Research Watch

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.

Fresh on the heels of Goldman Sachs’ giant 'bull call’ last week, JPMorgan is out with its own appeal for optimism. The big surprise, it says, will be no surprises, and that’s great for markets like these. You’ll find the highlights below. Meanwhile, Macquarie makes a big gold call – buy the dip! – while developments in oil futures markets could signal the end of triple-digit prices. Researchers from the World Bank and IMF question just how much exchange rate movements in one country affect its competitors (a lot, apparently), while overseas, BNP Paribas examines the Japanification of the US economy. Also this week, Krugman versus Keen, bankers behaving badly, and guess which stock now makes up more than 1% of global equity markets? On video, the super-bull versus the super-bear: Thomas Lee, chief US equity strategist at JPMorgan Chase, debates David Rosenberg, chief economist and strategist at Gluskin Sheff.

Five reasons to stay bullish '¦ A Q&A with JPMorgan:

“1. The fundamentals are no good. – Agreed that the macroeconomic fundamentals are not enticing. But the financial fundamentals of high risk premia versus falling uncertainty are compellingly attractive and truly at the core of what defines asset price value.
2. The rally is just a house of cards built on easy money. – High risk premia on equities and credit are indeed due to the near-zero yield on cash and safe government bonds, not because equity and corporate bonds are themselves that attractive. But that is how monetary stimulus works. And central banks will not take back this stimulus until the economies and markets can stand on their own feet, which is several years from now. Remember the old adage of “Don’t fight the Fed”. Surely one should not do so when the Fed works in concord with all other central banks in the world.
3. Everyone is long now. – Speculative positions in futures and by macro hedge funds clearly show they are aggressively long risk now. '¦ But overall leverage by hedge funds remains subdued, and asset allocators have only shallow longs. Retail investors continue to pour more money into safer bonds funds than equities or high yield. The world as a whole has higher than average cash holdings and some 70% of world holdings offer no positive yield after taxes and inflation.
4. What trigger is left to push up risk markets to the next level? – '¦ Within our line of thinking, the true surprise, and thus trigger, is no surprises. High risk premia mean the market is priced for risks and thus negative surprises. If these risks, ill-defined as they may be, do not show up, then that is by itself an event that surprises relative to market pricing.
5. There remain tons of risks in front of us. The US and Euro governments have simply kicked the can down the road, China is weakening dramatically, and Israel will not wait forever. – Yes, monetary easing and fiscal stopgaps have simply bought time, but time is what is needed to heal wounds. US fiscal decisions will have to await the elections while Europe has a lot of work to do to put together its fiscal compact. The US Administration will want to exhaust all diplomatic tools before making a military decision on Iran, if it ever will. The markets thus face a lull in event risk over coming months, even as long-term uncertainties remain.” (JPMorgan via Pragmatic Capitalism, March 25)

Gold to $US2250! '¦

“Macquarie Private Wealth advises buying the dip for five reasons:
1. Sentiment towards gold has now reached 'extreme pessimism’ levels.
2. March is seasonally the weakest month for gold.
3. Excess slack in the US economy will prompt the Fed to say on hold until 2014, as indicated, keeping short rates low.
4.The extent of the long-term rate rise is over. The Fed will ease some more.
5. Sovereign risk is not over.
Ultimately, they see it going to $2250/oz.” (Business Insider, March 25)

Oil to $US95! '¦ “Oil contracts for delivery in three to five years’ time are trading at their biggest ever discount to spot prices, prompting a debate about whether the era of triple-digit oil prices will be a short-term phenomenon. Spot oil prices have rallied nearly $20 since the start of the year and traded above $125 a barrel yesterday '¦ Over the same period, oil for delivery in December 2018 has risen $1 to about $95. This has opened a record gap of more than $30 between spot and five-year contracts. 'The market has the perception that oil supply will increase in the future and that is holding back the price of forward contracts,’ said Mark Thomas, head of energy futures at commodities brokerage Marex Spectron, citing expectations of higher output in Iraq, Brazil, the US and Canada.” (Financial Times, March 27)

Do exchange rates matter? '¦ “We examine the spillover effect of movements in China’s exchange rate on exports of other developing countries in third country markets '¦ [and] find robust evidence for the existence of a statistically and economically significant spillover effect. In particular, exports to third markets of countries with a greater degree of competition with China tend to rise significantly more as the renminbi appreciates. Our estimates suggest that a 10% appreciation of the renminbi increases a developing country’s exports at the product level on average by about 1.5%-2%. Where competition between a developing country and China is especially intense, the increase could be as large as 6%. The results imply that going forward, an appreciation of the renminbi could provide a substantial boost to developing country exports. Our spillover estimates are robust to a variety of statistical tests, to alternative measures of exchange rates, to alternative disaggregation of the trade data, and also across exporting and importing regions. They are also robust to incorporating the effect of competition from countries (other than China) whose currencies move with the renminbi.” (Aaditya Mattoo (World Bank), Prachi Mishra (IMF), Arvind Subramanian (John Hopkins University) via VoxEU, March 23)

And is the US turning Japanese? '¦

Federal govt net interest payments as percent of GDP
(Source: BNP Paribas)

“Low rates '¦ reduce incentives to deal with the long-term fiscal gap and lull legislators into a false sense of security about the cost of their policies. It remains an open question as to whether US policy makers will be able to address the deteriorating fiscal outlook outside of a crisis. ... A partial Japanization of the US economy where nominal interest rates remain low and the government has little incentive to implement fiscal austerity remains a possible outcome for the US.” (BNP Paribas, March 22)

