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ETFs for a Deleveraging World

The rich-world is in a balance-sheet recession, a rare kind that demands unusual responses. Here are ETFs that will do well.

Samuel Lee, 11/09/2011

Those who predicted a phoenixlike recovery from the financial crisis were wrong. Even some bearish prognosticators have been surprised by the rich world's weak growth. Why has this been the case? And what can investors do about it?

The last recession wasn't like others. Prognosticators wedded to the traditional, central-bank-induced recession framework have consistently gotten things wrong. The economy didn't swiftly bounce back up to its trend line. The Federal Reserve's unprecedented monetary expansion hasn't resulted in hyperinflation, nor does it seem to have helped the economy much. Massive government deficits haven't caused interest rates to surge.

One approach stands out for its ability to explain these facts: 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 money at any interest rate. The deleveraging process takes years and smothers growth until private balance sheets are repaired. In the mean time, 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 the watchword. The model motivating the balance-sheet recession suggests closing the public purse will hurt the economy and prolong the pain.

According to the McKinsey Global Institute report "Debt and deleveraging: The global credit bubble and its economic consequences," the rich world has only 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 caused 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 rich-world 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 flow 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 worldwide because of investor biases and skewed fund manager incentives--they're just a good idea in general.

Deleveragings are sometimes helped along 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 insurancelike qualities warrant a premium. Because gold prices tend to exhibit strong autocorrelation--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. The value effect is also stronger in less-efficient markets, so DEM might reap a higher premium than value strategies in developed markets.

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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Samuel Lee is an ETF Analyst with Morningstar.
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