Developed and EM equity risk premiums - current results should not surprise

The performance of emerging markets has been horrible relative to global stock markets. It has bad for the last few years with emerging markets (EEM) moving sideways since the decline in commodity markets post-crisis peak. To some this has been surprising with analysts saying that emerging markets have changed and become more integrated to developed markets, but a close look at some of the research on emerging market equity risk premiums suggest that this story should have been expected.

There should be a difference between the equity risk premium in developed and emerging markets; however, the difference between these ERP should change with the level of integration between these groups. In fact, integration will be the great equalizer and the basis for convergence in risk premium between developed and emerging markets. This is consistent from what we should expect with any trade integration. However, financial integration is not stable or one-directional. If there is an outflow of capital, there can be a decline in integration.

The issue is how fast will this occur and are there other issues which cause differences in risk premia. Clearly, an increase in volatility differentials will change the risk premiums between developed and emerging markets. With the increase in volatility in emerging markets and declines in developed markets risk over the last few years, there will be a change in the risk premium differentials. Additionally, there are two other factors that have a strong effect on EM risk premiums. One, the global business cycle and two, overall market liquidity.

The growth in emerging markets has been revised down a number of times of the last few years, so the global business cycle has turned against emerging markets. EM growth rates have disappointed the markets and economists.  This disappointment is reflected in risk premiums. The downturn in commodities is another cycle that has worked against many EM countries. Liquidity, as measure by the capital flows into emerging markets, has also turned against these markets. With US rates up, capital flows have reversed.

The decline in EM should not be overly surprising. The strong performance of the developed world is what should have been more surprising. This gap may be closing without the support of the Fed.