Summary & Conclusions

Declining risk premium has been driving the emerging market (EM) boom. The EM sovereign risk premium has declined from an average of 352 bps in 1H04 to 52 bps. MXEF has risen by 82% since mid-2004. In 2006, the EM sovereign spread has declined from 76 bps to 52 bps and the MXEF index has risen by 11%. As the EM risk premium gets close to zero, the base effect suggests that the EM ‘re-rating’ story is also coming to an end.

Recent social, security, and economic risk events suggest that the decline in EM risk premium cannot be justified by fundamentals. Liquidity and momentum explain most of the decline in EM risk premium, I believe, with much of the gain in EMXF due to overshooting.

As the EM boom stalls due to a high base, events have greater potential to trigger the risk reduction trade than before. The reverse momentum could have the same power as the forward momentum. I believe the EM boom overshooting could reverse and then some in 2006.

The Incredible Shrinking Risk Premium …

The rapidly declining risk premium of EM debt rivals the flattening yield curve as a conundrum for financial markets today. The EM sovereign risk premium averaged 352 bps in 1H04, when the perceived risk was not high. It has since declined to 52 bps.

Substantial improvements in EM fundamentals have accompanied the risk premium decline. Brazil and Russian have been taking advantage of their good fortune from high commodity prices to pay down foreign debts. Korea has become a developed economy by most measurements. The three economies that were embroiled in financial crises in 1998 have fundamentally changed their balance sheets.

Further, most emerging economies have been running trade surpluses during the current boom, unlike in previous booms. The surging US trade deficit is the main factor enabling emerging economies to enjoy trade surpluses. The liquidity boom that may have caused the flat yield curve and strong consumption in the US has allowed EM economies to improve their fundamentals. Hence, the improving EM fundamentals would appear part of the bubble, rather than suggestive of a change in secular trend.

However, the fundamentals do not explain all the decline in the risk premium. The trend of improving fundamentals in Brazil, Russia, and Korea was well established in 1H04. Many small EM economies without similar improvements in fundamentals have enjoyed a similar decline in risk premium. The ‘liquidity effect’ may be a bigger factor in explaining the declining risk premium than improving fundamentals. Momentum-investors piling into a winning trend without improved liquidity may explain the entire decline in risk premium in recent months, I believe.

… and the Meteoric Rise of EM Equity …

EM equity has enjoyed a meteoric rise as the sovereign risk premium has declined, with the MSCI Emerging Market Index (EXMF) rising by over 80% since mid-2004. The same force – the global liquidity boom – drives both. There is no fundamental causality between the two. As equity investors tend to use bond risk premiums in calculating equity values, the declining sovereign bond risk premium technically causes a rising EM equity market. MXFM has appreciated by 11% so far in 2006, while the EM sovereign risk premium has declined to 52 bps from 76 bps.

I estimate the declining risk premium may explain 90% of the appreciation in EM equity since mid-2004. However, momentum has now emerged as a more important factor. The change in the risk premium may explain less than half of the EM equity rise in 2006, I believe. As the EM sovereign risk premium becomes too low to fall, momentum becomes the main factor explaining EM equity movement.

… but There Are Risk Events Aplenty …

Events in recent days suggest that the low EM risk premium may not be justified. The terrorist attack on an oil facility at Abqaiq, the imposition of a state of emergency in the Philippines, Mr. Thaksin’s dissolution of the Thai parliament and call for an early election, and the abolition of the Unification Council in Taiwan are events that can change the economic trajectory for a regional or global economy.

EM risk premium exists not just because of the external balance situation. The lack of institutions that enhance future visibility is far more important. It seems to me absurd to believe that such economies can enjoy just 50 bps of risk premium.

Economic risks are rising also. India, Thailand, and the US may be behind the curve in tackling their inflation problem. This could lead to worsening trade balances for these economies.

The policy of the Bank of Japan is perhaps the biggest area of uncertainty as regards the EM boom. The BoJ is probably the lender of last resort in the global financial system. The massive carry trade – borrowing yen to borrow US treasuries for interest spread income – may be the explanation for the flat yield curve. Indirectly, I believe the BoJ liquidity may have caused the collapse in the EM risk premium.

… and the Risk Premium Cannot Drop Below Zero

While momentum is still strong in favor of high beta assets, the near zero risk premium on EM sovereign debt suggests that the boom is nearing its end. The base effect is about to boomerang on EM assets, I believe. Simply put, the risk premium cannot drop below zero. If the EM sovereign risk premium drops to zero, the implied increase in EM equity value is another 12% at most, on my estimates.

The high base effect suggests to me that the momentum in the EM market could hit a wall this year. We could see repeated surges and retreats in the coming weeks. However, maths is against forward momentum. When markets fail to reach new highs a few times, momentum tends to shift the other way. Then, it may take just one event to trigger reverse momentum – that is, the risk reduction trade.

India’s Sensex, China’s H-share index, and Japan’s TOPIX are where risk-takers have been congregating. I believe comparing them against the NASDAQ in 2000 yields potentially useful indications of when these markets might run out of steam and reverse.

Posted by toughiee on Tuesday, February 28, 2006 at 8:49 PM | Permalink