Saturday, August 20, 2011

Conventional Wisdom (cont.)

I recently noted the overwhelming consensus when the S & P downgraded U.S. Government debt that U.S. Treasury notes and bonds should be avoided or shorted.

Related to that thinking is that the U.S. and other developed nations are in inexorable decline, and emerging nations are where the action is.  The BRICs (Brazil, Russia, India, and China) have indeed posted rapid economic growth.  That hardly went unnoticed, as individual investors in the U.S. withdrew $344 billion from domestic stock funds from 2007 through June, 2011 but added $68 billion to emerging-market funds (according to the Investment Company Institute).  

Some of that might have been the usual performance chasing behavior that has caused investors in mutual funds to significantly lag the returns from indexes or the mutual funds themselves.  Part of that shift in assets, though, was probably an appropriate strategic shift in asset allocation that reflects the increased relative size of emerging economies and their stock markets.  Allocations by both institutional and individual investors are likely still far too small on a longer-term basis.

The other day, however, I emphasized the importance of strategic versus tactical investment decisions.  While the strategic, fundamental case for emerging economies and their currencies, bonds, and stocks is compelling, the tactical position is different.  Though it has drawn little attention, in two of the key emerging economies--India and Brazil--the yield curve has inverted.  This condition of short-term rates being higher than long-term rates has typically preceded economic recessions and bear markets.

Brazilian authorities have struggled with massive popularity of their country's currency, bonds, and stocks.  The Brazilian real has risen sharply and with local interest rates in the double digits, a surge of foreign funds into the domestic bond market led the authorities to impose fees on the inflow of foreign bond investments.  The Brazilian stock market has already fallen 25% from its peak during the last year, so perhaps the inverted yield curve and an economic slowdown--if not an outright recession--are already being discounted.

I just think that the bullish case for emerging markets might seem a bit obvious and would be cautious in the short term.  China is crucial to global commodity markets and the risk tolerance of market participants, and I think trouble in China is not yet sufficiently discounted in markets.

If global markets have another leg down in the next few weeks, then I'd feel more comfortable in raising the allocation to emerging markets in line with the strong secular case.

Steve Lehman

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