(ZeroHedge) The Credit Crunch Is Back: Banks Scramble To Collateralize Loans



From: thechek@gmail.com At: Dec 27 2015 18:26:49
To: LAURENT CHEKROUN (MAKOR SECURITIES LO)
Subject: Fwd:(ZeroHedge) The Credit Crunch Is Back: Banks Scramble To Collateralize Loans To Record Levels

One of the biggest quandaries of this cycle for the US economy has been the amount and growth of commercial bank loans. Virtually non-existent for the first three years of the centrally-planned new normal, something changed in 2012 at which point US bank loans, led by Commercial and Industrial or C&I lending growing at a double-digit pop, started to rise at an impressive pace, asking many to wonder: maybe the biggest driver for a sustainable economic recovery is in fact present, because where there is loan demand, there is velocity of money.

 

A few years later, as the loan growth persisted with virtually no flow through to GDP growth, we - and others - wondered: we know there is a "source of funds", but what about the "use of funds" - how can banks be creating tens of billions in loans if virtually nothing was ending up in the broader economy?
The first flashing red flag appeared last July, when we reported that companies were using secured bank debt to repurchase stock: a stunning, foolhardy development, comparable to taking out a mortgage on one's house and using the proceeds to buy deep out of the money calls on the S&P 500. This is what the FT said at the time:
For the top 25 US commercial banks by assets, C & I lending grew by 10.5 per cent in the quarter to June 25 from the previous quarter, according to annualised weekly data from the Federal Reserve.

 

This type of lending is an important source of business for the largest US banks, representing about a fifth of all loans made by the likes of Bank of America, JPMorgan Chase and Wells Fargo, according to Citigroup research. While low interest rates have made business lending less lucrative, the relationships it forges open doors for the banks to sell other services such as treasury management, hedging and leasing.

 

A second corporate banking executive at a large regional lender said: “The larger part of the usage in the market right now are loan refinancings where companies are paying dividends back out.” He added: "They’re requesting increased loans or usage under a lien in order to pay a dividend or equity holders of a company. Traditionally banks have been very cautious of that."
After scratching our heads for a few weeks afterward, we let the subject go: after all there is no way banks would be lending companies secured loans to use the proceeds to cash out existing stakeholders, in the process asset-stripping the corporation. This would mean that the loan officers at these banks are either criminally stupid, or corrupt and have been bribed by the borrower to close their eyes when signing the dotted line and wiring the funds.
But then, in mid-October it all came back with a bang when CLSA's Chris Wood spotted something very dramatic when looking at the several most recent loan officer surveys:
... American banks, in terms of the quite impressive pickup seen in commercial and industrial (C&I) loan growth (see Figure 10), have been financing financial engineering, be it M&A or share buybacks, not capex. Thus, C&I loans rose by 10.7% YoY in September. Yet in the Fed’s July Senior Loan Officer Survey, 26% and 18% respectively of US banks reporting stronger C&I loan demand stated that the ‘very important’ reason for stronger loan demand over the past three months were financing needs for M&A and debt refinancing, compared with only 6% for capital investment (see Figure 11). Meanwhile, the lack of healthy creative destruction associated with zero rates has long been associated with the Japanese experience of so-called zombie borrowers.

 

With this data in hand, the circle was almost closed, however one major question remained unanswered: how are banks so eager to lend out billions not for asset-backed growth projects but for the worst possible form of financial engineering: uncollateralized cashing out of existing investors, either through prefunding buybacks, or M&A? In other words, banks were the de facto sponsors of management teams and shareholders.
And more importantly, now with the credit cycle rolling over and the default cycle about to see a spike higher, when would banks wake up to the huge threat that their loans would end up being wiped out as a result of funding such terrible investments as the Bed Bath and Beyond stock buybacks, which as we showed recently, has resulted in a -27% return over the past 5 years.

 

Now we have the final answer, because according to the latest "Survey of Terms of Business Lending", the banks have finally woken up to the risk their billions in C&I loans issued to fund "financial engineering" are exposed to.
The reaction: an unprecedented surge in loan collateralization demands - as the chart below shows, the percent of total loans secured by collateral has soared by nearly 50% in the past quarter to a record 55.9% from 37.9%, the highest ever, surpassing even the loan collateralization demands hit after the financial crisis, which peaked at 52.3%.

 

Where does this sudden demand for collateral come from? While one can see a surge in collateral requirements across virtually every product, particularly at large domestic banks, where this ratio soared from 39.2% to 64.4% (small domestic banks have traditionally been prudent and here the collateralization ratio rose only from 86.6% to 88.9%), where the sudden risk appreciation was most obvious, was in "Commercial and industrial loans made under participation or syndication." Here, the ratio of collateralization of C&I loans made by large domestic banks has tripled from 23.8% to 74.9%, leading to an almost as dramatic jump across all domestic banks, where it soared from 26.5% to 75.7%.

 

What is the explanation?
Since syndication involves bank balance sheet retention risk (anything not sold remains on the bank books), and since loan funds have been recently slammed with near record outflows...
... leading to a historic plunge in the price of the leveraged loan index, as all of a sudden nobody wants any loan exposure and is selling anything that is not nailed down ...

 

...  suddenly banks don't want any risk from residual loan exposure which they can't offload, and as a result are demanding companies pledge assets and otherwise collateralize whatever loans they issue (via bank syndication) "just in case."
Said simply, the credit crunch is back.
And the kicker: all this took place when ZIRP was still around. Now that both LIBOR and Prime have jumped following the Fed's rate hike, and now that financial conditions are far tighter than they were even back in October, expect collateralization demands to approach 100%, as a result of which C&A loan issuance will fall off a cliff as corporations, delighted to issue loans when collateral demands were at 25%, suddenly realize they have an all too real risk of seeing their assets "repoed" if and when the cash flow to satisfy interest payments suddenly dries up.

(ZeroHedge) 12,000 Oil Tanker Trucks Parked At Iraq-Turkey Border Aren't Car

In our classic piece “ISIS Oil Trade Full Frontal: "Raqqa's Rockefellers", Bilal Erdogan, KRG Crude, And The Israel Connection,” we discussed how Masoud Barzani and the Iraqi Kurds transport some 600,000 b/d of crude to the Turkish port of Ceyhan in defiance of SOMO amid an ongoing budget dispute between Baghdad and Erbil.
Turkey facilitates this trade and we suggested that ISIS (which Turkey is suspected of supporting in order that the group might continue to destabilize Assad) may be using the same networks to get its illicit oil to market. 
There’s some evidence that links ISIS to Ceyhan. As documented in an academic study by George Kiourktsoglou and Dr Alec D Coutroubis, tanker rates at Ceyhan seem to spike around significant oil-related events involving Islamic State. Here's the chart:
Additionally, an ISIS fighter captured by the YPG in Syria claims to have lived with an Islamic State commander in Adana, home to Ceyhan. 
We also highlighted a piece by Al-Araby al-Jadeed that outlines what the site says is a trafficking route that runs through Zakho. Here are some key passages:
The information was verified by Kurdish security officials, employees at the Ibrahim Khalil border crossing between Turkey and Iraqi Kurdistan, and an official at one of three oil companies that deal in IS-smuggled oil.

