Research Watch

Disaster economics, the lion in the grass, don’t get caught short in China, corporate crime and rebuilding Versailles.

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.

Much has been made of a recent bond rally in the US, Germany and even Australia: some say it’s a dangerous new bubble driven by reckless central banks, while others view it as a ‘buy’ signal for stocks. This week, researchers at Fulcrum Asset Management put forward a new argument based on what they call “disaster risk”, with ramifications not only for bonds and equities, but also modern-day portfolio theory. Find out how to respond below. As investors prepare for earnings season, Macquarie outlines a simple strategy for profiting from positive and negative surprises. Meanwhile, market watchers wonder if the Australian dollar is departing from its fundamentals, and whether that's such a bad thing. JPMorgan warns about the crowded QE3 trade, while HSBC says shorting China could be dangerous. Elsewhere, John Mauldin thinks France is the new Greece, the Wall Street legend credited with dismantling Glass–Steagall wants it back, and The Economist says corporate crime pays — quite handsomely, in fact. On video, meet the property tycoon who set out to build the biggest home in America — modelled on the Parisian palace Versailles — then watched his plan crumble.

‘Disaster economics’ and your portfolio... “During most of the past few decades, Fulcrum Asset Management argues, investors and economists did not discuss ‘disaster’ much. … But now the world has changed. And so investor behaviour has shifted too, Fulcrum says. For the key point to understand about investing is that assets have two functions: they can produce returns, but they also offer protection. … In countries where government default risk is deemed low, bonds are better than equities for ‘protection’; but in markets where default risk is higher, equities and bonds are correlated. Fulcrum thinks there is a clear statistical way to tell which country is in which camp: when the sovereign CDS spread jumps above 200bp, bond and equities move together. But when CDS spreads are below 200bp, government bonds retain their ‘safe’ status, and yields and CDS prices are uncorrelated. Spain and Greece are in the first camp, and France is almost in that group too. But the US and Germany are in the second group. Hence bond yields can fall – even as default concerns rise in a moderate way. … First, it suggests that governments may have overstated the degree to which quantitative easing, not fear, has reduced bond yields. Second, it implies that the investor grab for safe assets may not be a short-term phenomenon; ‘disaster risk’ could influence asset prices for a long time. Third, there is a bigger point: the financial world may need to overhaul its investment frameworks. When portfolio theory developed in the second half of the 20th century, financiers assumed that the world would always be fairly stable; but … this low-disaster period may have been an exception to the norm. … In a world of 'disaster' economics, in other words, bond markets could remain ‘baffling’ for a long time...” (Gillian Tett, July 23)

Earnings opportunities...

“...stocks that issue a positive earnings surprise continue outperforming with a median return of 1.7% over the following month, excluding the returns on announcement day. … [There] is still [an] opportunity to profit from a negative surprise also post the announcement. We find that over the last two years stocks that have a negative earnings surprise underperform the market by 2.15% in the 20 days following.” (Macquarie Research, July 23)

Is France the new Greece?... “Don’t look now, but the lion that lies hidden in the grass is France. Yes, the France that is supposedly a big part of the solution to eurozone woes and Germany’s stalwart partner in guaranteeing all that debt. … First, let’s look at this chart from the IMF, examining the debt prospects of six countries (The entire study was of 18 countries.) The dotted lines are three paths that the debt-to-GDP ratio can follow. The top line is the trajectory without any actions by the individual governments. The middle dotted line is what the debt trajectory would look like with mild reforms to entitlements, and the bottom line is the debt trajectory if very draconian measures are taken. See if you can spot the hidden lion by guessing which country’s debt situation looks most like France’s.

Yes, the country most like France is Greece. Yes, THAT Greece. The one that just defaulted. The one that everyone agrees is dysfunctional. Also notice that if Greece were to follow the suggested draconian path, it could stabilise its debt. And then notice that if France were to make the same level of draconian cuts, its debt-to-GDP ratio would merely rise to almost 200% within 25 years. Oops. … So, what has been the response of the new French government? It has decided to double down on what was already an irresponsible path. Do you think the average German understands just how bad off their 'partner' is? For that matter, do you think the average French politician understands how bad off France is? Certainly not the majority of them, and it is doubtful that their counterparts in Germany do, either. This is going to be a train wreck of truly biblical proportions. Think 12 plagues, not the run of the mill 10.” (John Mauldin of Mauldin Economics, July 21)

The crowded QE3 trade...

“Leveraged investors such as hedge funds are piling into longer-term treasuries and other rate product in anticipation of QE3. ... That means that these leveraged investors could find themselves on the wrong side of a crowded trade if the Fed sticks to some form of Maturity Extension Program rather than outright QE. And the unwind of this trade could end up being quite violent, pushing treasury yields considerably higher.” (Sober Look, July 22)

Don't get caught short in China... “Betting on declines in Chinese stock market could be ‘dangerous’, as Chinese equity markets are already cheap and the economy is poised to rebound,” said Herald Van Der Linde, head of equity strategy for Asia-Pacific at HSBC Holdings Plc. “At this point in time, with low valuation and massive shorts in the market, it is not rational to bet that China will further fall from here,” he said. ... One measure of bearish sentiment, the Hang Seng China Enterprises Index, has fallen 19% from February 29’s peak and the price/earnings ratios was down to 7.7 times, compared with an average of 14.8 times in the past five years. The Shanghai composite index also shed 11.4% from the peak the first half of the year had seen on March 2. The analyst highlighted owning Chinese telecoms, railway, cement and retail shares, as the most favoured trades for the year. He also predicted China to cut the reserve requirement ratio for banks for the fourth time this year.” (, July 20)

