Posted on August 19, 2011

The slow moving European train wreck, coupled with poor fundamentals in the U.S., has Morgan Stanley cutting global GDP growth to 3.9% from 4.2%. What’s interesting about those numbers is the fact that nearly all of that growth is coming from Asia.

Nevertheless, despite Asian growth, global equities from Hong Kong to New York are in decline because of the systematic risk stemming from the U.S. and Europe. The sovereign debt crisis there is hurting the balance sheet of European banks, with the market wondering if Europe is now facing its own 2008.

When this kind of uncertainty happens in the market, fund managers move into safe haven assets, mainly U.S. Treasurys. When the Dow declines over 470 points in a day, U.S. bond prices rise by nearly 1%. U.S. 10 year bonds are now yielding just 2.07%. Five year Treasury TIPS, sold on Thursday, are negative. In other words, money going into U.S. short-term debt today is either losing money, or returning barely above inflation.

Where are the places to hide in this market? Utilities? Those are defensive dividend paying stocks and people like them. But they are still equities and equties are selling off so investors are getting the dividend yield but their share value is eroding. AES Corporation (AES) underperformed the market on Thursday, falling 5.22%. Calpine Corporation (CPN) fell 3.76%. The diversified SPDR Utility (XLU) dropped 1.73%. It yields 4.09%. But investors can get that kind of yield elsewhere without watching their portfolio value decline. That leaves fixed income, and U.S. bonds have zero returns, so where do you park a million dollars without losing it?

With new countries being added to the European sovereign debt crisis, emerging market sovereign credit managers should consider it a fairly safe assumption that there will be more such credit crisis episodes in Europe until the final catharsis occurs, whatever that may be. Drawing heavily on the first EU sovereign debt crisis episode in May 2010, several observed EM regional sovereign relationships are repeating during the present episode — July and August 2011. Bond prices have held up, despite the risk aversion that tends to keep investors away from emerging markets. That’s because savvy investors are realizing that the risk is in the advanced economies, and not in Asia and Gulf Coast sovereigns, for example. Both regions’ bonds have proven to be superior performers through this crisis.

Doha West Bay | Qatar

A million dollars in investment grade bonds in Qatar or Singapore means annual income of around $50,000. The upside is that that income is not in dollars, so there is a chance to earn even more from those investments as the dollar tends to weaken against Asian currencies.

“We would suggest an overweight position to Asian and Middle Eastern bonds,” says Michael Roche, a fixed income strategist at MF Global in New York.   How do you spot a safe haven investment…?

See which government bonds have low debt-to-GDP, preferably under 30%, with low budget deficits and a current account surplus or strong current account balance in a country that is growing at least 3% GDP annually. It has to have a stable, trustworthy government that is carrying out a set of constant development reforms that bring in new industries, reform the banking sector and have a good amount of foreign currency reserves in order to pay for foreign obligations and protect against attacks on their currencies. Those are the credit metrics, and few countries in the north meet that criteria. The Scandinavian countries do, but their bonds yield under 3%. Finnish 10 year bonds, for example, yield around 2.7%.

“There’s no yield in the advanced economies, so failing this your best bet is the investment grade Gulf States like Qatar and United Arab Emirates and in the Asian sovereigns,” Roche says.

Both regions have held up during the crisis as investors are discovering this new safe haven. For example, the spread on emerging market sovereign bonds as measured by the JP Morgan EMBI+ index was 242 basis points over USTs pre-EU sovereign debt crisis in 2010, widening by 128 basis points more during the 2010 crisis. In 2011, the spread was 263bp, and rose by only 117bp during the crisis, which means investors didn’t perceive as much contagion to EM bonds this year compared to last. The high the spread, the higher the yield.

Asia and the Middle East did even better. In 2010, prior to the EU crisis, average Asian debt yielded 174bp over USTs, rising by 96bp during the crisis. In 2011, Asian debt was 143bp over USTs and widened a bit more, but not by much, to 102 basis over USTs during the crisis this summer.

In the Middle East, yields were 239bp over USTs earlier this year, and then during the crisis they were on par with Asian debt with a 102bp spread over USTs.

Anyone trying to set aside money for retirement is not going to get yield in U.S. Treasurys. People are going to have to buy something. There is very little growth in the advanced economies, so that’s a negative for equities. Yet, interest rates are at zero, so borrowing costs are good for equities. However, a lot of the gains on Wall Street are among the big name companies who are doing very well in the big emerging markets. Companies are cash rich, but are not putting their money to work into the U.S. because of political risk and a simple lack of new business in the pipeline, says Richard Soultanian, a managing director at NUS Consulting Group.

The emerging markets are where the growth is, but global equities are struggling so equity in these markets are struggling, too. They are also higher beta. So for every 1% drop in the S&P, EMs drop around 1.5%. Once again, that brings investors back to fixed income. It might be easier to sleep at night knowing you’re getting 5% returns rather than hoping for 50% returns, and getting -5% instead.

Over the last three months, EMBI+ yields rose 15 basis points to 4.2% on average, nearly double USTs. Over the last year, the EMBI+ average yields are 8.1%, not even in the same universe as USTs.

Looking closer, soveriegn yields in countries like China, Singapore, Indonesia and Korea are averaging 6.3% over the last three months and 8.6% over the last year. Setting aside the investment grade among them, the big emerging markets are yielding nearly 5% in the last three months, and 7.5% over the last 12 months. Not only is there an alternative to equities, but there is an alternative in the fixed income space, too…

The professional investing public for the most part seems to have recognized this alternative and are quietly, but noticeably, rotating out of U.S. dollar debt. The financial services industry pumps a lot of money into marketing equities, but there is a tilt away from equities at the moment. It’s time to get out of the way of this market, says Barclays Capital North American fixed income strategist, Jose Wynne, and sell dollar denominated debt and buy Asia. Anything Asia, he told Forbes recently, including equities.

Where do you park a million dollars? Or even just $1,000? Investors are reconsidering holding debt that pays nothing in yield. The credit markets are starting to ask not only what debt to buy, but in what currency to buy it in.

Not everyone has a million bucks to buy Hyundai corporate bonds priced in Korea or AA rated Qatar’s sovereign debt. A portfolio of one part gold, one part U.S. Treasurys, one part Russell 2000 and one part foreign currency debt might be the perfect portfolio, says Roche of MF Global. Notice a portfolio like that is underweight equities from a balanced fund perspective, which is usually 60% equities and 40% fixed income. An investor could even reduce U.S. Treasury exposure and replace it with emerging market debt, says Roche, whose own world beta virtual portfolio is up three times compared to the S&P 500 since 1999.

For investors with just a cool grand to invest, consider the Permament Portfolio (PRPFX), Roche says. Initial investment in the fund is just $1,000. The Morningstar 5 star rated $15.1 billion mutual fund is up 7.88% YTD thanks to its gold, Swiss Franc and some older, higher yielding long dated U.S. Treasury bonds. Not everyone out there is still holding 7% USTs bought over a decade ago. And no one can buy that kind of yield in the U.S. market today.

By comparison, the iShares 3-5yr UST (IEI) exchange traded fund is up 5.9% and the Goldman Sachs Emerging Markets Debt (GSDIX) fund is up 3.2%. Over the last 10 years, the Permament Portfolio is up 181%, while the 3-5yr UST ETF is up 21.6%, Goldman’s Emerging Markets debt fund is up 27.8% since it launched in 2003, and the S&P 500 is down 22.7%.

author: Kenneth Rapoza, Contributor, FORBES