Research Watch

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.

One of the most talked about investment phenomena post-crisis has been the rise in market correlation, or the so-called ‘risk on, risk off‘ trade. But this frustrating paradigm could finally be coming to an end, according to the Royal Bank of Canada, which points out important sections of the market are finally beginning to decouple. It could be that we’re turning back towards the Old Normal – if we ever left. Credit Suisse says the economic rebound, long and painful as it has been, is actually in line with similar periods in the not-so-distant past. But while scores of international bourses remain weak, a broker lists its favourite good stocks in bad markets, while another commentator argues Australian banks – “floating on an air of invincibility” – could be bad stocks in a good market. Discover the most significant tail risk being ignored right now, and what incoming Chinese premier Li Keqiang’s recommended reading list says about the communist party’s grip on power. Elsewhere, risk makes a big return, and so do the BRICs – although others are turning to Myanmar (never mind it doesn’t yet have a stock exchange). And listen to a chemical engineer explain what makes gold such a uniquely valuable – and tradable – element. Dust off your Periodic Table.

WOOT! RoRo is fading...

“There are more currency pairs uncorrelated to equities right now than at any time for five years. In fact, [RBC’s Adam Cole] says, correlations have started to break down to the extent that a majority of G10 currency pairs were uncorrelated with equity returns over the last three months. Another false dawn or an actual end to the dominant RoRo [risk on, risk off] paradigm?

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… A major factor is simply the range-bound nature of markets in recent weeks–markets don’t appear correlated simply because they are not moving. US equity prices have traded a range 2% either side of their average level since early September and the same applies to most G10 currency pairs. Whether or not the decline in correlation is robust to a rise in volatility has not yet been tested... Another factor we have previously identified as holding us in the WOOT [World of one trade] is the tendency for correlations to become self-fulfilling. The longer that cross-asset correlations persist, the greater the tendency for investors to ‘use’ them, either by treating relative price movements as an arbitrage trade (AUD/JPY vs. S&P, for example) or by using FX as a proxy hedge for the asset price movements it seems to follow. The more the correlations get used, the more entrenched they become. But this process (hopefully) should also work in reverse, and as correlations start to weaken, the process should become self-sustaining, which should at least work to moderate cross-asset correlations going forward.” (Adam Cole of Royal Bank of Canada via FT Alphaville, November 9)

Welcome to the old normal...

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“First, the cumulative rise in global production from its cyclical trough in March 2009 has been considerably larger than in the three previous global recoveries (troughs in November 1982, December 1992, November 2001), and virtually identical to the recovery from the oil shock recession of 1974/75.

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“Second, growth momentum has so far described a rather classic arc, with the highest growth rates coming early in the recovery when inventory dynamics are usually most intense, followed by a gradual ratcheting down towards zero growth about 3 ½ years from the prior recession trough. … If one knew nothing but the past numbers, the obvious forecast for the next 12-18 months would be for a meaningful and sustained pick-up in global IP growth and a (slight) narrowing of the global output gap to mirror what happened at this stage of the three previous cycles. … By now, of course, investors have become highly sensitized to deflation risk, since the combination of high debt levels and a large output gap leaves any system highly vulnerable to negative demand shocks. ... So another part of today’s unrenumerative safe asset yields has to do with fear of low probability, but catastrophic events. The global plane is flying so close to the ground and so close to stalling speed, the analogy goes, that even a small risk of a major policy mistake, oil shock, etc. is not worth taking. So long as this psychology remains prevalent, there will be a significant negative risk premium for bad outcomes priced into ‘safe’ bond markets. … So perhaps one can sum it all up by saying we are stuck in a weird sort of oscillating equilibrium between fear and hope, in which the main question macro investors should be asking themselves is this: will the marginal investor (and business leader) feel significantly less or significantly more fearful a few weeks to a few months down the road? If your answer is more fearful, expect lower risk appetite, equity prices, and safe bond yields (and with a short lag somewhat slower growth). If your answer is less fearful, then expect the opposite. (And if you have no opinion, hide in hybrid asset like riskier credit!)” (Credit Suisse, November 5)

You’ll find good stocks in bad markets...

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“Low valuations suggest investors continue to remain wary of Bad Markets. The 2013 PE for Bad Markets is 20% lower than that for Good Markets. Even if we adjust for industry biases, we find the discount remains considerable. This, we believe, is where the opportunity lies for bottom-up investors. … Our Good Stocks are up 26%. By comparison, the markets they are listed in are down an average of 7%. Our portfolio has held ground during sideways and weak markets like we had in 2011 and has outperformed in rising markets. We think the Good Stock basket is well-positioned to benefit further as top-down drivers subside. … [The basket includes: Andritz (Austria), Orascom Construction Industries (Egypt), LVMH (France), Pernod Ricard (France), Essilor (France), EADS (France), PPR (France), Saipem (Italy), Fiat Industrial (Italy), Luxottica (Italy), PKO Bank (Poland), Jeronimo Martins (Portugal), Uralkali (Russia), Magnit (Russia), Inditex (Spain), Amadeus (Spain) and Swedish Match (Sweden)].” (Citigroup, November 9)

Australian banks: floating on air of invincibility...

