Are emerging markets the new relative safe haven for stock investors?

Despite a regional market collapse across Eastern and Central Europe this year the MSCI Emerging Markets Index is down just 7% versus a 17% loss for the S&P 500 Index and a decline of 18.8% for the MSCI World Index of mature markets.

While the ongoing rally in world markets is probably occurring within the confines of a bear market, emerging market bourses are generally faring much better; several developing economy markets, including Chile, Brazil, China, Taiwan and South Korea are now in positive territory in 2009 while other advanced economy indexes remain deep in the red despite big rallies lately.

From its low on October 27, 2008, the benchmark MSCI Emerging Markets Index has gained a cumulative 18.9% versus a 12.5% loss for the S&P 500 Index and -7.9% for the MSCI World Index.

Major Break in Correlation

Historically, most emerging markets have risen or declined in sympathy with Wall Street. Indeed, emerging markets got slammed in 2008 along with all bourses and, in most cases, declined more than some major markets. Last year, emerging markets as a group plunged 45%.

The largest emerging market, China, for example, collapsed more than 70% in 2008 while Russian equities – ranked at 5.4% of the MSCI Emerging Markets universe – tanked 75%.

Yet over the last several months a clear break in correlation trends appears to have occurred. Emerging markets might be evolving into a relative safe-haven for equity investors following a deluge of dumping last year; the big sellers are now largely long gone.

What’s even more impressive is that this rally is happening even as East and Central European markets bleed profusely under the weight of a regional debt and currency crisis.

This marks the first time since the advent of the MSCI Emerging Markets Index that this asset class have clearly outpaced the major markets in the midst of a bear market.

East Europe Aside, Banking Crisis a Western Phenomenon

Part of this performance anomaly between major and emerging markets since October might be explained by a growing realization among investors that this time the crisis in confidence is largely a mature market phenomenon, not an emerging markets crisis.

For the most part, the crisis in banking is largely tied to the boom in credit derivatives and mortgage-backed securities issuance in the United States and Western Europe. Most banks in the emerging markets are not exposed to subprime and are largely not affected by ongoing credit-related losses. Banks in Brazil, Chile, China and other stronger emerging markets have not recorded big losses tied to Wall Street’s folly.

There’s no doubt that a dozen or more emerging markets, mainly in Eastern Europe and Russia, rank as the worst-performing bourses since late 2007. Aside from Russia, reeling from a collapse in energy prices and a plunging rouble, regional neighbors in Eastern Europe are indeed in the throes of a full-blown funding crisis as reserves dwindle and, in some cases, require International Monetary Fund (IMF) assistance. But that’s not the case with other emerging markets in South America and the Pacific.

Lessons of 1997-1998

Many emerging markets experienced a serious economic contraction or outright depression starting in 1997 as Thailand triggered the developing markets crisis. Asia has emerged much stronger from that period of deflation and did not over-leverage bank balance sheets to the same degree as Western banks over the last ten years; importantly, Asia has largely avoided mortgage-backed securities and has suffered only small write-downs or losses.

Some emerging markets remain healthy following years of fat trade surpluses. These include China, Brazil, Taiwan and Chile. Brazil, for example, is probably the best managed emerging market economy along with Chile. Both countries have positive trade balances, strong currencies and benefited enormously from the recent boom in raw materials. And, as regional currencies in Europe have declined or crashed recently (except the Norwegian krone), the Chilean peso has climbed 6% against the U.S. dollar this year while the Brazilian real is up 0.5%.

It’s still too early to claim a full victory for emerging markets.

Not Clear Sailing -- Yet

The global financial system is still reeling from bank insolvency across major markets in the United States and Europe; until this crisis finally passes investors will remain vulnerable investing in common stocks, including the emerging markets.

It’s also possible that a distressed emerging market sovereign borrower in Eastern Europe might default on its foreign debt. Credit spreads in the region are at all-time highs with Ukraine and Hungary the most vulnerable – even after receiving IMF assistance.

The good news is that Eastern and Central European markets represent just 8.6% of the MSCI Emerging Markets Index. Though not an insignificant weighting, other constituents of the index can offset this vulnerable regional allocation assuming they continue to advance – namely China, Brazil and South Korea. These three emerging markets should be monitored closely since they represent a hefty 41.3% of the MSCI Emerging Markets Index.

For the first time in their history, most emerging markets might be evolving into a safe-haven at a time when advanced economies are still reeling from a brutal credit deflation, bank insolvency and a crisis in investor confidence.