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.

In addition, more emerging market countries are paying off debts and sitting on large cushions of cash, often because of booming exports. China is the obvious example, having amassed the world’s second biggest stash of Treasuries after Japan. Another example: Brazil announced last December that it would pay off its entire $15.5 billion debt to the IMF–well ahead of schedule.
No wonder then that emerging markets have been stellar investments in recent years. Consider that in local currency terms, the MSCI Emerging Markets Index has climbed by an annualized total return of 15.6% a year for the five years through this past May. By contrast, the standard benchmark for developed market equities, the MSCI EAFE, has advanced a paltry 0.8% a year over that stretch, measured by local currency terms.
But if emerging markets are doing so well, and looking a tad more like developed economies in terms of self-financing and higher financial ratings, shouldn’t the returns generated by these markets also look more like their developed-market brethren? In other words, is the case for breaking out emerging markets as a separate asset class waning?
Not necessarily, advises Curtis Mewbourne, executive vice president at Pimco, the giant bond shop. Although he considers emerging markets primarily from a debt investment perspective, he explains in a new essay that the main allure of emerging markets is their relatively high economic growth rates. The fact that they’re paying off debt faster than some expected doesn’t change the rosy outlook for GDP growth in many of these countries.
“According to the IMF, emerging economies account for 48% of global GDP…and these economies are growing at an average rate of 7% versus 3% for the developed economies,” Mewbourne writes. “Thus their share of the global pie is large and growing.”
One supporting milestone can be found with the so-called BRIC countries–Brazil, Russia, India and China, which are the four largest so-called emerging market economies. Last year, for the first time, the combined GDP of the BRIC nations exceeded that of Japan, the world’s second-biggest economy, Mewbourne notes. The BRICs are reportedly growing at an average nominal rate of 10%, or more than three times as fast as Japan. “If those rates of growth continue, then China’s nominal GDP will be larger than Japan’s within a decade,” he writes.
Overall, Mewbourne opines that the emerging markets as an asset class “is undergoing an important structural change, namely an expansion of corporate financing and a migration from external to domestic financing.”
If economic maturing is a problem, one might expect to find it unfolding in South Korea, a former emerging market country that some economists now consider as a fully developed nation. If so, the developed status suits South Korea. For the three years through last month, the MSCI Korea Index has climbed by an annualized 36.9%–easily beating both the MSCI EAFE and MSCI EM indices over that span.
But even an optimist like Mewbourne recognizes that volatility will remain standard fare with emerging markets, fiscal prudence or not. Yes, the long run may look bright, but in the short run emerging markets are still a roller coaster.
Indeed, the MSCI EM in local currency has crumbled by more than 9% in the four week through last night. The local currency version of MSCI EAFE, on the other hand, is off by just 3.8%.
Some things never seem to change with emerging markets. Perhaps, then, long-term investors have nothing to fear. Higher risk appears to be alive and well in emerging market stocks. Will it continue to translate into higher returns? History suggests as much, at least for those who can hang on for the wild ride that surely awaits.