 

The Iraqi colonel, who along with US investigators is working on a way to stop terrorist finance streams, told al-Araby about the stages that the smuggled oil goes through from the points of extraction in Iraqi oil fields to its destination - notably including the port of Ashdod, Israel.

 

"After the oil is extracted and loaded, the oil tankers leave Nineveh province and head north to the city of Zakho, 88km north of Mosul," the colonel said. Zakho is a Kurdish city in Iraqi Kurdistan, right on the border with Turkey.

 

"After IS oil lorries arrive in Zakho - normally 70 to 100 of them at a time - they are met by oil smuggling mafias, a mix of Syrian and Iraqi Kurds, in addition to some Turks and Iranians," the colonel continued.
We bring all of this up again because less than 48 hours ago, Russia said it spotted some 12,000 tankers and trucks on the Turkish-Iraqi border. Where, precisely, are the tankers you ask? Why Zakho of course. Here's Lieutenant-General Sergey Rudskoy: “The [aerial] imagery was made in the vicinity of Zakho (a city in Iraqi Kurdistan), there were 11,775 tankers and trucks on both sides of the Turkish-Iraqi border." 
“It must be noted that oil from both Iraq and Syria come through this [Zakho] checkpoint,” Rudskoy added, in case it was in any way unclear what Russia was suggesting.
As for the Kurds, well they swear it's there oil and not Islamic State's that's tied up at the border. From Bloomberg:
Iraq Kurds say own oil pumped to Turkey, not Islamic State Crude

 

Turkey closed border with Iraq during past few days due to war with Kurdish militants, causing long lines of oil tankers, Kifah Mahmoud, adviser to president of self-governed Kurdish region in north Iraq, says by phone.
Of course Kurdish crude is just as "undocumented" as ISIS oil given that technically, it belongs to Baghdad and not Erbil but we'll leave that aside for now. The important point here is that what the Kurds want you to believe is that none of the nearly 12,000 tankers parked at Zakho contain any ISIS crude even as more than one Kurdish security official specifically told Al-Araby al-Jadeed that Zakho is the key transit point.
Additionally, note the timing. ISIS is losing ground and is on the verge of relinquishing Ramadi to Iraqi forces. One certainly wonders if the group's funding needs are rising just as the Russians are cutting off their revenue stream forcing Baghdadi to get as much of the oil through as possible while he still can.
Finally, it's also worth noting that there's something nefarious about the whole thing. That is, the Peshmerga are paid out of money Erbil collects from selling Kurdish crude and the Peshmerga are fighting ISIS. It's thus perverse that the Kurds apparently allow ISIS to use their transit routes on the way to securing the funding the group needs to keep fighting.
In any event, we wonder how long it will be before Baghdad green lights Russian strikes over Iraq, and how Moscow will deal with the intermingling of Kurdish crude with ISIS oil.

WSJ : Central Banks’ Shock Therapy Has Investors on Edge

Central Banks’ Shock Therapy Has Investors on Edge

Policy makers had a habit of delivering surprises that jolted markets during 2015

Behind the biggest market meltdowns of 2015 were familiar culprits: central banks.

And more volatility is likely to follow in 2016 as investors navigate the Federal Reserve’s gradual exit from easy-money policies after the U.S. central bank raised rates for the first time in nearly a decade.

From the Swiss National Bank’s shock decision in January to abandon the Swiss franc’s link to the euro, to the European Central Bank’s disappointing stimulus package in December, a series of central bank decisions have provoked extreme market reactions. In between, the decision by China’s central bank in August to weaken the value of its currency fueled fears about the state of the Chinese economy that spurred a global stock selloff.

The bouts of turmoil highlight markets’ growing reliance on the words and actions of central banks in the years following the financial crisis. Rock-bottom interest rates and massive asset purchases designed to kick-start ailing economies have encouraged investors to push into ever-riskier assets in search of returns. That has left many markets vulnerable to sharp reversals when popular trades turn sour.

“This year was a sign of things to come, and it will probably get worse before it gets better,” said Paul Lambert, head of currency at London-based asset manager Insight Investment. “Central bank policy has pushed many investors beyond their comfort zone. Now we’re seeing the consequences.”

In 2016, the biggest challenge may be the one faced by the most influential central bank: the Fed. U.S. rate-setters have sought to reassure markets that the move up from near-zero rates will be slow. But they’re treading a fine line: Let investors know the easy-money party is over, without giving markets a sharp jolt that could spread to the economy.

Meanwhile, the ECB and the Bank of Japan continue to grapple with weak economies and low inflation that may force them to ramp up stimulus. Japan’s central bank jolted markets when it announced a modest expansion of its quantitative-easing program on Dec. 18, initially boosting Japanese stocks before they turned sharply lower.

“I think 2016 will be quite challenging for central banks,’’ said Stephen Jen, managing partner at SLJ Macro Partners LLP and a former economist at the International Monetary Fund. “This is like an 18-wheeler trucker not being sure when and where to turn, but has promised the world that he would use the turn signal in ample time.”

Compounding the problem are tighter regulations that have limited investment banks’ ability to trade large quantities of stocks, bonds and currencies. For investors, that means less liquidity—or the ability to buy or sell assets without moving prices appreciably—and wild market swings when a central bank delivers a surprise.

ENLARGE
“Investors are vulnerable to more episodes like these in the future,’’ said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management Inc., which has $20 billion in assets under management. “Central bank actions have been fueling volatile trading, and in the current low-liquidity environment, holding a crowded position is a recipe for disaster.”

On Jan. 15, the Swiss franc rocketed by more than 40% against the euro after the SNB abruptly removed its cap on the currency’s value—the sharpest one-day move for a major currency in more than 40 years of floating exchange rates. The SNB had been intervening in markets to prevent the franc from climbing too far and hurting Swiss exporters, but threw in the towel after growing uneasy with the enormous pile of euros it had bought. The decision caught out many investors who had bet on a falling franc.

December brought another bout of whiplash for currency investors that spilled into stock markets. The euro climbed more than 4% against the dollar after the ECB delivered a smaller stimulus package than many had expected. The surge—a massive daily move for euro-dollar, the world’s most heavily traded financial instrument—was just the latest in a series of sharp swings in 2015 as investors tried to second guess the rate at which ECB and Fed policy were headed in opposite directions.

The episode highlights another issue for major central banks: how to guide market expectations in a time of uncertainty.

In China, monetary-policy makers caused several rounds of market gyrations this year, as investors struggled to interpret signals from a central bank that often fails to clarify its intentions.

The People’s Bank of China, together with other Chinese regulators, helped fuel an epic run-up in share prices early this year, only to contribute to a dramatic stock-market crash over the summer through a series of conflicting messages. The slump wiped out $5 trillion of value in June and July. The central bank was then front and center in an unprecedented government effort aimed at propping up share prices, pledging to provide unlimited liquidity to aid stock purchases by state companies.

As stock investors were still licking their wounds, the central bank stunned the world with a devaluation of the Chinese yuan in mid-August. The PBOC said the move was intended to bring the yuan’s value more in line with market expectations, but the surprise action triggered a sharp selloff of the yuan and the currencies in some of China’s trading partners. Many saw the devaluation as an attempt to shore up China’s export sector and a sign that the country’s economy was slowing more sharply than thought.

