Research Watch

Hugh Hendry gets bearish on China. Oil bucks a super-cycle. Apple's tax tricks. On video: buying beer with a bar of gold.

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.

Hedge fund manager Hugh Hendry is finally back with a giant new letter to shareholders – his first substantial offering in almost two years. In it, the acerbic contrarian says the BRICs are done and Japan's in trouble, but he also identifies the next big bright spot in the world economy and a “generational” buying opportunity ahead. Meanwhile, emerging market enthusiast Mark Mobius is much more upbeat about China, pushing aside the debate about hard or soft landings to argue that the country will continue to soar. Still on China, Standard Chartered toured the Middle Kingdom recently and discovered that copper inventories are literally spilling into the streets, which is bound to have an impact on prices, while Citigroup thinks it's found the one resource that will survive the end of the so-called commodities super-cycle. Paul Krugman charts the western world's swing to austerity, while another analyst finds strange solace in America's “ridiculously large” fiscal cliff. The old market adage “sell in May and go away” is reworked at Pragmatic Capitalism, Apple's global tax dodge is picked apart at Business Insider, and Australia is the new China, according to General Electric. Also, find out how you could help repair Goldman Sachs' reputation. On video, Felix Salmon attempts to trade gold for beer – an important test for any serious currency.

Hugh Hendry is back ... “In Hugh Hendry's first big letter since 2010, the most surprising insight from the perpetual contrarian is his almost predictable contrary view of the dominant investing meme at the moment. To wit: 'We are, as a result, long the debt saddled west and short the vastly over vaunted and over owned BRICs. '¦ There is a near consensus that China will supplant America this decade. We do not believe this. We are more bullish on US growth than most. The momentous nature of recent advances in shale oil and gas extraction and America's acceptance of the unpleasantness of debt and labour price restructuring looks to us as if it is creating yet another historic turning point. By embracing his inadequacies and leaping on his luck, the strong man may have finally broken the binds that had previously held him back. We are also more pessimistic on Chinese growth than ever. This makes us bearish on most Asian stocks, bearish on industrial commodity prices, interested in some US stocks, a seller of high variance equities and deeply concerned that Japan could become the focal point of the next global leg down [because it is most exposed to a Chinese slowdown]. On the plus side we also believe that we are much closer than before to the beginning of a bull market of perhaps 1982, if not 1932, proportions. We just need the last shoe to drop.' Ultimately, he thinks we'll see one more washout in the market, with 30-year Treasury yields hitting 2.5% (they're currently at 3.125%) and the VIX surging to 80, at which point we'll have a truly 'generational' opportunity to buy risk assets. For now, Hendry is a buyer of credit-default swaps on bonds issued by Japanese companies that benefit from Chinese growth. The contracts become more valuable when investors become more concerned that a company will default on its debt. He has bought CDS on Toshiba and called the shares of Hitachi 'too expensive.' Read the full letter here.” (Hugh Hendry of Eclectica Asset Management via Zero Hedge, April 29)

China's buried in copper '¦ “Case in point, the following picture from a Standard Chartered trip to examine copper inventories in bonded areas in eastern Shanghai last week:

Source: Standard Chartered Research

What you are looking at here is a staff car park that’s currently serving as a spillover area for copper inventory storage at a major warehouse. From Standard Chartered’s Judy Zhu and Han Pin Hsi: 'On a routine trip to examine copper inventories in the bonded area in eastern Shanghai last week, we were astounded by how much copper is being stored in warehouses. We visited one of the biggest warehouse operators (which holds nearly one-third of the inventory in Shanghai's bonded area) and saw some interesting sights. Copper plates were piled to the maximum allowable height (based on weight so as not to damage the land it is sitting on). The covered warehouses were full. The staff car park was used to store copper. The driveway between warehouses was blocked by copper. The warehouse operator told us that it cannot accept additional inventory until existing inventory is shipped out. '¦ The same operator told us that warehouses in Yangshan, another bonded area in Shanghai – but more remote and hence not a preferred place to store copper – is also full of copper. We estimate that total copper inventory in China, which includes inventory outside of the bonded areas, has reached about 1mn tonnes (mt).'” (Judy Zhu and Han Pin Hsi of Standard Chartered, via FT Alphaville, April 26)

