The Symbiosis of Institutional Investors and Activist Hedge Funds

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Second quarter 2016 has waxed brutally for hedge funds in the realm of regulatory compliance. The Securities and Exchange Commission (SEC) has called on investigative authority over hedge funds such as RD Legal Capital LLC and Platinum Partners LP for full disclosure of investment vehicles and practices. Of late, Visium Asset Management has joined the growing list of hedge funds flagged for insider-trading. The Wall Street Journal recently cited SEC’s Director Andrew Ceresney as stating hedge fund “Valuation [to be] one of the core issues.”

As we pointed out in our prior article Hedge Fund Performance and Regulation hedge funds historically had greater leeway in choosing how to value and categorize the portfolio’s underlying investments, drawing on the Securities Act of 1933’s Regulation D safe harbor rules. We also stated that regulatory compliance dictates from the SEC should remain constant, and not increase as hedge funds are above all performance driven. There is deep reasoning behind support for hedge funds, especially activist hedge funds, in the investment world – reasoning that laymen may not understand, but which focuses on the benefits institutional investors derive from seemingly mutually exclusive activist hedge fund activity.

Activist hedge funds exhibit corporate control activism, which according to L. Bebchuk, A.Brav, and W. Jiang, Harvard Law Review authors of The Long-Term Effects of Hedge Fund Activism, can be categorized via three strategies. First, as shareholders of a potential acquirer company, the strategy involves taking high stakes in a target company to ensure full acquisition over competition. Second, as shareholders of a potential target, hedge funds may use blocking strategies to benefit target shareholders. Third, hedge funds have themselves taken aggressive positions in a portfolio of companies solely in order to become activist, rather than diversifying and becoming involved when companies are exhibiting non-performance. Although not widely publicized, traditional institutional investors such as large pension and mutual funds engage in shareholder activism mainly through SEC Rule 14a-8, forcing inclusion of shareholder proposals in the proxy statements of vested public companies.

Marcel Kahan and Edward B. Rock of University of Pennsylvania Law Review do a superb job of explaining the constraints of institutional investor activism and the ensuing need for hedge fund activism via Hedge Funds in Corporate Governance and Corporate Control. We examine the most poignant points:

Pension Funds

  • Governance changes through shareholder proposals have largely been a practice of public pension funds due to the sheer asset size and scope. We have seen a surge of shareholder engagement from pension funds from 2015 to present, with the plunge in global economic and business climates. However, while proxy contests from pension funds aid in activism, the activism is more post-event reactive to company performance than pre-event business structuring. As the authors put it, pension funds traditionally handle only the “motherhood and apple pie issues” of shareholder engagement.
  • Pension funds have political constraints that inhibit an aggressively proactive approach to shareholder activism. Many pension fund trustees tend to overlap between private and public sector duties such as “gubernatorial appointees or elected politicians.” Such positions may lead to a bias towards political establishment dictates as opposed to actively working with company Boards to ensure optimal investment returns. The authors cite CalPERS as a prime example of such constraints, as historically the pension fund has held a strong pro-union position and has widely held union representatives on the Board.

Mutual Funds

  • Mutual Funds are generally retail investors.  The authors state that only TIAA-CREF has held what can be considered as an activist position in the industry. Mutual funds tend to take even a more passive position than pension funds in shareholder engagement.  Specifically, the necessary semiannual filing of all amounts and values of securities renders it difficult for mutual funds to take aggressive “pre-emptive strike” positions in a portfolio of companies.
  • SEC guidelines clearly stipulate the percentage of assets that all mutual funds can have in illiquid investments. In addition, mutual funds have requirements to redeem shares on short notice. These requirements put mutual funds in a passive shareholder engagement position.
  • Diversified mutual funds have major regulatory barriers and expenses that inhibit assertive activism. Unlike hedge funds, mutual funds for the most part do not charge performance based fees, and so depend on feed based on a fixed percentage of the of the mutual fund’s assets under management. Since activist investor proxy contests are costly, we find that most index mutual fund management would prefer to take a reactive position.
  • Most mutual funds have conflict of relationships due to affiliations with other non-activist financial institutions such as insurance companies and conservative pension funds. Many mutual funds have corporate pension plans as core business, and may not want to practice aggressive shareholder activism so as to not jeopardize client preferences.

