Emerging Markets...

In last few years emerging markets investments proved to be extremely fruitful and everyone on the street wanted to be invested in the emerging markets..why not? Between 2003 and 2007 MSCI Emerging Market index annualized 48% in returns. However at the begining of 2008, when we were deciding our allocations to long short managers we had done a small study if emerging markets were gonna continue to do well or not? In hindsight not increasing our emerging market exposure seemed to be fruitful this year to date.

The study done was really simple..we analyzed the significance of the Emerging Market Index against the World Index. The ratio of price between the world index and the emerging market index touched a low of 0.2446 in 1998 after hitting a high of 0.92 in 1994. This ratio stood at 0.8 at the begining of the year and things weren't looking that good fundamentally (I will explain this in the fundamentals sections)

Also, when we looked at the Alpha generated by the emerging markets over the world index we found that this alpha was never significant in the long run. The 20 years weekly data gave an alpha of 0.016 and the standard error of alpha was 0.011 (0.016 +/- 0.011*1.96 would include 0). However during the period between 2003 and 2007 this alpha was actually significant and emerging market index did produce excess returns over world index.


Fundametals:



So when do emerging markets tend to perform better?

1. Commodity boom: Commodity boom explains the most significant factor contributing to the positive excess performance of the emerging markets. If we look at all the emerging markets; they have one thing in common..excess commodity .. may it be minerals, oil & gas, agro commodities or most importantly labour

2. Global Liquidity: Global liquidity is another major reason for the emerging markets to do well. Liquidity drives consumption which drives demand for emerging market commodities. Hence, now when the global liquidity is drying up we see dwindling growth rates for the emerging markets.


At the begining of 2008 both of these factors seemed to had ran out of steam, however we did see a final frenzy rally for commodities till the middle of 2008. The ratio of emerging market index to the world index now stands at 0.60; a decline of 20% YTD. Emerging Market Index has declined 52% YTD against a decline of 37% for the world index. I believe this ratio will fall further; emerging markets would underperform the developed markets for some time to come. I wont be surprised if we see this ratio going down to 0.40 in the coming months. Long term mean of the ratio is at 0.48 with std dev of 0.16 and I am sure we are going to see one std.dev move on the downside. We shall all wait for the global liquidity to come back with a bang for emerging markets to do well in future.


(P.S. World Index does include a proportion of Emerging Market Index in its composition)