vanguard, PIMCO, Bridgewater nor GMO, however, has discovered a cure for the common cold. Our performance periodically, and sometimes for frustrating long stretches, stuffs our noses or aches our heads, and makes us wonder why we hadn't been more careful about washing our hands during flu season. Our firms make mistakes, even if, in Vanguard's case, it's the indexed mantra of being fully invested in an overvalued market.

Where might our future mistakes be hiding? What keeps us up at night? Well I can't speak for the others, having spoken too much already to please PIMCO's marketing specialists, but I will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the creator of the "New Normal" characterization of our post-Lehman global economy, now focuses on the possibility of a" T junction" investment future where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world. We are both in agreement on the perilous future potential of market movements. Mohamed's T, I believe, was meant to be more descriptive than literal, and is a concept, like the New Normal, that may gain acceptance over the next few months or years.

But aside from a financial nuclear bomb à la Lehman Brothers, our actual scenario is likely to play out more gradually as private markets realize that the policy Kings/Queens have no clothes and as investors gradually vacate historical asset classes inrecognition of insufficient returns relative to increasing risk. The actual T might in reality be shaped something like this:

perhaps a wingled eagle signifying something more gradually sloping left or right. This year's April taper talk by the Federal Reserve is perhaps a good example of this forward path of asset returns. Admittedly the reaction in the bond market was rather sudden and it precipitated not only the disillusioning of bond holders, but also an increase in redemptions in retail mutual fund space. But then the Fed recognized the negative aspects of "financial conditions," postponed the taper, and interest rates came back down. Sort of a reverse "Sisyphus" moment – two steps upward, one step back as it applies to yields and more of a

than a T. Investors now await nervously for news on the real economy as well as the medicine that Janet Yellen will apply to it.

That medicine, however, will most assuredly include negative real interest rates that at some point will give bond and stock investors pause as to the continued potency of historical total return policies generated primarily by capital gains. Bond investors found that out in May, June and July after 10-year Treasuries had bottomed at 1.65%. Stock investors, however, were only mildly discouraged and continued their faith-based, capital gain dependent investments despite what should be the obvious conclusion that QE and low interest rates were as critical to their market as they were to bonds. "What other choice do we have?" has become the mantra of stock investors globally, which speaks more to desperation than logical thinking.

Well, my point about the gradual as opposed to sudden disillusioning of investors worldwide is just that. The standard "three musketeers" menu for retail investors has always been 1) investment grade and 2) high yield bonds as well as 3) stocks. In recent years, institutional investors have gravitated into 4) alternative assets, 5) hedge funds and 6) unconstrained space, and so for them there appears to be an increasing array of higher return alternatives. All of the above 1-6, however, contain artificially priced assets based on artificially low interest rates. Some are unlevered, like Treasury bonds, but nonetheless priced too high by the Fed in an effort to encourage migration to riskier bonds and/or asset classes. Others, such as many alternative assets, depend on the levering of portfolios themselves, borrowing at 10-50 basis points in overnight repo and investing at higher rates of return despite their artificiality. But investors are all playing the same dangerous game that depends on a near perpetual policy of cheap financing and artificially low interest rates in a desperate gamble to promote growth. The Fed, the BOJ (certainly), the ECB and the BOE are setting the example for global markets, basically telling investors that they have no alternative than to invest in riskier assets or to lever high quality assets. "You have no other choice," their policies insinuate. "Get used to negative real interest rates, move out on the risk spectrum and in the process help heal the real economy," they seem to command.

Yet this now near 5-year migration across the global asset plains in search of taller grass and deeper water has had limits, both in price and real growth space. If monetary and fiscal policies cannot produce the real growth that markets are priced for (and they have not), then investors at the margin – astute active investors like PIMCO, Bridgewater and GMO – will begin to prefer the comforts of a less risk-oriented migration. If they cannot smell the distant water or sense a taller strand of Serengeti grass, astute investors might move away from traditional risk such as duration as opposed to towards it. Deep in the bowels of central banks research staffs must lay the unmodelable fear that zero-bound interest rates supporting Dow 16,000 stock prices will slowly lose momentum after the real economy fails to reach orbit, even with zero-bound yields and QE.

