I am still on alert for a larger pullback in the market. The larger picture suggests the SPX will li...
Now it's the turn of world's developed markets to be riskier for investors
04/08/2011 8:30 am EST
For the last six months the world’s emerging stock markets have been riskier than their developed market peers.
For the next six months—and perhaps more—the world’s developed markets carry greater risk.
And, in my opinion, you ought to start weighting your portfolio to reflect that shift in risk.
Why mark this shift down to this week in particular?
The interest rate increase from the European Central Bank on Thursday, April 7, wasn’t much—just a move to a 1.25% benchmark rate from the historic low at 1%--but it does mark the beginning of a cycle of interest rate increases in the big developed economies of the European Union, the United Kingdom, and the United States. Central banks in all three of these economies are about to embark on a cycle of interest rate increases that will stretch well into 2012.
The European Central Bank, the Bank of England, and the U.S. Federal Reserve are all looking to slow rising inflation—although with different degrees of urgency and different timetables. To fight inflation the banks will raise interest rates, slow or reverse growth in money supply, and lower economic growth rates.
Slower growth, tighter money, and higher interest rates have historically not done good things for stock prices. At the least they act as a drag on any potential rally.
Six months ago it was the emerging economies of Brazil, China, India, Indonesia, Turkey and more that were looking at the beginning of a cycle of multiple interest rate increases, policy moves to restrict growth in money supply, and lower growth rates. Those cycles of interest rate increases aren’t over, but in some countries I can see the end of the cycle within a quarter or two. And in some of these economies the slow down that these policies was intended to produce has already visibly taken hold.
Stocks in these markets could still move somewhat lower in the near term as expectations for growth move from reasonable to extreme pessimism. But the end of the downward pressures is in sight.
Contrast these two sets of markets, emerging and developed, using Brazil and the European Union as examples.
In Brazil, the Banco Central do Brasil has aggressively raised interest rates to 11.75% starting in April 2010. The economy has started to slow even though inflation has continued to climb.
But the financial markets are pricing in an end to a cycle of interest rate increases that began with the benchmark Selic rate at 8.75%. Expectations are now that the central bank will raise the benchmark again in April, but that the top to this cycle isn’t so far away at 12.5%. Inflation will peak, the consensus now holds at 6.5% in the third quarter and then gradually pull back to the central bank’s target of 4.5% in 2012.
In other words, at some point not too far down the road investors will be able to start anticipating not just an end of increases in interest rates, but below-target inflation, potential interest rate cuts, and rising economic growth again.
Contrast that to the situation in the European Union after yesterday’s interest rate increase. The financial markets now project that the central bank will raise rates three times—in small 0.25 percentage point increments—in 2011.
But that doesn’t mean the cycle will include just those three interest rate increases. In March inflation climbed to a two-year high of 2.6%--well above the bank’s target of close to but not above 2%. Unlike the U.S. Federal Reserve, the European Central Bank includes food and fuel costs in its inflation measures and with prices in both those sectors climbing getting inflation under control won’t be easy.
The three interest rate increases projected by the financial markets in 2011 aren’t really an indication that the markets think the job will be easily accomplished after just those moves. Rather, I think, that projection is an indication of how carefully the markets think the European Central Bank will have to move to avoid turning inflation-fighting measures into a new and deeper crisis for Greece, Ireland, Portugal and the other budget-deficit challenged members of the European Union. The bank can’t fight inflation as vigorously as it might prefer, the markets are saying, because it doesn’t want to completely tank the Eurozone’s weakest economies.
In other words, there’s really no end point in sight here. The central bank will raise interest rates as aggressively as it can and reduce economic growth as much as it can, but no one really knows how long this cycle will last.
Risk from monetary policy isn’t the only area in which risk is headed in different directions in the emerging and developing markets at the moment. There’s also the little matter of fiscal policy.
On this front, let’s contrast Brazil and the United States.
On Monday, April 4, Fitch Ratings upgraded Brazil’s credit rating again to BBB from BBB-. Brazil earned its first investment grade rating—that’s first EVER—in April 2008. In upping the country’s rating on April 4 Fitch Ratings sited strong growth trends in the economy and signs that President Dilma Rousseff was “exercising greater fiscal restraint.” Brazil’s Finance Minister Guido Mantega called the upgrade “an acknowledgment that the Brazilian economy is increasing stable and doesn’t present risks.”
Can you think of anyone outside Arkham Asylum who would apply those terms to the United States at the moment? The current budget deficit seems restrained only in comparison to projections which show it headed to the stratosphere as the U.S. population ages and government spending on healthcare eats up the all federal income. Serious discussions about the credit rating of the country focus upon whether any of the credit rating companies will have the guts to downgrade the world’s largest economy—and the world’s largest debtor.
I can name a handful of emerging economies that have seen upgrades in the last few years to investment grade (or better) or that are headed in that direction—Brazil, Turkey, Indonesia, Columbia, and Peru come to mind. I can’t think of a single major developed economy that’s not looking at the possibility of a downgrade.
All things being equal, upgrades mean lower interest rates, faster economic growth, and higher stock and bond prices (as investors decide that these assets carry less risk). Downgrades mean higher interest rates, slower growth and lower asset prices.
And finally investors need to consider the way in which higher risk leads to higher risk.
For example, the world’s central banks know that they have to tread with incredible caution in raising interest rates since higher oil prices, which feed into inflation, themselves slow economic growth. But the world’s central banks don’t all have the same margin of error. A central bank trying to lower inflation in an economy growing at 2.5% with rising oil prices doesn’t have the same leeway as a central bank in an economy growing at 5% or 7% or more. A mistake in the first situation could tip an economy into recession. A mistake in the second situation could, well, reduce growth to 3% from 7%.
For all of these reasons, I think the smart move now is to reduce your portfolio exposure to the riskier developed economies of the world and increase your exposure to the least risky of the world’s emerging economies. You don’t need to dump everything in developed markets—that’s not the point of this kind of relative risk assessment. What you would like to do is to reduce the risk in your portfolio by shifting market weightings and by, within, individual markets, selling stocks that look extended or that would fall inordinately if risk went from being theoretical to actual.
You don’t need to do this all today—although starting this kind of reallocation when stocks in developed markets are near highs is a good idea.
Take your time to go through your portfolio looking for over-extended or underperforming stocks to sell. I’ve got one suggestion for you from Jubak’s Picks that I’ll post later today.
And don’t load up on just any emerging market stock. Remember that some emerging market stocks, especially the big commodity producers, are incredibly sensitive to fears of lower growth in developed markets. In the coming days I’ll have a few suggestions for emerging market stocks that you can use as part of this portfolio reallocation.
It would be a reasonable goal to have this process pretty much completed by sometime around the end o the second quarter or the beginning of the third.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of January see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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