Research Watch July 20

Hyperinflation, Rio's Spain pain, cops and bankers, and remembering Barton Biggs.

PORTFOLIO POINT: This is a sampling of this week'€™s best research notes. In a world of too much information, we hope our selection helps you spot the market'€™s key signals.

In a slowing global economy, hyperinflation isn'€™t a word you hear a lot. But this week, researchers at UBS warn that fears about deflation, and the policies used to tackle it, are precisely what caused almost every one of the 28 episodes of hyperinflation in the last century (they’re more common than you might think). Unfortunately for investors, there are some eery similarities to the situation that the West faces today. Meanwhile, two hedge fund titans battle it out over whether markets are under- or over-priced: Bridgewater'€™s Ray Dalio thinks investors have become too pessimistic, while Hugh Hendry warns more '€œbad things are going to happen'. JPMorgan spots an interesting reverse correlation in Rio'€™s stock price, which suggests Europe is more of a concern than China. And the Reserve Bank highlights just how expensive Australian banks are, as Citigroup looks offshore for better financial bargains. Researchers pit monkeys against fund managers, The New York Times uncovers dirty hedge fund secrets, and Iceland hires a police detective to bust the nation's economic criminals. On video, we remember Wall Street legend Barton Biggs.

The hyperinflation risk...

€œNeither the government deficits of many large countries nor the speed of the current global monetary policy expansion are sustainable. If government finances do not improve and the global monetary policy expansion is not halted in time, hyperinflation could set in. However, it is not clear how much fiscal and monetary policy can expand before a loss of confidence in paper money sets in. Bernholz notes that preceding a case of hyperinflation, government deficits usually amount to more than 20% of government expenditures, and that deficits amounting to 40% or more of government expenditures clearly cannot be maintained. Of the Top 10 deficit countries, India, the US, Japan, Spain and the UK all exhibit government net borrowing above 20% of government expenditures. However, Spain does not have its own currency and therefore cannot trigger hyperinflation on its own. The government net borrowing of the Eurozone as a whole amounts to only 11% of total government expenditures. The euro is therefore not a prime candidate for hyperinflation, as long as the core countries do not leave the currency union. Although India is one of the Top 10 deficit countries, an outbreak of hyperinflation there would be of relatively minor concern to the global investor.... We think that a creditor nation [like Japan] is less at risk of hyperinflation than a debtor nation, as a debtor nation relies not only on the confidence of domestic creditors, but also of foreign creditors. We therefore think that the hyperinflation risk to global investors is largest in the US and the UK. The more the fiscal situation deteriorates and the more central banks debase their currencies, the higher the risk of a loss of confidence in the future purchasing power of money. (Caesar Lack of UBS via Zero Hedge, July 18)

A decade of disaster?... €œThe fat tail possibility that Europe’s deleveraging will become disorderly must be considered a real possibility that would be significantly bullish for bonds. However, markets are now pricing in low growth and continued deleveraging for an extended period of time. This shift from pricing in a normal recovery to a deleveraging makes sense to us; however, what is priced in now suggests a low probability that even in 10 years much progress will have been made.


Global equity markets continue to price in fairly pessimistic long-term earnings growth rates. The recent deterioration in global financial conditions and growth rates will certainly be a headwind to top-line revenue growth, but companies still retain plenty of ability to protect their operating margins and profitability by keeping labor costs down (given labor market slack and labor market competition from emerging markets). Yet the markets are currently pricing in the worst real earnings growth rate in a 100 years. To further exemplify this, the dividend yield of US non-financial corporations is higher than the yield on US government notes, something that has only happened once in the past 50 years, during the peak of the 2008 credit crisis. And this is now occurring in an environment in which companies have abundant liquidity to cover their dividends.€ (Ray Dalio of Bridgewater via Scribd, July 18)

€˜Bad things are going to happen€™... We have reached a profound point in economic history where the truth is unpalatable to the political class – and that truth is that the scale and magnitude of the problem is larger than their ability to respond and it terrifies them” [says Hugh Hendry]. Three years after Mr Hendry posted videos on YouTube of his visits to Chinese 'ghost’ towns, he remains pessimistic about the Middle Kingdom. He is shorting the equity of Chinese state-owned enterprises, balanced by a long position in a basket of Asian non-discretionary consumer stocks. He is also using credit default swaps to bet against the debt of financially leveraged Japanese companies such as Toshiba, which he believes are particularly exposed to a Chinese slowdown. Mr Hendry insists that his reputation as a 'contrarian’ investor is wrong, and that his approach is in fact to take advantage of the prevailing momentum in markets.

€œOur ideas are harshly disciplined by market trends. You will never see us pursue a homegrown idea when it is to the detriment of the prevailing trend.” For example, he reckons US government bond yields, already at record lows, will continue to fall. And, although he professes not to be a contrarian, he is more optimistic about the US than many investors and is “long the debt-saddled west and short the vastly over-vaunted and over-owned” Bric quartet of Brazil, Russia, India and China. He believes that financial markets are single-digit years away from a crash that will present investors with opportunities of a lifetime. “Bad things are going to happen and I still think the closest analogy is the 1930s.” (Financial Times, July 17)

Rio's pain in Spain...