Shareholder proposals from both pension and mutual funds are more a corporate governance wish list from shareholders, and fall more under the category of broad shareholder engagement than the activism partaken by activist hedge funds. Mutual and pension funds do not use the leverage that activist hedge funds employ to take the necessary positions for pre-emptive strikes to change company financial and operating structures.  As the authors rightly state, “hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position and become active.”  Hedge funds have become almost synonymous with activism. However, Kahan and Rock point out that only US$50 billion of the US$3 trillion global hedge fund assets under management are structured for shareholder activism. The point being that hedge funds are not solely formed to be activist investors. Yet, the small number of hedge funds that are activists truly pack a punch in active corporate governance.

The Columbia Law School’s Blue Sky blog’s article, Hedge Fund Activism: A Guide for the Perplexed has a bit of a mixed review when it comes to the activist hedge fund outlook. While there is an acknowledgement of activist hedge fund influence on company performance, the article takes an almost tongue in cheek approach to the effectiveness of activism, stating that  “institutional investors and knee-jerk academics…both believe that activists are doing the Lord’s work” as the champion of shareholder engagement, but in actuality hedge funds are by and large self-interested. From the points offered by Kathan and Rock on the limits of institutional investors to actively engage in pre-emptive structuring of companies to bolster shareholder interests, the industry must avow to the need for activist hedge fund activity, whether the motives are self-interested or otherwise. Regulatory dictates of the hedge fund industry may bring about transparency in valuations and curb insider-trading in the short term, which can be beneficial. However, a plethora of punitive regulatory barriers can seriously hinder effective shareholder engagement and corporate governance that may only be achieved through hedge fund activism.

REFERENCES

  • Bebchuk et al. 2015. “The Long Term Effects of Hedge Fund Activism.” Harvard Business Law Discussion Paper. Columbia Law Review. Pages 1064 – 1154.
  • Coffee, John C. Jr. 2016. “Hedge Fund Activism: A Guide for the Perplexed.”  The Columbia Law School Blue Sky Blog.
  • Copeland, Rob et al. 2016. “Scrutiny of Funds Grows.” The Wall Street Journal. Print Edition.
  • Kahan, Marcel, et al. 2007. “Hedge Funds in Corporate Governance and Corporate Control.”  University of Pennsylvania Law Review. Pages 1029 – 1069.

 

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Emerging Economies – Black Holes or Treasure Troves?

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Diamonds South Africa

It is often said that there is no gain without risk. The greater the risk, the greater the potential gain; and the greater the potential gain, the greater the potential risk. Investors look to emerging economies because the potential for gain is great; but at the same time, the potential risk is great. Until just recently, the investment world looked to the BRICS group of emerging markets to produce much of the growth for the world economy, and these five emerging markets played every-increasing political roles in the world due to their growing economic clout.

A look at Brazil, the “B” of the BRICS group, gives rise to concern. President Dilma Roussef just lost an impeachment vote against her, and this shows just how far Brazil’s current government has fallen in recent years. Since she took office, President Roussef has faced a host of problems, many of which are the direct result of her and her party’s leadership. The largest of these problems is corruption, which has been the undoing of many regimes in Brazil. Now, the massive Petrobras scandal has destroyed the credibility of the government and, in particular, of President Roussef. The scandal has created a loss of confidence in the Brazilian economy, plunging the nation into a recession, one of the worst in Brazil’s recent history. Shortly before, Brazil believed it was positioned for a long period of China-like rates of economic growth, allowing the country to play a dominant role in Latin America and giving it a major voice on the world stage. Instead, thanks in large part to President Rousseff’s government’s lackluster performance and corruption, Brazil has fallen further behind most of the world’s other leading powers in political power and economic development. Rousseff appears to be on the way out. Last weekend, the lower house of Brazil’s parliament voted in favor of launching impeachment proceedings against her, easily exceeding the two-thirds’ majority required to do so. This motion will now go to the Brazilian Senate, which is expected to suspend President Rousseff for the duration of the trial, and then to sit in trial over her next month. President Rousseff has countered by accusing her political opposition of staging a coup.

India and China continue to meet expectations, despite China’s recent slowdown and India’s struggle with internal divisions; and Russia continues to play a greater role in many of the leading political and security issues facing the world today, despite its recent economic woes. However, the woes of Brazil and South Africa show that they have undoubtedly failed live up to expectations on the political and economic fronts in recent years. For both countries, much of the blame lies with their political leadership, which has led both countries astray. Unfortunately, this poor political leadership has caused great harm to both countries and could result in long-term loss of power and influence.