If China is serious about its push to open up its financial markets and internationalize the use of its currency, “improving PBOC’s communication with investors is very important,” said Puay Yeong Goh, a senior economist at Neuberger Berman, an investment-management firm in New York.

The tumultuous year has left many investors wary of the risks of placing too much faith in central banks.

“Credibility, or rather confidence in central banks has diminished,’’ said Jim Caron, global fixed income portfolio manager at Morgan Stanley Investment Management, which had $404 billion in assets under management at the end of September. “The consequence is that they may not be able to stabilize prices as effectively as they have in the past.”

FT : The oil price in 2016. How low is the ceiling?

There are two divergent views of what is happening to the oil price within the industry and among serious investors. 2016 may help us to see which is correct.

The first view is that the price is inherently cyclical. What has come down must go back up again and the deeper the trough the higher the next mountain.

The alternative analysis is that the shift we have seen over the past three years is the beginning of a long-term structural shift which will see energy prices materially lower in real terms in the next half century than in the last. Those who take this view believe, to put it very simply, that the likely growth in supply is stronger than the growth in demand.

Of course the two approaches are not totally incompatible. There are clearly still short-term cyclical issues which cannot be ignored. The Chinese economy will come out of recession at some point not least because if it does not President Xi Jinping and the Chinese Communist party will be in big trouble. We will surely have price spikes — after all political decisions, not least in Saudi Arabia, are still important factors in shaping the market and much of the world’s supply comes from countries in the Middle East and north and west Africa, which are inherently unstable.

But the structural factors are more important because they set the upper limit to the extent and durability of any such spikes. No one knows where the ceiling is (my guess is $60 a barrel) but it is clear that if you accept the structural argument you must also accept that the ceiling itself is liable to fall over time.

The overwhelming weight of the coverage of the oil market by analysts and commentators concentrates on the supply side and the volumes being produced and exported from Saudi Arabia or elsewhere. Supply is important but costs matter more.

Some people remain attached to a theory that can be described as resource scarcity. At its heart this theory suggests that resource development follows a linear pattern in which low-cost resources are developed first, meaning that most if not all future development must be more costly. Unfortunately the history of the industry does not support this view. If anything the experience of the past few decades suggests that the opposite is true.

Exploration and production costs are on average lower now than when I joined the industry almost 40 years ago. Multiple technical advances — from advanced seismic analysis to enhanced recovery techniques — allow companies to produce more for less. The cost reductions have been pushed on by each cyclical fall in prices — in the mid 1980s, late 1990s and now over the past two years. When prices fall companies find different and cheaper ways of working. Such cost reductions set a new baseline and soon spread across a global industry.

The North Sea which was said to be uneconomic at prices below $80 a barrel two years ago is still going strong. The break-even price is now said to be around $60 and, of course, in cash terms alone it is much lower. Once platforms and infrastructure are in place the actually operating costs of an oilfield are very low indeed.

In the US despite numerous pronouncements of doom crude oil production in November was up 265,000 barrels a day compared to November 2014. Behind the headline the story is mixed and some areas are clearly more expensive. But the main tight oil provinces such as the Eagle Ford in Texas and the Bakken in North Dakota have carried on producing because costs have fallen. Platts — one of the most serious and objective observers of the market — suggests in its latest report that production in both areas could go still higher, even at current prices. The shale industry in the US is well on the way to being viable at $50 and I don’t doubt that many producers would continue to thrive at even lower prices. If some production is held back waiting for prices to go up again the prospect is of a new surge of supply whenever there is an increase.

The cyclical theory depends on a dearth of new investment creating a supply crunch in two, three or five years. A lot of projects are being postponed but postponement is no more than a signal to project managers to find a way of cutting costs. Many are doing exactly that.

I can well imagine that in 2016 the oil price will bounce back from its current sub $40 level. The Saudis may try to cut production, there could be more conflict in Iraq, terrorists could attack some of the prize targets such as the oil terminals at Ras Tanura and Abqaiq. Anything is possible, something is likely. But the question is how far the bounce will go.

If the bounce is minimal and transitory it will be clear that the structural shift is under way. I hope the companies which are over invested in expensive projects and countries still overwhelmingly dependent on oil and gas revenues are ready.

WSJ : French Children Add to ISIS Ranks

French Children Add to ISIS Ranks

Some young men and women leave France to start families in Syria, according to those who study the radicalization of French residents

NICE, France—Valérie Aubry-Dumont got the news in a WhatsApp message from deep inside Islamic State territory. “Mom, you’re going to be a grandmother,” wrote her teenage daughter, Cléa.

When Ms. Aubry-Dumont last saw her daughter, Cléa was a 16-year-old girl attending Catholic school in a Paris suburb. After a breakup, Cléa met a young man online and within months the couple fled France to live in a stretch of northern Syria ruled by Islamic State.

“I wish Cléa never had children,” Ms. Aubry-Dumont, a child-care worker, says now that her grandson has been born. Her daughter talks some days of returning to France, Ms. Aubry-Dumont said, but is afraid of losing her baby if she tries to leave. “She is trapped.”

In France, the West’s biggest supplier of foreign fighters in Syria, the loss of sons, daughters and grandchildren to Islamic State has been a slow-motion tragedy. For some French families, the Paris attacks, while deepening the wedge between militants and the West, were a painful reminder of their ties to the enemy.

The French wife of Foued Mohamed-Aggad—who along with two others killed 90 people in Paris’s Bataclan concert hall on Nov. 13—is living in Islamic State territory and ready to give birth “any day now,” said Françoise Cotta, a lawyer Mr. Mohamed-Aggad’s mother approached in an attempt to bring the child back to France.

“An alarming number of young men and women are leaving France to start a family in Syria,” said Alain Ruffion, director at Unimed, a group that works to prevent the radicalization of residents around the southern French city of Nice.

Raising children in Islamic State-held territory bolsters its ranks. More than 1,100 children under age 16 joined its training camps this year, according to the Syrian Observatory for Human Rights, a U.K.-based opposition monitor. The alleged ringleader of the Paris attacks, Abdelhamid Abaaoud, had brought his 13-year-old brother to Syria to join the militants. Mr. Abaaoud was killed last month by police.

The number of children born of a French parent joined to Islamic State is nearly impossible to tally, authorities said. The French government estimates that about 50 children have been taken to Syria since 2012.

Among them was a 5th-grade boy named Rayan, who stopped showing up at his redbrick elementary school on the outskirts of Toulouse in April 2014. He resurfaced nearly a year later—in an Islamic State video.

Rayan appears clad in military fatigues, holding a handgun. At his side is Sabri Essid, a radical who married Rayan’s French mother and moved her and her four children to northern Syria, French officials said.

In the video, Mr. Essid calls Rayan a “lion cub” prepared to kill Islamic State enemies. An Israeli Arab hostage is shown kneeling before the boy. Moments later, Rayan shoots the hostage.

Last year in Nice, a French family of 11 people, including four children between the ages of 6 months and 6 years, left for Syria.

“I went to pick up my two grandsons at school as usual,” said Ivano Sovieri whose daughter, Andrea, married into the Muslim family several years ago. “But I was told the entire family had left for Tunisia after a relative died.”

