Global Investors & EM
Global investors have become so comfortable with the emerging markets that there is hardly any difference today between the rates of interest on bonds from developed nations and those from emerging markets. Or, in other words, spreads on emerging market bonds are wafer thin. This shows that investors believe that putting their money in, say, an Indonesia is not far more risky than putting it in a Germany. The result: bonds and equities from emerging markets have outperformed other asset classes over the past five years or so.
Sober minds have been cautioning against giddy-headed euphoria about emerging markets, both in India and elsewhere. While there is little doubt that the economic fundamentals of countries and compa- nies in Asia, East Europe and Latin America have improved remarkably in recent years, the risk of markets in these regions toppling because of an external shock persist.
The International Monetary Fund (IMF) says in its new Global Financial Stability Report that the improvement in economic fundamentals can explain only half of the 422-basis-point drop in emerging markets bond spread since 2003. External factors account for the other half. We commonly hear analysts speaking of how loose monetary policy in the US has driven up bond (and equity prices) in the emerging markets; and how a tightening of US interest rates could harm the prices of financial assets here. That’s why traders and investors hang on to every announcement made by the US Federal Reserve.
Are they barking up the wrong tree? Of far greater significance than US monetary policy is investors’ perception of global financial risk, says the IMF. It is the single most important factor in the Fund’s econometric model on bond spreads. An increase in risk perception by one standard deviation causes spreads to increase by 29 per cent. A corresponding change in the Fed funds futures rate and the volatility in the Fed funds futures market will lead to a 10 per cent rise in bond spreads, respectively.
In effect, what this means is that when assessing external risks, analysts would do well to focus on a factor that is even more important than US monetary policy — and that is risk perception.
The Chicago Board Options Exchange created the VIX volatility index in 1993. It measures the market’s expectations of near-term volatility as reflected in the options prices of the S&P 500 stock index. The VIX index is popularly regarded as a “investor fear gauge” by derivative traders. It is currently at historically low levels, indicating that risk tolerance is at record highs. Investors in Indian bonds and stocks would be well advised to keep an eye on the VIX index to figure out which way the smart money is moving.
Source: BW
