Emerging Markets Have Now Become the Safer Bet

Macroeconomic uncertainties in the U.S. are driving up market volatility in developed countries, making emerging markets a smart play for risk-averse investors.

Illustration by II

Illustration by II

Volatility is typically higher in emerging markets than in developed countries, but the trend has been reversed in the past few months.

“For the year-to-date period, we’ve seen EM volatility lower than [it is in] developed markets,” said Melissa Brown, managing director of applied research at Qontigo. In the last month, the volatility in EM countries has dropped, and it’s now about 25 percent lower than the swings in developed markets, the biggest gap between the two camps since 2006, according to data from Qontigo. Emerging market currencies have also seen a low level of volatility in the current market down cycle, a signal that developing countries are in better health than they were in prior drawdowns.

Lower volatility in emerging markets means that investors should reconsider the role of these securities in their portfolios. “What [investors] should be concerned about is the risk-return tradeoff,” Brown told Institutional Investor. “Maybe you need a higher return expectation in the U.S. relative to EM to justify taking on a higher volatility.”

The volatility gap is largely attributable to the growing macroeconomic uncertainties in the U.S. and the relative stability of Chinese markets, which dominate EM indices. Inflation and rate hikes have led to increased volatility in the U.S. and other developed markets, but such changes aren’t generally seen in China, according to Brown.

“The Chinese market, I would say, is typically more volatile than most other markets, [but] right now that’s really not the case.” Brown said, adding that “it’s a bit unusual” for China to have lower volatility amid the turmoil in global markets. Besides China, other EM countries such as India and Mexico have also been showing lower risk levels than developed countries in the past few months, she said.

But Brown cautioned that emerging markets may not be an ideal long-term strategy for risk-averse investors. “Emerging markets can be very sensitive to interest rates,” she said. Many of these countries have dollar-denominated assets that are vulnerable to rate hikes imposed by the Federal Reserve. Other major central banks, such as the Bank of England, the European Central Bank, and the Bank of Japan, might also make monetary policy decisions that could jeopardize the return of EM portfolios, according to Brown.

“So far, emerging markets [have been] less risky than developed [countries], even in the face of rising interest rates,” she said. “But the question is, is it likely to change quickly? It’s just something that we’ll all need to keep in mind.”