South Africa, the smallest of the BRICS – and the least qualified for membership in such a group – has been backsliding in recent years. This is due largely to the disastrous leadership of President Jacob Zuma and the deep divisions that have emerged in that country’s dominant political party, the African National Congress (ANC). Of course, low natural resource prices have severely hurt the South African economy. However, the current government there has failed to take the steps needed to diversify the country’s economy away from its dependence upon natural resource exports, and instead has rolled back many of the programs that had been enacted by its predecessors. Meanwhile, President Zuma also has faced a number of corruption scandals in recent years that have weakened his ability to govern South Africa. As a result of these economic struggles and corruption scandals, South Africa has found it more difficult to play the leading role in Sub-Saharan Africa that it has sought to do since the end of apartheid.

The problems facing Brazil and South Africa are clear examples of how poor governance (corrupt governance that does not understand the market economy) can squander massive economic and resource advantages. Brazil and South Africa are both incredibly rich in natural resources. In Brazil, President Rousseff’s disastrous leadership has caused Brazil’s failure to take advantage of its huge resource and demographic advantages that are in many ways similar to that of other large “New World” economies. Meanwhile, although South Africa has great resource and infrastructure advantages over many of its emerging market rivals, President Zuma’s numerous missteps are squandering these advantages. As a result, South Africa is losing political clout in its region, while its economic lead over its neighbors is shrinking. While both presidents are nearing the end of their reigns, both countries have the opportunity to elect more capable leaders. Nevertheless, the opportunities wasted by both countries could have long-term consequences, both within their borders and across their respective regions.

So, what is the interested investor to do? An investor may park his or her funds in more predictable economies, minimizing the investment risk. Alternatively, the investor can perform thorough research and invest carefully in the BRICS, being careful to hedge the bets. Some investors, instead of investing in companies in these countries, invest directly, creating industry in those countries. That can have a high degree of risk, but also a very high level of reward. The BRICS are like diamonds in the rough – indistinguishable to the untrained eye from clear quartz.

Image credit: http://static.rappler.com/images/Diamonds%20South%20Africa%20hands%20AFP.jpg

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Financial Impacts of Foreign Events

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Events around the world have an impact on financial policy, investment strategy, trade and commerce, and each of these has an impact on the others. It is time to do another review of global events and their financial impact. This article contains both analysis and my own editorial opinion. It does not necessarily reflect the opinions of whoever publishes it.

One issue that has attracted a great deal of interest in news reports is the issue of internal and external security threats to Europe. Much of this has to do with the mass immigration of refugees from the tumult in the Middle East, and Islamist Jihadist extremists in their midst. However, in my opinion, the greatest threat at present is the deepening fragmentation within Europe of public opinion camps – and policymaking camps – over policies and policy-making of the European Union. Three factors are influencing this: the rising power of Germany within the EU; the apparent inability of the regions minorities – and particularly the recently-arrived Islamic minorities – to integrate into European society; and the threat of terrorism, largely from Islamist Jihadist cells within the immigrant population. These threaten to stall the region’s efforts at greater integration and enhanced common security. External factors that are affecting this are: the collapse of previously stable states in North Africa and the Middle East into failed states; the retreat of the United States from the world stage, both militarily and from its historic leadership role; and the resurgence of Russian State military ambitions and its apparent efforts to resume the empire-building of Peter the Great. Middle Eastern events have produced the flood of refugees that provides internal instability; the retreat of the United States leads to increased instability world-wide, and a fragmented Europe has difficulty in dealing with this without US leadership; and Russia provides threats to the eastern frontiers of Europe. Unfortunately, all of these factors are likely to intensify in the near future rather than to wane.

Europe is beset by some of its most serious threats internally since the collapse of the Soviet Union. The European Union has failed to achieve the unity of purpose and policy needed to handle the complex issues it faces. National policies tend to take precedent over pan-European issues in the stronger European countries. Economic uncertainties and failures have awoken the struggles between left and right that had remained largely submerged when Europe was facing the threat of Soviet invasion. Ethnic and religious minorities that remained relatively quiet during the Cold War are now asserting themselves, in large part either in opposition to, or emboldened by, the influx of Muslims. This threatens to balkanize Europe politically, even as national boundaries and states remain as they were. High levels of joblessness and financial insecurity among many of these minority populations produce demands that the State “do something.” Germany, Sweden, Greece, France, Italy, and Belgium are particularly affected by this. Recent terrorist attacks in France and Belgium have highlighted the problems resulting from uncontrolled immigration and the failure to screen out dangerous immigrants from those simply seeking a better life.

