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.

With all the focus on US and the PIIGS, could it be that we’ve missed a major risk at the heart of Europe? Belgium could be on the brink of political collapse, and bond markets haven’t even begun to price in the risk. Back in the States, David Rosenberg graphs the upside-down recovery and Nouriel Roubini warns that there’s no ammunition left to fight the next global shock. If that’s avoided, though, Bank of America shows why markets will likely rally from here to the end of the year. Citigroup advises female employees not to “smile inappropriately” and we read over the details of Reagan, a big-budget Hollywood flick about the life and times of the 40th US president. In commodities, a look at what oil prices tell us about the long-term fortunes of gas, and at why gold’s base is strengthening. We also show you how to buy into hot new frontier markets and, on video, provide an investor’s guide to the upcoming Brazilian election.

A new crisis in the heart of Europe? '¦ “Things don’t look good on the continent. Hogging all the attention are Ireland, Portugal and Greece (where there is a continued run on bank deposits – they’ve now lost 11% of their deposit base since January, and one bank, National Bank of Greece, now has to raise new capital), with CDS and 10-year spreads over German government bonds widening sharply. But over in Belgium, things have become critical. Negotiations to form a new government, which have been dragging on since May, have broken down ... [and] talk from the Francophone Socialist Party about the end of Belgium as a national entity is starting to be taken seriously. So far, secession has been the agenda of a minority: the now largest Flemish party, Nieuw-Vlaamse Alliantie '¦ “We must start preparing for the end of Belgium,” senior French-speaking Socialist Laurette Onkelinx told the La Derniere Heure newspaper: Rudi Demotte, president of the French-speaking region of Wallonia, told Belgian radio that francophones should start to consider their options, including a future without Belgium '¦ At the moment, 10-year Belgian government bonds yield just 7 basis points more than Germans, so the market is discounting neither secession in Belgium nor the continued failure to form a government capable of sorting out the Belgian budget '¦ But if it begins to be clear that the secessionist idea really is getting wider traction on both sides of Belgium’s ethnic divide, those bond spreads will start to go Greek-sized and, worse, and not inch by inch. Then – voila, we have a sharp crisis right at the centre of Europe, not the periphery.” (Naked Capitalism, September 9)

Meanwhile, the US is in the middle of an upside-down recovery '¦

(David Rosenberg of Gluskin Sheff, September 8)

And there’s no defence against a double-dip '¦ “ 'The US has run out of bullets,’ says Nouriel Roubini, professor at New York University, and one of a cast of luminaries with grim forecasts at the annual Ambrosetti conference on Lake Como. 'More quantitative easing (bond purchases) by the Federal Reserve is not going to make any difference. Treasury yields are already down to 2.5% yet credit spreads are widening again. Monetary policy can boost liquidity but it can’t deal with solvency problems,’ he told Europe’s policy elite. Dr Roubini said the US growth rate was likely to fall below 1% in the second half of the year, despite the biggest stimulus in history: a cut in interest rates from 5% to zero, a budget deficit of 10% of GDP, and $US3 trillion to shore up the financial system '¦ 'We have reached stall speed. Any shock at this point can tip you back into recession. With interbank spreads rising, you can get a vicious circle like 2008-09,’ he said, describing a self-feeding process as the real economy and the credit system hurt each other. 'There is a 40% chance of double-dip recession in the US, and worse in Japan.’ Dr Roubini thinks average public debt in the rich countries will rise to 120% of GDP by 2015, leaving no scope for a further fiscal stimulus. If they push their luck, they too risk the sort of bond crises seen in Southern Europe this year. In the US, the fiscal boost has faded, switching to tightening over coming months. The lift from the inventory cycle is finished. Capex spending by companies has held up well, but this slowed sharply in July. Housing is already in a double-dip. The last support for the US economy is consumption, barely growing at 1%. 'All we did was kick the can down the road and stole demand from the future,’ Roubini said.” (Ambrose Evans-Pritchard, September 5)

But if it’s avoided, stocks look good '¦ “In the prior near-miss recessions of 1967, 1985, 1995, 1998 and the 2003 near-double-dip, the S&P 500 delivered an average return of 15% from the start of September to January-end. Once recession fears subside, we believe the global cyclicals – energy, materials, industrials and technology – should rally the most, as they are best positioned to benefit from exceptionally low rates in the US and healthy global growth. They are also the sectors most exposed to healthy US business spending.” (David Bianco at Bank of America Merrill Lynch via the Money Game, September 8)

Citibank’s advice to career women in 2010 '¦ “While interviewing at Citibank, my friend stole this from the office '¦ Citi had these cards lying on every desk in the HR department, a department dominated by women in many firms.”

