Global Markets are Diverging

Even the U.S. equity market seems to be waking up to the reality that the world isn’t perfect. Faced with the growing probability of a global slowdown, U.S. stocks have stalled out in recent months after a spectacular run for the first four months, leading me to the belief second half of 2013 might not prove as rosy as conventional wisdom predicted back in January.

According to my calculations, the divergence between the U.S. and emerging markets are now becoming too glaring for ordinary investors to ignore. Through August 19, the Standard & Poor’s 500 was up 17% for the year, while the MSCI emerging market index was down 8.5%.

When you break down the different emerging markets components, the picture starts to crystallize. Latin America is down a full 16%, trailing the U.S. by more than 33%. In contrast, Asia and Eastern Europe are down about 5.5%.
The gap in performance between those two markets is extreme.
Investors should be concerned about relative valuations in America but so far they seem to be more worried about risks in China, Brazil and elsewhere in the developing world.

Brazil’s commodity links to China explain only part of the giant South American nation’s problems. Reports show the real rates of return demanded by investors in Brazil has shrunken from their historical 5.0-5.5% norms to around 1.0-1.5%.

It’s now back to approximately 3.0% to 3.5%, as equity markets in Brazil have sold off to levels beyond what real rates of return should imply.

This is producing opportunities to play both sides of the Brazilian equity market. Some analysts think that [the correction in Brazilian stocks] makes markets like Brazil relatively attractive. Mainly as a long-short play.”

When correlations are rising, in-active trading becomes less appealing.
Strategies like managed futures and global macro that have gone sideways after performing brilliantly in 2008 might be a tough sell compared to the S&P 500 which has produced consistent double-digit gains since 2009.

Equities look good for the intermediate term and long term. But over the next couple of quarters, the divergence in correlations indicates that markets around the world could remain bumpy.
For the last five years, equities have been moving with the herd. But the switch from a high correlation regime to a low correlation regime favors active managers and long-short strategies offer downside protection.
One asset class all money managers are de-emphasizing is credit-oriented strategies. They are all exiting credit in favor of long-short and event-driven strategies. Credit has had a great track record in recent years, but much of its excess return can be attributed to tailwinds coming from the Federal Reserve’s QE policy.
When QE ends, it will put a headwind in the face of credit strategies.