fundamentals oct14

7/24/2019 Fundamentals Oct14

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OCTOBER 2014 ECONOMIC AND INVESTMENT COMMENTARY

Active ownership: driving the change

Fundamentals:

NSIDE:

Market overview:tuck in limbo

napshot:ellensashboard

K forecast:hese changeshange nothing

In this edition ofFundamentals,

Corporate

Governance Director

Sacha Sadan looks

at two relatively

new aspects of corporate governance

board effectiveness reviews and

cyber security looking at how these

can affect company performance and

how they can be addressed.

the quality of the debate and interactioninside companies is difcult for investors to

determine from the outside.

In 2010, the Financial Reporting Council

(FRC) made it a formal requirement that

FTSE 350 companies undertake an externally

facilitated board review every three years. We

welcomed this, as we believe these reviews

are powerful tools to help companies improve

and evolve. Reviewers can bring a fresh pair

of eyes, as well as experience of how otherboards operate and how common problems

can be solved.

HOW DO YOU JUDGE EFFECTIVENESS?

The board review industry is still in its infancy;

over 40 different providers undertook FTSE

350 externally facilitated board reviews

in 2013. At present there are no minimum

BOARD EFFECTIVENESS

An effective board is central to any

successful company. A board should

promote diversity of thought and

succession planning to ensure it has

the skills and experience required to be

best positioned for its future direction.

Moreover, it creates and fosters a culture of

openness and transparency to build trustand encourage rigorous debate between the

executives and non-executives. However,

Corporate Governance continues to evolve. Active ownership is a

philosophy that looks at all areas of corporate performance to reduce

potential risks and maximise shareholder value.


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02OCTOBER 2014 ECONOMIC AND INVESTMENT COMMENTARY

standards in place for reviews and

with a diverse range of providers

being used, the quality of reviews

is inevitably variable.

Methodologies vary. In some

cases, practitioners didnt observe

an actual board meeting, instead

relying only on questionnaires

and interviews. Moreover, there

are inherent conicts of interest

when practitioners organisations

offer additional professional

services. The aim should be to

improve company boards in the

interests of investors.

As a signicant investor, we want

all companies in the market to

undertake board reviews that

are rigorous and a value-added

exercise; not just undertaking a

review because they have to or

to tick a box.

MAKING PROGRESSIt is clear that there is scope to

improve communication around

review processes and outcomes, as

highlighted by figure 1, particularly

among mid-cap companies (Grant

Thornton, 2013). Companiesshould provide a summary of

ndings and an action plan to

address areas of improvements in

the annual report and accounts.

CREATING AN INDUSTRY CODEOF PRACTICE

We believe that a code of practice

will provide an important

framework, ensuring that a

minimum standard of boardreview is upheld and that

potential conicts of interest are

managed appropriately. Figure 2

shows some of the components

that we believe will help deliver

more effective reviews. In short,

these are all driven by our belief

that these reviews should be

thorough and transparent, with

subsequent actions (or lack of)

clearly explained.

A REALISTIC APPROACH

A code of practice is not about

creating a one-size-ts-all

approach, or re-writing the

rules to add another reporting

requirement for companies, but to

ensure that the purpose of these

reviews is more in equilibrium

between investors and companiesrather than tilted towards

management. Transparency

with regards to the methodology

undertaken is fundamental to this,

albeit recognising that sensitivity

around some issues may prevent

full public disclosure.

Source: Grant Thornton Corporate Governance Review 2013

Figure 1. Level of explanation of Board Evaluations

Figure 2. LGIM ideas for new code of practice

LEVEL OF EXPLANATION OF BOARD EVALUATIONS (THOSE GIVING MORE

DESCRIPTION OF PROCESS)

IS INFORMATION GIVEN ABOUT EVALUATION FINDINGS?