Nexen’s Brent connection... “Chinese state-backed oil producer CNOOC Ltd will get more than just more crude oil assets with its $15.1 billion takeover of Canada’s Nexen Inc. The acquisition will also move CNOOC into the heart of the North Sea BFOE physical oil benchmark, giving a Chinese company for the first time unprecedented insight and access into this secretive, yet enormously influential market. … Nexen operates the 210,000 barrels per day capacity Buzzard oil field, the largest contributor to the Forties oil blend [that sets the Dated Brent price, used for most globally-traded grades of oil]. Once the takeover is complete, CNOOC will become the operator, gaining a critical role at the heart of the world oil pricing system. The ownership stake in Buzzard will give CNOOC equity cargoes of forties, allowing it to actively trade in the so-called 25-day BFOE forward market that sets the Dated Brent price. More valuable than equity cargoes, given the decline in North Sea supplies and the growing susceptibility of the Brent market to temporary distortions due to falling liquidity, will be the critical market intelligence on the supply situation in the North Sea that CNOOC will obtain.” (Robert Campbell, market analyst at Reuters, July 23)

A curious call to break up the banks... “Former Citigroup Chairman & CEO Sanford I. Weill, the man who invented the financial supermarket, called for the breakup of big banks in an interview on CNBC Wednesday. ‘What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail,’ Weill told CNBC’s ‘Squawk Box’' … He essentially called for the return of the Glass–Steagall Act, which imposed banking reforms that split banks from other financial institutions such as insurance companies. … He said banks should be split off entirely from investment banks, and they should operate with a leverage ratio of 12 times to 15 times of what they have on their balance sheets. Banks should also be completely transparent, Weill said, with everything on balance sheet. … If banks hedge in any way, Weill added, positions should be mark-to-market  and cleared through an exchange. Weill said that by breaking up banks, they would be ‘much’ more profitable.” (CNBC, July 25)

The dollar is decoupling from iron ore... “If you’d asked any economic grey-beard over the past few years why the dollar has been so strong they would have told you that the main reason was the iron ore price. Combined with coking coal, the two make up around 40% of the terms of trade and are, really, the commodities boom that underpins the dollar. But if you look at an AUD versus iron ore spot chart, you will see that that relationship is breaking, and fast:

The brown and green lines are the 200 day moving averages. You can see the nice correlation post GFC and the more recent widening departure. It is well documented that the strength in the dollar is now based upon a number of other factors, including mining capital inflows, as well as financial flows from reserve banks and carry traders, but to my mind, so long as iron ore falls away like this, the dollar is departing from fundamentals.” (Macro Business, July 20)

But it’s not such a bad thing... “The reporting of recent AUD strength is getting a little unbalanced. ... The vast majority of Australians are consumers and the increase in the AUD has been the primary means by which their standard of living has been raised by the mining boom (fuel would be over A$2.5 per litre if the AUD was ~0.50, for example). It is double counting in a sense, but I think it’s worth recognising that most Australian households are net debtors, and at least considering that rates would be higher if the AUD was weaker. The reason I say this is that the stronger AUD has been a part of the reason that inflation has been (and is likely to remain) very low. Thanks to the strong AUD, the RBA has been free to cut its policy rate. … The AUD is strong because we have lots of stuff that folks want to buy – and because of that, folks want to invest their capital in our strong businesses (or an average of Australian firms, which is what you get when you buy any Government bond as it’s a claim on future taxation revenues). Yes, there are losers in this process – but every relative price shift creates winners and losers. I fear that (just like in the tariff debates) the concentrated ‘losers’ (the exporters) are getting too much pity.” (Ricardian Ambivalence, July 20)

The economics of corporate crime... “While fines keep going up, corporate rule breaking – for example, the LIBOR banksters – seems to be booming. Why aren’t high fines deterring bad behaviour? … Many crime economists use a framework set out by Gary Becker of the University of Chicago. The idea is that would-be criminals rationally weigh up the expected costs and benefits of breaking the rules. If the probability of being caught or the level of fine is too low, then the expected costs might be outweighed by the benefits. In this case, crime does pay and crime can be rational. … The notion of rational crime can be used to assess whether fines are set at sensible levels. One rule of thumb antitrust economists use is that cartels can achieve overcharges of 20-30%. But the agencies that police cartels use fines of between 10-40%. Mr Becker’s crime calculus shows the problem with this: with a 50% detection rate, and fines ranging between 10-40%, the expected cost of cartel crime is in the 5-20% range. Use a 10% detection rate, and expected punishment costs fall to 1-4%. So the expected benefits outweigh the costs. At the moment, it seems, some corporate crimes pay handsomely.” (The Economist, July 23)

Video of the Week: Rebuilding Versailles... Meet the billionaire property tycoon, and his former beauty queen wife, who set out to build America's biggest home and failed miserably.

Graph for Research Watch

(USA Today, July 20)

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