Mr. Sovieri eventually learned his daughter, who converted to Islam, had gone to Syria. She left behind a message with her best friend: “I shouldn’t have left, but I couldn’t back down in front of Allah.”

Ms. Aubry-Dumont said she tagged along on the first date between her daughter, Cléa, and a young bearded man from a dating website. “Who’s this guy who won’t look me in the eye or shake my hand?” she recalled asking her daughter after the date in December 2012.

The couple disappeared a few months later. Ms. Aubry-Dumont said she later recognized her daughter’s suitor in a video posted by Islamic State. He called himself Abdul Wadud, and, brandishing a rifle, swore revenge against French President François Hollande.
Ms. Aubry-Dumont said she tried to persuade her daughter to come home. The teenager instead asked her parents to join her in Syria. “If it was dangerous here, I wouldn’t ask you to come,” Ms. Aubry-Dumont recalled her daughter saying. Eventually, the teenager told her mother why she wanted her: She was pregnant.

“I almost collapsed when I got the news,” said Ms. Aubry-Dumont, who was so angry she cut off communication. A few weeks later, when U.S. forces started airstrikes in Syria, a frantic Ms. Aubry-Dumont called Cléa.

The runaway couple and their son now live in a villa in northern Syria. “They are given everything they need,” Ms. Aubry-Dumont said, “a house, money and even formula for the baby.”

The two women now chat on WhatsApp and sometimes talk by phone. The daughter sends baby pictures. “I try to continue to play my role as mother, somehow,” Ms. Aubry-Dumont said.

Some grandparents weigh the risks of trying to see family members, including those they have never met. Beyond personal loss, these families face government surveillance and risk prosecution if they try to meet with their loved ones abroad.

Annie-Claude, a French retiree from the southern town of Avignon, said her son left home two years ago to join militants in northern Syria, where he fathered a child with a young Syrian woman. He was killed fighting for Islamic State in March, said Annie-Claude, who declined to give her last name.

A few months ago, the child’s widowed mother contacted Annie-Claude about meeting her new grandson. The Syrian woman suggested they rendezvous in Gaziantep, a Turkish town near the Syrian border.

“He’s all I have left from my son, and the only grandchild I’ll ever have,” Annie-Claude said. “I want to see him.”

Under Islamic State rules, the young woman isn’t allowed to travel without male guards, said Annie-Claude: “I want to go, but I’m scared.” France has banned travel to Syria and Iraq.

The 17-year-old Syrian woman who Annie-Claude considers her daughter-in-law speaks no French or English. The two women communicate via a mobile messaging service, trading emoticons: smiley or sad faces, puckered lips and hearts.

Zora, a shy junior-high student from a Paris suburb, left France after her 14th birthday, said her father, a vendor at a local market. She wound up in a villa in Deir Ezzour, near Syria’s border with Iraq.

Police later told her father she had been recruited over Facebook by three young women in southern France. The girl traveled to Syria on a circuitous route through Belgium, the Netherlands and Turkey.

For months, Zora used the mobile messaging service Viber to communicate with her father. She described life in the villa that was home to about 50 girls from foreign countries including the U.S., U.K. and Belgium, said the father.

Surrounded by armed guards, the girls were rarely allowed to step out, the father said. Zora told her father she had been forced to watch beheadings. Bomb blasts woke her at night. “I can’t stop crying,” she wrote.

Six months ago, Zora’s text messages seemed more upbeat. “She talked about her plans for when she’d be back in France, asked for advice on which studies to pursue,” her father said. “When she was a little girl, she wanted to be a nurse. Now, she says she can’t see any more blood.”

The father pleaded with Zora to find someone who could arrange an escape. “I’ll pay anything,” he wrote. He sent a scanned copy of her French birth certificate to use if she managed to reach the Turkish border.

That was the last time he heard from her, he said. Standing in his market stall, he dialed his daughter from his cellphone. No one answered.

“I call every morning,” he said. “I’m waiting for her to get back online.”

WSJ : Activism’s Long Road From Corporate Raiding to Banner Year

Activism’s Long Road From Corporate Raiding to Banner Year

Change in tactics let industry move beyond controversial past

When activist investor Nelson Peltz demanded board seats at H.J. Heinz Co. in 2006, both the company and its headquarters city were indignant.

The Pittsburgh newspaper ran editorials urging support for the “hometown team.” Heinz gave employees bottles of its signature ketchup with custom labels urging them to vote against Mr. Peltz’s nominees. “We thought, ‘Gosh, we don’t need outside help,’ ” recalls Art Winkleblack, then the company’s chief financial officer.

This June, nearly a decade later, Mr. Peltz’s Trian Fund Management LP got an entirely different reception after buying a 7% stake in Pentair PLC, a Minnesota maker of pumps and valves. Pentair Chief Executive Randall Hogan spoke several times with Trian co-founder Ed Garden about corporate strategies and promptly moved to add Mr. Garden to its board.

“You never know what you don’t know,” Mr. Hogan says of his willingness to listen to the activists.

After decades of being treated as boorish gate-crashers, activist investors are infiltrating the boardrooms of large companies like never before. This year activists launched more campaigns in the U.S.—360 through Dec. 17—than any other year on record, according to FactSet. They secured corporate board seats in 127 of those campaigns, blowing past last year’s record of 107. Activists now manage more than $120 billion in investor capital, double what they had just three years ago, according to researcher HFR.

The industry has come a long way since the 1980s, when Carl Icahn, Saul Steinberg, T. Boone Pickens and other mavericks would amass large stakes in companies and demand a sale of the entire company. They were called “corporate raiders” and “greenmailers” and were widely criticized.

These days activists, while not exactly welcomed in corporate boardrooms, are rarely treated as ill-mannered outsiders. “These activist funds are just a different asset class who have the same pensions and endowments investing in them as other funds,” says Rob Kindler, head of mergers and acquisitions at Morgan Stanley. “The demonization of activists, when really what they are doing is providing returns to the same pension and endowment plans, just seems overdone.”

Several factors contributed to this shift, according to corporate executives, activists, bankers and lawyers. The financial crisis fanned dissatisfaction with corporate executives and brought low interest rates that helped activists thrive. Activists got more sophisticated about analyzing target companies and built alliances with other big shareholders, including mutual funds. And broad shifts in corporate governance gave more power to all shareholders, including activists.

ENLARGE
M&A lawyer Martin Lipton, who for years has represented companies facing battles for board seats, this year called on clients to consider settling with some activists. “There is no timely way anymore for a company to be slow about responding to a decline in performance or pursuit of the strategy,” he noted in an interview.

This year, returns for activist hedge funds averaged 3.4% through November, beating the hedge-fund average of 0.3% and the S&P 500’s 3% total return, according to industry research group HFR. Over the past five years, activist funds have returned an annual average of 8.2%, compared with the average hedge fund’s 3.2% return, HFR says.

The debate about whether activism is good for U.S. companies over the long term hasn’t gone away, most recently popping up in the presidential campaign of Hillary Clinton. She has decried “hit-and-run” activists, while also saying some activists help hold managers accountable.