63%

40%

52%

35%

55%

32%

41%

30%

80%

56%

73%

44%

2013

2013

2012

2012

FTSE 350

FTSE 100

Mid 250

Consultants should undertake one-to-one interviews with all board members

and the company secretary Consultants should be allowed to attend board meetings to maximise the value

of the exercise or state if they do not attend any

Investors should know the review methodology

Consultants should have the opportunity to attend board sub-committee

meetings

Consultants should be able to meet the executive committee to get the executive

directors views on the board

Consultants should be allowed access to other stakeholders such as

shareholders, auditors and lawyers

The ndings from the review should be fed back separately to the senior

independent director (SID) as well as the chairman

A follow-up meeting should be held between the chairman or the board and the

consultant to discuss how the action points have been / are being implemented

The same consultant can do no more than two reviews in a row before the

company uses a different reviewer

The consultant should sign off the statement that relates to the board review that

is included in the annual report

Additional services provided by the practitioner must be disclosed and

minimum periods of being offside must occur and be disclosed


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As long-term investors we want to

help companies be as good as they

can be. Therefore, we would like to

engage with the Chairman and/or

SID following a review to discussthe outcomes of the review for

the board and its committees and

processes, as well as what changes

have been made and the action

points to take forward.

WIDER BOARD IMPROVEMENT

Looking at this area naturally

dovetails our work on board

diversity (rst discussed in

Fundamentals in November 2011).In our view, a diverse board with

directors who can offer truly

fresh insights from a variety of

perspectives enhances debate

which in turn, improves decision

making. Board reviews can aid

companies with this.

We have been encouraged by

companies positive experiences,

particularly after initial scepticismof how valuable and worthwhile

an exercise it was for them

undertaking an external review.

Board reviews are an evolving

practice and LGIM will help in

trying to set up a code of conduct

in the near future. Board reviews

represent an opportunity to

improve the way a company

operates. However, active

ownership increasingly also looks

to help address potential threats to

long-term shareholder value.

CYBER SECURITY

Companies depend on

technology to improve efciency,

communication and management

of information to a greater extent

than ever before. Although

this can spur growth, the fast

pace of change has also led to

the emergence of new risks for

companies. These threats are hard

to measure, difcult to predict and

have a high element of uncertainty

due to the evolutionary nature

of technology. As businesses

recognise the importance of dataintelligence, the protection of

information becomes vital.

There are many denitions of

cyber security. At LGIM, we

believe the main focus is on

the protection of a companys

information assets. This is where

we believe companies should start

when examining this issue.

WHAT ARE THE TYPES OF RISKSCOMPANIES FACE?

There are a number of different

methods that can be employed

to create a cyber-attack and the

threat can come in a number

of different forms. We have

categorised these risks into ve

high impact areas. These risk

factors are key focus areas for

us as investors because it can

potentially destroy shareholder

value by negatively affecting

earnings or result in a company

losing its key intellectual property.

1. Data theft

Whether the data is customer

information, supplier details

or nancial, it is mostly stored

somewhere electronically.

Another example is intellectual

property. This may be in the form

of research and development

projects. Such information

enables a business to have a

competitive advantage above its

peers and therefore is essential to

creating value.

2. Day to day operations

A lot of companies use technology

in some shape or form every day

and any disruption will impact

operations with potentially severe

consequences. For example, in

the extractive industries, any

compromise to control systems

and processes will not only

impact production and nancial

performance but also the safety ofthe employees on the ground.

3. M&A and Tendering contracts

In these situations,cyber

attacks are often not designed

to be disruptive, but to gain an

advantage over a competitor,

often by obtaining access

to information regarding a

companys strategy. This may

include information regardingbidding prices and competing

for assets against competitors.

Having an insight into what their

opposition is doing can materially

strengthen a competitors

bargaining power during

negotiations. This could make a

difference between winning and

losing a contract.

4. ReputationalClearly, a breach of systems

raises security concerns on

the protection of customer

information. This impacts brand

loyalty and public trust, loss of

revenues and prots.

5. Insider threat

Information security behaviours

are greatly inuenced by an

individuals perception of risk.

Although it may be impossible to

completely eliminate an insider

threat, we believe boards and

management play an important

part in creating a culture within an

organisation that is cyber resilient.

Although some progress has

been made, it is still a concern

that only around half of FTSE 350

Chairmen think that their main

board has a clear understanding

of potential impact of information

and data asset losses1.

1FTSE 350 Cyber Governance Health Check tracker report, November 2013


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WHAT DOES LGIM WANT TO SEE?

As a long-term investor we believecompanies should take signicant

steps to protect their digital

infrastructure.

