From the November 2011 issue of Investment Advisor • Subscribe!

Domestic, Emerging Market Debt Diverge

Investors are so pessimistic, just a hint of good news will lead to gains

As in most downturns, the middle and lower classes are taking the brunt of this less-than-stellar economic environment. The current abundance of pessimism has resulted in the “Occupy Wall Street” movement, a demonstration that bemoans the fact that while banks got bailed out by the government, the working class have been left to fend for themselves.

But a funny thing happened on the way to the demonstration. Stock prices dropped, even as profitability stabilized and, in many cases, increased. Nearly 72% of the firms in the S&P 500 index profited more than consensus estimates. For the 21st quarter in a row, companies spent less money than they generated.

Meanwhile, Standard & Poor’s downgrade of U.S. debt caused a perverse flight to quality rally in the very same asset S&P sought to disparage. Bond prices rose dramatically, yields fell and, for income-oriented investors, even long-dated Treasuries can’t generate enough interest to meet their needs.

The situation in Europe is dominated by fiscal problems in Greece, Italy and Spain. There is concern that the instability of the EU could eventually lead to its demise. That, combined with the region’s unemployment issues and debt issues, has led to a remarkable divergence between emerging and domestic market sovereign debt.

According to Morningstar, the 12-month yield of intermediate U.S.  government debt is 2.77%—dramatically lower than the 4.85% of emerging markets in local currencies. Similar differentials can be seen between the P/E ratios of domestic and emerging market equities. As in the above example, these gaps should eventually converge.

But it is less important to consider the existence of these opportunities than to contemplate why they came into existence in the first place. As forward-looking mechanisms, markets tend to overshoot. Savvy investors who have the courage to act against the prevailing consensus can benefit from positive portfolio convexity—capturing more market upside and less market downside. This is the key to generating attractive risk-adjusted returns.

How does this factor into our fourth quarter outlook? In a word, we see opportunities. Investors who need income—and this includes pension plans, sovereign funds and individuals—don’t have a choice but to take some risk in order to make a sensible return. As valuations have improved in many asset classes, we expect to see positive performance among risk assets and negative returns for Treasuries. In a nutshell, investor sentiment has shifted so far to the negative that even the slightest hint of good news should result in gains.

Our prosaic outlook does come with a caveat, however. The current environment has made it difficult to diversify returns. The correlation between the major sectors of the S&P 500 have lately been moving in lockstep—meaning that even the most creative asset allocator would have problems adding diversification within the domestic equity universe.

The best way to deal with this issue is to maintain an extra degree of diversification. It is very difficult, especially in the short term, to know exactly which asset class will perform the best.

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