Before I get into my specific calls, here’s my take on the proximate cause of last week’s market correction and how investors should consider positioning their portfolios given recent events including Friday’s downgrade of US debt.
I believe investors last week were reacting to the increased likelihood of a double-dip recession. What’s made such a situation more likely? From an economic perspective, a few things have recently changed investor expectations. First, the government’s downward revision in late July of the last several GDP reports demonstrated that the economy was never as strong as it seemed and is in fact more vulnerable to sliding back into a recession.
Second, the economy is slowing in response to the fading impact of fiscal and monetary stimulus. Finally, most of the growth we did have in 2010 was driven by a one-time replenishment of inventories. With that now over, the US and global economies are reliant on real demand from consumers and businesses, and unfortunately there is not much demand.
One of the reasons that demand is so weak is something we first started talking about almost three years ago: the deleveraging of the US consumer. While consumer debt has dropped, it still has further to go. This is critical for the economy because consumption gains can only come from one of three sources: income gains, gains in wealth or borrowing. For much of the previous decade, consumers were able to compensate for the lack of real income gains through a surging housing market and a related debt binge, neither of which can be relied on today.
While consumers have been paying down debts for three straight years, this process arguably has further to go. As the consumer is still reducing their debt, consumption is likely to be slow along with overall economic growth. To be clear, we still think the odds favor muddling through rather than slipping back into a recession; however; as we’ve been talking about for some time, it is going to be a slow, anemic and uneven recovery.
To be sure, the odds of a double dip recession have certainly risen and to the extent it further undermines consumer and investor confidence, Friday’s downgrade of US debt will not help the situation. At the very least, it will add to investor anxiety and market volatility.
Still, most equity markets are already discounting a lot of bad news. Developed market equities are trading at around 12x trailing earnings, right back where they were in February of 2009. As such, I think now is the wrong time to sell, and I would actually be looking for longer-term opportunities to add selectively. Now, here are my specific calls for this week.
Call #1: Neutral European Equities ex-Germany
First, I am removing my underweight view of European equities ex-Germany. While Europe will continue to struggle with sovereign debt issues, with the exception of Greece and a few peripheral countries, the risks facing Europe appear adequately reflected in the country’s price (potential iShares solution: IEV).
Call #2: Neutral European Banks
I’m also removing my underweight view of European banks. Since my underweight call earlier this year, the iShares MSCI Europe Financials Sector Index Fund ETF (EUFN) has lost approximately 24%, dramatically underperforming developed markets (potential iShares solution: EUFN). Past performance does not guarantee future results. For standardized EUFN performance, please click here.
Call #3: Overweight Brazil
Finally, as I discussed last week, I’m establishing new overweight views of certain emerging market countries and I’m starting this week with Brazil. I’ll cover Brazil in more detail in an upcoming post, but the main reasons for my overweight are that Brazil appears cheap, at 1.5x book value, and compared to most of the developed world, it has a relatively sound fiscal and financial position.
In addition, to the extent the global slowdown removes inflationary pressure; Brazil is likely to be big beneficiary. In other words, a moderation in inflation will likely benefit Brazil more than it would benefit other emerging markets such as India and China. Finally, while I would not establish an overweight view of other countries in Latin America yet, I am monitoring them. And I’m paying extra close attention to Chile, which also appears interesting (potential iShares solution: EWZ).
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility.