Research Watch

The euro winners and losers, heading for a trade slump, Black September looms, and a word from capuchin monkeys.

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.

As Europe embarks on another round of Greek austerity talks, UBS revisits the popular argument that Germany has gained the most from the euro – the cheaper currency gave its exports a tremendous boost – and should now pay back the periphery. However, the broker ranks the winners and losers in another way, in a chart it fears will play into the hands of a growing army of nationalist politicians. Closer to home, one researcher names Australian banks among the top yield plays in the world, while another cautions they’re overbought. And in the wake of BHP Billiton’s sharply lower profit result, Bank of America spots an underreported new problem for our mining giants. Doug Kass points out stockmarkets are strangely subdued, with the VIX suggesting a big fall is coming, and he’s backed up by Citigroup, which points out September is traditionally the worst month for equities. Elsewhere, introducing the “great quarter, guys” earnings gauge, how to trade with Jon Corzine, and, on video, income advice from capuchin monkeys.

Who really wins with the euro?...

“Each country shows the cumulative real disposable household income growth for each of its income deciles. The lowest income decile is to the left of each country’s selection, and the highest to the right. Austria looks to be alarmingly weak – what this actually represents is very little change in nominal disposable income growth, coupled with inflation. Germany, Ireland, most of Italy and the French middle class all experience a decline in their standards of living. ... What stands out are Greece, Portugal and Spain. These economies have benefited from increased standards of living under the euro (at least, until 2010), as nominal incomes have overcome inflation pressures. … This chart unfortunately plays into the hands of the more nationally minded politicians of the euro core. The argument can be made (and increasingly is being made) that periphery economies must simply accept the declines in living standards that their non-periphery counterparts have had to accept. … However, such an interpretation is not entirely fair. The countries that have experienced some moderation in their living standards are generally those that had the highest absolute disposable income levels in the first place. Someone occupying the bottom decile of French income distribution has twice the level of income of someone in the bottom decile of Greek income distribution in 2010. The income inequality between countries in the euro area has been narrowed by the pattern of real disposable income growth (as a rule).” (UBS, August 17)

Australia’s capex cliff...

“Given the recent declines in Chinese steel prices and the spot iron ore price, Deutsche Bank economist Adam Boyton reckons Australia’s terms of trade (the price of exportable goods divided by price of importable goods) could be 15% lower year-on-year by the fourth quarter. Now, over the past 50 years such declines have only been seen five times and in three of those five instances the economy has entered recession, says Boyton. ‘If we look back over the past 50 years we find only five instances of a 12% or larger year over year decline in the terms of trade: 1961, 1971, 1975, 1985 and 2009. In 1961, 1971 and 1975 the economy entered recession. The originally published GDP releases for 1986 almost show a technical recession (i.e. two consecutive quarters of negative growth) with a contraction of 0.4% in Q4 1985, zero growth in Q1 1986 and a further 0.4% contraction in Q2 1986; although these have over the years been revised to 0.1% qoq, 0.6% qoq and – 0.1% qoq, respectively. The real exception was 2009, with a large fiscal stimulus offsetting the impact on the real economy of the sharp turn lower in the terms of trade. … While there may be reasons as to why this time is different – the energy (i.e. LNG) intensive nature of the forward investment pipeline and the still high level of the terms of trade stand as cases in point – history would counsel some caution on the investment outlook. Indeed, an average response to a circa 15% decline in the terms of trade would see business investment falling in year over year terms by early 2013.” (FT Alphaville, August 22)

Our banks offer world-class yields...

(Bank of America Merrill Lynch, August 20)

And they’re getting expensive...

"We view the Aussie banks as a strong, well capitalised sector delivering mid-teen ROE in a low growth environment. However, given the global chase for yield we believe it has rallied too far, too fast. Since September the Banking Sector has rallied 35% while EPS forecasts are almost unchanged and the sector has delivered~1.5% EPS growth. Post this rally we are left with an Underweight sector stance and no remaining Buy ratings.” (UBS, August 22)

Yanking Australia’s coal exports…

“Coal exports by the US to China, a relatively unnoticed trend, can have significant and long-lasting substitution effects on Australia, in our view. In fact, the effect has already started showing up in recent months. … With US coal exports rising and grabbing share of China’s imports, Australia stands to get hurt the most, being the second-largest coal exporter to China (after Indonesia), in our view. China’s coal imports from Australia dropped 2mn tons in June over May, while its imports from the US surged 1mn tons – signs of an early substitution effect that could impact demand for Australian coal... It is interesting to note that the substitution effect does not seem to have gained the attention of Australian mining companies yet. If so, the damaging effect can potentially lead to large delays/cancellation of coal mining projects in Australia due to price pressure and excessive supply, in our view.” (Bank of America Merill Lynch, August 22)

Are markets calm or complacent?...

“VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets. The VIX closed last week at a multiyear low of 13.45. [Australia’s S&P/ASX 200 VIX level edged down to 15.22 earlier this week.] As can be seen in the two charts below (which compare the VIX to the S&P 500), the VIX is an uncanny forecaster of market tops and bottoms. A high and peaking VIX typically indicates a market bottom and a low and bottoming VIX often spells out a market top. This month is the fifth time in over two years that the VIX has hit 15.0 or below (The blue circles in the first chart below indicate points of time in which the VIX closed the week at under 15.0.)

“Typically, the decline in the markets, off of a low VIX, is quick and relatively severe. On average the S&P dropped by about 10% (and took about two months to correct), with the smallest decline of 6% in February 2011 and the largest drop of 19% in July 2011. (If we go further back in history, the same relationships hold; complacent markets are almost always associated with market peaks and vice versa.) … In conclusion, rather than grow more constructive with higher stock prices (fueled by low volume and a contracting number of new highs), I have grown more cautious over the near term, based principally on what I see as a blurring in the demarcation between global economic progress and fantasy as well as the political and geopolitical issues raised above. Accordingly, at current levels, most investors and traders who share my views might consider below-average exposure to the US stock market. More aggressive investors might ponder shorting opportunities in the days and weeks ahead.” (Doug Kass, October 21)

We’re entering the worst month for markets...

September historically has not been kind to the stockmarket. A review of monthly index performance shows that despite two market crashes in October, the worst typical month for stocks has been September when looking back 60 years. The explanation may be that the third quarter is less predictable than other quarters due to summer vacation-related corporate sector downtime in the US and Europe (during July and August, respectively) leaving it more dependent on the only full month of business activity which makes accurate forecasting inherently more difficult.” (Citigroup, August 20)

But it’s been a ‘great quarter, guys’...

“For those who have been too busy to tune into company earnings calls, that’s a dollop of praise analysts have lately ladled over companies ranging from Broadcom to Bonanza Creek Energy. Indeed, despite the snickers the sycophantic phrase induces, ‘great quarter, guys’ was uttered on 26 separate US earnings calls between July 1 and August 15, according to a search of Thomson StreetEvents transcripts. So, um, guys, just how great a quarter was it? Not as good as the first quarter: ‘Great quarter, guys’ comes up in transcripts of 34 earnings calls from April 1 to May 15. But it was better than the fourth quarter, when over the similar reporting period ‘great quarter, guys’ was put forth in just 13 calls.” (Wall Street Journal, August 20)

Searching for the next Soros...

“While it’s true that the euro crisis hasn’t yet produced its George Soros or John Paulson – someone who bets against the herd and wins big – that doesn’t mean it won’t in due course. … There are no strategies that will succeed during this phase of the crisis. The only real opportunities will be when the single currency finally breaks apart. Then there will be two massive trades. One will be selling Germany. Despite what everyone keeps saying, it will be the big loser from the crisis in the medium term. An artificially low currency has turned it into an export machine – China with sausages. With its own currency that will soar in value, its manufacturers will be wiped out. At the same time its banks will be stuck with all the losses from the debt of the peripheral countries. It will be bankrupt for a generation. The other will be buying Spanish and Italian equities. Both countries have plenty of big successful companies, from retail to food to engineering. If they come out of the euro, they will renege on their debts or see them written off. And their new currencies will massively devalue, giving an immediate competitive boost to their domestic industries. Either would be a significant stimulus – together they will turbo-charge both economies. They will recover far faster than anyone expects. And so will their equity markets, which are already trading at bargain-basement levels. Both will be completely against the herd, which will be flocking into the new deutschemark and trashing the new peseta and lira. And both will be big winners. But that could be a couple of years away, which is probably too long a time horizon for most fund managers.” (Matthew Lynn via Market Watch, August 22)

A Jon Corzine comeback…

“In the most telling indication yet that the MF Global investigation is winding down, federal authorities are seeking to interview the former chief of the firm, Jon S. Corzine, next month, according to the people involved in the case. … Those developments indicate that federal prosecutors do not expect to file criminal charges against the former New Jersey governor. … Mr. Corzine, in a bid to rebuild his image and engage his passion for trading, is now weighing whether to start a hedge fund, according to people with knowledge of his plans. He is currently trading with his family’s wealth. If he is successful as a hedge fund manager, it would be the latest career comeback for a man who was ousted from both the top seat at Goldman Sachs and the New Jersey governor’s mansion.” (New York Times, August 15)

Video of the Week: Monkeys reject unequal pay...

It’s Occupy for animals.

Graph for Research Watch

(YouTube via Greg Mankiw, professor and chairman of the economics department at Harvard University, August 20)

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