Identifying and monitoring

information assets: as this is a

strategic issue, we believe that

proper governance oversight

should be done at board level

and not seen solely as the

remit of IT or delegated to arisk committee (figure 3). There

should be sufcient resources

and regular reporting on the

top cyber risk priorities.

Audit and external recognition:

reassurance should be provided

that the risks are being managed

e.g. the UK governments Cyber

Essentials Scheme

Communication: the board

should communicate the

importance of managing cyber

risk to the whole company in

order to strengthen culture and

integrate protocols in to other

business functions e.g. sales,

marketing, nance, business

continuity

TAKING THE CYBER THREATSERIOUSLY

Cyber Security is a Tier 1 threat

to the UKs national interest

alongside acts of terrorism and

natural hazards. Signicant

progress has been made by

the UK government educating

businesses, raising awareness

amongst company directors,

co-ordinating different

institutions such as FCA and

the Bank of England to get

involved and nally developing

a set of standards called Cyber

Essentials which sets the barfor companies to have minimum

protections in place.

As investors, we welcome this

effort and believe the role of

government is essential for setting

the right infrastructure in place to

help companies. Boards need to

be aware of these threats when

making strategic decisions or

building processes to support thebusiness. However, in the long

term, businesses need to be more

self-sufcient. Cyber security

needs to be treated as any other

key risk a company faces in its

daily operations. As long-term

investors we will continue to ask

more questions in this area.

Source: FTSE 350 Cyber Governance Health Check tracker report, November 2013.Main board chairs and audit committee chairs were asked which corporate body orindividual hold principal responsibility for assessing and monitoring the impact and

likelihood of cyber threats to the company?

Figure 3. Who is responsible?

Figure 4. Top 5 Cyber Risks for companies

Main Board

Operating Board or Executive Committee

Audit Committee

Risk Board or Committee

IT or Security Committee

Chief Executive Officer

Chief Financial Officer

Chief Operating Officer

Chair of main Board

Head of IT

Head of Security

Other executive. Please specify.....

No corporate body or individual has this responsibility

I don't know

Not Applicable. Please explain...

0 5 10 15 20 25

Percentage of responses

(Total number of responses: 325)

Chairs Audit Committee Chairs

Data theft

Shareholder

value

Disruption to

operationsInsider Threat

Mergers and

Acquisitions

Reputation

and brand


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80

90

100

110

120

130

Sep 2013 Dec 2013 Mar 2014 Jun 2014 Sep 2014

Indexed

S&P 500 Nikkei 225Eurostoxx 50 FTSE All-ShareMSCI Emerging markets

Whilst most investors now

accept the likely divergencein central bank policy

between the US and the UK

from the rest of the world,

investors lacked a concrete

statement that could drive

sentiment in a definitive

direction over the month.

Wariness over the potential

pitfalls such as the Scottish

referendum and weaker

economic dataflow saw

markets move sideways with

government bond yields still

in a cushioned range due to

central bank rhetoric.

Market overview:

Stuck in limbo

Figure 1. Global equity markets

Source: Bloomberg L.P. chart shows price indexperformance in local currency terms

UK

Better together

US

Yellen holds firm

After months of ticking along

behind the scenes, the Scottish

referendum came into full focus

in September. Sterling weakened

as investors grew concerned

about the potential implications of

independence. Large businesses

based in Scotland added to

concern as they threatened to

move their headquarters should

a yes vote for independence

prevail. In the end, the centuries

old union remains intact and much

of the weakness has reversed.

However, there will undoubtedly

be longer-term repercussions as

promises were made to Scotland

for increased powers even in the

case of a no vote and other parts

of the UK are becoming morevocal about devolved powers

from Westminster.

The Federal Reserve has

continued to roll down its asset

purchases programme as the US

maintained good momentum

on the month. Going into the

latest FOMC meeting, Yellen

was expected to become more

explicit in dening the time period

between the end of QE and the

start of rate rises. However, Yellen

held her language steady and

the considerable time period

remains just as ambiguous,

which has helped the S&P 500

break through the 2,000 barrier.

However, there is an increasing

disparate of opinions within

the committee and the point at

which the Fed alters its rhetoric to

prepare markets for rate increaseslooms closer.


6/8


Figure 2. 10-year government bond yields

Source: Bloomberg L.P.

