A myth that never turned into reality

Over the last three months, members of the New Markets team of BNP Paribas Investments Partners have been traveling a lot. This proved refreshing and insightful following the market’s pause due to the November 2008 market crash. In the crisis aftermath, investors were focused on risk aversion solutions, such as money market funds and cash.

This year we have noticed increased and tangible interest in emerging equities on our numerous trips as this convinced us that risk appetite is gradually returning to the markets. A number of clients have taken part in multiple conference calls and have answered a large variety of questions from investor, distributors and sales teams in Asia, Europe and the Americas.

Many investors both institutional and retail were surprised by the violence of the correction. They had heard many convincing stories about how solid emerging economies had become and were not expecting to suffer from such heavy losses. So, people wanted to understand why they have lost their money and whether emerging markets represent a viable investment option in the future. It is useful to have a look back at the chronology of events.

Until the end of 2007, emerging markets had outperformed developed ones, driven by fund inflows and attractive fundamentals, China’s market bubble was the first to burst after exceptionally strong rally between August and November of 2007.

From August to November 2008 the developed markets crashed and emerging markets followed. From October 2008 up to 2009, emerging markets have out performed developed markets.

To understand why emerging markets fell, and why investors were so disappointed we must look at the popular de-correlation theory. Many people had believed that emerging markets had definitely de-correlated from developed ones – a myth that never turned into reality. Paradoxically, we actually believe that de correlation does exist. However our analysis differs from the common opinion our analysis differs from the common opinion because it has a nuance we think that de-correlation lies in the macroeconomic field, and less in the area of financial markets, in particular during periods of high risk aversion.

Emerging countries have grown faster that developed ones and will continue to do so in the foreseeable future (thus, providing economic de-correlation), but because of the globalization of investment portfolios and the mobility of short term fund flows, during periods of high risk aversion, all risky assets behave in a similar way – a correlation re-appears even between assets classes which used to perform very differently in normal times. Indeed when markets corrected, international investors cut their exposure to risky assets, and emerging equities were among the first to suffer from such risk-aversion. Most institutional investors still don’t consider emerging equities as part of their core portfolios.

As a result markets remain a high beta asset class they are extremely sensitive to the level of risk aversion. But this logic works both ways on the downside and on the upside. Indeed, in June-November of 2008, emerging markets suffered so much from outflows caused by indiscriminate selling that valuations were pushed to extremely low levels. In fact, entire sectors were trading at below their book value. After the risk aversion receded, emerging markets started to perform much better than developed ones. Some markets have even rebounded by 50% or more from their bottom and there is still for further upside.

Emerging markets have been and will stay risky. Emerging countries do, however, benefit from a relatively healthy macroeconomic environment and over the longer term i.e. the full market cycles, their markets deliver positive excess returns, well above developed ones. When markets are driven by risk aversion and short term money flows, it is difficult to escape from devastating selling pressure but once the situation returns to normality, returns are higher.

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