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Journal of Indexes

Emerging Markets And The Great Moderation

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The Origins And Evolution Of Delta-One

The idea that securities outside of well-established markets present reasonable risks for institutional investors dates back to the late 1970s and early 1980s when World Bank economist Antoine van Agtmael coined the phrase “emerging markets” and the first indexes covering these markets were introduced by the International Finance Corporation (IFC), a unit of the World Bank. Following the 1981-82 recession, the developed economies settled into the “great moderation,” a 25-year period of long expansions, shallow recessions and sustained bull markets. Investors searching for greater returns came to expect emerging markets to provide those returns, but with more volatility and greater risks than typically found in developed markets in the United States, Canada, Western Europe and Japan.

Risks in emerging markets differed from those in developed markets in both size and scope. Developed markets were marked by modest returns and annualized standard deviations of returns usually under 20 percent. Even the 1987 market crash didn’t disrupt this pattern, as the markets recovered quickly and closed slightly higher that year. The major economies had surmounted inflation by the early 1980s, recessions become fewer and milder, and expansions became longer and more reliable. The increasing macroeconomic stability of the great moderation provided developed markets with positive returns and modest risks.

There was no great moderation for emerging markets. Emerging markets suffered currency crises, high inflation and repeated periods of soaring debt. The problem was periodic crises, not day-to-day market volatility. Currencies collapsed, debts reached surreal levels compared with GDP, inflation surged, credit crunched and stock markets crashed. Various Latin American countries—including Mexico, Argentina, Uruguay, Ecuador and Chile—suffered sharp reversals as debts exploded, and currencies responded by collapsing during the 1980s and 1990s. The 1997 Asian currency crisis rolled over many countries, while nations emerging from the former Soviet Union during the 1990s staggered toward free-market economies. These crises—which wreaked havoc on stock markets—started with excess credit that led to rising debts, weakening economies and falling currencies.

Crises did occur in developed markets, but they were generally taken in stride in stable economies and followed by fast recoveries. For example, the 1998 Russian debt default brought down Long Term Capital Management, an American hedge fund. However, the Fed encouraged the major creditor-banks to organize an orderly wind-down. The damage in Russia, where the crisis began, was far greater and took much longer to recover from.

During the great moderation, investing in developed markets was viewed as safe, and the risks were perceived as measurable and understandable. Developed-market stocks were seen as primary building blocks of virtually any complete portfolio. Investors willing to take more risk saw emerging markets as potentially rewarding, but also fraught with potential disasters. While the collapse of technology stocks in 2000 and the 2000-2002 bear market tempered investors’ love of equities, the short and shallow 2001 recession convinced many that great moderation was intact when stocks resumed their climb from the 2002 market bottom.

 

 

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