PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.
“What do you call a credit bubble built on a commodity bull market built on a much bigger Chinese credit bubble?” quips Dylan Grice in a new note. “Leveraged leverage? A CDO squared? No, it’s Australia.” Societe Generale's resident uber-bear paid a visit Down Under last month and didn't like what he saw; find out why, and how he thinks you should respond, below. On a more positive note, Bank of America has identified a trough in the global economic cycle, which signals that stocks are a buy, and Jeff Saut reckons the latest market contraction could just be a small bump in an ongoing bull run. Following Britain's surprise technical recession, Paul Krugman charts the remarkable effect David Cameron's austerity measures have had on the UK economy. Meanwhile, Nouriel Roubini says the ECB has the power to prevent a European recession from getting worse. Elsewhere, JPMorgan tackles three big questions in world markets – taking in Europe, the threat of global deflation and the big run-up in commodities prices; Jefferies analysts unveil the new Silk Road; and Martin Scorsese takes on Wall Street in the next finance blockbuster. Also, behold: the (faulty) stock-picking robot. Finally, following Michael Feller's analysis of 'RORO' (risk on, risk off), HSBC's head of FX quant strategy offers his own take on how to respond (on video).
The bubble Down Under'¦ “After a recent trip to the 'quarry in China’s backyard' SocGen’s Dylan Grice is even more worried about Australia's economy than he was beforehand: 'When you scratch the surface of the Australian miracle you don’t just find an unmiraculous commodity super-cycle: you also find an equally unmiraculous credit super-cycle as well. A credit bubble built on a commodity market built on an even bigger Chinese credit bubble, Australia looks like leveraged leverage, a CDO squared.' As he notes, debt to disposable income has risen from 40 per cent in the 1990s to around 150 per cent today. Partly as a result, Australia now has five of the world’s top 15 most expensive cities. But a potential housing crash looks unlikely as there has not been a sudden flood of supply. The boom in construction engineering projects, however, is a problem. Australia has been investing in mines as if Chinese demand is just going to keep growing:
Grice doesn’t think putting all your chips on China is a good idea: 'How healthy is China's iron ore demand? If its steel prospects were so attractive why does Wuhan Iron & Steel for one think pigs are the future? Why has the company recently announced plans to invest nearly $5bn over the next five years in industries in which it has no expertise, such as pig, fish and organic vegetable farming? Probably because steelmakers are now loss making and there is excess capacity. And if they have no confidence in the Chinese steel industry, why should Australia?' Grice argues there may be trouble in Australia even if China’s resource demand somehow holds up, because of the strength of the local currency: 'The improvement in Australia’s terms of trade (the ratio of its export prices to its import prices) has been spectacular thanks to the bull run in commodities. It should be running large current account surpluses, like Norway. But it isn’t. It’s running a deficit of 3%. So the AUD is overvalued and vulnerable. For Australians, buying bonds makes some sense to me '¦ while buying gold makes a lot of sense (because gold is very cheap in AUD terms).'” (Dylan Grice via FT Alphaville, April 25)
Ride the global economic wave'¦ “Bank of America strategist Nigel Tupper recently published an update on the firm's proprietary 'Global Wave.' And it's flashing a buy signal for stocks:
From BofA: 'The Global Wave is signalling a trough in the global cycle. Macro data improved enough recently to suggest investors position for an economic upturn. The diverse but coincident policy response across the world (monetary easing, Operation Twist, LTRO, etc) appears to be having a positive impact. History suggests that once the Global Wave troughs, the MSCI ACWI (All Country World Index) averages 14.2% in the next 12 months with a positive return 86% of the time. This indicator quantifies global economic trends, and it is used to forecast stock market performance. It's an aggregation of seven proprietary indicators: global industrial confidence, global consumer confidence, global capacity utilisation, global unemployment, global producer prices, global credit spreads, and global earnings revisions ratio.' (Bank of America via Money Game, April 23)
