3 ETFs to Benefit from Deleveraging

09/23/2011 7:30 am EST

Focus: GLOBAL

Those who predicted a phoenix-like recovery from the financial crisis were wrong. Even some bearish prognosticators have been surprised by the rich world’s weak growth, says Samuel Lee of Morningstar ETFInvestor.

There are lots of views on the economy, but one approach stands out for its predictive ability over the past few years: a rich-world “balance-sheet” recession postulated by international economist Richard Koo.

Such a recession begins when a nationwide, debt-fueled asset bubble pops and burdens firms and households with devalued assets and mounds of debt. Normal profit-maximizing behavior is turned on its head, as private actors focus on paying down their debts. Monetary policy becomes impotent as firms become unwilling to borrow at any interest rate.

The deleveraging process takes years and smothers growth until private balance sheets are repaired. In the meantime, public deficit spending has to take up the slack lest the economy shrivel.

However, the rich world lacks the appetite for more public spending; austerity is probably around the corner. The models motivating the balance-sheet recession suggest closing the public purse will hurt the economy and prolong the pain.

According to a McKinsey Global Institute report, the rich world has only just started deleveraging, thanks to government spending taking up the slack. The report identifies four deleveraging patterns based on 45 episodes from 1930 to the present: belt-tightening, high inflation, massive default, and growing out of debt.

Deleveragings have historically taken about seven years and usually cause recessions in the first few years. Growing out of debt has been rare; the few times it occurred were associated with a peace-time dividend or an oil boom.

If history repeats, a recession is a good possibility, motivating our first pick: PowerShares S&P 500 Low Volatility (SPLV). Its constituent stocks are slower-growing enterprises with low debt and ample cash flows, and are less sensitive to the market’s gyrations.

We’re hedging our bets here. If the market tanks, this fund will go down with it, just not as much. However, if the economy picks up, we still get rewarded.

Besides, low-volatility stocks seem to be underpriced because of investor biases and skewed fund-manager incentives—they’re just a good idea in general.

Deleveragings are sometimes achieved by inflation, currency devaluation, or financial repression. Inflation and currency devaluation are usually the tools of emerging markets.

Carmen Reinhardt argues that many developed countries have engaged in “financial repression,” the subtle liquidation of government debt through policies such as interest-rate caps, capital controls, and forced lending to captive audiences.

Gold generally does well under any of the three scenarios. Our pick is iShares Gold Trust (IAU).

Gold prices have been on an upward tear recently, raising fears of frothiness. However, its attractive insurance-like qualities warrant a premium. Because gold prices tend to exhibit auto-correlation—trendiness—gold’s risk can be mitigated by keeping an eye on the price trend.

Finally, avoiding deleveraging economies may make sense. Emerging markets are engaged in massive expansion of their balance sheets, leading to a virtuous cycle of asset appreciation and income growth, which in turn spurs further asset appreciation.

With relatively low debt/GDP ratios and massive foreign-exchange reserves, some emerging markets have years to go before they reach rich-world levels of leverage. However, emerging markets still have endemic corruption and poor rule of law.

We like WisdomTree Emerging Markets Equity Income (DEM) for its focus on dividend-paying companies, which we believe muzzles manager misbehavior such as share dilution and empire-building.

Many investors seem to think that the last recession was like others, just deeper. History and theory suggest that massive deleveragings are creatures unto themselves. Ignore them at your peril.

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