EMERGING MARKETS THE NEW SAFE HAVEN??

As far as return on investment is concerned, high risk is supposed to carry the chance to earn high rewards, and nowhere has that ratio been more implicit than in Emerging markets. But right now, a funny thing is happening in the US, Europe, and Japan resulting in the tail wagging the dog. "Emerging markets can actually be viewed a little more defensively than the developed markets today," says Jeff Palma, the head of global equity strategy at UBS. "Clearly over the last decade, Emerging market balance sheets have become much stronger, and clearly stronger than their developed market peers. So it does appear that they're more defensive. I am not sure investors are quite there to regard them as defensive yet, but we are clearly moving in that direction," says Palma. Even though the superior growth prospects have them in strong demand, Palma says the Emerging market universe is trading at about a 10% discount to the developed world. He says they are growing faster, their demand is more sustainable, and in the face of a global slowdown, they can still deploy fiscal or monetary measures to stimulate their economies. While UBS is recouping from a premature call on Europe made in July, Palma says the day will come when investors will need to revisit the battered continent. "On valuations alone today you would look at Europe and say it is cheap... but it's cheap for a reason," he reminds us. Palma is predicting things will get worse in Europe, until a massive policy response triggers a recapitalization of their financial system. Only then will Europe be worth a look. "Valuation is just not going to be the reason to buy Europe. You're not really paid to be early to that trade. But once you get that policy response, it seems to me, in a relative sense, Europe is the cheapest of all the markets we look at," he says. Similar superlatives are often used to describe US stocks, but Palma says stocks here aren't as cheap as they look, and has argued that low price-to-earnings (PE) ratios alone will not be enough to drive markets. "My view is that earnings expectations have to fall and that means that the PE is probably going to rise a little bit," Palma says, adding that the market is already discounting that to some degree. More precisely, he thinks earnings expectations need to move from the mid double-digits down to single-digits. Once we get to that point, he says "markets are going to be much more comfortable with those expectations. In the meantime, Palma's research shows that on a global basis we have only seen two-months of earnings reductions so far, but he thinks that will mark the beginning of a longer trend. "Those (earnings reduction) cycles tend to be be very, very prolonged. That's really because we are at a stage where analysts are continuing to forecast an increase in profit margin expectations, a view that I think is quite unlikely at this stage of the cycle," explains Palma. As a result, we need to see estimates and multiples come down, the European debt crisis brought under control, and our own economy producing some growth. Palma says "until we get some view that conditions are improving, markets will remain skeptical."