Mr. Lipton has voiced similar complaints. “Much of what is wrong with America today—slow growth, widespread corporate scandals, inadequate investment in long-term projects, low wages that have not kept pace with inflation, wide swings in the economy accompanied by uncertain employment and rising inequality—is attributable to short-termism and attacks, and threats of attacks, by activist hedge funds,” he wrote recently.

Activist were a different breed back in the late 1970s and 1980s. They made “midnight raids” on stocks, building large, often controlling, stakes. Then they pushed companies to sell themselves to the highest bidder or to the raider himself, or to buy back their positions at above-market prices, a practice known as greenmail.

When Mr. Pickens bought stock in Gulf Oil Corp. in 1982, he was greeted by a lawsuit and spent months trying to get a meeting with the Chief Executive James Lee. Mr. Pickens contended the company was mismanaged, and he wanted to take control.

Other shareholders were suspicious. “One said ‘He’s a fast-buck artist,’ ” Mr. Pickens recalled in a recent interview. “I said, ‘Who in the hell wants to be a slow-buck artist?’ ”

The saga ended two years later when the company later known as Chevron Corp. swooped in to buy Gulf for $13 billion, delivering Mr. Pickens a substantial profit.

In 1984 alone, public companies paid $3.5 billion in greenmail, with payments above market price accounting for $600 million, according to a study by the Securities and Exchange Commission.

Such tactics generally outraged other investors and ensured that raiders remained on the investment world’s fringe. In 1987, the Internal Revenue Service introduced a tax of 50% on profits from greenmail, and several states passed laws making it hard for companies to buy back stakes from short-term investors at a premium.

By the 1990s, when a bull market took hold, those practices had largely faded. Targeting big companies was out of the reach for most activists because their funds remained small. And with stocks booming, there was scant investor demand for taking on prominent CEOs.

Activist Investor Report Card
See what happened at large U.S. companies targeted by activist investors.

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The collapse of Enron Corp. and WorldCom Inc. in the early 2000s led more shareholders to question whether managers were acting in their best interests. It was around that time that today’s activists started forming funds, including what would become Starboard Value Fund and Barry Rosenstein’s Jana Partners LLC.

Mr. Rosenstein, who once worked for corporate raider Asher Edelman, launched his fund in 2001 but found few investors interested in targeting companies and agitating for change.

“One person I pitched said ‘This is not a strategy,’” Mr. Rosenstein recalls. “Nobody was doing it.”

He raised about $20 million, opened shop with just three employees and started investing in small companies, including Herbalife Ltd., then a lesser-known nutritional-shake maker, and York Group Inc., a casket maker.

Mr. Rosenstein and his fellow activists hoped to follow a path to respectability blazed by private-equity funds, who had largely shed their image as buyout “barbarians” and transformed themselves into respected, publicly traded institutions. To do that, activists needed to persuade others, including potential allies at mutual funds, they were interested in building value at target companies, not just making a quick buck.

It was during this period that Mr. Peltz launched his proxy fight at Heinz. When company shareholders met to elect the board, the tension was thick. Mutual fund Capital Research & Management Co., a large shareholder, voted for some Trian nominees, stunning Heinz executives and helping put Mr. Peltz and an ally on the board.

After winning the vote, Trian didn’t push a quick sale, but stayed around. Board members say Trian helped focus the company on cutting certain costs and increased spending on marketing, and sped up the company’s timetable for moves that improved profit margins.

“They didn’t come in with a sledgehammer saying you have to do it this way,” says Mr. Winkleblack, then CFO.

Investor T. Boone Pickens, left, greeted Gulf Oil CEO James Lee in 1983 after he bought stock in the company. ENLARGE
Investor T. Boone Pickens, left, greeted Gulf Oil CEO James Lee in 1983 after he bought stock in the company. PHOTO: GENE J. PUSKAR/ASSOCIATED PRESS
“It was so seminal because it was a huge company to go after at that time,” says Chris Young, an activism-defense banker at Credit Suisse Group AG. “It was operational in nature, and you got mainstream, long-only investor support. That, I think, started opening people’s minds to the art of the possible.”

In 2013, Heinz was sold to Brazilian private-equity firm 3G Capital Partners LP and Warren Buffett’s Berkshire Hathaway Inc. William Johnson, then Heinz’s CEO, now is an adviser to Trian, and Mr. Winkleblack was a Trian board nominee at DuPont Co.
The financial crisis that began in 2008 was a setback for many activists, who saw their funds lose billions. But ultimately it created fertile conditions for the current activism boom.

In the wake of the crisis, many corporate executives took a more-conservative approach, not wanting to be seen as risk-takers. They hoarded cash and avoided big spending. When interest rates dropped, they borrowed money not for expansion, but to buy back stock and increase dividends—exactly what some activists were pushing for. Critics of such moves say companies would be better off using capital on long-term investments such as infrastructure, research and employees, but activists say managers have proven poor spenders and shareholders can handle the money better.

At the same time, changes in corporate governance were making it easier for activists to win board seats. Between 2011 to 2014, a group at Harvard University led by professor Lucian Bebchuk campaigned to get more than 100 major companies to put their entire boards up for annual election, instead of staggering directors in multiyear terms.

Annual elections give activists leverage because boards can be overturned in one fell swoop rather than over a series of years. In 2000, 300 of the S&P 500 companies had staggered boards. This year, only 49 do.

Barry Rosenstein found few investors interested in activism when he launched Jana Partners in 2001. ENLARGE
Barry Rosenstein found few investors interested in activism when he launched Jana Partners in 2001. PHOTO: ERIC THAYER/REUTERS
Perhaps the most important change, according to both activists and their detractors, is that activists got more sophisticated about analyzing how to improve operations at target companies. They recruited executives with experience in the relevant industries to work alongside them on campaigns.

In 2012, for example, William Ackman’s Pershing Square Capital Management LP launched a proxy fight against Canadian Pacific Railway Ltd. When Pershing Square called the former boss of rival Canadian National Railway Co., Hunter Harrison, for advice, it found a willing partner. Pershing Square campaigned with Mr. Harrison as its CEO candidate, eventually winning seven board seats and putting Mr. Harrison in charge.

Mr. Rosenstein’s Jana Partners, which now employs more than 50 and runs more than $10 billion in assets, typically presents companies with several-step plans about how they can cut costs, restructure their balance sheets, shed assets and change strategy.

Last year, drugstore chain Walgreen Co. agreed to put Mr. Rosenstein on its board and gave him a say in two other seats, all without a threat of a public fight and a stake of only 1%.

Similarly, in 2013, Microsoft Corp. said it would add a ValueAct Capital Management LP partner to its board, even though ValueAct held a stake of just 1%. Behind the scenes, ValueAct had support from some of Microsoft’s biggest shareholders, including Franklin Templeton Investments and Capital Research.

Trian has gained board seats, without a fight, at companies ranging from fast-food chain Wendy’s Co. to Bank of New York Mellon Corp. This year, it took a stake in food distributor Sysco Corp. and was given two seats only a week after meeting management.

“They aren’t on a search-and-destroy mission,” says Wesley von Schack, the lead director of Bank of New York Mellon. “They come in and speak to the right issues.”