Externally, the situation is worsening as well. The unprecedented period of peace along the eastern periphery that followed the ending of the wars in the former Yugoslavia enabled Europe and the European nations to focus on internal issues, downsize their militaries, and further subsidize and adjust their social subsidies. The resulting decrease in levels of military, security and intelligence activity paved the way not only for internal attacks by terrorists but for Russia’s expansionist imperialism. When Europe needs her most, the United States is “leading from behind,” which means not leading. There are even calls by US politicians to reconsider whether NATO is even useful.

Internal and external political and security risks to Europe and its nations are at their highest levels in decades, and rising. The resulting instability depresses legitimate trade, encourages smuggling, increases illegal arms trade and distribution, and produces demands on central banks to “do something.” From the standpoint of central banks, there is little that can be done financially without cooperation from the political sphere. Trade and commerce need these things in order to prosper: the rule of law; stable currency; lack of barriers to trade; low levels of regulation; societal security and prosperity; and government policy that aids all of these. These things can be summed up as small government, economic freedom, and stable currency. Many politicians (and their followers), however, are headed left, which will only make the situation worse. A central bank can only do so much. All it can do is to stabilize its currency. This causes profligate governments to fail financially, and leftist politicians don’t like that. A resurgence of capitalism is needed, and the world needs the US to lead that resurgence.

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Hedge Fund Performance and Regulation

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The hedge fund industry has taken quite a hit over the past year, leaving institutional investors fairly disappointed with ROI expectations. Preqin, the industry’s leading investment analytics company cited its 2015’s aggregate 2.02% return as the worst since 2011. Preqin further reported that 44% of fund managers reported failure to meet return objectives. The hedge fund industry is no lightweight; globally the industry accounts for over USD3 trillion assets under management. Poor hedge fund performance is a strong indicator of how unstable the overall financial system has become, even though the industry is not considered a market maker. Both large and boutique hedge funds that pursued single strategy objectives bore the brunt of poor performance. Hedge funds that focused on equity, macroeconomic, managed futures and relative value strategies had the most fund closures for last quarter 2015. Funds with multi-strategy, event-driven strategies and credit strategies had the best overall performance, and a larger number of fund launches. On a positive note, the entire industry saw an increased transfer of capital flows from family offices and high-net-worth individuals in 2015. Evidently, private wealth investors have waning confidence in public capital markets.

Key-Drivers-Hedge
Table 1: Key Drivers of the Hedge Fund Industry. Source: Preqin Hedge Fund Manager Outlook 2016.

While performance and handling market volatility are key drivers for the overall 2016 hedge fund outlook, Preqin cites the number one concern among hedge fund managers to be transparency and risk management, with the need to adapt to new regulations. Hedge funds face conflicting tasks of handling increased costs of improved business infrastructure, while remaining cost competitive with investor fees, in the face of industry regulation. In October 2015 the Securities and Exchange Commission (SEC) found via spot checks that certain hedge fund managers were breaching fiduciary relationships with investors. Fund managers were found to be personally profiting from trades before executing trading strategies, while shrouding performance numbers in performance reports. The SEC has promised further compliance enforcement for private equity and alternative investment firms in 2016, and now mandates hedge funds to provide strict standard data upon registration with the SEC. All private equity funds and investment advisers must file Form ADV to provide fund size and organization structure with the SEC. Funds with at least USD150 million assets under management (AUM) must file an annual Form PF to update leverage, liquidity and investment criteria, and investment fees. The SEC posts all aggregate private equity data derived from reporting publicly, thus satisfying Section 404 of the Dodd-Frank Act’s financial and risk reporting requirements.

Historically, hedge funds needed to meet only Section 4(2) of the Securities Act of 1933 and specifically, the Regulation D safe harbor rules. Hedge funds need to especially adhere to Rule 502, which prohibited general advertising through media and meetings; Rule 505, which exempts offering registration of USD5 million or less, and requires no more than 35 non-accredited investors to be vested in the fund; Rule 506, which allows the hedge fund to offer an unlimited amount of interests to investors. In addition, hedge funds need to file a state-specific “blue sky” filing with the SEC 15 days from the date of an investment into the fund. Under SEC Rule 12(g-1) hedge funds did not have to submit frequent reporting if the fund had less than 500 accredited and non-accredited investors. Hedge funds have been very vigilant in following exemption requirements to avoid over reporting and registration.

