Long-term view better than focus on hot spots

When global markets began their downward spiral a few years back, nearly every nation felt the pain. The co-ordinated efforts of central banks and governments helped avoid systemic collapse, and the global economy has been on the road to recovery since March 2009.

However, fears about sovereign debt have escalated in recent months as the global recession has forced governments to run massive deficits.

Greece and peripheral Europe have recently dominated the headlines, but other developed nations haven't been spared. Credit-rating agencies have discussed potential downgrades for both the United States and the United Kingdom from their current AAA ratings due to the dramatic increase in both nations' debt levels with respect to their gross domestic products (GDPs).

The attention has led to speculation about possible sovereign debt defaults and raised questions about the viability of investing in sovereign debt securities issued by developed nations.

Riskier on a relative basis

Sovereign debt issued by developed nations is, indeed, riskier relative to levels witnessed a few years ago. While the situation in Greece has led to speculation about possible contagion for other European countries, the potential for default varies greatly from country to country.

Among the developed nations, a double-digit debt-to-GDP ratio scenario in the United States is not the same as an identical situation in Greece due to differences in the size of the two economies and the amount of potential buyers for their debt.

Despite troubles in the US or the UK, we don't expect bond yields to skyrocket since both nations are sorting through issues such as debt reduction.

Japan's experience is a case in point. Although Japan's fiscal position is worse than those of the US and the UK, its government-bond yields have remained near one per cent due to price deflation.

We believe that deflation is a far greater concern right now than inflation for developed nations because there is still excess capacity in factories and wages remain low due to the weak labour market.

The private sector will likely take a hit as interest rates increase (making it more expensive to borrow funds), taxes go up (resulting in less corporate revenue) and lending decreases due to more stringent regulation and higher capital reserve requirements (making it more difficult to borrow).

In the long run, countries need to become more conservative with regard to fiscal spending, and many of them are already taking steps to do so. Greece's "austerity plan" and efforts to cut debt at the state level in the US are examples of such measures.

Emerging markets instead?

Concerns about sovereign debt in developed markets have investors speculating about the merits of turning to emerging markets. Although investing in emerging markets is often viewed as riskier than investing in developed markets, volatility within emerging markets has been trending lower for years.

In addition, emerging markets have evolved significantly over the last decade, and a large inflow of capital has resulted in greater liquidity and more efficient market conditions. As an asset class, emerging-market debt can provide an expanded opportunity set to investors who have risk tolerances geared toward growth. Our view on emerging-market debt is currently neutral relative to developed-market debt following the very sharp recovery in the former during 2009.

There are several reasons for this position, as each of these asset classes has advantages. Emerging nations often have less debt than their developed counterparts. In addition, some market participants have argued that local-currency emerging-market debt in Asia is becoming more attractive because emerging Asian currencies are expected to appreciate versus the US dollar and the euro in the near term.

Summary

In short, we believe it is necessary for long-term investors to keep a cool head when faced with panic-inducing news stories.

If investment time horizons are measured in years, it does no good to worry about the latest "hot spots" around the globe that occur from week to week. As the current crisis continues to mend, we believe some of the best defences investors have at their disposal are diversified investment portfolios.

- The author is Senior Executive Officer at SEI Investments. This information is intended to be educational and is not intended as investment advice. The views expressed are his own