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James Nesci
Senior Vice President
Chief Wealth Management Officer
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Alan D. Segars
Vice President
Investment Management Officer
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In last month’s Wealth Management Monitor, we examined US sovereign debt relative to other AAA-rated countries, AA-rated countries, and the infamous PIIGS (Portugal, Italy, Ireland, Greece and Spain). Our conclusion was that, based on financial ratios measuring macroeconomic performance, government performance, and external balances, the US profile was only marginally better than that of the PIIGS. This exercise addressed sovereign debt credit quality in developed countries. An interesting question is, “If there is credit risk within the developed community, is there opportunity within the emerging market (EM) universe of sovereign debt?”
Let’s start with a view from 30,000 feet. In the aggregate, emerging markets have several financial advantages over the developed world. Balance sheets are stronger, fiscal and monetary policies are generally more responsible, and growth prospects are superior. According to IMF data, for example, emerging markets had a 2009 current account surplus of $355 billion, projected to increase to $550 billion in 2010. Developed markets by contrast had a current account deficit of $262 billion, which is expected to decline only to $161 billion in 2010. Gross national savings in EM equaled 33% of GDP in 2009 and are expected to rise to 34% this year. Developed markets had national savings of 17% with 18% forecast for 2010. Clearly there are political and other risk considerations in EM. Dependence on foreign demand, higher inflation, and unsettling capital inflows are a few of the additional risks. At the same time, however, bond risk premiums are considerably higher and could compress in relation to developed countries which are confronted with rating downgrades, debt defaults and debt servicing issues. Further, in a global environment of deleveraging, growth challenges, and low policy interest rates, yield will be an important factor in investors’ total return. EM bond yields have a considerable advantage in that regard.
Drilling down to specifics, we are utilizing the same ROD (Ranking Of Data) analysis used last month for developed country sovereign debt. The EM country universe is taken from the PCY Exchange Traded Fund, Powershares Emerging Markets Sovereign Debt Portfolio. As shown in the table below, data categories are the same as our previous exercise: real GDP growth, unemployment rate, debt % GDP, and external debt % GDP. We compare the PCY 22-country average to the 14-country AAA average, the 10-country AA average, and the US average. EM results are superior in all categories except unemployment rate which is nonetheless better than the US rate and only marginally higher than the AA average. The countries are in approximate descending order based on portfolio weight.
The table highlights the stronger growth profile and, perhaps most importantly, significantly lower debt % GDP versus developed countries. The IMF expects emerging economies to grow 6% this year or about three times the growth of developed economies. The PCY ETF has a 12-month yield of 6.4% compared to 1.2% for the ISHG ETF, iShares S&P/Citigroup 1-3 Year International Treasury Bond Fund. ISHG is comprised of developed country debt. Although PCY has a longer duration (about 7 years) than ISHG, its risk profile (volatility, downside risk, upside/downside capture, maximum drawdown) is equal to or better than ISHG. Finally, PCY’s Sharpe Ratio (excess return per unit of risk) is 2.42% versus (0.69%) for ISHG.
Asset Allocation Recommendation
We made one change to the Asset Allocation Model this month. We initiated a 2% position in PCY, PowerShares Emerging Markets Sovereign Debt Portfolio, for Balanced and Aggressive strategies and a 1% position for the Conservative strategy. We sold corresponding percentages of ISHG. As shown in the chart, we continue to underweight equities and international bonds. We are neutral domestic bonds.
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MARKET CLOSES
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| S&P 500 Index - 1,113.2 |
Dow Jones Industrial Average - 10,442.4 |
10-Year Treasury Yield - 3.24% |
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The Wealth Management Group of The Provident Bank has prepared this commentary for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or a solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security or pursuing a particular investment strategy. Any opinions expressed herein reflect our best judgment as of the date of this publication and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and may involve general market risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements.
The opinions, views, and information expressed in this commentary regarding portfolio holdings are subject to change without notice. The information provided regarding portfolio holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to change based on market conditions and other factors. Investors should consider their individual circumstances, investment goals, and risk tolerance prior to making an investment decision.
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