Columbia Law School professors Wulf Kaal and Dale Osterle pinpoint why hedge funds have been subjected to further regulation in their blog article, The History of Hedge Fund Regulation in the United States. Long Term Capital Management’s 1998 failure put hedge funds at the forefront of regulation. Prior to LTCM’s bailout by the New York Federal Reserve Bank, hedge funds were not considered as main influencers of systematic risk. However, the SEC began inquiries to regulate transparency and quantify reporting data in the alternative asset management industry. Kaal and Osterle cite the SEC’s failure to achieve all hedge fund registration in 2006’s Goldstein v. SEC case, by which hedge funds were able to deregister and return to the original registration exemptions under the Securities Act of 1933. However, as Kaal and Osterle explain, Title IV of the Dodd-Frank Act finally allowed the SEC to enforce stricture hedge fund regulation, and mandated that the SEC create and enforce rules requiring investment advisors, private equity and asset management firms to complete registration and annual data reporting. Data must include planned strategy disclosure; all risk analytics, credit limits, fund manager positions, and leverage figures must be included as quantifiable metrics.

Fund managers will have a veritable balancing act for the entire fiscal 2016 with continued regulation, and a call for further transparency within the extremely performance driven alternative asset management industry. While hedge funds may not be systematic drivers of the global financial economy in comparison to big banks, the industry’s USD3.2 trillion size is no laughing matter. In addition, sovereign wealth funds are significant players in funding emerging market debt, as we have seen recently with Argentina’s bond debt settlements. While continued regulation is necessary for transparency, fund managers need to have adequate reign in focusing on fund performance, especially in such a volatile macroeconomic system. Fund managers have taken it upon themselves to focus on risk and transparency. Thus, we expect that current data reporting based on Title IV of the Dodd-Frank Act continue with no additional punitive requirements, so as to give hedge funds room for performance improvement in 2016.

REFERENCES

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The World In a (Cracked) Nutshell: Things Happen

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Picture used with permission from William Reid of www.northernpecans.blogspot.com

Investors and people in the business world need to be aware of world events and the impact they have on their business outcomes. Recent events of which we should all be aware are:

  • The Russian-Turkish Rivalry
  • The Apparent Steadying of the European Economy
  • The Death of Supreme Court Justice Antonin Scalia
  • Prison Riot in Mexico City
  • The Northwards Spread of the Vika Virus
  • Trade Dispute between Russia and Ukraine
  • Rapid Changes in the Syrian Civil War
  • Economic, Security and Political Developments in Central Africa
  • Growing Civilian Casualties in Afghanistan
  • The Weakening of the Indian Rupee
  • Growing Stresses between North and South Korea
  • Poor Performance of Japan’s Economy
  • The Persistent Decline of Oil and Gas Prices
  • American Political Chaos

Some of these are of more concern to some of us than others – it all depends on the nature of our investments and business interests. Let’s look at these and their impacts. It is through politics that events will have their greatest impact on business and investment clients.

American Political Chaos

American politics is becoming increasingly chaotic because fewer and fewer people identify with either of the two, dominant political parties, but are now “independents.” These “Independents,” however, cover the entire spectrum of politics from far right to far left. In my neighborhood alone, which is majority Democrat by voter registration, I know voters who are not affiliated with either the Democratic Party nor with the Republican Party who have not registered as members of a party because (1) the Republican party is too far to the left for them; (2) the Democratic Party is too far to the right for them; (3) The Republican Party is too far to the right and the Democratic Party is too far to the Left; (4) the Republican party and the Democratic Party are both too far to the right; and (5) The Republican Party and the Democratic Party are both too far to the left. Many of these “Independents” are not registered to vote at all, because they don’t think they should have to declare their party preferences when registering. At the same time, they say they are angry because they have no voice in the selection of candidates. Many of the Independents, many of the Republicans, and Many of the Democrats are angry at both major parties, are angry at the government in Washington because they feel it does not represent them or serve their interests, and so they’re “Mad as Hell and aren’t going to take it any more.”

