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.

As a debate rages about when and how the world should exit long-running stimulus programs, there are fears that global growth will be the biggest loser. Nouriel Roubini outlines seven steps the world must now take to avoid an economic relapse, as a key set of indicators align to show that the US is already sinking back into recession. Silver might outpace gold as investors search for a safe place to plant their money, while others are suggesting you allocate 50% of your capital to emerging markets. The outlook for markets based on the winner of the World Cup and a graphic look at why BP can’t ring-fence its US operations as fresh allegations emerge, on video, that the company is undermining the Gulf cleanup effort by hiding animal carcasses and intercepting damaging cleanup communications.

Seven steps the world must take to avoid a disastrous relapse '¦ “First, in countries where early fiscal austerity is necessary to prevent a fiscal crisis, monetary policy should be much easier to compensate for the recessionary and deflationary effects of fiscal tightening '¦ Second, countries where bond-market vigilantes have not yet awakened – the US, the UK, and Japan – should maintain their fiscal stimulus while designing credible fiscal consolidation plans to be implemented later over the medium term. Third, over-saving countries '¦ should implement policies that reduce their savings and current-account surpluses. Specifically, China and emerging Asia should implement reforms that reduce the need for precautionary savings and let their currencies appreciate; Germany should maintain its fiscal stimulus into 2011 rather than starting its ill-conceived fiscal austerity now; and Japan should pursue measures to reduce its current account surplus and stimulate real incomes and consumption. Fourth, countries with current account surpluses should let their undervalued currencies appreciate, while the ECB should follow an easier monetary policy that accommodates a gradual further weakening of the euro to restore competitiveness and growth in the eurozone. Fifth, in countries where private sector deleveraging is very rapid via a fall in private consumption and private investment, the fiscal stimulus should be maintained and extended, as long as financial markets do not perceive those deficits as unsustainable. Sixth, while regulatory reform that increases the liquidity and capital ratios for financial institutions is necessary, those higher ratios should be phased in gradually to prevent a further worsening of the credit crunch. Seventh, in countries where private and public debt levels are unsustainable '¦ liabilities should be restructured and reduced to prevent a severe debt deflation and contraction of spending. Finally, the International Monetary Fund, the European Union, and other multilateral institutions should provide generous lender-of-last-resort support in order to prevent a severe deflationary recession in countries that need private and public deleveraging.” (Nouriel Roubini in Project Syndicate, June 15)

Although the US might be back in recession already '¦ “The following is our refined set of criteria for identifying oncoming recessions '¦ In every instance we've observed these conditions, the US economy has either already been in a recession, or has been within a few weeks of what turned out in hindsight to be the official beginning of a recession. There have been no false signals. 1: An increase over the past six months in either the spread between commercial paper and three-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields. This criterion is currently in place. 2: A yield spread between the 10-year Treasury yield and the three-month Treasury yield of anything less than 3.1%. As of last week, the 10-year Treasury yield was 3.22%. The three-month Treasury bill yield was 0.08%. So virtually any decline in the 10-year yield from here will put this criterion in place. 3: S&P 500 below its level of six months earlier. This is not terribly unusual by itself '¦ but falling stock prices are very important as part of the broader syndrome. This criterion is currently in place. 4: Manufacturing PMI (at or) below 54, coupled with either total nonfarm employment growth below 1.3% over the preceding year, or an unemployment rate up 0.4% or more from its 12-month low. At present, both of the employment measures are in place. Last month, the ISM PMI dropped from 60.4 to 59.7.” (John Hussman, June 14)

And the Fed is more likely to cut rates to zero than hike any time soon '¦ This applies to the upcoming June 23, August 10, and even September 21 meetings. The current interest rate is 0.25%.

(Goldman Sachs, via The Money Game, June 16)

A case for silver '¦ “First, you might hesitate plunking down $US1200 for an ounce of gold, but you can pick up 32 ounces of silver for half that amount. Second, silver has wide industrial use and this component can help or hinder its price. As its consumption increases across a growing number of industries, this should help place a floor under demand. And because of its unique properties, new uses continue to be discovered. Third, silver is money and has served this role more than any other material on earth, save gold. Due to its historical role, silver will always have monetary value and offer similar protection as gold to the ongoing global currency devaluations '¦ Fourth, silver could possibly outperform gold before this bull market is over '¦ In the latter part of the 1970s precious metals bull market, gold gained over 700% – but silver soared over 1400% '¦ Right now, silver is well below its inflation-adjusted peak reached in 1980 (and the gold/silver price ratio shows silver is rising faster than gold and suggests there is good upside potential) '¦ These big-picture signals tell us silver is undervalued and, at the moment, a better bargain than gold. And given the currency crisis we’re convinced is in the cards, we wouldn’t want to be caught without any. If you have a long-term mindset, silver is a buy today. Our suggestion for your precious metal holdings is roughly 80% gold and 20% silver.” (Jeff Clark of Casey's Gold and Resource Guide, via Zero Hedge, June 16)

But gold is still the safest of the havens '¦

(Clusterstock, June 14)