0

1

2

3

4

5

6

7

8

9

Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013 Mar 2014 Sep 2014

Yield/%

Germany US Italy Spain UK

FIXED INCOME

Rate rise still proving elusive

A much smaller than expected

number of banks utilised the

latest stimulus measure from

the European Central Bank (ECB)

targeted LTROs. European

banks only borrowed 82.6bn,

signicantly lower than market

expectations of around 400bn.

The low demand seemed

to raise hopes of even more

drastic initiatives from the ECB

such as outright quantitative

easing measures. It rekindledthe bad news is good news

driver of markets in Europe as

equity markets rallied when the

numbers were released. With

seven more LTRO sessions

planned between now and 2016,

the real impact is unlikely to be

visible for some time.

Whilst positive signs of a

gradual recovery emerge in

India, expectations for Russia

and Brazilian growth have been

revised down. The former is

due to knock-on effects from

the Ukraine crisis while the

latter reects weak growth in

the rst half and disappointing

capital expenditure. In China,

economic data have been weaker

over the last month, with a

meaningful drop in the growth

rate of investment and industrial

production. However, one month

of data cannot yet be counted as

a trend, and the policy support

and reform from earlier in the

year may yet gain momentum

later in 2014.

China disappoints

ASIA PACIFIC/EMEA

Predictably, markets have

reacted positively to the

European Central Banks

support via the LTRO liquidity

injection. Since ECBs

Draghis announcement, euro

denominated investment grade

corporate bonds have rallied,

notably outperforming US

dollar and sterling denominated

corporate bonds. Market

participants are becoming

more impatient about explicit

guidance on rate rises in the US

and the UK. When they do arrive,

it will have knock-on implications

for the entire xed income

market. In the meantime, factors

such as low default rates and

reasonable corporate balance

sheets should remain supportivefor investment grade bonds.

JAPAN

Looking through the short term

Japanese economic gures have

been weak in recent months,

but there was an encouraging

jump in Japanese wage growth

in July as contractual pay rose

at its fastest rate since 2007. As

the yen has experienced further

weakness, coupled with the

prospect for additional purchases

of domestic equities by pension

funds, equities have received

a considerable tailwind and

many investors have been able

to look though any short-term

disappointment. Indeed, even

after a 17% rise in equity prices

since the spring lows earlier in the

year, we believe that Japanese

stocks remain cheap compared toother developed markets.

EUROPE

Low pick-up in LTROs


7/8


Snapshot:

Yellens Dashboard

The US economy is making progress towards its maximum employment mandate, but the Fed is still

guiding that the rst rate hike will come a considerable time after asset purchases end in October. The Fed

continues to believe a range of labour market indicators suggest there remains signicant underutilization

of labour resources. These include measures of unemployment and underemployment, employment,

length of work week, wages, vacancies, hiring and quits, layoffs and consumer and business surveys. They

have been combined into one single indicator by the Fed staff. This was published in May for the rst time,

but no regular updates are available. Fortunately, the Kansas City Fed has produced a similar composite

indicator which tracks the Fed staff measure closely. Both these track momentum in the labour market

which is currently well above normal. In addition, the Kansas Fed captures the level of labour market slack.

Taken together, Figure 1suggests the labour market is warming up, but that there is some degree of slack

remaining. In recent speeches, Yellen has pointed to the number of part-time workers wishing to work full-

time and the lack of wage pressure as evidence for labour market slack.

Figure 2. On some metrics the US labour market already appears tight

Source: Macrobond

Figure 1. The Fed still sees considerable labour market slack

Source: Macrobond

1

2

3

4

5

6

7

01 02 03 04 05 06 07 08 09 10 11 12 13 14

Ratio

US labour market tightnesss

Unemployment divided by job openings

First rate hike in June 2004 to 1.25% from 1% and promise to

hike at a measured pace (25bp per meeting)

-50

-40

-30

-20

-10

0

10

20

-5

-4

-3

-2

-1

0

1

2

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

zero

=

long

run

average

zero=

long-run

average

Fed and Kansas labour market conditions indices

Kansas Fed LMCI momentum (LHS) Kansas Fed LMCI level (LHS) Fed staff LMCI (RHS)

We wish to highlight that recruitment difculties (both ofcial job openings and survey measures) have

risen sharply. When this is compared with the headline unemployment rate (Figure 2) the degree of slack

appears limited. In fact, in the last cycle when job openings had risen this much relative to the decline in

unemployment, the Fed had already began to raise interest rates.

