After reaching an all-time high early this year, the MSCI Emerging Market (EM) index declined 14% in US$ terms between January and August. Although EM equity declines have been broadly spread, there has been a great deal of variation across markets. For example, Turkey and Brazil have taken the biggest hits (with US$ declines of 56% and 30% respectively), while India and Taiwan have posted only modest declines (of 4% and 1% respectively).
Recent EM declines can be understood as a “risk off” phenomenon. At this stage of the extended global economic recovery, investors are keenly on the look-out for nascent problems, and many investors are quick to sell in reaction to negative news. In the case of Turkey, the negative news has included U.S. sanctions, the country’s heavy reliance on short-term external financing, and accelerating inflation; while in Brazil, the negative news has included a truckers’ strike and a general lack of confidence in government policy making.
At this point, we thought it would be worthwhile to examine the relationship between recent EM market declines and quantifiable measures of country risk. The table below shows the cross-market correlations between recent equity declines and various measures of risk (as measured prior to the recent EM declines).
A key result is that recent EM declines have been correlated with risk factors related to short-term external financing concerns, including current account deficits and low levels of international reserves. Turkey is a case in point with a large current account deficit (5% of GDP) and a relatively low initial level of international reserves (12% of GDP).
The recent EM sell-off has been somewhat less correlated with some standard risk measures, including sovereign risk spreads and external debt. For example, the Czech Republic has much greater external debt than Turkey (78% of GDP vs. 47% of GDP), yet the Czech market held up well during the recent EM sell-off, declining only 1% in USD terms between January and August.
|Correlations Between Risk Factors and Recent Emerging Market Equity Declines|
|Low International Reserves/GDP||56%|
|Current Account Deficit/GDP||39%|
|Sovereign Risk Spread||31%|
|Excess Domestic Credit Growth||28%|
|Real FX Overvaluation||11%|
Note: Risk indicators measured prior to recent EM declines.
Source: DCM Advisors LLC
John Mullin is a Senior Portfolio Manager on the International Equity team at DCM Advisors. John can be reached at email@example.com.