Investors buying into emerging markets for a leveraged bet on global growth and portfolio diversification are having to rethink their strategies as the integration of major developing markets such as Brazil and China into the global economy intensifies.
Generating outperformance from what is defined as a riskier asset class has become more challenging as these fast-expanding economies become more intertwined with their developed peers.
More than mere diversification away from mature markets, portfolio allocations into this asset class will increasingly be driven by a recognition that emerging equities, currencies and bonds are moving out of sync with each other.
"We've never seen such a meaningful breakdown in correlations (within emerging markets)," said Daniel Tenengauzer, global emerging markets fixed income strategist at Bank of America-Merrill Lynch.
"If you map out correlations on a six-month basis over the past 10 years, the breakdown you see in the past three months have never been there before... We're going to see more of this because emerging markets are maturing," he said.
But while assets and currencies within the broad spectrum of emerging markets show an unprecedented idiosyncrasy, correlations between emerging equities and their developed-market peers are now higher than during the global credit crisis.
More significantly, the beta of emerging equities, measuring price fluctuations relative to developed markets, has fallen to one since the start of the year, suggesting that emerging markets now merely track developed markets.
Gains are thus likely be modest even when global sentiment picks up.
"The long-term outperformance of emerging markets is a powerful and secular story but in the short term, it's still very much risk-on/risk-off," said Trevor Greetham, asset allocation director at Fidelity International.
Of course there is still a differentiation. The benchmark MSCI Emerging Markets Index is down 0.3 percent so far this year, versus a 3.4-percent decline in its global equity counterpart.
Emerging equity funds remain huge money magnets though allocations to global equities have dipped, EPFR figures show.
But some investors are pushing out to markets less integrated with the global economy to generate high-beta returns that mainstream emerging markets are not providing.
Africa and Arab Gulf markets are among the so-called "frontier markets" seeing strong interest.
"Investors are looking for markets that have low or even negative correlations to the global market," said Mohamed Al-Hashemi, Head of Asset Management at Invest AD.
MSCI's Emerging and Frontiers Africa excluding South Africa Index is up nearly 12 percent this year, beating the S&P 500 Index's 1.2 percent year-to-date decline.
Domestic-oriented economies such as Turkey and Poland are also viewed by investors as better positioned to elude the gravitational pull of any slowdown in the global economy.
Turkish shares are up 13 percent this year while Polish stocks have risen 4 percent.
Outside of equities, the outperformance of other emerging securities against the global average has been more dramatic.
So far this year, JPMorgan's sovereign emerging dollar debt index generated returns of over 9 percent while its local-currency emerging debt index returned 8 percent.
Both compare favorably against JPMorgan's GBI Broad Traded Index, measuring a broad swathe of government debt, which has returned 2.2 percent this year.
Such divergent returns from fixed income investments are perhaps no surprise given that central banks around the world are now at different stages of the monetary policy cycle after their coordinated effort to boost liquidity at the height of the financial crisis.
With some emerging-market central banks starting to raise interest rates and others holding them steady, correlations between currencies that have long moved in tandem will come under increasing strain.
The correlation coefficient between Brazil's real currency and the Mexican peso has fallen to around 0.7, from 0.8 late June while the measure between the Polish zloty and Turkey's lira has slipped from last year's historic highs, according to Benoit Anne, head of emerging markets strategy at Societe Generale.
Taking positions on relative-value crosses on currency pairs such as the lira/South African rand and zloty/Hungarian forint is one way investors can better differentiate between markets, Anne said.
"The world is a lot more complicated now but you can still make money," he added.
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