Emerging Markets Become Safer Havens

Long feared for their regular crises and high volatility, emerging markets are now being sought out by some investors who want to protect themselves from the U.S. subprime mortgage turbulence buffeting more developed markets.

Emerging markets "may be benefiting from - dare we say - a flight-to-quality effect," Deutsche Bank analysts wrote in a recent report. "The improvement in the relative performance of emerging markets during each successive shock to global credit spreads over the past year could be an indication that the asset class is indeed being treated as a safe haven." This would be a sharp reversal from the previous norm, when investors in emerging markets, so often panicked by internal and external factors, would jump into safer U.S. Treasurys during times of market stress. U.S. credit measures have ballooned in recent months, wracked by fears over interest rates and a meltdown in the lower-quality, or subprime mortgage market. But emerging market assets have held up, with a number of stock market indexes hitting record levels, currencies appreciating and bond yields falling. Emerging market risk premiums, as measured by JPMorgan's EMBI Global Diversified, were four basis points tighter Thursday, at 190 basis points over U.S. Treasurys, while the MSCI Emerging Markets stock index has returned just over 24% so far this year, in dollar terms. Christopher Wood, an Asia equities strategist at CLSA, a unit of Credit Lyonnais, said in a Thursday note the potential for emerging market debt to secure lower interest rates than U.S. Treasury bond yields "can no longer be dismissed out of hand." "Emerging market debt spreads will suffer a bit of a wobble if commodities are hit, most particularly the oil price. But if commodities remain strong, the surprise will be that debt spreads in the emerging area will keep declining whatever happens(in U.S. credit markets)," said Wood. "Any clear decoupling of emerging market debt from U.S.-related consumer and corporate debt is highly bullish for Asia and the rest of the emerging market equity universe," Wood said. It's by no means the end of risk, as we know it. Emerging markets will continue to entail political risks - nationalizations in Venezuela, tightened state control over "strategic resource" sectors in Russia and capital controls in Thailand are some of the more recent examples. They also face several market challenges. Interest rates, particularly in the developed world, are rising, which could withdraw some of the ample global financial market liquidity that has helped lift emerging markets. A drop in commodities' prices would hurt because so many developing countries have reaped vast rewards from the soaring values of raw materials such as oil, iron ore, copper, soy and wheat. These high prices have helped move many of these countries into current account surpluses.

Epochal Shift

But there has been an epochal improvement in developing country creditworthiness, which means emerging market are no longer as vulnerable to these types of global shocks as they may have been just a few years ago, nor are they as likely to become the source of a meltdown. There has been a "dramatic improvement in credit fundamentals in emerging markets in recent years," said Ramin Toloui, a senior vice president on the emerging markets portfolio management team at Pimco, the world's largest bond fund. For the most part, governments in countries such as Mexico, Brazil and Russia have used the money they've earned to pay down debts, reduce inflation and decrease or eliminate budget deficits. Indeed, emerging market countries are now acting as large-scale creditors to developed countries, which is "unprecedented historically," said Toloui. According to a report prepared by Toloui in June, the emerging world began to run a current account surplus and export capital to the rest of the world in 1999, and this reached a "staggering" 1.3% of world GDP in 2006. A large number of countries in emerging markets are at, or close to, their highest credit ratings ever, and upgrades are more likely than downgrades. Countries such as Brazil and Peru are on the cusp of attaining investment grade ratings. There are some exceptions. Countries that have persistent current account deficits, such as Turkey, South Africa and a number of countries in Eastern Europe, are often highlighted as being those that remain vulnerable to a sharp change in market fortunes. On the whole, though, emerging markets will continue to grow faster than most developed countries. According to Allianz Dresdner, "the uncurbed economic momentum" will push up emerging markets' share in world gross domestic product from 24% in 2006 to 31% in 2012. In the debt market, the turnaround has had an equally dramatic effect. Huge overseas borrowing requirements that used to be such a burden have been slashed to far more manageable levels, reducing the risks for both governments and investors. "In the past, governments were vulnerable to being cut off from capital markets," said Toloui. "Now they can respond to market turbulence by... plowing funds the other way" through debt buybacks, he said. "This is the most important reason why they've been resilient in relative terms as other segments of the credit market have come under pressure," Toloui said. "When market participants are aware of that context, that changes the dynamic for how emerging markets trade during periods of volatility." Declining risk usually means declining returns. So some emerging market investors are having to go further afield to obtain the yields they're used to, and this has meant incursions into emerging market currencies and local debt markets.