Emerging markets as an equity asset class have provided an edge to investor portfolios that have dared to look beyond developed markets. Historically, emerging markets have been used as a diversification tool and hopeful alpha generator. In a break from previous trends, the diversification benefits may be wearing thin.
The graph below shows the correlation between the following two ETFs:
Correlation between financial instrument prices is measured by the correlation coefficient which can range from -1 to +1. A correlation coefficient in the positive direction implies that the securities in question move in tandem in the same direction; i.e., if one of the securities decreases in price, the other does too. The higher the coefficient, the more closely the two securities prices move in lockstep.
This means that a high positive correlation is detrimental to diversification.
A high negative correlation, on the other hand, is highly desirable.
The graph above shows that the correlation coefficient between the SPY and the EEM had dove sharply after the US Presidential election in November 2016. It fell to its lowest point of 0.32 in February this year indicating a decoupling.
The decoupling accelerated in the days leading up to the inauguration on January 20 and continued in same direction for the first three weeks after that date due to concerns over the prospects of emerging market equities. A stronger USD, expected tighter monetary policy by the Fed and fears regarding trade protectionism were among reasons for the somber outlook on emerging markets.
However, since then, prices seem to be exhibiting trends of re-coupling.
The correlation coefficient is close to the 0.7 level at present — it had nearly touched the 0.9 level in late September 2016.
What does this increased coupling mean for your emerging market investment? Let’s assess in the next article.