Activist thinking now appears to be influencing even executives who haven’t been targeted. Executives now routinely talk about the return on every dollar spent—a frequent focus of activists. Chief executives appointed this year by McDonald’s Corp. and United Technologies Corp. have called themselves internal activists.

“We’re the activists at UTC,” United Technologies CEO Gregory Hayes said in October. “If an activist wants to come in and make a suggestion that we do it, we can say, ‘Been there, done that.’ ”

General Electric Co. Chief Executive Jeffrey Immelt has gone so far as to invite one activist to get involved in his company.

When GE announced in April that it would shed GE Capital, its finance arm, Mr. Peltz, who wasn’t an investor, called to congratulate Mr. Immelt.

“I’d love to have you in the stock,” Mr. Immelt told Mr. Peltz.

As Trian did due diligence, it urged Mr. Immelt and his team to eliminate more of GE Capital than planned and to tap the debt markets for buybacks. GE executives felt the activist was in the right ballpark. Trian invested $2.5 billion, its biggest investment ever.

A month after the stake was disclosed, GE’s stock crossed $30 a share for the first time since the financial crisis.

Barron's : Emerging Markets: Best and Worst Bets for 2016

Emerging Markets: Best and Worst Bets for 2016

Countries most capable of contending with higher U.S. rates and lower commodities prices include Korea and Mexico. Latin America is the most vulnerable.

After a series of challenges in 2015, emerging markets are expected to recover somewhat in the year ahead. However, the journey is likely to be slow and the path tortuous.

Countries with winning stock markets in 2016 will likely be those that succeed in making structural reforms, attracting foreign investment, and maintaining monetary and fiscal discipline amid political pressure. Tighter monetary policy in the U.S. and lower commodity prices remain the most significant risks across virtually all emerging markets.

Among those in the best position at the starting gate are Korea and Mexico. Each economy is growing and its central bank has some room to maneuver. In turn, much of Latin America, aside from Mexico, will face strong headwinds.

Although Mexico is an oil exporter, it has been relatively unaffected by China’s economic slowdown because 80% of its overall exports (much from manufacturing) head north to an expanding U.S. economy. In addition, expectations for annual inflation, which is at the lowest level in 45 years, have recently fallen to 2.2%, mainly due to the collapse of oil prices, a slow-growth economy, and a credible central bank whose mandate is to keep inflation under 3%. Mexican GDP is expected to rise 2.45% in 2015 and 2.74% in 2016. With inflation contained, Mexico was able to raise rates by a quarter of a percentage point to 3.25% in mid-December, keeping pace with the Federal Reserve’s rate hike.

Korea, one of the largest importers of oil, is projected to grow output by 2.7% for 2015, once the books are closed, and by 3.1% in 2016, due in part to government stimulus. That has driven a rebound in domestic demand after the negative effects on exports related to slower global and Chinese growth.

Research firm Capital Economics says there are signs that consumer spending in oil-importing emerging markets is accelerating. In emerging Asia, excluding China, it expects growth in consumer spending to rise from the 3.9% annual average of the past decade to an average of 4.7% a year from 2015 to 2020. That should be a help in countries like Korea.

By contrast, most countries in Latin America have little room to tighten monetary policies aggressively if the Fed accelerates the pace of hikes. Countries such as Brazil have large debt burdens in foreign currencies and it will become more expensive to service this debt as the dollar appreciates, and as investors repatriate cash to invest in higher-yielding and safer assets in the U.S.

GDP growth in most parts of the region is decelerating and inflation is growing. According to Fitch Ratings, the region will see average GDP contract by 0.6% in 2015, with just 0.6% growth in 2016. Most of the deceleration will be caused by Brazil’s worsening economic crisis and impeachment proceedings against President Dilma Rousseff. Brazil and Colombia will have a hard time attracting or retaining foreign investment. Venezuela, whose oil revenues account for about 95% of export earnings, could be headed to a default unless prices rise.

Still, there are optimists about emerging markets. “Concerns about the outlook for emerging markets look increasingly overdone,” says Neil Shearing, chief emerging-markets economist at Capital Economics. “Pockets of vulnerability exist, but…emerging-market growth is more likely to recover over the next three to six months than it is to suffer a fresh downturn.” That could make for an interesting bet in 2016, although it’s one many investors shunned in 2015.

Barron's : Looking for 2016 Winners

Looking for 2016 Winners

At year’s end, investors are often tempted to buy poorly performing stocks in the hope that mean reversion will boost the losers in the next 12 months. This bull market’s numbers, however, don’t support that approach.

At year’s end, investors are often tempted to buy poorly performing stocks in the hope that mean reversion will boost the losers in the next 12 months. This bull market’s numbers, however, don’t support that approach. Bespoke Investment Group compared buying the 50 best-performing stocks in the S&P 500 index to the 50 worst since 2009, and found that sticking with the winners was better, on average. (See table.) But it wasn’t a whole lot better than the index on an equal-weighted basis.

Other data suggest fortune favors the fortunate. When choosing sectors for the new year, according to Sam Stovall, U.S. equity strategist at S&P Capital IQ, “history says you are better off owning the three best sectors of the previous year.”

Going back to 1990, picking the three best sectors from the previous year provided a mean 10.4% total return the next year. That’s better than both the 9.1% index return and 8.7% from selecting the three worst-performing sectors. Additionally, the three best groups outperformed two-thirds of the time while the worst, only 40% of the time. As of Thursday’s close, the three best sectors of 2015 are consumer discretionary, up 9%; health care, up 6%; and technology, up 5%.

Tom Stringfellow, president of Frost Investment Management, expects good things from consumers next year, due to job and wage growth and lower gasoline prices. He believes increased consumer spending could help the auto, airline, and hotel companies.

The energy sector, down 22% after a 10% drop in 2014, appears ripe for mean reversion, but it is still too early, as oil seems not to have bottomed. The first part of 2016 could prove treacherous, although by the end of 2016 energy might be looking better. From a technical standpoint, we’d like to see the stocks stop falling in lockstep with the commodity.

On Dec. 18 crude plunged to a new 52-week low of $34.73 per barrel, the S&P Energy Sector falling along with it. To get more optimistic, an improvement in that dynamic is desirable: That is, energy stocks should stay flat or even inch up when oil slips. If that happens, it indicates the stocks are washed out, an encouraging sign.

We waxed enthusiastic about ExxonMobil (XOM) in a recent column, and consider it attractive for an investor with a two-year timeframe. With a near-4% dividend that seems secure, you are paid to wait, and a double-digit return seems unchallenging once oil stabilizes.

Financial stocks, banks in particular, seem a better bet for 2016. Down 2.6% for the year through Thursday, the sector isn’t in line to finish as one of the top three performers of 2015. However, rising interest rates, which boost loan income and net interest margin, argue in favor of the group.

Alan Lancz, who runs money manager Alan B. Lancz & Associates, likes financials. Among them, Bank of Nova Scotia (BNS), a solid Canadian bank, with a 5% dividend yield, could do well when oil stabilizes, he says. Mutual-fund manager AllianceBernstein Holding (AB), another favorite for 2016, has been hurt by volatility in the high-yield market, but is cutting costs and the stock is near its lows, he says. His firm owns both.

