Short Term Risks of Investing in Emerging Markets Significantly Higher

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Prieur du Plessis submits:

Emerging-market equity prices as measured by the MSCI Emerging Markets Free Index are primarily driven by commodity prices and in particular by metal prices as measured by the Economist Metals Price Index. Currently emerging-market equities are approximately 8 - 10% overpriced given the level of metal prices.

Click on charts below to enlarge:


Sources: I-Net Bridge; Plexus Asset Management.

The ratio of the MSCI Emerging Market Free Index and MSCI Global Index is also driven by commodity prices and specifically metal prices. On a relative basis emerging-market equities tend to bottom earlier than mature markets and the ratio therefore acts as a leading indicator of metal prices. At this stage the still-rising and elevated level of the ratio suggests that metal prices are likely to hold up well despite the recent sell-off.

Sources: I-Net Bridge; Plexus Asset Management.

The yield on the JP Morgan Emerging Market Bond Index is at its lowest on record. Sentiment regarding emerging-market bonds is also significantly influenced by metal prices. The JP Morgan Emerging Market Bond Index yield (please note the reverse axis) has dropped significantly more than what metal prices suggested and therefore points to increased risk in emerging-market bonds.

Sources: I-Net Bridge; Plexus Asset Management.

Emerging-market bond yields took their cue from mature-market bonds, though, as the yield spread narrowly tracks that of the Metals Index. However, the yield spread (please note reverse axis) is currently 50 basis points lower than what it should have been given the current levels of the Metals Index. It therefore also indicates that emerging-market bonds are expensive relative to mature-market bonds.

Sources: I-Net Bridge; Plexus Asset Management.

The yield spread between the JP Morgan Emerging Market Bond Index and the calculated mature-market bond index is even lower than the range that existed before the economic malaise started in 2008. It will need a big push in metal prices to reduce the spread further.

My equally-weighted commodity currency index − consisting of the Australian dollar, Turkish lira, Brazilian real, Czech koruna, Thai baht, Hungarian forint, Russian rouble and SA rand - is driven by the same forces behind investments in emerging markets, namely metal prices. For some unknown reason the commodity currency index lagged and opened a gap with metal prices towards the end of last year. The gap closed only recently.

Sources: I-Net Bridge; Plexus Asset Management.

The commodity currency index has an inverse relationship with the yield spread of emerging-market bonds to U.S. treasuries, thereby indicating that commodity currencies rise when the risk of investing in emerging markets − as measured by the yield spread - declines and vice versa.

With the emerging-market bond yield spread expected to widen somewhat in the short term, commodity currencies can be expected to follow suit and weaken.

Sources: I-Net Bridge; Plexus Asset Management.

My country's currency, the South African rand, is currently slightly (5%) overvalued against the commodity currency index.

Sources: I-Net Bridge; Plexus Asset Management.

Bar the current situation where emerging-market equities and bonds are somewhat overpriced and a healthy market correction is needed to pull them back to realistic levels compared to mature markets, the longer-term outlook for investment markets in emerging economies is cloudy and becoming increasingly uncertain. Despite QE2, I see no quick fix to substantially boost consumer sentiment in the U.S., especially in light of the absence of new fixed investment given the significantly surplus capacity, severe problems in the housing market and the inelasticity of job creation to stimulatory measures.

Furthermore, global demand is likely to remain under pressure. I expect demand in the Eurozone to be lethargic, especially in light of the fiscal crisis in the PIIGS, Japan running the risk of returning to a recession, and emerging economies and China in particular reigning in their economies by hiking interest rates.

I do not see emerging-market economies tanking, though, but in my opinion the short-term risk of investing in emerging markets has increased significantly.

Disclosure : None

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , International

Referenced Stocks: ADRE , DEM , EDD , EEM

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