“It will be interesting to see how the Australian banks trade now they have passed on their bi-annual dividend. We reckon many people were purely hanging around for the dividend and will take the money and run for the time being. After all, the economy is slowing. Credit growth is at multi-decade lows. Up until now, the Australian banks have been almost bullet-proof. Up until now, that is. We continue to marvel at the resiliency of the Australian banking system. … Margins, revenue and profit are all under pressure. But the Australian banks keep churning out record profits. Profitability, as measured by return on equity, is amongst the best in the world (when compared to other banking sectors). While the Australian banks may be resilient, they are not immune. Aussie banks are at the core of the economy. And when the economy slows, capital moves from the periphery to the core, giving Aussie banks an air of invincibility. But if the slowdown becomes pronounced, it will eventually infect the core too. We’re not at that point yet, but we’re approaching it. Australian Banks are priced for a benign outcome. There will be no ‘fat tail’ event to derail the banking profit machine. Australian banks are defensive AND offer some growth. Low risk, modest rewards. They’re the perfect investment and are at the core of nearly all professionally constructed portfolios. That’s the conventional wisdom, anyway. From a contrarian perspective then, the Australian banks are a screaming sell. We’re sorry to say, but this financial crisis isn’t finished with us yet. At some point, it will attack the core of the system, and when it does, it will find all those investors hiding in the banks, and it will teach them a lesson.” (Greg Canavan via The Daily Reckoning, November 9)

The biggest tail risk everyone is ignoring...

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“The one risk that appears to us under appreciated by investors is the risk of higher oil prices - mentioned by only 6% of investors as a major concern - especially as there are significant risks of an escalation of the geopolitical situation in the Middle East. … Although tighter sanctions and the blockade of crude exports from Iran have reduced the country’s oil exports, Iran is still OPEC’s fourth largest oil producer, exporting about 1 million barrels a day. According to Commodity Strategist Francisco Blanch, a full blown Iranian oil supply disruption could push Brent oil prices up by $20-40/bbl and have twice the impact of Libya on global supplies and prices. Indeed, the potential fallout from an Iranian strike could be much, much greater given that the oil market is already tight and that 20% of the world’s oil is transported through the Strait of Hormuz. A sustained rise in oil prices above $150/bbl would likely result in a recession and necessitate a significantly more defensive asset allocation.” (Bank of America Merrill Lynch via Business Insider, November 12)

Risk is back... 

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(Sober Look, November 11)

And so are the BRICs...

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“Led by rising demand for Chinese stocks and bonds, BRIC markets have outperformed their emerging-market peers. Over the past three months, the MSCI BRIC index has returned 5.8% compared with the broader MSCI EM index’s 4.9% as of last Friday. ... Investors say Brazilian and Russian local debt, Chinese and Indian equities and the Indian rupee and Russian rouble are particularly attractive. [Marcelo Assalin, head of emerging market sovereign debt at ING Investment Management] boosted his exposure to Russian local-currency bonds in August. Yields are as high as 8% on 15-year bonds, and Mr. Assalin expects demand for these bonds to jump when they become eligible for clearance through Euroclear, an international settlement system. Easier settlement of bonds is the latest sign that investors continue to embrace Russia despite the state’s strong role in the economy. Ratings firms in 2003 deemed Russia investment grade, meaning it is seen as having a low probability of default. ‘Where else in the world can we invest in investment-grade-rated debt with high yield and currency appreciation?’ Mr. Assalin asks. The rouble recently traded at 31.62 rubbles to the dollar, down for the day but up 7.5% from June lows.” (Wall Street Journal, November 12)

Buy maybe Myanmar is more your style...

“The recent completion of Myanmar’s new foreign investment law has further fuelled investor interest in the country with almost daily news of investment plans, distribution deals and high-level business missions. Now the creation of an equity index to track Myanmar-related stocks gives portfolio investors an early chance to grab a share of the action – even though the country has no stock exchange. The Silk Road Myanmar Index was launched on Wednesday by Silk Road Management, a Mongolia-based investment firm specialising in high-growth frontier markets. … The new equity index will initially track the share price performance of eight Myanmar-related companies listed on various Asian stock exchanges. The companies: Daewoo International Corp (listed in South Korea); Ratchaburi Electricity (Thailand); Super Group (Singapore); Italian-Thai Development (Thailand); Yoma Strategic Holdings (Singapore); Interra Resources (Singapore); Shangri-La Hotel (Thailand); and Ntegrator International (Singapore), all with assets and operations in Myanmar, had a total market capitalisation of US$9.3bn as of October 31.” (Beyond Brics, November 14)

Google eats newspapers...

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“Remember back in the day how Google was supposedly a "great partner" to the newspaper industry?” (The Reformed Broker, November 13)

Li Keqiang’s recommended reading…

“The word among the politically well-connected in Beijing is that Li Keqiang, the man who will be confirmed as China’s next premier at the end of next week, has started recommending to his colleagues that they read Alexis de Tocqueville’s ‘L’Ancien Régime et la Révolution’. One might read a few things into that but some Chinese academics see it as a warning – de Tocqueville blamed the 1789 French revolution in part on the fact that the bourgeoisie inspired envy among the masses while the nobles elicited scorn. Popular wisdom has often blamed the revolution on the terrible living conditions of the unwashed masses and the ‘let them eat cake’ arrogance of the elite. But the widely accepted theory now is that the French Revolution was one of rising expectations that eventually could not be met. After 30 years of breakneck growth and rapidly rising living standards, the Chinese people’s expectation that their lives will keep getting better is already very high. It is now up to Mr Xi, Mr Li and their comrades to meet those expectations.” (Financial Times, November 13)

Audio of the week: What makes gold so unique?...

Sanat Kumar, a chemical engineer at Columbia goes through the periodic table and simply using the process of elimination (crossing out elements one by one) determines what makes gold such a uniquely valuable element in human history.

(NPR, November 16)