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.

As you consider your investment options for 2013, it’s constructive to expect the unexpected. And with that in mind, Morgan Stanley is out with a list of plausible left-field scenarios that would represent a meaningful surprise to the prevailing consensus – from a “Brixit”, to recession in Australia. We’ve chosen the six most relevant points, but the full list offers plenty more of food for thought over the holiday break. Meanwhile, the normally bearish Dave Rosenberg offers a surprise of his own: he’s becoming more optimistic as dark market clouds begin to part. Although BofA Merrill Lynch says stocks could still enter a bear market next year. Elsewhere, McKinsey shows how the world’s economic centre of gravity is shifting east, where the Pew Research Centre discovers a very different set of financial and political concerns. Tips on building your own hedge fund using ETFs, cosmic GDP is collapsing, and, on video, Ray Dalio goes long on Australian agricultural property.

Six surprises for 2013...

1. “Inflation Returns (Joachim Fels/Charles Goodhart). A strong economic rebound in China and the US, adverse supply shocks in agriculture and worries about swelling central bank balance sheets lead to a sharp rise in actual and expected global inflation. Central banks don’t dare to respond, given high debt levels and financial fragilities, and either continue to ignore or abandon their inflation targets. Rising wheat prices lead to bread riots. In the UK, Chancellor Osborne advises the British to eat oatcakes instead.
2. Debt Cancellation (Spyros Andreopoulos). The US Treasury, Japan’s Ministry of Finance and Her Majesty’s Treasury jointly announce that the Treasury debt held by the Federal Reserve, Bank of Japan and Bank of England respectively as a consequence of QE purchases are cancelled, and that these central banks will operate with negative equity until further notice. As a consequence, government debt/GDP ratios are brought down by 11pp, 18pp and 25pp, respectively. Ratings agencies love it, as does the bond market – until it realises that large-scale debt monetisation has just taken place, and sells off sharply.
3. US Over the Cliff and Likes it (Vincent Reinhart). … A deal delayed to early 2013, in which politicians compromise because of concerns about financial markets would resolve uncertainty more assuredly than the baseline of stop-gap legislation followed by a plan later in the year. As a consequence, confidence gets a boost, pent-up business investment kicks in and the labour market improves more rapidly.
4. From ‘Grexit’ to ‘Brixit’ (Elga Bartsch). Financial markets come round to the idea that Greece will stay in the euro for the foreseeable future. Instead, investors are getting increasingly concerned about the UK’s political stance on Europe, especially in view of a possible referendum on EU membership. Polls during 1H13 start to suggest that an exit of the UK from the EU is now seen as more likely than an exit of Greece from the euro. The London property market wobbles as financial institutions start making contingency plans for moving employees to Frankfurt and Paris.
5. Recession Returns to Australia (Gerard Minack). Australia hasn’t had a recession for 21 years - arguably, one is overdue. Markets view the risk as low: fixed income markets are pricing in only 1-2 more rate cuts, and equities have re-rated through 2012.
6. China’s Shocking Tightening (Helen Qiao). The Chinese government inadvertently tightens financial conditions aggressively by applying a ‘shock therapy’ during the early stage of the recovery. Off-balance sheet lending activities are banned and forced to roll back onto commercial banks’ balance sheets, causing a major liquidity freeze in the system. More credit defaults occur, giving rise to higher systemic risks. The economic recovery unravels.”

(Morgan Stanley via Zero Hedge, December 16)

Economic clouds are parting...

1. “...Some stabilisation of the US data should prevent further downgrades at least as Q4 GDP consensus call is concerned.
2. ...We are moving closer to a deal on the fiscal front. The cliff will likely be avoided but Q1 will still be a steep hill.
3. ...China not only managed to successfully guide its economy into a soft landing, there are now signs of renewal in industrial activity.
4. ...There are [US housing market] experts who I have a ton of respect for (Michele Meyer at BAML, for one) who sees sustained strength in 2013.
5. Japan just elected a new government that is much more dedicated towards reflation than its predecessor.
6. ...We know that the ECB has managed to put a floor in regarding the Euro area crisis which has not suffered a flare-up in a year.”

(David Rosenberg of Gluskin Sheff, December 18)

But stocks could still enter a bear market next year...

“BofA Merrill Lynch technical analyst Mary Ann Bartels... says that if certain underlying market trends don’t turn around soon, there could be a big correction in stocks that ushers in a bear market next year. ‘We expect the equity market to remain strong moving into year-end 2012 and into early 2013, but the risk of a bear market is in excess of 20% beginning in 2013,’ she writes. There are three things that have Bartels worried.

