By now, most investors are very familiar with the challenges of reduced economic growth and large sovereign deficits in the United States and across Europe. But while these major economies have mostly languished in 2011, opportunities for fixed-income value from the smaller economies have quietly flourished. For several quarters we have maintained the opinion that the smaller, more dynamic economies of the world are likely to outperform the larger, more mature economies that have been weighed down by low growth, housing downturns, and massive deficits. That thesis has largely proved correct in 2011, and we see little reason for it to change in the upcoming quarters.

Source: First International Advisors
Growth expectations are forward-looking and based upon the reasonable beliefs of First International Advisors and are not a guarantee of future GDP growth. Real GDP is a measure of nominal GDP minus inflation.

In fact, those trends that we observed a year ago have only deepened in the second half of 2011. Sovereign bond yields that were already extraordinarily low in the United States, Germany, and the United Kingdom declined sharply further in the third quarter of 2011. Real interest rates (central bank lending rates minus inflation) have been negative in the major economic regions since 2009, implying an environment of low compensation for fixed-income investments and a potential depreciation in currency over the long run. Of additional concern is the fact that real yields (average bond yields minus inflation) in the major economic regions of the United States, the eurozone, and the United Kingdom have now turned negative in 2011.

Source: First International Advisors
Past performance is no guarantee of future results.

By contrast, the smaller economic regions, with healthier fiscal balance sheets and better growth prospects, have continued to offer positive real yields in 2011. Brazil notably has significantly higher real yields compared with most global economies, offering the potential for greater levels of investment value. Other smaller economies such as Mexico, Australia, and South Korea have also offered investors positive real yields in 2011 while simultaneously sustaining currency appreciation for much of the year.

Strategies for investing in the current global bond markets are best served, in our view, by continuing to underweight the bond markets of the older economies (U.S., U.K., eurozone, and Japan) in favor of overweight exposures to the smaller, healthier economies with lower deficits. Among the better-valued markets that we favor are Brazil, Australia, Poland, Mexico, Chile, New Zealand, the Czech Republic, and Norway.

Foreign currency management should also follow a similar thesis, as we believe massive structural deficits in the largest economies will eventually necessitate a decline in currency valuations over the long term. In our view, the U.S. dollar continues to demonstrate a long-term structural decline, while British sterling looks equally vulnerable. The currencies of the smaller, more dynamic economies with trade surpluses, healthier growth, higher yields, and higher interest rates are positioned to appreciate against the U.S. dollar, the euro, and British sterling, in our view.

Concluding observations
While economic conditions in the largest economies continue to languish, growth expectations and fixed-income valuations from several smaller economies continue to show promise. For several quarters we have maintained the opinion that the smaller, more dynamic economies of the world are likely to outperform the larger, more mature economies that have been weighed down by low growth and massive deficits. Those themes have continued in 2011, and we see little reason for them to change in the upcoming quarters. In our view, investors can continue to find the best opportunities to add value from a diversified overweight in the bond markets and currencies of the smaller economies, while underweighting exposures to the four major economies—the U.S., the U.K., Japan, and the eurozone.