The rally in risky assets that began early in March is continuing with varying degrees of intensity in different asset classes. Equity markets are performing well, particularly in the developing world. Credit markets have not done as well. Average yields on Moody’s corporate bond indices rated AA or BAA have not declined much.
In contrast, the average yield on the JPMorgan high-yield corporate bonds in Asia has declined quite dramatically. At the peak of the crisis, the average yield per annum was 27-28%. Now, it is a little above 20%. Of course, we are a long way from the levels that prevailed in happier days, when such yields were in the low double digits or high single digits. Adequate compensation for risk seems to be still available.
The divergence between performance in the developing world and in the developed world is actually gathering strength. Morgan Stanley Capital International (MSCI) stock indices for emerging markets tell their own story. The Emerging Markets Index has delivered 12.6% year-to-date, whereas MSCI US is still down 3.2% and MSCI World is down 4.2%, dragged down by Europe, which is down 7.2% (all performance calculated in dollar terms).
Even more impressive, from the beginning of this decade up to end-March 2009, MSCI Asia (ex-Japan), MSCI Latin America and MSCI US had earned 36.36%, 137.15% and -39.25%, respectively. The numbers for MSCI China and MSCI India are 82.7% and 100.6%, respectively.
The year 2008 was the only one in which the two major emerging market regions—Asia and Latin America—did worse than the US. This is an impressive performance. The inferior performance in 2008 came after five years of continuous and significantly large positive returns. There was profit-taking because there were huge profits to be taken in these markets. Liquidity and cash flow needs in the US and redemption pressures forced many investors to sell their investments in the developing world. That played a large, if not total, role in explaining the larger losses in 2008.
One key fact to be remembered, however, is this: Except in 2009, in all the other years, returns generated by the stock indices of the emerging regions bore the same sign as the US stock index. In other words, until 2008, there was no decoupling. Many empirical studies show that correlations strengthened, not weakened, in recent years. In fact, when the US stock index is on a losing streak, emerging markets lose more. However, that was in evidence only in 2008 but not in 2001, 2002 and not so far this year.
There are sound reasons to believe that this year might turn out to be the first time in many years that emerging markets diverge both in the magnitude and in the direction of the stock markets’ performance. After all, while there is a balance sheet recession in the US, the UK and parts of Europe, most developing nations, particularly in Asia, do not have a balance sheet problem at the systemic level. That makes the prospect of an early and better recovery in emerging markets more credible.
Recent empirical work by Carmen Reinhart and Kenneth Rogoff shows that, in the aftermath of financial crises, the rise in unemployment and the declines in output, per capita income and investment are more severe and play out over a longer time frame than in normal recessions. Chapters 3 and 4 of the forthcoming April edition of the World Economic Outlook (WEO) of the International Monetary Fund (IMF) reinforce this message.
While WEO is not sanguine about prospects for the developed world, given the synchronized global recession, it is clear that parts of emerging markets are doing reasonably and comparatively well. Domestic demand is holding up well in Indonesia, India and China.
That said, there are negative aspects, too, to be kept in view. Fixed asset investment and fixed capital formation are rising strongly. That could aggravate the excess capacity problem. China is beginning to experience deflation both at the wholesale and the retail levels.
However, David Dollar of the World Bank argues that many of the projects in the stimulus package are aimed more at household welfare than at increasing production capacity: projects such as passenger rail, urban public transport, waste water treatment, and earthquake reconstruction.
Further, the developing world—again focusing on Asia—has unsettled politics to deal with. In Asia, the political situation is fluid in Malaysia, is significantly counterproductive for Thailand, is fraught with risks in India and is dynamite in Pakistan.
Overall, emerging markets will not make progress in a straight line, nor is it fair to expect them to do so. Advanced countries took a couple of centuries to evolve. Developing countries are doing it in far less time. Therefore, from an investment perspective, it makes sense to raise exposure to emerging assets gradually on sell-offs and hedge the risk by positioning for declines in asset prices in the developed world.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org