Why we like emerging market debt in 2013

As we approach 2013, all eyes are on the fiscal cliff. Government spending makes up a significant percentage of overall US GDP. If Congress fails to act to avert the deep expected spending cuts, I believe we will fall into a recession. There are still macroeconomic risks globally, particularly in Europe. In the near term, my biggest concern is the way that the fiscal cliff issue is handled and ultimately resolved.

It is difficult to predict the way that Congress will ultimately address this issue. For a lack of a better example for a historical precedent for this, we may examine the impact of the debt ceiling debates on the financial markets. During the summer of last year, we faced the looming debt ceiling. In response, there was a lot of bickering from both Republicans and Democrats, the decision came down to the wire, and we reached only a temporary solution.

During this time, I think that many investors simply lost their confidence. In the five week period surrounding the debt ceiling debates back in 2011 the stock market lost as much as 17%.

In our Covestor Asset Allocation model, we remained more on the balanced and cautious side through the final quarter of 2012. We included investments in asset classes such as cash, managed futures, and emerging market debt. In order to access emerging market debt, we used the Wisdom Tree Emerging Markets Local Debt Fund (ELD). With ELD, in addition to the diversification from the US sovereign risk, we get a currency hedge against US dollar denominated assets.

Our asset allocation helped to produce relatively favorable upside returns, while maintaining diversification benefits due to our reduced correlation to the general stock market. It has become increasingly difficult for investors to achieve the benefits of diversification in the stock market alone. Since the financial crisis, the correlations across different asset classes of stocks have remained elevated. In this risk-on, risk-off environment that we have seen, many kinds of stocks have traded closely together.

Part of the fiscal cliff also can be extended to the so called dividend cliff that is also set to take place at the beginning of 2013. We have the expiration of the Bush Tax Cuts and the overall potential tax increases currently being discussed as part of the fiscal cliff. This includes proposed changes to dividend tax rates. They are likely to increase in 2013, although there is uncertainty as to new rates.

This is why many US companies such as Costco (COST), Las Vegas Sands (LVS) and Walt Disney (DIS) are proactively paying out special dividends in order to lock in today’s historically low rates. If rates rise, dividend stocks can become slightly less attractive in terms of total returns. Investors might say, “Well, I own my dividend stocks in an IRA, so increased dividend tax rates don’t affect me.”

This is not entirely true because many investors own the shares in a taxable account. If those investors choose to dump their shares, it can affect all investors. Furthermore, many dividend paying securities have run up in value over the past few years. As bond yields have fallen to very low levels, yield starved investors have sought out dividend payers. In response, some of these stocks have traded up to lofty levels. Should dividend taxes end up at significantly higher rates; these stocks will be vulnerable to a downturn.

Any index comparisons provided in the blogs are for informational purposes only and should not be used as the basis for making an investment decision. There are significant differences between client accounts and the indices referenced including, but not limited to, risk profile, liquidity, volatility and asset composition. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry, among other factors.

Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.

Daniel Beckerman

Daniel Beckerman