OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

Fundamentals:
Active ownership: driving the change

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.
In this edition of
Fundamentals,
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.

INSIDE:
Market overview:
Stuck in limbo
Snapshot:
Yellens
Dashboard
UK forecast:
These changes
change nothing

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 trust
and encourage rigorous debate between the
executives and non-executives. However,

the quality of the debate and interaction

inside companies is difficult 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 other
boards 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

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

Figure 1. Level of explanation of Board Evaluations

LEVEL OF EXPLANATION OF BOARD EVALUATIONS (THOSE GIVING MORE
DESCRIPTION OF PROCESS)

2013
80%

55% 63%
2012
73%

41% 52%
IS INFORMATION GIVEN ABOUT EVALUATION FINDINGS?

2013
32% 40%

56%

2012
FTSE 100

CREATING AN INDUSTRY CODE

OF PRACTICE
We believe that a code of practice
will provide an important
framework, ensuring that a
minimum standard of board
review is upheld and that
potential conflicts 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

30% 35% 44%

FTSE 350

02

Mid 250

Source: Grant Thornton Corporate Governance Review 2013

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 conflicts of interest
when practitioners organisations
offer additional professional
services. The aim should be to
improve company boards in the
interests of investors.
As a significant 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 PROGRESS
It 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). Companies
should provide a summary of
findings and an action plan to
address areas of improvements in
the annual report and accounts.

A code of practice is not about

creating a one-size-fits-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 companies
rather 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.

Figure 2. LGIM ideas for new code of practice

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 findings 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

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

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 discuss
the 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 (first 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 scepticism
of 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 efficiency,
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, difficult to predict and

have a high element of uncertainty
due to the evolutionary nature
of technology. As businesses
recognise the importance of data
intelligence, the protection of
information becomes vital.
There are many definitions 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 RISKS
COMPANIES 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 five
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 financial, 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

FTSE 350 Cyber Governance Health Check tracker report, November 2013

03

the extractive industries, any

compromise to control systems
and processes will not only
impact production and financial
performance but also the safety of
the 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 regarding
bidding 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. Reputational
Clearly, a breach of systems
raises security concerns on
the protection of customer
information. This impacts brand
loyalty and public trust, loss of
revenues and profits.
5. Insider threat
Information security behaviours
are greatly influenced 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.

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

04

TAKING THE CYBER THREAT

SERIOUSLY

Figure 3. Who is responsible?

Main Board

Cyber Security is a Tier 1 threat

to the UKs national interest
alongside acts of terrorism and
natural hazards. Significant
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 finally developing
a set of standards called Cyber
Essentials which sets the bar
for companies to have minimum
protections in place.

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
Chairs

Audit Committee Chairs

10

15

20

25

Percentage of responses
(Total number of responses: 325)

Source: FTSE 350 Cyber Governance Health Check tracker report, November 2013.
Main board chairs and audit committee chairs were asked which corporate body or
individual hold principal responsibility for assessing and monitoring the impact and
likelihood of cyber threats to the company?

WHAT DOES LGIM WANT TO SEE?

As a long-term investor we believe
companies should take significant
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 a
risk committee (figure 3). There
should be sufficient 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, finance, business
continuity

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 the
business. However, in the long
term, businesses need to be more
self-sufficient. 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.

Figure 4. Top 5 Cyber Risks for companies

Data theft

Disruption to

Insider Threat

operations

Shareholder
value

Reputation

Mergers and

and brand

Acquisitions

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

05

Market overview:
Stuck in limbo
UK

US

Better together

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 more
vocal 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 defining 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 increases
looms closer.

Figure 1. Global equity markets

130
120
Indexed

Whilst most investors now

accept the likely divergence
in 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.

110
100
90
80
Sep 2013

Dec 2013
S&P 500
Eurostoxx 50
MSCI Emerging markets

Mar 2014

Jun 2014

Sep 2014

Nikkei 225
FTSE All-Share

Source: Bloomberg L.P. chart shows price index

performance in local currency terms

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

EUROPE

Figure 2. 10-year government bond yields

9

Low pick-up in LTROs

JAPAN

Looking through the short term

Japanese economic figures 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 to
other developed markets.

8
7
Yield / %

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,
significantly 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 rekindled
the 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.

06

6
5
4
3
2
1
0
Sep 2011

Mar 2012
Germany

Sep 2012

Mar 2013

US

Italy

Sep 2013

Mar 2014
Spain

Sep 2014
UK

Source: Bloomberg L.P.

ASIA PACIFIC/EMEA

FIXED INCOME

China disappoints

Rate rise still proving elusive

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 reflects weak growth in
the first 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.

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 fixed income
market. In the meantime, factors
such as low default rates and
reasonable corporate balance
sheets should remain supportive
for investment grade bonds.

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

07

Snapshot:
Yellens Dashboard
The US economy is making progress towards its maximum employment mandate, but the Fed is still
guiding that the first 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 significant 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 first 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 1 suggests 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 fulltime and the lack of wage pressure as evidence for labour market slack.
Figure 1. The Fed still sees considerable labour market slack
20

10

-1

-10

-2

-20

-3

-30

-4

-40

-5

-50
92

93

94

95

96

97

98

99

00

01

02

Kansas Fed LMCI momentum (LHS)

03

04

05

06

07

08

09

Kansas Fed LMCI level (LHS)

10

11

12

13

zero = long run average

zero = long-run average

Fed and Kansas labour market conditions indices

2

14

Fed staff LMCI (RHS)

Source: Macrobond

We wish to highlight that recruitment difficulties (both official 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.
Figure 2. On some metrics the US labour market already appears tight
US labour market tightnesss

7
6
Ratio

5
First rate hike in June 2004 to 1.25% from 1% and promise to
hike at a measured pace (25bp per meeting)

4
3
2
1
01

02

03

04

05

06

07

08

09

10

11

12

13

14

Unemployment divided by job openings

Source: Macrobond

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 sufficiently 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-off
point for the first 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.

OCTOBER 2014

ECONOMIC AND INVESTMENT COMMENTARY

08

UK forecast:
These changes change nothing
UK economy

Price inflation
(CPI)

GDP
(growth)

10-year
gilt 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

Source: Bloomberg L.P. and LGIM estimates

*Consensus forecasts are for end of Q2 2015
**End 2015 forecast

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 Office for National Statistics at the start of
the month was far more interesting.
The ONS revised its GDP figures 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 that
headline inflation is likely to fall further below target, particularly given lower energy prices. However, the Bank of
England sets rates according to its forecast of inflation in three years. If we look at 1999 and 2004, the Bank hiked
rates despite inflation 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 difficulties. 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 first increase have shifted a little 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 2040 different market participants
(depending on the economic variable). The high and low figures 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 jennifer.daly@lgim.com
For all IFA enquiries or for additional copies, please call 0845 273 0008 or email cst@landg.com
For an electronic version of this newsletter and previous versions please go to our website
http://www.lgim.com/fundamentals
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