A financials exchange-traded fund might be a good way to play the sector, as it removes the single-stock risk. One popular ETF is the Financial Select Sector SPDR Fund (XLF), but there are plenty more. More ETF choices can be found at etf.com.

Barron's : Whither the Market in 2016?

Whither the Market in 2016?
It’s time for The Trader to consult his crystal ball for clues to the U.S. stock market’s prospects next year.

It’s time for The Trader to consult his crystal ball for clues to the U.S. stock market’s prospects next year. Twelve months ago, we suggested the S&P 500 would rise 5% to 10% this year. That’s off the mark, but less so than other widely held forecasts for a double-digit return.

What worries us? Well, oil prices might fall further, with unhealthy ripple effects on more than just energy stocks, although it would be a positive for consumer sectors. The dollar could bulk up some more in 2016, but probably most of that move is done.

“Head winds are abating. The repricing of the dollar is behind us and oil could stabilize,” says Mike Ryan, chief investment strategist for UBS Wealth Management Americas. Earnings growth is likely to recover from this year’s stall, he adds.

Then there’s the Federal Reserve, which will likely raise rates more slowly than it has indicated. Yet, this might not go smoothly. “Investors will continue to see volatility over the pace of the Fed hikes,” predicts E. William Stone, chief investment strategist at PNC Wealth Management. “The market will struggle with that at times.”

“The Fed proved much more of a hostage to [volatility in] global financial markets than people desired,” says James McDonald, chief investment strategist at Northern Trust. Nevertheless, the Fed will likely move more slowly than its own predictions indicate. “The Fed will be the dog that doesn’t bite,” he adds.

One thing the Fed doesn’t want to do: cut rates after having raised them, if the global economy doesn’t pick up.

There’s a good chance earnings for S&P 500 companies will end up declining for this year, no small factor in the market’s malaise. Next year, however, we see a little bit of growth, if only because poor quarterly earnings comparisons caused by lower oil and the higher dollar should improve.

Still, we are worried about profits because revenue growth seems hard to find. In the third quarter, the gap between the number of companies beating the earnings per share consensus and those beating revenue estimates was the widest since the dark days of the first quarter of 2009, according to Bank of America Merrill Lynch. A recession isn’t expected, but The Trader doesn’t see the U.S. or the global economy perking up much, either.

That suggests no market-multiple expansion, and perhaps some decline. The trailing S&P 500 price/earnings ratio should remain around 17 times, while S&P 500 EPS could rise to $125 in 2016 from $118 this year. Given that investor confidence seems wobbly, at least anecdotally, the market will be hard- pressed to advance more than 5%, short of major improvements in global growth.

Yet, a boxer is rarely felled by the expected punch, and inflation is one threat not much discussed. If it flares up, it could force the Fed to move faster than the market desires in raising rates. China’s economic growth could weaken more, too, causing problems for other markets.

Perhaps the biggest risk to stocks is geopolitical, ranging from more violence in the Middle East to more terrorist attacks elsewhere. The awful attacks in Paris give us little hope for a respite

Barron's : Niall Ferguson Takes on the World

Niall Ferguson Takes on the World
Ferguson sees more trouble ahead for Europe, China, and Saudi Arabia. But countries with cheap stocks and political stability could beckon investors.

Niall Ferguson, the historian, Harvard professor, and author of more than a dozen books on the nexus of economics, finance, and geopolitics, argues that America’s abdication of its role as the world’s policeman is one cause of the global economic malaise. U.S. policies, or lack thereof, have allowed terrorism to breed and dictatorial states such as Russia and China to assume a larger role in world affairs.

The author of Civilization: The West and the Rest, Ferguson says China’s attempt to move to a true market economy probably will fail, potentially causing serious disruptions to other markets. He likens Saudi Arabia to Iran in 1979—a state ripe for destabilization. In the U.S., he sees tax reform coming, but worries that America’s love affair with regulation will continue to dampen its growth prospects. India gets a thumbs-up, but Europe’s prospects are bleak.

Ferguson recently announced that he’ll leave Harvard next year to become a senior fellow at Stanford University’s Hoover Institution. He spoke with Barron’s at our offices just after November’s terrorist attacks in Paris, and was every bit as thoughtful and provocative as when we last chatted, three years ago.

Barron’s: The U.S. economy has been growing by only 2% to 3% a year. Why isn’t it firing on all cylinders?

Ferguson: There are at least three theories. The seven-year hangover theory suggests that the U.S. will shake off the effects of the 2008 financial crisis next year. The secular-stagnation theory posits that, for a variety of reasons, the economy is in a depressed state. That is most obviously [expressed] in interest rates.

I’m attracted to a third argument, the geopolitical one, that says growth in modern American history has tended to be high at times of national strength and low at times of national weakness, because our weakness has ramifications for the world as a whole. One has to combine the three theories to understand why growth is lower than expectations. It isn’t low based on a pretty long-term average, but it is sluggish compared with the glory days of the Cold War.

What was so glorious about the Cold War?

There were two phases of growth, one associated with the Eisenhower and Reagan administrations, and one with the depressed period in between. Since 9/11, things have gone from bad to worse. We find ourselves in a deflationary version of the 1970s, marked by stagnation, not stagflation. [Russian President Vladimir] Putin is doing his best to give us reasons to man up. But we’re not really doing so.

The global economy needs a strong hegemonic power to reduce conflict, ensure freedom of the seas, and so forth. In the 19th century, it was Great Britain, and for much of the 20th, the U.S. But in 2013, President Obama said there was no global policeman. There are deleterious consequences if the leading power in the world abdicates its leadership role.

What are some of these ramifications?

Part of the reason the world isn’t as buoyant as it might be is that Europe is doing much worse than the U.S. It doesn’t help Europe to have a massive influx of real and “not so real” refugees. Some 220,000 people arrived in the European Union in October, a direct consequence of the disintegration of order in a whole bunch of countries, Syria principally, but not only.

The U.S. walking away from the Middle East has had a direct impact. We’re only beginning to see the ramifications, in Paris most recently. It isn’t going to stop there. There is growing anxiety in East Asia about the rise of China. Japan remains a large economy, but a depressed one in yet another recession. Economists tend to underestimate geopolitical factors because they aren’t in their models. Global order and stability need to be underwritten. It doesn’t just happen spontaneously.

Are you suggesting that the U.S. ought to be the world’s policeman?

Somebody’s got to do it. It better not be the Chinese or Russians. The market system requires an effective state that enforces the rule of law. That is true internationally, as well. As the world becomes less secure, it becomes a less safe place to do business.

A world in which the U.S. yields regional power to China or Russia is one in which the rule of law is driven back. We underestimate the extent to which the age of globalization depended on an American underwriting, and that is gradually unraveling.

Can the U.S. afford to keep the peace?

The U.S. has a fundamental problem: Gradually, its national security is being squeezed by Social Security, particularly its health-care system. It will be squeezed by the burden of interest payments on Federal debt as interest rates go up. In theory, as the biggest economy in the world, the U.S. should be able to afford to build up its military power. In practice, the congressional budget sequester was a blunt instrument applied to the defense budget, cutting it indiscriminately.

The U.S. should be investing to maintain its lead, particularly in areas where it is vulnerable, such as cybersecurity. No matter how many aircraft carriers we have, it might not be that big of a technological leap for us to be matched in the new theaters of war that are emerging.