“Both BHP and RIO look attractive from an investment point of view in absolute terms, in our view, with both stocks trading at a significant discount to our valuations. On a relative basis, we prefer RIO over BHP, due to cheaper valuation metrics, higher returning projects and greater leverage to iron ore. The critical issue for both stocks continues to be the outlook for the EU sovereign debt crisis (both stocks appear to have been tracking the Spanish 10yr Government bond yield since the start of the year). As the problems in EU begin to stabilise, we expect the miners to re-rate sharply.” (JPMorgan via Scribd, July 18)

Australian banks are expensive...
(Philip Lowe, deputy governor of the Reserve Bank of Australia, July 12)

The best banking bargains are offshore... €œ1) Credicorp is the largest bank in Peru, with over 30% loan market share. It’s riding on Peru's high GDP growth rate, and its low a loan-to-GDP ratio relative to other Latin American countries. Return On Equity: 21.4%. Expected Return: 36.5%. 2) JP Morgan’s robust balance sheet and surplus capital will get it through an uncertain economy. Return On Equity: 8.8%. Expected Return: 27.8%. 3) Mitsubishi UFJ Financial Group is in the best position to take advantage of overseas opportunities as European banks continue to deleverage. Japanese banks [are also experiencing] lower loan loss provisions in the wake of the Japanese earthquake. Return On Equity: 5.4%. Expected Return: 58.6%. 4) Sberbank stands to benefit from increasing its retail lending business in its home market of Russia, where penetration is low. Return On Equity: 23.8%. Expected Return: 28.7%. 5) Standard Chartered has strong capital ratios and is benefitting from double-digit loan growth rates to Asia and other emerging markets. Standard Chartered also stands to benefit from the ongoing deleveraging going on among the European banks. Return On Equity: 12.2%. Expected Return: 29.0%.€ (Citigroup via Clusterstock, July 16)

Monkey versus fund manager... €œIt turns out to be surprisingly easy to outperform the market index, which makes fund managers’ underperformance even more galling. '¦ Jason Hsu and Vitali Kalesnik at Research Affiliates re-examined many well-known investment strategies, including several variants of value and the low-volatility anomaly. All, over long periods, do indeed beat the market. The surprise is that when they constructed exact opposite portfolios, they also beat the market. For example, a portfolio of large US stocks weighted by company book value returned an annualised 11.4%, against 9.7% for the (market capitalisation-weighted) index, with only a fractionally higher volatility. '¦ But the opposite strategy does even better. Weighting the portfolio by the inverse of book, so preferring shares that are expensive relative to book value, returned 14.2%. '¦ This is particularly striking in the monkey experiment. Intuitively one should expect a random selection of 100 portfolios by the simulated monkey to have about half beating the market, and about half underperforming. In fact, in the US, global, Japanese and French random selections, every portfolio outperformed. In the UK 92 out of 100 beat the market, in Canada 93, and in Australia, the worst, 88. '¦ Messrs Hsu and Kalesnik make a convincing case that it is not mere luck. Instead, this shows just how poor most of the strategies are. All give something approximating the average stock – an equal-weighted portfolio – give or take a bit. The market capitalisation-weighted index gives a much lower return than the average, because it is more heavily invested in the one thing almost guaranteed to do badly: the biggest companies.” (Financial Times, July 15)

Demographics of capital...

"The first of the baby boomers '¦ have reached their mid-60s. The median age is 55 and going on 56. They are no longer in their capital appreciation/aggressive growth part of the life cycle as they were in the 1980s and 1990s. The aging but net yet aged 50 crowd is still making up a greater share of the population pie, and as such will still pack a powerful punch when it comes to driving fund flows across various asset classes.” (Dave Rosenberg, chief economist at Gluskin Sheff, via Business Insider, July 15)

Front-running funds... “They are supposed to be among Wall Street’s most closely guarded secrets: changes in research analysts’ views, up or down, of a company’s prospects. But some of the biggest brokerage firms appear to be giving a handful of top hedge funds an early peek at these sentiments '” allowing them to trade on the information before other investors get the word. The signals come from questionnaires that analysts answer and submit electronically, either monthly or quarterly, to some of their firms’ largest hedge fund clients. Chief among the questions posed to the analysts are those about possible earnings surprises at companies they follow. '¦ Analysts at many companies, including Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch and UBS, have participated in the programs. The analysts’ answers are fed into the hedge funds’ trading algorithms, determining which stocks to buy or sell. '¦ The funds say they ask only for public information, but in at least four cases, documents from Barclays Global Investors, now a unit of BlackRock, state the goal is to receive nonpublic information. Two documents state that the surveys allow for front-running analyst recommendations. '¦ “We expect the earnings surprise direction to be able to capture the information not released to the market,” stated a confidential BlackRock memo from November 2008, detailing its analyst surveys of nine brokerage firms in Asia.” (New York Times, July 15)

Cops and bankers... “In a twist more akin to a Hollywood film than traditional banking procedure, the Icelandic government has hired a white collar detective and former Police Lieutenant to track down Iceland’s economic criminals, and are calling on the rest of Europe to follow suit. Most of those targeted are former banking sector officials or were board members of banks before the crisis. Ólafur Þór Hauksson, who prior to the economic crisis, was police commissioner in Akranes, a small port town of 6,500 inhabitants stranded at the end of a frozen peninsula some fifty kilometers from Reykjavik, will be assisted by a team of 100 researchers to track down various staff of major banks both inside Iceland and Internationally.” (Business Review Europe, July 15)

Video of the Week: Remembering Barton Biggs... Barton Biggs, the money manager whose attention to emerging markets during a 30-year career at Morgan Stanley made him one of the first global investment strategists, died this week at 79. Here are some of his best calls.


(Bloomberg, July 16)