Homogenous or Divergent Emerging Markets?

``Venezuela, Nigeria, Iraq, Iran!” Everyone is supposed to be terrified and pay up for oil. But, the horror story is not raising risk premiums on risky assets such as emerging market bonds. Nobody seems bothered by the inconsistency.” Andy Xie

Given that emerging markets which is said to have an .85 correlation with developed markets, according to a report from Bloomberg, a correlation of 1 indicates lockstep movement, the activities of the developed markets particularly that of the US has served as a very significant gauge in assessing the risk-return dynamics and determining portfolio allocations.

Would you believe that due to the tsunami of worldwide liquidity which has practically distorted the pricing of different asset classes, emerging market debts have now been priced MORE than the US corporate debts?

According to a report from the Tom Stevenson of the Telegraph (emphasis mine), ``Globe-trotting investors have become so immune to risk that they are happy to accept lower yields on emerging country sovereign debt than on equivalently-rated US corporate bonds, one of the world's largest fixed-income investors said yesterday.”

In what was traditionally considered as riskier investments, investors typically asked for higher yields to compensate for the risks undertaken, as measured relative to “safe” US Treasury bills, where the difference or the spread represented as the premium. As the perception of risks grows or increases, so does the spread or the premium. That was then.

Today comes in a different context; the reasons investors have priced emerging market debts higher could be due to higher growth prospects, improving fiscal conditions and lesser supply relative to the demand of the issued sovereign debt instruments, according to Mr. Stevenson.

Generally this implies that global investors appear to be immune to the political risk spectrum which could translate to financial risks. In addition, this underscores the one track determination in the quest for higher returns. The desperate search for yields has essentially blinded investors into mispricing or discounting such risks. How could one underestimate the political risks considering the emerging tide of leftist leaders being elected in Latin America or of growing geopolitical tensions in the Middle East or of the recent attempts to impose capital control in Thailand?

And largely because of the hunt for yields and the attempts by fund managers to diversify their portfolios to assets which are lesser correlated to developed markets, the S&P came up with a new investing index, as an offshoot to the emerging market class, the S&P/IFCG Frontier Markets Composite Index, which accounts for 22 emerging markets that are too thinly traded or too small, according to a report from Bloomberg. Naturally such exotic themes as we previously discussed continues to outperform most indices considering their high risks nature.

Now comes the highly respected independent research BCA Research, whose recent outlook tells of the surfacing of a lesser degree of homogeneity or divergence among the emerging market class.

Figure 4: BCA Research: Emerging Markets are No longer Homogenous

According to BCA Research, ``The correlation among emerging equity markets and equity sectors has fallen dramatically in recent weeks. This has largely been driven by fundamental factors such as varying valuations in different segments of the equity universe, as well as diverging country trends in inflation, interest rates and cyclical growth profiles. We expect these divergences to persist heading forward.”

Could the present outperformance of the Phisix translate to internal strength of the Philippine asset classes in the eyes of foreign investors? I doubt so, but we will see.