The major regional emerging market equity benchmarks are highly correlated to developed market equities, both in local currency terms and hard currency terms. This doesn’t undermine the argument for investing in emerging markets overall, but it’s inconvenient for the view that emerging market investment can help diversify a portfolio.
However, the examples we looked at in previous articles are regional indices – so it’s worth considering what happens at the level of individual countries. At first glance, it might seem as if this won’t make much difference, since a regional benchmark is drawn from the country benchmarks. But there are reasons why what’s true at the regional level might not hold so strongly at the national level.
For example, many smaller markets have little or no representation in regional benchmarks. As a result, they may be less likely to suffer the swings in inflows and outflows from foreign investors that have such an impact on more popular markets.
Second, the stocks in the regional indices are the ones that foreign investors are most likely to trade – they’re large, liquid, well-known and part of key benchmarks. Smaller stocks that are outside the regional index but within country indices may receive lower flows – and depending on how much the leading stocks dominate their local market, this can lead to slightly different market performance at the country level.
So what do the data say? As before, we’re considering monthly correlations between the MSCI USA and the relevant EM MSCI index over the last ten years; local currency benchmarks have been used and the data is from Bloomberg.
First, the most closely linked markets. Many individual emerging markets show a relatively high level of correlation with the MSCI USA, even if it is usually a bit lower than the correlation between their regional benchmark and American equities. Here’s the top 10:
| MSCI Mexico | 0.746 |
| MSCI Singapore | 0.746 |
| MSCI Poland | 0.728 |
| MSCI Hungary | 0.714 |
| MSCI Romania | 0.708 |
| MSCI Korea | 0.702 |
| MSCI Hong Kong | 0.687 |
| MSCI Taiwan | 0.684 |
| MSCI Brazil | 0.665 |
| MSCI Bulgaria | 0.657 |
It’s absolutely no surprise to see markets such as Mexico and Brazil, Singapore, Hong Kong, Korea and Taiwan, or Poland and Hungary routinely rising and falling in line with the developed world. Most of the rest of the markets you’d expect – Russia, Indonesia, Malaysia, Thailand etc – rank not far below the cut-off.
But what about the bottom of the list? There are a number of countries that have shown little correlation with the MSCI USA. They are typically the frontier markets (note that many of these are relatively new indices and often don’t have ten full years of history).
| MSCI Morocco | 0.187 |
| MSCI Pakistan | 0.154 |
| MSCI Bosnia | 0.142 |
| MSCI Jamaica | 0.136 |
| MSCI Tunisia | 0.065 |
| MSCI Botswana | 0.002 |
| MSCI Zimbabwe | -0.005 |
| MSCI Trinidad and Tobago | -0.017 |
| MSCI Ghana | -0.102 |
| MSCI Bangladesh | -0.305 |
Very clearly, there’s a reason why these markets are not part of the crowd – accessibility is often difficult and so foreign involvement is limited. Performance is likely to be driven more by local factors – often purely sentiment – than what’s going on in Wall Street.
Does that make frontier market more interesting in some respects than more widely traded markets? Perhaps for a small number of investors – but the value of this low correlation with the rest of the world shouldn’t be overstated.
Let’s consider the market at the very bottom of the table – Bangladesh, which has been negatively correlated with the MSCI USA over the MSCI Bangladesh’s short history (just under two years). As the chart below shows, this lack of correlation has not meant good returns.
These kinds of markets are highly volatile, prone to boom and bust, and often with very significant political and other threats. Some may deliver strong returns – but not without on greater risk. Take Pakistan, the largest and most accessible of themarkets in the table above: The MSCI Pakistan is up 241% over the past decade – but that includes a 434% rise to mid-2008, a 78% plunge from there to early 2009 and a 187% recovery to date.
Meanwhile, as we saw previously, the high short-term correlation between mainstream emerging markets and developed markets generally has not stopped emerging markets delivering far stronger performance than their Western peers in the longer-term. So while some frontier markets may offerstrong investment cases of their own, there’s no need to be drawn to them purely because they are likely to march to a different beat to the rest of the world.