The global financial crisis has made clear the faulty logic justifying risk premiums on emerging-market securities, which suggests these are going to fade, says Jorge Mariscal, co-founder and head of global strategy at The Rohatyn Group, a $3 billion New York-based hedge fund manager specialising in emerging markets.
He credits an 8% gain in TRG's Asian equities fund in 2008 in part to the firm's read of what's happening to the United States and its role in the world economy.
Mariscal, who helped set up TRG in 2001 after serving as managing director responsible for coordinating emerging-market research and portfolio management at Goldman Sachs, says the main implication of the crisis for asset allocation is that the dollar is going to weaken; the question is, against what?
America's policymakers are using interest rates and money supply to keep long-term mortgage rates low, support financial institutions and encourage borrowing. Basic economics teach that among the trinity of interest rates, money supply and exchange rates, governments can control two. That leaves, in this case, exchange rates as the variable that adjusts in reaction. However, the lack of sufficiently liquid alternatives will prevent a dollar crisis, and means foreign investors will only gradually diversify out of the dollar. "The real depreciation comes in the form of inflation, not nominal exchange rates," Mariscal says.
While this means the euro or other developed-country currencies are not going to benefit, TRG is bullish on emerging-market currencies, thanks to their superior economic growth, high savings rates and commodity bases. That is because it is now the US which deserves to be saddled with a risk premium.
"When investing in the US, we relied upon its robust market structure, its accounting practices, its transparency, its efficient price formulation," he says. "Now all of these things are deeply under question."
He says the Securities & Exchange Commission not only missed giant scandals like Bernie Madoff, but, more fundamentally, had no clue as to the risks on the balance sheets of American financial institutions. This suggests that, until the government writes new rules for the market that restores confidence in financial institutions, US equities will carry a risk premium.
Meanwhile the inefficiency, opacity and corruption that characterised emerging markets in the 1980s and 1990s has been addressed. Yet emerging markets, with their better growth stories and strong corporate balance sheets, continue to trade at a 25% discount to the S&P 500. "This premium is not justifiable," Mariscal says, adding that among global mutual funds, only 13.5% invest in emerging markets.
So why does the risk premium endure? Mariscal says it will erode as the world comes to realise that the resilience of economies such as Brazil, China and India, which was unthinkable 10 years ago, will contribute the most growth. These economies are not without their problems either. China and Russia are not open societies while others, such as those in central Europe, are wrestling with a transition to democracy. Brazil and Mexico still face huge challenges in poverty and inequality. But, in all of these cases, policy in emerging markets has been prudent and pragmatic -- while the robustness of markets in America and western Europe are now in doubt.
This reality is now being felt in bond markets, where sovereign spreads of emerging market bonds are not at historical highs, while volatility in emerging markets has become less sharp relative to industrialised countries.
This said, Mariscal does have one caveat. If America's economy does not stabilise within the next year or so, emerging markets will not escape. The risk of protectionism and competitive currency devaluations continues to put export industries at risk. "Emerging markets can probably survive two more years without growth from exports, but after that all bets are off."