With global markets beginning to factor in a slowing U.S. economy, higher oil prices, and a weaker euro, the performance of emerging market assets diverged sharply in the third quarter of 2000. Equity markets almost unanimously registered losses in the period, while emerging debt markets ranked as the best performing fixed-income asset class. The current issue of Emerging Market Financing, which is published quarterly on the IMF’s website (www.imf.org) and is an integral part of the IMF’s surveillance of capital market developments, analyzes the causes and consequences of this bifurcation between bond and equity markets, and examines several structural changes in emerging market financing, the outlook for emerging market financing in the near term, and potential risks (such as those posed by the convergence of yields of U.S. high-yield, or “junk,” bonds and emerging market bonds).
Divergent emerging market asset trends
In the third quarter, emerging market debt, which rose 5.2 percent, outperformed all other fixed-income asset classes. Emerging market equity, which experienced a 13 percent decline, was among the worst performers. According to the report, some of this divergence can be traced to global fund managers who shifted from equity to bond markets in the face of a U.S. slowdown, with the accompanying decline in corporate earnings and lower interest rates encouraging this shift. High returns in emerging debt markets stemmed largely from positive developments in yields and capital gains on U.S. treasury securities (against which dollar-denominated emerging market bonds are priced) and from the high yields on emerging market debt. Perceived improvements in the quality of emerging market credit made a relatively modest contribution to the quarter’s returns. Asian debt was also supported by the relatively modest supply of sovereign debt from the region, with Latin America accounting for the bulk of new and outstanding emerging market bonds. Conversely, Asian companies dominate emerging market equities. Given the direct sectoral links between Nasdaq and global equity markets, and the larger proportion of technology shares in Asia, the region was more affected by the U.S. tech stock correction than other regions. Higher oil prices also had a greater impact on Asian equities, given the region’s higher dependence on imported oil, while large reserve accumulations in Asia protected sovereign Asian bonds.
“Free float” adjustments
With $2 trillion to $4 trillion of equity funds benchmarked against Morgan Stanley Capital International’s All Country World Index and an additional amount against the family of Emerging Markets Free Indices, changes in the composition of these indices have an enormous potential impact on flows to emerging equity markets. Morgan Stanley Capital International is considering changing the way it constructs its indices and moving to a “free float.” A free float would weight constituent companies in the indices according to how easily a company’s shares can trade, and it would adjust for such factors as cross-shareholdings, block holdings, government ownership, and foreign ownership restrictions.
Emerging market equities typically have a lower free float than equities in mature markets, reflecting higher government stakes, more pervasive restrictions on foreign ownership, and greater cross shareholdings in conglomerates. If Morgan Stanley Capital International moves to a free float, the share of emerging markets in world indices is expected to drop significantly, with potential outflows from emerging equity markets of between $30 billion and $60 billion. Within emerging markets, Latin American and Asian equities are generally expected to gain at the expense of emerging markets in Europe.
A move to a free float, observes Emerging Market Financing, would avoid some types of mispricing and help reduce volatility, as more liquid stocks would merit relatively higher weights. Competition among emerging markets for investment would also encourage countries to privatize state enterprises and reduce restrictions on foreign investor participation in local stock markets.
Emerging market-high yield nexus
As yields on emerging market bonds continued to inch closer to U.S. high-yield bonds during the third quarter (see chart, this page), Emerging Market Finance notes that high yields available from U.S. high-yield bonds may pose a risk to emerging markets, despite improved fundamentals in emerging markets and continued deterioration in the U.S. high-yield sector. Historically, average emerging market yields have been higher than those in the high-yield sector, and past episodes of convergence have been brief and followed by a sharp and persistent widening of emerging market debt spreads. Those who invest primarily in mature market assets but occasionally “cross over” into emerging markets to enhance returns view the two as competing asset classes, contributing to this dynamic.
But as the Emerging Market Financing report points out, the current episode of yield convergence is different. It has occurred at a higher level of average absolute yields for both asset classes, with yields on the high-yield sector rising, unlike in the previous two notable episodes of convergence in October 1997 and December 1993. Since the current convergence has been motivated by differential movements in fundamentals rather than by a broad-based hunt for yields from the high-yield sector into emerging markets, it should not be surprising if emerging market yields fall below that of the high-yield sector. But emerging market yields are not likely to fall too far below the high-yield sector, as the two asset classes still compete for funds from a large variety of investors.
Emerging market and high-yield bonds, July-November 2000
Data: IMF, Emerging Market Financing
Finally, surveying the outlook for emerging market financing, the current issue of Emerging Market Financing is guarded. Conditions for emerging market borrowers have deteriorated in international capital markets. Overall financing flows in the fourth quarter are expected to moderate, but syndicated lending—lending in which a group of international banks jointly make a loan at floating interest rates—is expected to remain supportive in spite of choppy conditions in bond and equity markets.