1. The advance-decline line, which she says hasn’t confirmed the recent rally in stocks. (The advance-decline line measures the number of stocks that are rising, less the number of stocks that are falling.) While the S&P 500 has rallied, the A/D line has remained flat.
2. The presidential cycle. Bartels writes that ‘after a presidential election, in the month of February the market is often down sharply, on average by 2.3%.’ The chart below suggests 2013 will mark the ‘weakest period of the presidential cycle,’ based on historical trends:

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3. The big run in stocks that started in the spring of 2009 may be approaching the end of its shelf life. March 2013 will mark four years of expansion in the market. However, Bartels writes, ‘The average time a bull market for the S&P 500 in excess of 20% lasts [is] 2.5 years and the cyclical bull from March 2009 is the eighth longest out of the 25 bull markets that have occurred since late 1929.’”

(Mary Ann Bartels of Bank of America Merrill Lynch via Money Game, December 17)

There’s no respect for ratings...

“The global bond market disagreed with Moody’s Investors Service and Standard & Poor’s more often than not this year when the companies told investors that governments were becoming safer or more risky. Yields on sovereign securities moved in the opposite direction from what ratings suggested in 53% of the 32 upgrades, downgrades and changes in credit outlook, according to data compiled by Bloomberg. That’s worse than the longer-term average of 47%, based on more than 300 changes since 1974. … ‘Policy makers should be more preoccupied with the market than with the ratings companies, because that’s where the real costs bear out,’ said Brett Wander, the chief investment officer for fixed income in San Francisco at Charles Schwab Investment Management Inc. ‘Credit-rating agencies historically lag the real economic fundamentals, whereas markets are ahead.’” (Bloomberg, December 17)

Build your own hedge fund...

“According to [William] Bernstein’s analysis, investors can more or less replicate hedge funds with just a handful of low-cost ETFs containing the same essential nutrients–market beta, size and style. The building blocks are simple: varying amounts of just two ETFs, plus cash. One ETF tracks the Russell 3000 index, which includes 98% of the US stock market. The other includes the Russell 3000’s ‘growth stocks’–companies with high prices relative to their ‘book value,’ or the total value of their assets minus debts. … There are four broad categories of hedge funds. They have the same nutrients–just in different proportions.

1. ‘Equity-hedge’ funds. These funds buy stocks they believe in while betting against companies whose shares they think will drop. … To mimic the typical equity fund, you could use a portfolio with 38% in the growth ETF, 16% in the Russell 3000 ETF, and 46% in cash, Mr. Bernstein says. …
2. ‘Relative-value’ funds. Such funds wager on the price differences between related investments. To replicate the average relative-value index, investors could put 14% in the growth ETF, 15% in the total market ETF, and 71% in cash. …
3. ‘Event-driven’ funds. These funds seek to profit from special situations, like big news events, mergers and takeovers. They can be replicated with a portfolio of 14% in the growth ETF, 24% in the total market ETF and 62% in cash. …
4. ‘Macro’ funds. The fourth broad category of portfolio, macro funds can rapidly change their exposure to asset classes and countries based on macroeconomic factors. They are almost impossible to mimic with a passive ETF portfolio. Very little of macro hedge funds’ performance over the last five years can be explained by beta, size and style, according to Mr. Bernstein’s analysis.”

(Wall Street Journal, December 14)

The world’s economic centre of gravity is shifting...

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“In a single visual, this McKinsey map shows the shift of the world’s economic center of gravity over the past 1,000 years–and forecasts an accelerating move farther east in the coming 15.” (McKinsey Global Institute, December 17)

Giving weight to a whole new set of concerns...

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“[This chart] not only tells us the top 12 issues Chinese people are becoming more worried about, but what problems we’ve been missing in our reporting on China. Food safety – a topic that was in the news a lot in 2008 after the Sanlu milk formula scandal but not since – saw the highest increase in anxiety between 2008 and 2012. While over half of people surveyed think government corruption is a problem, that’s only about a 10% increase since 2008. This is a guess, but if anything is going to bring on mass protests and take down China’s dictatorial government, it’s more likely to be bad food than a massive graft scandal.” (Pew Research Centre via Quartz, December 17)

Cosmic GDP is crashing...

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“The Royal Astronomical Society writes: ‘Cosmic GDP’ crashes 97% as star formation slumps... While parts of the world experience economic hardship, a team of Portuguese, UK, Japanese, Italian and Dutch astronomers has found an even bigger slump happening on a cosmic scale. In the largest ever study of its kind, the international team of astronomers has established that the rate of formation of new stars in the Universe is now only 1/30th of its peak and that this decline is only set to continue.’ …  Dr Sobral comments: ‘You might say that the universe has been suffering from a long, serious “crisis”: cosmic GDP output is now only 3% of what it used to be at the peak in star production!’ The decline in the universe’s star production appears structural and secular to us. … The universe must be suffering from not enough demand, too much austerity, and thus needs the cosmic central bank to engage in some QE.   That is, Quasar Easing.” (Global Macro Monitor, December 18)

Video of the Week: Ray Dalio...

The head of Bridgewater Associates offers his thoughts on markets today, and some of his favourite trades – including buying Australian farmland and shorting bonds.

(Dealbook via Pragmatic Capitalism, December 13)