But as you note, our finances are hobbled.

Entitlements are the obvious problem. Republicans discovered that if you want to cut entitlements, it is hard to win the presidency. I’m optimistic that the U.S. can make its health-care system far more efficient and less expensive as new technology comes into place. With the application of technology, we will start seeing not only stuff about our own health, but also which doctors and hospitals do which things best.

The employer-pays insurance system is loopy and ripe for revolution, in the way that Uber is revolutionizing transportation. We will see similar types of companies revolutionizing health care. At that point, you may be surprised to find that costs start coming down. I can’t imagine in 10 years’ time that when you visit your doctor, someone will hand you a clipboard with a badly photocopied form that you’ll have to fill out for nth time. That’s ludicrous.

You have written about the toxic combination of litigation and regulation in the U.S. What are the odds of reform?

I don’t see any light at the end of the tunnel. The Federal Register has never been so large. The Dodd-Frank and Affordable Care Acts alone produced a staggering volume of regulation. Now we have the Trans-Pacific Partnership Agreement, with a document even larger than Dodd-Frank. It is really disheartening. That there hasn’t been more rapid U.S. growth is due at least in part to these head winds.

Many U.S. companies won’t bring home the cash they have overseas because it would be subject to a hefty tax. Is there any chance this might change soon?

The income-tax code has to be simplified, and corporate tax has to be reduced to some internationally competitive rate. Otherwise, corporations are going to continue to emigrate to wherever the tax burden is lower. Tax reform must be on the agenda of the next president in year one. Tax reform will happen. The political class gets it; the voters get it. It is much harder to tackle excessively complex regulation because there are too many people who benefit from it.

Let’s turn to Asia. You have said that regarding China as an emerging market is absurd. Why?

It is now the second-largest economy in the world, or the largest based on purchasing-power parity, with an influence on the global economy second only to the U.S. China is sui generis. Is China is going to go further in the direction of a market economy? Will it reduce the importance of state-owned enterprises and remove the state from the financial system? Is it going to open its capital account and allow the Chinese to invest abroad freely? Each answer has ramifications for the rest of us like no other economy.

Give us your answers.

We don’t know whether China will be more of a market economy 10 years from now. It is risky for a one-party state to continue increasing the economic freedom of its citizens. President Xi Jinping, who is more interested in power than anything else, understands this well. Consequently, plans for privatization of state-owned enterprises, liberalization of the financial system, and the opening of the capital account will remain plans, but won’t be implemented.

China has created the biggest middle class in history, but middle-class people want property rights. That implies law courts and officials who aren’t corrupt. The moment you demand these things, you are asking the one-party state to loosen its grip on power. The Chinese are terrified of anything like that.

What impact might Jinping’s foreign policy have on markets around the world?

To ensure the one-party state’s legitimacy, Jinping won’t shy away from a relatively saber-rattling foreign policy, because this plays well [domestically]. There is also an element that isn’t propaganda. China is building up its naval capability, modernizing its pretty antiquated army. It has a financial diplomacy that has proved effective. The Chinese have been using their considerable resources to win friends and influence people around the world, including in Central Asia and Africa. China says, “Let us build your infrastructure.” That increases its leverage over a whole bunch of countries that the U.S. has neglected.

What is the outlook for India?

The Indian economy looks to be growing faster than the Chinese economy. India is good for a couple of reasons, including demographics, which turn out to be a lot more important than most people thought. India didn’t have the one-child policy, unlike China, whose workforce is shrinking.

India has rule of law—slow, maybe, but it is there, and a representative government and free press. Unless you think the success of the West is pure luck, which I don’t, those are advantages. There are many thickets of vested interest, but I’m broadly bullish about India’s prospects. The problems India faces are fixable, like infrastructure and housing. China’s problems are much more difficult.

Will the Middle East roil markets in the years ahead?

I expect next year to be more violent than 2015. Many investors don’t realize that since the outbreak of the Arab Spring in 2011, fatalities due to armed conflicts are up by about a factor of four; terrorism is up by a factor of six.

The events in Paris are a reminder that the jihadist network doesn’t confine itself to the majority-Muslim world. It is now embedded in minority-Muslim communities all over Europe. There will be more such attacks, and at some point the terrorists will be successful in the U.S. again. [This interview was conducted before radicalized Islamists killed 14 people in San Bernardino, Calif.] The resources that go into producing radicalism aren’t about to disappear. Networks are difficult to decapitate.

The president has failed to understand this because his model is decapitation. You think, let’s take out the boss. Then you are amazed to find the network [still] grows. We won’t see this go away in the next 10 years. The threat of violent instability in the region will go up, and probably will affect Saudi Arabia. Support for the Islamic State is high among the Saudi population.

Why is that?

An Islamic state can credibly argue that the Saudi royal family is corrupt, Westernized, and hypocritical. The family itself is divided. Saudi Arabia is a weak link, the way Iran was in 1979. If you had to ask what headline would move markets tomorrow morning, a revolution in Riyadh, especially a messy one, would be a pretty good answer. You could see a big terrorist attack on Saudi facilities, and markets would move the price of oil up.

The dollar is strong, and commodity prices are weak. What does that mean for countries like Brazil and Russia?

There comes a point when an investor says, “Hey, that’s attractively priced.” Argentina has been one of the great trades of the year. You might ask, “Where is the political problem horrible, and where is it about to get solved?” It is pretty horrible in Brazil, and I don’t see a fix in the short run. Things will be solved in Argentina, more or less. South Africa? No, that looks bad politically. Turkey? [Prime Minister Recep Tayyip] Erdogan is a dodgy customer. Egypt? I don’t like the way that’s going.

The key is attractive prices and political stability. Money is going to start flowing back into emerging markets that don’t have a political problem, such as Indonesia and maybe Malaysia. In Russia, suppose the sanctions get relaxed, as seems likely next year. Russian bonds have been one of the great performers this year. Everybody was too negative about Russia. There are some interesting opportunities in the rest of the world. It is hard to see the dollar- strength story continuing indefinitely.

What is the biggest risk to global markets?

China. It was so crucial as an engine of growth through the financial crisis. If there is a policy error in China, it could cause huge instability. The government could ease restrictions on cross-border capital flows, which would result in a great wall of money coming out of China. Money would be deployed in Western assets, and it might be difficult for China to cope. Imagine the devaluation impact on the renminbi, and the effect on all other emerging markets, if China suddenly devalues by 20% or 30%.

On the other hand, if Jinping turns the clock back, this could lead to a big downside shock.

Will Europe get its act together?

Europe faces three extraordinary challenges. It wants to have a foreign policy to be able to influence the fate of Syria, but it can’t act independently of the U.S. because it has slashed its defense capability. Secondly, Europe can’t stop this huge wave of refugees. The border is enormous, vastly larger than the Mexican border with the U.S., and much of it is a sea border.

The biggest problem is the fifth column within Europe—people who aren’t loyal to their European states even though they are citizens, second- and third-generation. Potentially, there are thousands of jihadists or sympathizers.

Europe’s problems are unsolvable. Anybody who thinks this great wave of immigration solves Europe’s demographic deficit hasn’t been to the suburbs of Paris.