(David Xia, August 12)

Eight years of earnings pain for gas producers? '¦ “For many years, oil prices (measured in US dollars per barrel) tended to be six to 12 times natural gas prices (as measured in US dollars per MMBtu). That ratio blew out to more than 20 in late 2009, briefly receded toward more traditional levels, and then expanded again. This week, the ratio stands at around 19.4, far above its historical range:

The unusual pricing of the last two years reflects two factors. First, there has been a dramatic expansion in natural gas supplies '¦ Second, there is limited opportunity for energy users – utilities, businesses, and home owners – to switch from oil to natural gas. Years ago, such switching linked oil and natural gas prices relatively closely. But today those prices appear largely decoupled '¦ As illustrated in dark blue above, futures prices imply that the ratio of oil to natural gas prices will remain well above historical levels for at least the next eight years. The new normal will be for oil prices to average about 15 times natural gas prices.” (Donald Marron, September 7)

Gold’s latest support '¦ “When the world’s second-largest and fastest-growing economy liberalises gold ownership by individuals and repeals the death penalty for the illegal importation of the yellow metal, you'd better pay attention '¦ In 2009, China imported 73 metric tonnes of the barbaric relic worth $US2.6 billion to bring its official holdings to 1054 metric tonnes. That leaves it far behind the US, which at 8133 tonnes is the world’s largest gold owner. China’s gold holdings amount to only $US37 billion, or only 1.5% of its $2.45 trillion foreign exchange reserves. To get China’s gold investment up to American levels on a GDP basis, it needs to buy 25 million ounces worth $31 billion. That amounts to 34% of the 2009 global annual production of $US110 billion '¦ Expect a quiet diversion of new current account surpluses out of the greenback and into gold. You can also expect other emerging market central banks to make the same move '¦ If non-G7 central banks from the current 20% average of reserves to the 35% weighting now owned by the G7, it will require 1.3 billion ounces of new purchases, or 20% of the total world supply '¦ The Chinese aren’t going to provide the next spike in gold prices, but they are building a floor higher than anyone expects. That’s why the last sell-off took us down only 8% to $US1158 before a rebound ... I’m starting to wonder if my long-term target of $US2300 an ounce is too conservative.” (Mad Hedge Fund Trader via Zero Hedge, September 7)

Emerging markets go mainstream '¦ “Goldman Sachs says faster economic expansion and growing capital markets may lift emerging nations’ share of world equity capitalisation to 55% by 2030, from 31% today. The market value of emerging-market stocks is expected to surge more than five-fold to $80 trillion, overtaking developed nations, as China becomes the world’s largest stockmarket. Institutional investors in developed nations will probably buy a net $4 trillion of emerging-market equities, lifting holdings to 18% of their total portfolios from 6% now, Goldman says. 'The primary drivers are rapid economic growth and the maturing of equity markets that are at earlier stages of development '¦ Developed-market institutional asset management pools will need to increase their holdings of emerging-market equities '¦ Investors, financial intermediaries and developed-market corporates will have significant opportunities as well as challenges from these shifts in the equity landscape.” (Bloomberg, September 8)

And frontier markets could be the next big bet – here’s how to play '¦ “Expect better returns with frontier markets over time, just don't expect to predict when and where. ETFs can simplify the process at vastly less expense, although during the past year, some of these have made emerging market (EEM) look stable:

Claymore/BNY Mellon Frontier Markets ETF (FRN) has perhaps the broadest of any frontier ETF. It provides solid exposure to 10 worthwhile countries such as Egypt, Colombia and Kazakhstan. Although it has high exposure to Chile at 31%, the February earthquake had surprisingly little effect. Fees are reasonable at 0.65% '¦ At the SPDR S&P Emerging Middle East & Africa ETF (GAF), almost 90% of holdings are from South Africa and Israel GAF neglects Nigeria, Asia, or Gulf States, which would have made it more useful to the frontier investor '¦ For African-only exposure, there is Van Eck Market Vectors Africa Index ETF (AFK), with annual fees of 0.83%. It contains large amounts of South Africa, Nigeria, Morocco and Egypt. Some view South Africa as emerging, but its economy is tied to other African frontier markets. The iShares MSCI South Africa ETF (EZA) allows direct exposure to that continent-leading country. The Gulf and Middle East is represented by WisdomTree Middle East Dividend ETF (GULF), with annual fees of 0.88%, and Van Eck Market Vectors Gulf States ETF (MES), with annual fees of 0.98% '¦ Some quite risky Eastern European countries may be found in SPDR S&P Emerging Europe ETF (NYSEArca:GUR), with annual fees of 0.6%. GUR has large exposure to Russia, whose Wild West atmosphere could easily put it in the frontier camp despite its superpower diplomatic status ... The rule of thumb is that the further from Western Europe, the slower market reforms have been.” (EFT Zone, August 9)

Reagan: The movie '¦ “The story of Ronald Reagan's life – from boyhood to Hollywood actor to leader of the free world – is about to spill out on the big screen '¦ The feature film, titled Reagan, and sporting a $30 million production budget, is set for release late next year and will be based on two best-selling biographies of the 40th US president by Paul Kengor: The Crusader and God and Ronald Reagan '¦ No actors or director have been signed, and the producers are currently considering two distribution offers.” (Hollywood Reporter, September 7)

Video of the week: Bullish on Brazilian elections '¦ Brazil goes to the polls in a few weeks – here’s what it means for markets.

(Wall Street Journal, September 7)