Emerging Market Cycles
An Extension of Developed Markets
By: Igor Vasilachi with Katina Martin
Emerging markets are often perceived as an economic monolith. But inside the “EM” umbrella there are tens of countries that span five continents, tens of currencies and many different economic and political doctrines. In theory, this should provide investors near-perfect diversification.
In practice, emerging and developed business cycles move hand in hand. US and EM high-yield spreads, one of the key business cycle proxies we track, display nearly identical patterns and are 92% correlated. Below we compare the two series starting in 1999, when EM high-yield spreads first become available.
Figure 1: US and EM High-Yield Spread Indicator (1/1999 – 6/2022)
Source: FRED
On top of this near-perfect correlation, EM has also seemed more volatile, especially during deteriorating economic environments when spreads are widening. Despite their geographic diversification, emerging markets have experienced heightened volatility compared to the US in bad times, confirming the adage that “when the US sneezes, emerging markets catch a cold.”
We wanted to understand how EM assets trade, considering this heightened market risk, and started by looking at bonds, the safest asset class. Below we show the CAGR and standard deviations of US 10Y Treasurys, US high-yield bonds, and the EM bond index—a basket of government and investment-grade corporate bonds—since 1994, when EM data first became available.
Figure 2: Performance Indicators by Asset Class (USD Returns, 1/1994 – 6/2022)
Source: Bloomberg, FRED.
Despite the relative safety net that sovereigns and investment-grade corporates should provide to investors, EM bond returns and volatility reflect the EM risk premium. In fact, the associated risk seems higher than that of the most hazardous US fixed-income securities, high-yield bonds.
This pattern partially holds for equities. EM equity market volatility is in line with arguably the most cyclical US equity class, small-cap value. However, EM returns are considerably worse.
Figure 3: Performance Indicators by Asset Class (USD Returns, 7/1989 – 6/2022)
Source: Capital IQ, MSCI, FRED.
Unlike in fixed income, equity investors do not seem to be compensated for the additional risk they take on. And we believe this is true for a subset of investors in EM, foreign investors, who are not compensated for the currency risk. In local terms, EM equity market returns double, while volatility remains the same.
In our previous research, we found that EM currencies tend to depreciate considerably against the USD in times of crisis, especially during global crises. However, we also found that rates tend to stabilize after such crashes, resulting in particularly resilient equity market recoveries. To put that in context, below we show annualized EM equity market returns by economic environment, as defined by US high-yield spreads, in local currencies and in USD. As a reminder, falling spreads are indicative of improving economic conditions, while rising spreads are indicative of deteriorating ones.
Figure 4: Annualized 1M FWD Returns of MSCI EM by High-Yield Spread Direction and Currency Denomination (1/1989 – 6/2022)
Source: MSCI, FRED, Verdad.
The return differential between USD and locally denominated EM equity market returns is widest in periods of deteriorating economic conditions. The FX headwind is weaker in good times. To that extent, we wanted to isolate and test returns in the best of times, when growth accelerates most: in recoveries. Below we show the average annualized returns across equity asset classes in Quadrant 1, a proxy for recoveries, defined as periods of wide but falling US high-yield spreads.
Figure 5: Annualized 1M FWD Returns in Quadrant 1 (Recoveries) by Asset Class (USD, 1/1989 – 6/2022)
Source: Capital IQ, MSCI, Ken French Data Library, FRED.
Emerging markets tend to present themselves as an attractive complement to US investor portfolios during recoveries. As shown earlier, MSCI EM has produced similar returns to US small value stocks during recoveries, while EM small value stocks have been the top performers in the pack. That said, picking the winners in the EM value flock is a tough nut on its own. Foreign investors should account for the limitations in liquidity, information flow, and counterparty risk, among others.
In conclusion, investing in EM is far from being a “no-brainer” for US investors. The volatility in high-yield spreads and across asset classes reflect a heightened risk in those regions. EM crises, which tend to be more frequent and more severe, are often accompanied by liquidity crunches and EM currency devaluations. And while foreign investors might be compensated for the risk of a market crash, as suggested by returns in local currencies, there seems to be no compensation for the ubiquitous risk of a currency crash. Until those risks are mitigated, we see no compelling reasons for an evergreen allocation to EM. However, EM equities perform particularly well during recoveries, when currencies stabilize and earnings and multiples rise. These are the same tailwinds that US value investors experience. Therefore, the same contrarian investors willing to bet on US value stocks during panics (i.e., at the beginning of recoveries) can reap additional rewards from a concurrent bet on EM value stocks.
Acknowledgment: This piece was co-authored by Katina Martin, a rising senior at Harvard. She is studying economics and is on the Harvard track and field team. Katina is interested in investment and wealth management, especially in emerging markets, and is actively seeking summer internship opportunities in those industries.