The allure of emerging market stocks is rooted in the notion that higher risk begets higher reward. But what happens if the higher risk loses some altitude? Does that imply that prospective returns will follow?
Such questions are topical these days in the wake of news that the financial profile of emerging market economies has improved considerably in recent years, and is poised for more of the same going forward. But will fiscal progress pare the extraordinary returns that emerging markets have been known to deliver relative to developed markets?
One indicator of the improving financial health of emerging countries can be found in the narrowing interest-rate spread of debt issued by these markets relative to high-grade bonds from developed countries. At the end of this year’s first quarter, the risk premium in yield for emerging market bonds was roughly 100 basis points over AAA-rated debt, according to the IMF’s 2006 World Economic Outlook. That’s a fraction of the 1,000-basis-point spread that prevailed in 1999.
The decline in risk spread has been driven by more than rank speculation. The underlying economic trends in emerging markets has been generally positive in the 21st century, in some cases extraordinarily so. Private capital net inflows, for example, have risen sharply for emerging markets in recent years, more than doubling in 2005 to $254 billion from just three years earlier, according to IMF data.