After a period where emerging and developed markets have shown much stronger alignment than in previous years, some market watchers are beginning to question whether the two are beginning to decouple.
In the post-financial crisis environment, huge inflows have poured into emerging markets as investors seek out alternative sources of growth and risk appetite has recovered.
The impact of governmental austerity measures and the need for banks to recapitalise have restricted growth in developed markets following the financial crisis. As a result, companies struggled to secure funding while consumers also spent less.
Quantitative easing helped banks to shore up capital while low interest rates were intended to help stimulate economies.
However, the combination of these measures helped to create a more pro-risk environment as investors sought greater levels of return on cash than those on offer in relatively low-risk savings accounts and government bonds.
As such, markets have witnessed on a bull run which has seen indices continue to climb higher.
Emerging markets were among the best performers of 2017, with the MSCI Emerging Markets index rising by 27.76 per cent, compared with a 16.27 per cent increase in the developed markets-focused MSCI World index, as the below chart shows.
Performance of indices during 2017
Source: FE Analytics
Mehvish Ayub, senior investment manager in State Street Global Advisors' investment solutions group, said correlations between emerging market and developed market returns had dropped to its lowest for many years.
She said: “At the same time, emerging market share prices have outperformed their developed market counterparts.
“So, does this mean emerging markets are finally ‘de-coupling’ from developed markets, more than a decade after many thought they would?”
As the below chart shows, correlation – here represented by the r-squared figure – between the MSCI Emerging Markets index and the MSCI World has been falling for some time.
More recently the r-squared figure has fallen to 0.2 – a figure of 1.0 represents perfect correlation, whereas a figure below 0.5 indicates no correlation at all – in recent months.
Rolling 1yr r-squared of MSCI Emerging Markets vs MSCI World over 3yrs
Source: FE Analytics
Ayub said two types of factors may have driven the fall in correlation between emerging and developed markets returns.
One reason for the decreased correlation between the two could be the lower levels of volatility that have been seen around the world more recently.
Indeed, volatility has been low generally despite a raft of potentially destabilising geopolitical events last year. Some commentators have suggested lower levels of volatility indicate that it has become an asset class in its own right.
Ayub said: “At a macro level, extraordinarily low volatility has prevailed in markets recently despite areas of heightened geopolitical risk.
“Based on historical patterns, this low volatility would appear to explain why the correlation between emerging market and developed market returns has fallen.
“During the last period of low volatility from 2012 to 2015, emerging market returns began to decouple from developed market ones.”
Ayub said correlations rose again during the 2015/2016 energy crisis, as earnings of commodity-exporting emerging markets economies and companies were hit.
“If volatility jumps, therefore, we would expect an impact on emerging markets, although the magnitude would depend on whether the next market crisis emanates from developed or emerging markets,” she added.
Another factor behind decreased correlation between developed and emerging markets could be the uptick in global trade, according to Ayub.
The investment manager said recovering commodity prices and better final demand in the US have had a positive impact on emerging markets generally.
“Global exports as a whole have been on an upward trend for the past five years — reflecting an increase in business and consumer confidence that encourages investors to feel more comfortable with moving up the risk spectrum, as evidenced by higher capital flows into emerging markets,” she explained.
A further factor driving the fall in correlation are rising earnings in non-resource, cyclical stocks that have driven share prices in higher, said Ayub, highlighting a “small group of Chinese internet stocks” that have accounted for almost half of all outperformance in emerging markets since April.
“Many are concerned about the concentration of returns among these stocks, but so far their earnings performance has justified their valuations,” she said.
“Irrespective of earnings, a large proportion of emerging market shares have already re-rated after being sold off following the 2013 taper tantrum, the energy crisis and country-specific factors.
“However, emerging market equities, along with those in other parts of the world such as Europe, have yet to recover fully from the effects of the financial crisis and some are still trading at a discount to their developed market counterparts.”
Lastly, a weaker US dollar could also prolong current favourable conditions in emerging markets, according to Ayub.
Policy normalisation and the unpredictability of the Donald Trump’s US presidency make a weaker dollar more likely.
She said: “Even if the US dollar strengthens in the coming months, it is not a given that emerging market debt and currency will suffer significantly or that equities will see a big reversal of flows thanks to the continuing yield and growth differential between emerging markets and developed markets.”
As such, the decoupling of markets could be set to continue for some time, according to Ayub, if volatility remains lower.
She said: “If current low volatility conditions persist, we expect emerging market and developed market equity returns to continue to diverge over the short term, as emerging markets benefit asymmetrically from the global recovery and higher capital flows.
Rolling 1yr volatility of MSCI Emerging Markets vs MSCI World over 3yrs
Source: FE Analytics
“Long term, however, we would need to see greater earnings growth from emerging market companies to sustain such a low correlation, as well as the continued ability to weather geopolitical risks,” added Ayub.