But ignore talk about a hard landing there '¦ A hard landing typically is viewed as a rapid slide into recession. I don’t see that happening [in China]. A soft landing would be considered a decline in growth to 2% or 3% which again, is not in the cards. '¦ The World Bank seems to define a gradual slowing of growth as 'soft landing' but a decline of growth from 8% to 7%, or from 10% to 8%, does not seem like a 'landing' at all. '¦ I suspect that the root of the dire talk about China’s economic fate may be some previously overly bullish economists who are disappointed by the recent data, and as such, are sounding the alarm bells. ... Our long-term view on China remains positive, despite the recent noise. Our main investment themes in general have been focused on consumers and commodities. It is our belief that Chinese consumers are likely to continue gaining clout, and Chinese macroeconomic policy has increasingly been moving from an export-based model to one fuelled by domestic demand. We also expect that demand for hard and soft commodities should remain strong as China and many other emerging markets industrialise, gain wealth and increase spending on infrastructure, which tends to tilt the balance between supply and demand in favour of producers.” (Mark Mobius, executive chairman of Templeton Emerging Markets Group, May 1)

Coordinated austerity '¦ “Antonia Fatas points out that there was a sharp turn to austerity on both sides of the Atlantic in 2010 '” which is a large factor in the weakness of economies in both places:

But guess who didn’t make an equally sharp turn? (All data from Eurostat)

In general, everything '” everything '” you hear conventionally, from the legend of Irish recovery to the legend of German austerity is just not true.” (Paul Krugman via The New York Times, May 1)

Take comfort at the edge of the cliff '¦ “The size of the so-called fiscal cliff at year end, which would unwind a decade’s worth of tax cuts and temporary income supports, is so ridiculously large relative to near- term growth prospects that markets may take some comfort in its scale. As Fed Chairman Bernanke warned Congress, the Fed would have 'no chance' of offsetting an instantaneous shock so severe and noted he was 'hoping' Congress would take action. '¦ Markets may in fact be feeling some calm that the resolve to once again delay and diffuse it will be found. '¦ Yet some doubt should remain, and we gather build at some point as to whether Congress and the President will be too divided to find an alternative to current law, particularly before the year is out and the new Congress is seated.” (Steven Wieting of Citigroup, May 1)

Sell in May? '¦ “The problems in Europe that caused last year’s weakness (e.g., Greece’s sovereign debt) have not gone away. Plus, Spanish bond yields have recently risen, French president Nicolas Sarkozy is in a closely contested run-off, the Dutch coalition government has collapsed and Britain’s economy is contracting. In Asia, China’s economy has shown signs of slowing, and Standard & Poor’s just lowered its outlook for India. In the US, many politicians remain more interested in bickering and getting quoted than agreeing on long-term solutions. Even with these legitimate concerns, things could still go right or, at least, conditions could hold up well enough to support stock prices. Europe could simply muddle along, as opposed to worsen. China’s economy may slow less than forecast. ... The US economy may maintain its uncomfortably slow, but ongoing, recovery. Plus, low valuations could limit any downside to stocks. '¦ What I can say is that you will be taking a risk either way, but over the long term, stocks reward those who take prudent risks. A middle-ground strategy is to see if your portfolio allocation is still close to your targets at the start of May and the end of October. If your allocations are more than five percentage points off target, rebalance. For example, if your strategy calls for a 60% allocation to stocks and stocks currently account for 66% of your portfolio, reduce your stock allocations back to 60% and shift the proceeds into the asset class that is currently underweight (e.g., bonds). This allows you take advantage of the best and worst six-month periods by selling high and buying low, while still adhering to your long-term investment plan.” (Pragmatic Capitalism, May 1)

One commodity can survive the super-cycle '¦ “Oil is different to the rest of the commodity complex thanks to the power of the OPEC cartel and the political fragility of the supply side. Unlike most other commodities, oil has many drivers outside Chinese infrastructure investment; as the only major commodity to rise in price in real terms during the twentieth century, its investment and price cycle has been quite different to that of the rest. '¦ In fact this is one area where Chinese demand can keep growing, judging by historical growth patterns.”