Never mind the contraction'¦ “In the last tactical bull market of October 2002 through October 2007 (60 months) there were nine such 4% or greater pullbacks, yet stocks traded higher after each correction. In the current tactical bull market of March 2009 to present (37 months) there have already been eleven 4% or greater pullbacks and each time stocks have also subsequently traded higher. Clearly the frequency of corrections/pullbacks has increased in the current cycle likely driven by memories of the Dow’s 54.4% massacre between October 2007 into the March 2009 bottom that at the time we deemed would be similar to the 'nominal' price-low of December 1974 (that was the 'nominal' price low of that wide-swinging, trading-range 1965 – 1982 affair). More recently, we have likened last year’s October 4th 'undercut low' to the valuation-low that occurred in August 1982 since valuations last October were at levels not seen in decades. Whether we have begun a secular bull market like that of August 1982 – January 2000 is debatable, but we doubt last October’s low will be violated. '¦ On the positive side: The stock market’s daily internal energy has a full charge of energy, an 8.53% drop in the price of gasoline last week, an earnings reporting season that has so far seen 72% of companies beating estimates, '¦ the IMF announced it has raised another $430 billion to be used if Euroquake worsens, a US dollar that looks like it is breaking down (read: a positive for stocks), and hereto the list goes on. All of this continues to leave us chanting, 'You can be cautious, but do not get bearish!'” (Jeff Saut of Raymond James, April 23)
China's Achilles heel '¦
“Over the past 30 years, China’s total fertility rate has fallen from 2.6, well above the rate needed to hold a population steady, to 1.56, well below that rate. '¦ If it stays low, the population will dip below 1 billion by 2060. In contrast, America’s population is set to rise by 30% in the next 40 years. '¦ In 1980 China’s median age was 22. That is characteristic of a young developing country. It is now 34.5, more like a rich country and not very different from America’s, which is 37. But China is ageing at an unprecedented pace, because fewer children are being born as larger generations of adults are getting older '¦ This trend will have profound financial and social consequences. Most obviously, it means China will have a bulge of pensioners before it has developed the means of looking after them. '¦ In the traditional Chinese family, children, especially sons, look after their parents. But rapid ageing also means China faces what is called the '4-2-1 phenomenon': each only child is responsible for two parents and four grandparents. Even with high savings rates, it seems unlikely that the younger generation will be able or willing to afford such a burden. So most elderly Chinese will be obliged to rely heavily on social-security pensions. '¦ But that is only part of a wider problem. Between 2010 and 2050 China’s workforce will shrink as a share of the population by 11 percentage points, from 72% to 61%'a huge contraction, even allowing for the fact that the workforce share is exceptionally large now. '¦ The shift spells the end of China as the world’s factory. The apparently endless stream of cheap labour is starting to run dry.” (The Economist, April 21)
David Cameron's remarkable achievement'¦
“When David Cameron became PM, and announced his austerity plans ' buying completely into both the confidence fairy and the invisible bond vigilantes ' many were the hosannas, from both sides of the Atlantic. Pundits urged Obama to 'do a Cameron'; Cameron and Osborne were the toast of Very Serious People everywhere. Now Britain is officially in double-dip recession, and has achieved the remarkable feat of doing worse this time around than it did in the 1930s. Britain is also unique in having chosen the Big Wrong freely, facing neither pressure from bond markets nor conditions imposed by Berlin and Frankfurt.” (Paul Krugman in The New York Times, April 25)
Nouriel Roubini versus the ECB'¦ “The NYU economist and crisis personality was one of just five carefully selected individuals at a large gathering in the International Monetary Fund HQ1 building’s towering atrium who actually got to ask questions of the policymakers on stage: ... 'I saw that on the panel there are four central bankers and the panel is about fiscal policy and sovereign debt. So the natural question is then to think maybe about what could be the contribution of central banks in resolving sovereign debt issues. Now, one simple answer would be to just monetize very large budget deficits and I understand why a central bank would say that’s a no-no. But there’s a more subtle argument and it’s the following one: we know that while fiscal austerity is necessary, in the short-run, as even Christine Lagarde said and the IMF’s work suggests, that has a net recessionary effect on the economy. You’re raising taxes, you’re reducing transfer payments, you’re reducing government spending, so you’re reducing disposable income, you’re reducing aggregate demand. It makes the recession worse and you can get a vicious circle. Not only do you have deleveraging of the public sector but the raising of taxes and cutting of transfer payments induces also deleveraging of the private sector. So if domestic demand is going to be anaemic and weak in this fiscal adjustment because of private and public sector deleveraging you need net exports to improve to restore growth. That’s what happened in emerging market crises. But in order to have an improvement in net exports you need a weaker currency and a much more easy monetary policy to help induce that nominal and real depreciation that is not occurring right now in the euro zone. That’s one of the reasons why we’re getting a recession that’s even more severe. So, can’t we think of monetary policy as helping to induce the change in relative prices that’s necessary to have a restoration of growth if domestic demand is weak through net export improvements?' ECB Vice President VÃtor ConstÃ¢ncio responded by stressing the institution’s price stability mandate as well as the difficulties of synchronising policy for a group of nations growing at different speeds.” (Reuters, April 23)
