Morningstar Advisor - Winter 2008 - 59

the biggest risk we’ve got right now in the markets is earnings disappointments. They are in my view about as close to inevitable as anything ever gets in the markets. KK: When you make this comment, it’s obviously a broad market comment. RA: Yes, it is. KK: If you go deeper, are there pockets where from the U.S. dollar, there’s nothing better out there in my view than emerging markets’ debt denominated in the local emerging markets’ currencies. Another thing I like is floating rate notes, floating income. It’s below-investment-grade, short-maturity paper. Now, the beauty of this asset category is that the yield pick up is three to four times the historical default rate. The risk, of course, is that the default rate picks up in a recession, but the subprime contagion hammered this sector, creating a wonderful buying opportunity because these assets are, for the most part, utterly unaffected by and unrelated to subprime. They’re related to the economic health of the individual companies. That represents a wonderful way to pick up additional yield without a lot of downside and without the kind of default risk that afflicts longer maturity high-yield debt. Third is TIPs. We’ve got inflation out there, which is a lot more than the government likes to acknowledge. A lot of it is fueled by the secular bull market in commodity prices, which I think has quite a ways to run. A lot of it is fueled by costs of goods and services that don’t compose the core inflation metrics. Now, to be sure, if we have a recession—and I think that’s better than 50/50 odds—inflation will not rear its ugly head in the coming year in any material way. But no one believes inflation is gone for good. And when inflation does come back, whether it’s next year or the year after or the year after that, how many people think that they’ll see it coming? Most people don’t. Having a protective anchor in your portfolio invested in assets that are priced to benefit from renewed inflation, such as TIPs, represents a very powerful alternative. KK: What do you think a good expected return Better Than Equities Rob Arnott says he has a cautious view on equities. Here’s more optimistic about these three areas: Emerging markets debt: “Very nice premium yield associated with the natural fears that emerging markets’ currencies will falter.” TIPs: “We’ve got inflation out there…a lot more than the government likes to acknowledge.” Floating Rate Notes: “Yield pick up is three to four times the historical default rate.” these problems are more prevalent than others, or do you think it’s a broader problem? RA: I think it’s a broad problem. I’d be hesitant to say specific sectors or industries are more or less vulnerable. Of course, they are, but I think the more powerful issue is that this is a valuation problem for the stock market. People are pointing to P/E ratios based on next year’s expectations that are in line with the 50-year average P/E ratio. Well, that’s true. But that’s if those earnings materialize, and that’s if the earnings continue to grow from that foundation, both of which I think are suspect. KK: Where are you putting your money? RA: The markets that I like are emerging markets’ debt in the local currency. There’s a very nice premium yield associated with the natural fears that emerging markets’ currencies will falter. Well, consider the fact that most of these economies have fiscal surpluses, current account surpluses, no off-balance sheet budget items the way the U.S. does, and that if the U.S. were not the dominant economy in the world, it would be getting referred to the IMF for counseling. is all that brilliant right now. I think stocks are priced to give us 5% to 7% on a 20-year horizon. So one of the implications in terms of direct action items for your readers is encourage clients to ramp up their savings and to ramp down the spending out of the portfolio. For individuals, it would be much the same. What’s the number one best place to put your investment dollars? Pay down credit-card debt. Beyond that, a nice defensive posture makes sense in today’s markets where people are paying much too much for risk, as if the risk doesn’t have two sides to it. K Kunal Kapoor is president and chief investment officer of Morningstar Investment Services. View video excerpts of Arnott and Kapoor’s conversation at: http://MorningstarAdvisor.com/Conversation.asp Coming Next Issue New research by Paul Kaplan, Morningstar’s vice president of quantitative research, throws some cold water on fundamental indexing. Proponents of fundamental indexing “may have a successful investment strategy, but they have not produced a revolution in investment theory,” Kaplan says. So, what’s the prospect for emerging markets’ currencies? I think it’s to go up, not down. I think you get a currency play that it is likely to be profitable and a yield play that’s likely to be profitable. But I like the short end of the curve a little better than the long end, because the yield pick up is still almost as good. If you want a non-dollar play to diversify away is for equities and some of the fixed-income asset classes you’ve mentioned? RA: I’d say 5% to 7% for many of these asset categories. I don’t think the equity risk premium MorningstarAdvisor.com 59

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Morningstar Advisor - Winter 2008

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