(Kingsmill Bond of Citigroup, April 26)

Apple's tax tricks '¦ “Last year, Apple's global cash tax rate was only 9.8%. It paid $3.3 billion of cash taxes on profits of $34 billion. '¦ Here are some of the company's tax-avoidance tricks: The cash generated by Apple's US business is not collected or managed by the company's headquarters in California. It's collected and managed by a subsidiary called Braeburn Capital located in Nevada (where there's no corporate tax rate). ... Thus, Apple pays no taxes on profits generated by its cash. '¦ At the same time that Apple is avoiding California taxes by managing its cash in Nevada, it is getting tax credits from California for conducting 'research and development' there (Apple has benefitted from more than $400 million of R&D credits since 1996). ... Internationally, Apple invented a tax-avoidance scheme known as the 'Double Irish With A Dutch Sandwich,' which ... routes royalties and profits generated on US inventions through [offshore] subsidiaries... On an accounting basis, Ireland 'generated' one-third of Apple's revenue last year. Apple has also assigned some of the ownership of its Ireland operation to a subsidiary with no employees in the Caribbean, and routes other Irish profits through the Netherlands, which is also basically tax-free. Apple makes sure that salespeople located in high-tax countries are actually employed by Apple subsidiaries in low-tax countries. For example, a salesperson located in high-tax Germany might sell Apple products on behalf of an Apple subsidiary located in low-tax Singapore, and the sales in Germany are then taxed at low Singaporean rates. Apple has decreed that many global iTunes sales legally happen in Luxembourg, because Luxembourg offers tax incentives for companies that process transactions there. This dodges taxes in the US, France, Britain, and other countries that would charge much higher rates.” (Business Insider, April 28)

What's driving the Australian dollar ...
(Yujiro Goto of Nomura, via FT Alphaville, April 30)

Australia is the new China (for GE, at least) '¦ The continent of 22 million people is set to generate more revenue for the industrial conglomerate this year than will the Middle Kingdom, with 1.3 billion. The shift stems in part from Chief Executive Jeff Immelt's '¦ [bet] that the price of energy and minerals will remain strong'”and that GE will have an easier time breaking into other markets to sell compressors, locomotives and power generators in countries that produce oil, gas and iron ore. The new approach elevates Canada, Peru, Mongolia and Australia into the circle of growth prospects once dominated by Brazil, Russia, India and China. 'These places have unbelievable opportunities," Mr. Immelt said at a Stanford University conference. 'China is big, but it is hard. These places are equally big, but they are not quite as hard.' '¦ Part of Australia's appeal is its reliable legal system and a free market, GE executives say. '¦ The company expects its revenue in resource-rich countries will rise as much as 25% for the next two years, compared with 10% to 15% in the fast-growing economies of China, India and Southeast Asia.” (Wall Street Journal, April 30)

Is this the toughest job in finance? '¦ “Goldman - sometimes known as the Vampire Squid - has placed an advert on its site looking for its first, full-time social media strategist to join its brand management group. The new recruit will have a tough job on their hands at an institution that has not so far taken social media to its heart. ... The @goldmansachs Twitter account has around 3,500 followers but has yet to tweet, making it significantly less prolific and popular than the @GSElevator account - 248,000 followers - which claims to spill the beans on lift chatter at the bank. '¦ The new person charged with improving the bank's Web image will moderate forums, work on marketing campaigns, write Facebook status updates and Twitter posts, and cover LinkedIn group management.” (Finextra, May 1)

Video of the Week: Will a gold bar buy a slab of beer? '¦ Reuters' finance blogger Felix Salmon hits the streets to test whether gold really is better than cash.

(Reuters, April 27)

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