In gradually moving away from traditional risk assets, I again refer to my August Investment Outlook called "Bond Wars." In it, I suggested that bonds and bond portfolios contain a number of inherent "carry" risks and that duration/maturity was but one of them. I suggested that if the Fed and other central banks had artificially lowered yields and elevated bond prices, then a traditional bond fund should underweight duration and perhaps overweight other carry alternatives such as volatility, curve and credit. This we have done, and our relative performance reflects it. The "PIMCO effect," as Jack Bogle calls it, is alive and well in 2013. Our primary thrust has been to focus on what we are most (although not totally) confident about, that the Fed will hold policy rates stable until 2016 or beyond.

While this and its conjoined policy of QE may have only redistributed wealth as opposed to creating it (picking savers' pockets while recapitalizing banks and the wealthiest 1% of our population), it is a policy that a Janet Yellen Fed seems determined to pursue. The taper will lead to the elimination of QE at some point in 2014, but the 25 basis point policy rate will continue until 6.5% unemployment and 2.0% inflation at a minimum have been achieved. If so, front-end Treasury, corporate and mortgage positions should provide low but attractively defensive returns. We have positioned our bond wars portfolio – heavily front-end maturity loaded along with credit, volatility and curve steepening positions, with the aim of outperforming Vanguard as well as many other active managers.

There is no doubt, however, that this portfolio construct is dependent on the eagle's wingsas opposed to the junction of a T. Overlevered economies and their financial markets must at some point pay a price, experience a haircut, and flush confident investors from the comfort of this Great Moderation Part II. We at PIMCO will prepare for that day while hopefully consistently beating Vanguard along the way.

Eagle's Speed Read

1) Be confident in the "PIMCO effect," as Jack Bogle calls it.

2) Look for constant policy rates until at least 2016. Front-end load portfolios. Don't fight central banks, but be afraid.

3) Global economies and their artificially priced markets are increasingly at risk, but the unwinding may occur gradually. Think !

>>> US After Hours

After Hours Summary: GWRE +4.9%, JCP +4.6%, OVTI -12.6%, UTI -2.8%, KMI -1.5% following earnings/guidance

After Hours Gainers:

Companies trading higher in after hours in reaction to earnings: GWRE +4.9%, JCP +4.6%, PGI +0.5%, POWL +0.3%

Companies trading higher in after hours in reaction to news: CCXI +9.8% (announces positive top-Line CCX168 Phase 2 data in ANCA-associated Renal Vasculitis), SAEX +9.2% (announced $40 million of new project awards, including first contract in Brazil, along with achievement of key milestone), ADEP +6.1% (received order for mobile robots from pharmacy automation system provider), LEN +0.5% (co prevailed in defamation and extortion case against Marsch; jury awards $1 billion in damages)

After Hours Losers:

Companies trading lower in after hours in reaction to earnings: OVTI -12.6%, UTI -2.8%, KMI -1.5%, GBDC -0.8%, XEL -0.4%

Companies trading lower in after hours in reaction to news: AMBI -31.3% (provided regulatory update following FDA meeting regarding quizartinib (AC220); based on FDA's current position, the co does not plan at this time to submit a NDA for accelerated approval of quizartinib based on the Phase 2 and 2b clinical trial data), ACMP -4.9% (announced secondary public offering of 6 mln common units), CLDX -4.4% (filed mixed securities shelf offering and announced offering 6.5 mln shares of common stock), WAVX -3.9% (disclosed it entered into a Factoring and Security Agreement with CapFlow Funding Group Managers), OAS -3.4% (announced public offering of 7 mln shares of common stock), SHLD -1.9% (ESL Partners decreases stake to 48.4% from 55.4%), SFUN -1.2% (announced proposed $250 mln convertible senior notes offering)