This has resulted in a primary campaign in which the front-runner in the Republican Party is an outsider to the political process, Donald Trump, who, until recently, was a Democrat and espoused Liberal positions, but who now has the backing of a large swath of the conservative Republican voters. On the Democrat side, the establishment candidate, Hillary Clinton, has the vast majority of convention delegates so far but is running neck and neck with “Democratic Socialist” Bernie Sanders, who is supported by the leftists in the party and the young voters in the party. For much of his political career, Bernie Sanders was a card-carrying official of the Trotskyite Marxist (with overtones of Maoism) Socialist Workers’ Party, but he then became a Democrat and proclaims himself a “Democratic Socialist.” It seems that the younger generation of voters has given up on capitalism, thinks Socialism is the most equitable economic system, and hates banks and big business. We will not know for sure how the Independents will vote until the November elections, but it is not impossible that the election will be between Trump and Sanders.

How does this affect investment and business? If Sanders wins, but the House and Senate remain Republican-controlled, there will likely be a standoff between the White House and Congress and the government will do very little. This means that business can proceed to do its own thing, and investors can invest without fearing a change in the regulatory environment. If Trump wins, and Republicans retain control of the House and Senate, there is likely to be a reform of regulation to promote business and investment. In either case, investors and businesses will likely not suffer at the hands of the US government, despite the present political chaos in America.

The death of Justice Scalia foretells a standoff in the Supreme Court, now evenly divided between liberals and conservatives. Republicans in the Senate seem poised to prevent President Obama from being able to appoint a successor to Scalia, saving the seat to be filled by an appointee of the next president.

In Mexico prison riots were sparked by battles between the Zetas cartel and the Gulf Cartel. The resulting fires spread to a number of areas of the prison. 49 people were killed. Conditions in other prisons in Mexico’s overpopulated prison system threaten to spark more unrest. The inability of the Mexican federal and state governments to reduce the influence and control of drug gangs over broad swaths of territory causes increasing concern. Continuing flows of migrants from south of Mexico through Mexico into the United States continue to raise flags, particularly political flags, in the US, where Republican candidates pledge to stop illegal immigration and Democrat candidates pledge to legalize it.

Middle East (West Asia)

Tensions between Turkey, which seeks the ouster of the regime in Syria, and Russia, which is actively supporting the regime with a military presence and military action in Syria, remain one of the major flashpoints in the world and the one flashpoint that could bring two nations to war with each other. Syria has already shot down a Russian jet that strayed over Turkish territory (but they shot it down over Syria). For the immediate future, Syria will remain the front line between Turkey and Russia.

Russia has desired for centuries to establish control over the Bosporus, which has been under Turkish control since the Turkish Sultan conquered Constantinople and renamed it Istanbul. Turkey has the ability to close the strait and keep a significant Russian fleet bottled up in the Black Sea. Turkey and Russia have fought wars against each other periodically for the past 300 years. The current tensions between Turkey and Syria are much deeper than just the issues involving Syria, but are not likely to provoke a conflict. If they come into conflict over Syria, however, each might take advantage of that to try to make gains in the Black Sea and Baltic areas. Russia’s entry into the Syrian conflict seems to have taken Turkey (and a number of other interested countries) by surprise. We all seem to have forgotten that nature abhors a (power) vacuum – and that when one exists, someone will fill it. Turkey has a number of potential conflicts along its borders other than Syria. Within its borders is ISIS, definitively an enemy of the regime. The Kurds in northeastern Syria and northern Iraq are seen by the Turks as enemies. Refugees streaming across Turkish borders from Syria and Iraq are a problem for Turkey if Europe will not let them go from Turkey into Europe. Because of the myriad crises along Turkey’s borders, Turkey is not in a strong position to intervene decisively in the Syrian conflict. Russia is likely to bog down in Syria, finding itself unable to withdraw without its withdrawal causing the collapse of the Assad regime. If other Middle Eastern States start to take an active role in Syria, the conflict could widen dramatically. Jordan, Saudi Arabia, Egypt and Israel are all affected by the Syrian Crisis and might be tempted to take an active role. Russia and the US have agreed to a cease fire, but must convince the various rebel and Islamist groups in Syria, and the other interested parties, to engage in a cease fire for it to become real. If a cease fire is not achievable, an active conflict between Russia and Turkey, or between either and other states in the Middle East, could have profound impact on investors and businesses around the world.

