Two Financial Scenarios from Gloom to Zoom

Two Financial Scenarios from Gloom to Zoom

Dominic Sata/iStockphoto

Do you feel lucky this year?

If so, you might want to bet on the optimistic side of the theoretical coin toss that the strategy team at BlackRock Investment Institute proposed in their investment outlook analysis, “The Year of Living Divergently.” On the one hand – let’s call it tails – there’s what BlackRock dubs the Nemesis scenario. It’s kind of like an investment nuclear winter. Named after the Greek goddess who seeks revenge on those who are afflicted by the mortal sin of hubris, or excessive pride, it projects the ripple effects from a European financial meltdown spreading and setting off tsunami-type waves that swamp other national economies worldwide, including that of China.

The bad news in Blackrock’s analysis, it wouldn’t take a lot to trigger the Nemesis scenario. A bank panic, perhaps, leading to the wholesale selloff of risky assets. (We’ve seen how that works….) Poor choices by policymakers, or markets that respond to apparently sensible choices in unexpected ways. The breakup of the eurozone.

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Investors may take comfort from the Dow’s relative strength so far this year. While there have been some days where the blue-chip indicator has ended the day in the red, it hasn’t yet closed below the level where it ended 2011, and is up 3.6 percent so far. The same is true of the S&P, which has rewarded investors and traders with a 4.7 percent advance thus far in 2012. That might be enough to convince investors (a) that the nemesis scenario is one of those scary tales told around campfires at night, and (b) that it’s OK to stay put right where they are. If you’re feeling lucky, well, maybe that’s a risk worth taking.

But the folks at BlackRock have a different outlook. They put the probability of Nemesis materializing at anywhere from 20 percent to 25 percent – in which case there aren’t very many places to shelter beyond the dollar, gold, and U.S., German and Japanese government bonds, the strategists opine.

But they ascribe a higher probability to another worldview, one they dub “Divergence.” In this scenario, there’s a real and significant decoupling between the debt-laden economies of the developed world and outperformance by emerging markets. This opens up whole panoply of investment options, from emerging markets stocks and bonds to energy and resource stocks and dividend-yielding securities in the developed markets.

It’s an intriguing scenario, and one that is likely to meet with a reasonable degree of skepticism from the market. After all, financial markets converged last year rather than diverging, to the pain and astonishment of investors who had been betting that emerging markets would reflect the relative resilience of the underlying economies. Indeed, the one investment call that left the most mud on the faces of the most brokers, private bankers, investment analysts and pundits last year was probably the suggestion that their clients should pile on the exposure to emerging markets. The premise was correct – the economies of these nations did very well indeed, particularly on a relative basis – but the markets didn’t follow suit, thanks to massive risk aversion on the part of investors.

Is it going to be any different this year?

BlackRock argues that it will. Firstly, they note that policymakers in this part of the world have plenty of room to ease monetary policy. Here, the report, published early this month, appears prescient: Both Chinese and Indian policymakers have moved to do just that in recent weeks. Secondly, emerging markets assets are no longer overvalued on a relative basis after disappointing everyone so badly last year. Well, the valuations now speak for themselves. What remains unclear is whether the third argument in favor of “it’s different this time” will really prove to be accurate – that emerging markets are becoming less risky. An even bigger question that BlackRock doesn’t raise is whether investors will subscribe to this scenario in sufficient numbers and with sufficient conviction to have an impact on market values. The logic may be clear, but as financial markets have shown over and over again throughout the centuries, investors are anything but logical, particular in uncertain times.

Still, the report is worth keeping in mind at the end of a month that, despite some disappointing earnings news, has largely been a comfortable one for U.S. stock market investors. It serves as a reminder that the world outside reminds a dangerous place, and that taking comfort in the U.S. stock market’s relatively robust performance in January may be foolish short-term thinking.

At some point, BlackRock’s pundits argue, we’ll all have to toss that coin and decide which scenario we believe is more probable and act accordingly. It’s an argument worth pondering, because the one certainty in any financial market scenario is that succumbing to complacency is the most dangerous path of all.