A 50% EM allocation is the new neutral '¦ “There’s an Interesting claim in a recent article about emerging markets. You should be allocating half of your portfolio to such markets based on their real share of global economies: 'Emerging markets constitute 13% of the MSCI all country world index, and by that measure most Western institutional investors are indeed underweight. But some analysts regard the MSCI weighting as excessively low. The index firm bases its weightings on the free float of shares in a given market and many emerging-markets companies have only a modest percentage of their shares in public hands, with the bulk still held by controlling families or governments. “Why should the somewhat arbitrary and fairly static rules of an index provider define useful investment allocations?” asks Jerome Booth, head of research at $33 billion-in-assets Ashmore Investment Management in London. He contends that investors should have a 50% exposure, which equals the emerging markets’ share of global economic output based on purchasing-power parity. “That’s if they’re neutral, not bullish,” he says.’ Of course if emerging markets deserve that sort of weighting then they are hardly emerging anymore. And that makes frontier markets – equatorial Africa, Vietnam, etc – the new emerging markets, a thesis I largely agree with.” (Infectious Greed, June 14)

The next black swan is closer than you think '¦ “I am referring to the new normal of disproportionate, high-impact, hard-to-predict rare events beyond the realm of 'normal expectations in business, history, science and technology’ that are occurring with startling frequency (such as the 9/11 terrorist attack, crises surrounding derivatives and the collapse of Lehman Brothers, BP’s Gulf oil spill and the recent Dow flash crash). Risks of black swans, previously perceived to be small by corporations, investors, politicians and regulators, are now being reassessed, owing to globalisation, tighter correlations, advancements in technology, the growing/excessive complexities of interlocking supply chains and derivatives, the acceptance of greater/extreme risk-taking, the greater connectivity of increasingly more complex systems and so forth '¦ We now know that these black swans are not only growth-deflating but, more importantly, are valuation-deflating '¦ Given the 'newness’ of these and other challenges as well as the greater frequency of black swan events, P/E multiples are being pressured and should continue to contract as a comparison between today's valuations to those of history can be expected to lose some of its significance and relevance '¦ In this setting, a more conservative asset mix and higher cash position than normal seems to be the prudent strategy.” (Doug Kass in The Street, June 15)

Here’s why BP can’t cut and run from the current disaster in the Gulf '¦

• For a larger version of this image, click here.

“That’s the corporate structure of BP, according to Citigroup, which went to the trouble of flow-charting the oil firm in response to client enquiries. Understandably, given the recent rhetoric from President Obama, they want to know whether BP could firewall its US business. And the answer to that question is that it would be very difficult, if not impossible. The reason is that BP American Production Company (that’s one of the red boxes half way down the graphic) is the primary subsidiary involved into oil and gas production and transportation in the US, Gulf of Mexico and other parts of the world, not to mention a number of BP’s other international assets. Citi says: 'The credit rating on this subsidiary appears to be tied to the parent BP Plc, which suggests the parent is a guarantor for BP America. The US subsidiaries also appear to be the domicile for many of BP’s international assets in, for example, Latin America, Trinidad and Tobago and Angola. BP Energy Company, Amoco International Petroleum Company, BP Exploration & Production and Amoco Caspian Sea Petroleum Company are major subsidiaries within BP America that we estimate hold not only much of the US production base but other international operations including much of BP’s assets in South America.’” (FT Alphaville, June 14)

And the World Cup could decide the fate of the euro '¦ “1) Spain wins: Buy the euro '¦ The European Union can afford to bail out Greece or Portugal if it has to, but not Spain – it is simply too big. Amid the euphoria of winning their first World Cup, the Spanish will accept any kind of austerity package imposed upon them by Brussels. A bailout will be avoided, and the euro saved. 2) Brazil wins: Buy the BRICs. Yet another win for the flamboyant Brazilians will remind everyone which countries are the rising powers in the world and which ones are in decline '¦ You can expect to see a big lift for all the BRIC equities, bonds and currencies as investors watch a member of that group celebrate. 3) Argentina wins: Argentines have a great team but they are managed by Diego Maradona – an eccentric genius with a history of cocaine addiction. If they triumph, investors will draw a simple lesson: management counts for little. What’s important is the raw materials. And with that in mind, they will pile into mining and resources assets. 4) England wins: Buy the FTSE 100 Index. The UK isn’t in great shape '¦ And yet if, by some miracle, Fabio Capello’s team can combine some Italian flair and discipline with English aggression, the country will be reminded that it is always at its best when it is in a deep hole. Expect a huge rise in patriotic determination to sort out the nation’s problems. 5) Germany wins: Sell the euro. The Germans haven’t got a great team by their historically high standards. But their traditional virtues of discipline, hard work and organisation may well pull them through. If so, the Germans will be reminded of the superiority of the Teutonic values of thrift and diligence, and wonder why they have tied their economy to a bunch of layabout Mediterraneans. The euro will collapse before the end of the year '¦ Finally, if the tournament is a success, expect to see a rise in all the African markets. Investors will note that African countries are perfectly capable of staging modern, global events and will start taking more of an interest in the potential of the continent.” (Matthew Lynn in Bloomberg, June 15)

Video of the week: A BP cover-up? '¦ BP faces new allegations it is suppressing evidence by hiding animal carcasses and interfering with phone and email communication at cleanup sites along the Gulf coast.

(MSNBC, June 14)