The agreement reached last week by Saudi Arabia, Russia, Venezuela and Qatar to freeze oil production at current levels helps to prevent further declines in oil prices, but will not reverse the trend because the current global oversupply in oil is partly the result of those levels of oil production. Of course, the dramatic increase in American oil production is also a significant contributor to global oil price declines, but the “free market” in the US will cure that factor by causing a reduction in US oil production. Oil drilling in the US is now dramatically reduced, with fewer than 10% as many rigs operating now compared with a year ago. While oil will remain at low levels until the surplus of stored oil is absorbed, eventually the market will right itself. In the mean time, there may be buying opportunities for investors interested in buying shares of companies whose share prices are depressed below the real value of the companies. It is also an opportunity for oil speculators who are positioned to buy oil and hold it until prices recover. This will have the effect of removing oil from the market and hastening the recovery of the oil market.

South America

The Venezuelan opposition is stepping up its efforts to oust President Nicolas Maduro from office. Possible conflict between the opposition and Maduro’s supporters could impact oil production in this important contributor to the world’s supply of oil. Until recently, it was difficult to determine the state of Venezuela’s economy because Venezuela has no independent official statistical agencies, but it is clear that Venezuela’s Socialist economy is in full collapse, having shrunk by 10% this year alone with inflation threatening to reach 700%.

Argentina, similarly, has been a significant unknown, with the official statistical agencies controlled by allies of the previous Argentinian government, skewing the results of their analysis to support the positions of the previous government. Now that President Mauricio Macri has taken office, he has moved to restore the independence of these statistical agencies. This has led to statistics that reveal the true inflation afflicting the Argentinian economy.

Bolivians are voting in a referendum on lifting term limits for the Bolivian presidency, which could risk the rise of a Marxist dictatorship in that country.

In the midst of all of this the Zika outbreak is moving northward. However, the fear of microcephaly may be overblown, because not all areas infected with Zika have similar rates of microcephaly. Scientists suspect that the combination of the Zika virus with certain insecticides used in certain areas may be causing local epidemics of microcephaly.

Central and South Asia

In Afghanistan, civilian casualties are continuing to rise even as Afghan forces, led by US Special Operations forces make gains against the Taliban and ISIS in Afghanistan. The level of civilian deaths was the same in 2015 as in 2014, but the level of civilians injured was the highest since civilian casualty records began in 2009. The Afghan government says that in areas of fighting, an increasing number of civilians is choosing to flee their homes, and that both death and casualty levels would be higher if they had not “chosen” to do so. This could affect the economies of other nations if the current conflict spreads into Pakistan.

In India, the Rupee is weakening, despite having been a much stronger currency than many of its emerging market rivals over the past two years. Last week, the Rupee approached an all-time low against the US dollar. The drop in the Rupee seems to be the result of falling levels of investor confidence in the global economy, as well as a response to some troubling economic data that emerged recently in India. India’s economy may continue to slow in the first quarter of the year, providing risky buying opportunity for adventurous investors.

East Asia and Pacific

Increasing tensions between North and South Korea, bolstered by the largest joint military and naval exercise by South Korean and US forces, give rise to concern. In the South China Sea, rising tensions between the conflicting territorial claims of the nations bordering that sea are primarily due to the expansive claims by China over virtually the entire sea. China has been building islands on which it places military-capable runways in the middle of the South China Sea, in order to bolster (and defend) its territorial claims. This risks increasing nationalism on the part of Japan, the Philippines, and South Korea, all of which are increasing their investments in their military forces, in particular in their navies. While actual conflict appears only a remote possibility, the increasing militarization gives rise to concern. Here again, is the operation of the vacuum principle. In the face of military weakness on the part of the United States, local powers are seeking to fill the power vacuum. In the meantime, Japan’s economy continues to struggle to generate growth. In the fourth quarter of 2014, it expanded just 0.5%, but shrank by 0.4% in comparison with the fourth quarter of the previous year. Domestic factors were the largest reasons for the poor performance of the economy. The real estate sector remained weak and consumer spending levels were disappointing. Export markets remained weak in the face of weak external demand. This places more pressure on Prime Minister Shinzo Abe to undertake more stimulus measures. While there may be buying opportunities in Japanese shares, it may be some time before they recover value. The Chinese Yuan will remain highly visible. Despite concerns over China’s economy, the Yuan is stronger than most of its emerging market rivals. This encourages Chinese companies to outsource rather than to build new capacity in China, which further stalls the Chinese economy.

Africa

Boco Haram, Al Qaeda, ISIS and affiliated groups in Africa continue to provide a source of political and economic instability. Nigeria faces significant economic and security problems. After taking office last year, President Muhammadu Buhari has taken significant steps to revive Nigeria’s economic and political stability, and to reduce the levels of unrest and corruption. Oil prices have fallen dramatically, which has harmed the oil-dependent national economy and dramatically reduced government revenues. Although Nigeria has mounted a strong military campaign against Boko Haram in the northeast, this has failed so far to bring an end to the Boko Haram threat to Nigeria.