Beyond the bear'¦
“Today’s chart illustrates rallies that followed massive bear markets. For today’s chart, a 'massive’ bear market is defined as a decline of greater than 50%. Since the Dow’s inception in 1896, there have been only three bear markets whereby the Dow declined more than 50% (early 1930s, late 1930s until early 1940s, and during the recent financial crisis). Today’s chart also adds the rally that followed the dot-com bust during which the Nasdaq declined 78%. The current Dow rally has followed a somewhat middle of the road path and has followed the post dot-com bust rally of the Nasdaq that began back in 2002 fairly closely ' especially over the past year. If the current rally were to continue to follow the post-massive bear market rally pattern, the market would have to work its way higher during much of the remainder of 2012.” (Chart of the Day, April 20)
Three big questions in global markets'¦ A Q&A with JPMorgan: “1) Why has the euro not collapsed, yet, given a recession and EMU break-up risk? The EMU periphery cannot devalue against the core, but would greatly benefit from a drop in the euro. The answer is likely that currencies are relative prices, and the fiscal situation in the US, UK, and Japan is as bad as in the Euro area, even as the latter has problems with internal funding. Each of these four currencies has fallen dramatically against the smaller G10 countries that are in better shape (CAD, CHF, AUD, NOK). The Euro area also has no external deficit, and funding problems may have led to capital repatriation, supporting the euro. '¦ 2) Why no deflation, given global slack, nor rise in inflation expectations given debt demonetization? Simple output gap models would indeed have suggested a dramatic drop in global inflation, if not outright deflation. We did not get this, showing there is clear downward rigidity to nominal wages, and also less useable slack than we thought. These give this puzzle a name but are not an explanation. A better explanation could be ultra easy monetary policy that killed deflation fears. But why have these not turned into inflation fears? Part of the explanation is that central bankers have done a tremendously good job in convincing us they are only combating deflation and will react decisively when inflation emerges. And the world wants them to be right. '¦ 3) Why are commodities up 65% since the recession, while the world economy is growing below capacity? The answer is likely an application of the hog cycle. During the recession, commodity prices cratered and project financing evaporated. Commodity producers cancelled investment projects, greatly restraining future supply growth. Demand growth since the recession has outstripped weak supply growth, pushing up commodity prices. But with much higher commodity prices and easier funding, producers are investing and capacity is increasing. The hog cycle is not dead.” (JPMorgan, April 23)
The Wolf of Wall Street'¦ “Martin Scorsese is partnering Leonardo DiCaprio on 'The Wolf of Wall Street', their fifth film collaboration. The movie is based on Jordan Belfort's 2008 memoir about his hedonistic run on Wall Street as a risk-taking, drug-using, high-level investment banker. DiCaprio will, of course, portray Belfort. '¦ Production begins August in New York, with a screenplay adapted by Terence Winter ('The Sopranos', 'Boardwalk Empire').” (Hollywood Reporter, April 20)
Never trust a stock-picking robot'¦ “Twin brothers Alexander and Thomas Hunter have been scamming stock market investors since they were just 16 years old, says the Securities and Exchange Commission. '¦ According to the lawsuit, Alexander and Thomas Hunter 'starting at the age of sixteen... developed an elaborate scheme to manipulate the prices of penny stocks at the expense of unwitting investors.' '¦ Their game had two angles, the SEC says. On the one hand, they told investors they had a 'stock-picking robot' ' no, really ' that had a phenomenal record for picking stocks. They sold subscription newsletters to the robot's latest tips, at their websites doublingstocks.com and daytradingrobot.com. '¦ On the other hand, they also secretly raised money from penny stock promoters with the promise of pumping their stocks through the same 'robot' newsletters. What kind of sucker falls for a 'stock-picking robot'? More than you think. According to the SEC, about 75,000 investors [right around the world] handed over at least $1.2 million for subscriptions.” (SmartMoney, April 24)
Video of the Week: This correlated life... Stacy Williams, HSBC’s head of FX quant strategy, discusses the growing challenge of investing in 'risk on, risk off' markets.
(HSBC April 19)