Still, we accept the Fed is likely to be deliberately slow to raise rates because of the reduced policy space

near the zero bound. The costs of raising rates prematurely and being unable to cut sufciently to provide

stimulus outweighs the risks of being too late to tighten policy. So the FOMC will wait till the evidence of

labour market tightness becomes overwhelming. This means we are comfortable with the expected lift-of fpoint for the rst rate hike (mid-2015), but believe the pace of tightening will be faster than the glacial speed

(approximately one percentage point a year) assumed by the market.


8/8


These changes change nothing

UK forecast:

Source: Bloomberg L.P. and LGIM estimates

*Consensus forecasts are for end of Q2 2015

**End 2015 forecast

UK economy Price inflation(CPI)

GDP(growth)

10-yeargilt yields

Base rates $/ /

Market participants forecasts 2014

%

2015

%

2014

%

2015

%

2014

%

2015*

%

2014

%

2015*

%

2014 2015** 2014 2015**

High 2.00 2.60 3.40 3.70 3.20 4.16 0.75 2.00 1.75 1.80 0.81 0.83

Low 1.30 1.10 1.70 2.00 2.50 2.30 0.50 1.00 1.58 1.48 0.75 0.72

Median 1.70 1.85 3.05 2.60 2.80 3.38 0.50 1.25 1.65 1.62 0.78 0.77

Last month median 1.70 1.90 3.10 2.60 3.06 3.40 0.50 1.25 1.69 1.66 0.78 0.78

Legal & General Investment Management 1.60 1.70 3.00 2.60 2.95 3.50 0.75 1.50 n/a n/a n/a n/a

The Scottish referendum dominated the news agenda for much of September. From an economist perspective,

while the result removed a source of uncertainty, the news from the Ofce for National Statistics at the start of

the month was far more interesting.

The ONS revised its GDP gures for the year 2008 to 2012, adding around 0.5% per annum to GDP growth. This

may sound relatively little, but in a period where GDP growth was persistently weak, this makes a difference. As

a result, the 2008-9 recession looks less severe, and the recovery since then looks a little stronger, particularly as

the revisions were driven by business investment. Across this whole time period, the recession and recovery now

look a little more normal in an historical context.

The changes show that the productivity gap we have highlighted before is not as large as previously thought

in effect, the same number of workers actually produced more than initially thought, hence productivity was

also higher. The implications for monetary policy are mixed. Faster productivity growth suggests the economy

has a faster speed limit than before. But stronger GDP growth also explains why unemployment has fallen so

rapidly, so the BoE is likely to revise down its unemployment forecast as a result. Moreover, stronger productivity

growth suggests the UK has a higher neutral interest rate and therefore current interest rates are even more

accommodative.

We still believe that the Bank should hike rates in November or February. The counter argument to this view is thatheadline ination is likely to fall further below target, particularly given lower energy prices. However, the Bank of

England sets rates according to its forecast of ination in three years. If we look at 1999 and 2004, the Bank hiked

rates despite ination rates at the time being under target.

Furthermore, we still see a number of surveys and data series that point to a rate increase in the near future.

Chief among these is evidence of recruitment difculties. Historically, the Bank has increased rates when skills

shortages increase sharply as seen in 1999, 2003 and 2006. The market had shifted in recent weeks to price out

any chance of a rate increase until May next year. The Scottish result removed a potential downside short-term

threat to the UK economy, and market expectations of that rst increase have shifted a lit tle earlier in 2015. We

still think that this will prove to be too optimistic.

The forecasts above are taken from Bloomberg L.P. and represent the views of between 20 40 different market participants

(depending on the economic variable). The high and low gures shown above represent the highest/ lowest single forecast from

the sample. The median number takes the middle estimate from the entire sample.

For further information on Fundamentals, or for additional copies, please contact [email protected]

For all IFA enquiries or for additional copies, please call 0845 273 0008 or email [email protected]

For an electronic version of this newsletter and previous versions please go to our website

http://www.lgim.com/fundamentals

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