The Central African Republic recently underwent the second round of voting in its presidential election. This round pitted former CAR prime ministers Faustin Touadera and Anicet Dologuele against one another. Both candidates promise to bring peace and stability to the republic and to restore the economy, but their ability to do so in the face of the Boco Haram regional threat is questionable. Boko Haram has mounted attacks in a number of central and western African countries, making foreign investment keep its distance.

In northern Africa, the failed nation-state of Libya dominates the area by spreading instability, terrorism and uncertainty. Libyan oil, once a significant supplier of Europe’s fuel needs, flows only intermittently, with ports often controlled by terrorists. No solution for Libya in particular (and northern Africa in general) appears in the offing. Egypt is taking a stronger role, but likely lacks the ability to exert power to bring ISIS and related groups in northern Africa to heel, despite having largely quelled the Muslim Brotherhood within its own borders. Islamist extremism is still strong in Egypt, and stronger in pockets of northern Africa like Libya. This is unlikely to change in the absence of any likelihood of a defeat for ISIS in the near future in Syria and Iraq.

Europe

We look at Europe last, because Europe is on the receiving end of the consequences of what is going on elsewhere in the world. The United States is as well, but it is a player of little influence as long as it tries to “lead from behind” and so it is a contributor to the instabilities that are impacting the Europeans rather than simply being a recipient of their consequences.

A major trade spat has developed between Russia and Ukraine. Two weeks ago, Russia prevented more than 150 trucks from Ukraine from travelling through Russia on their way to Kazakhstan. The Ukrainian government responded by banning Russian trucks from crossing Ukraine on their way to other countries. Economic ties between Russia and Ukraine have become significantly worse since the free trade deal between Ukraine and Europe took effect last month.

Despite the troubles between Russia and Ukraine, the economies of Central Europe in general have continued to grow, driven by high domestic demand and growing demand for exports from Central Europe in West Europe. Poland, the regions largest economy, grew by 3.6% year-on-year in the fourth quarter, continuing its impressive rates of economic growth. Hungary Slovakia and Romania also experienced impressive rates of growth in the fourth quarter, thanks to those countries strong manufacturing sectors. Poland has backed Ukraine in its recent trade dispute with Russia, which could inflame tensions between Poland and Russia.

The European economy in general remains stable. It is not known how it will respond to a possible (but unlikely) withdrawal from the European Union by the United Kingdom. What is more likely is a weakening of the voice of Europe in British affairs. All in all, we can expect a steadier European economy. The domino-effect crises that have occurred over the last six years have dominated the picture, ranging from the Greek economic collapse to the struggles of all the southern European economies. Despite the continuing problems in Greece, most of the news out of Europe over the past year has concentrated on the region’s slow and steady recovery from the struggles. Although the results from Europe have been unspectacular, they are much better than previous years and give the impression of steadiness, if not growth. The four largest economies outside of Eastern Europe grew by between 1% and 2% on a year-on-year basis, ranging from 1% in Italy (a good performance compared with recent history) to 1.9% in Britain. Countries that have taken steps to boost competitiveness (Spain and Eastern Europe) show growth rates in excess of 3%. This news is dampened somewhat by the fact that Greece and Finland remain in recession that are likely to continue in 2016. Overall growth in the European Union in 2015 was 1.8%, a better performance than in recent years. The British “motto” of World War II comes to mine: “Keep calm and carry on.”

Summary

So, we have just described the State of the World in a nutshell – a cracked nutshell. Nuts in cracked nutshells can leak crumbs out, reducing the size of the nut, and the nut itself is more likely to spoil. Our nations’ leaders need to concentrating on un-cracking the nut rather than on saving the contents, because they can’t save the contents while the nut remains cracked. Without global security (a coherent nutshell), the global economy itself cracks up. While there will always be trouble spots in the world, the task of the world’s leaders is to keep them contained so they don’t spread. In the absence of American exercise of power, the wildfires are spreading rapidly, and the global economy threatens to crack up along with the nutshell. Many are the times I have cracked the kernel of a walnut when attempting to crack only the shell and extract the kernel whole. It is time to restore security to broad swaths of the world, and there is no one capable of doing it but the United States. If we do not do it, we will suffer along with the rest of the world.

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