Welcome to the biggest fire sale in history '¦ “Europe’s banking sector holds 2.5 times as many assets as the US banking sector '¦ and it needs cash '” mountains of cash. As a result, it will have to sell more than $1.8 trillion of assets, which will likely take a decade to work through. ... This is our opportunity. There is no better, more-reliable way to make money than to buy something from someone who has to sell. Bankers are the best people in the world to buy from. '¦ Institutionally, banks can’t really hold bad debts for long. As soon as they report a big bad debt on a quarterly financial statement, some annoying things happen. It means they have to put aside more capital for this particular loan, which they hate to do, as it lowers profitability and requires a lot of paperwork. It can raise the attention of regulators, which banks hate. It can raise shareholder suspicions about lending practices, which banks hate. So the usual way to deal with bad debts is to clear ’em out as fast as possible. '¦ Normally, you need a fat wallet to get [access to these types of deals]. But I recently found a way to get into this club that a public-school teacher could afford. One such investor is a guy named Bill McMorrow. You’ve probably never heard his name before. But his current joint venture fund has returned 42% annually since it began in 1999 by buying up distressed property from banks. '¦ In 1995, he bought up property debt from troubled Japanese banks. In 1997, he waded into Hawaii’s busted property market '¦ In the US financial crisis in 2008, he bought up apartment buildings in California. '¦ His company and partners recently bought $1.8 billion of [high quality] UK real estate from the troubled Bank of Ireland at a 20% discount to the face value of the loans. '¦ I think the EU crisis, as boring as it is, is about to get a lot more interesting as investors get a chance to pick up cheap assets from the biggest fire sale in the history of earth.” (Chris Mayer in The Daily Reckoning, March 23)

iRational? '¦
(The Economist, March 24)

Beware financial advisers '¦ “Do financial advisers undo or reinforce the behavioural biases and misconceptions of their clients? We use an audit methodology where trained auditors meet with financial advisers and present different types of portfolios. These portfolios reflect either biases that are in line with the financial interests of the advisers (e.g., returns-chasing portfolio) or run counter to their interests (e.g., a portfolio with company stock or very low-fee index funds). We document that advisers fail to de-bias their clients and often reinforce biases that are in their interests. Advisers encourage returns-chasing behaviour and push for actively managed funds that have higher fees, even if the client starts with a well-diversified, low-fee portfolio.” (Sendhil Mullainathan, Markus Noeth and Antoinette Schoar in The Natioanl Bureau of Economic Research, March 28)

Krugman versus Keen '¦ “Steve Keen has a new post up about Minksyan (Minskyite?) economics, and how people like me get it wrong. '¦ His paper contains a number of assertions about what is crucial, without much explanation of why these things are crucial. And I guess I just don’t see it. In particular, he asserts that putting banks in the story is essential. Now, I’m all for including the banking sector in stories where it’s relevant; but why is it so crucial to a story about debt and leverage? Keen says that it’s because once you include banks, lending increases the money supply. OK, but why does that matter? He seems to assume that aggregate demand can’t increase unless the money supply rises, but that’s only true if the velocity of money is fixed; so have we suddenly become strict monetarists while I wasn’t looking? In the kind of model Gauti and I use, lending very much can and does increase aggregate demand, so what is the problem? Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand. My point is that there seems to be a lot of implicit theorizing going on here '” and at least at first glance, the implicit theorizing doesn’t make a lot of sense. I could be wrong, but that’s the whole point of simple models: to lay bare what you’re assuming, and make it clear what, specifically, is driving your conclusions.” (Paul Krugman in The New York Times, March 27)

A nasty surprise '¦

“The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance beating consensus. '¦ The index is now trending lower as the negative surprises are starting to weigh it down. Economic forecasters have gotten a bit ahead of themselves, which may indicate a need for caution.” (Sober Look, March 26)

How not to conduct a meeting '¦ “At issue is whether or not 'high powered financial adviser’ Amanda Daughters should be allowed to have her job back at Aqua Financial Solutions, the firm she founded and was fired from by the chairman a couple years back. She’s currently appealing the decision '¦ Here’s the rub: On January 22, 2010, Daughters left the office to sit down with a couple clients at an off-site meeting place (a bar). Naturally, she got there a few (4) hours early to have a bunch of drinks. So far, so good. When the clients arrived, one ordered a 'spritzer,’ which was not to Daughters’ liking, which would explain why she proceeded to 'berate’ the woman to the point of tears. Then Daughters had a few more drinks. '¦ Around this time, she 'dragged the other client outside to have a cigarette, even though he was a non-smoker’ and called him a **** (which, despite her obviously having meant as a joke, was received as 'shocking and offensive’). '¦ Daughters took herself home and '¦ had this weird feeling she’d done something she’d be embarrassed about the next day, so she called up her chairwoman to put it out there that she’d '****ed up again and offended a client.’ '¦ Unfortunately, the client and the chairwoman couldn’t forgive her, which resulted in Daughters’ firing for 'gross misconduct.’ And while Big D realises maybe she should have done a few things differently, she’s not in agreement that a few drinks, a few tears, and a few 'you’re a ****'s are necessarily grounds for dismissal.” (Dealbreaker, March 22)

Video of the week: Super-bear versus super-bull '¦ Watch David Rosenberg, chief economist and strategist at Gluskin Sheff, debate Thomas Lee, chief US equity strategist at JPMorgan Chase.

(Bloomberg, March 25)