Israel Suffers Straddle of Equity-Debt Fence for Emerging Label
Israel’s multilane Ayalon Highway runs parallel to the Mediterranean Sea, past Tel Aviv’s skyscrapers, funneling traffic to its wealthy suburbs.
The La Guardia exit leads to Google Inc. (GOOG)’s research and development center, which co-developed the auto complete function of the company’s search engine. At the HaShalom interchange is Check Point Software Technologies Ltd. (CHKP), the world’s No. 2 software security firm. Get off a few miles farther north and you reach Herzliya, where a team of Microsoft Corp. (MSFT) engineers developed a free anti-virus program.
The tech giants were lured by Israel’s educated workforce and gross domestic product per person of $31,000, which the Organization for Economic Cooperation and Development says ranks it among developed nations. And the country of 7.8 million people has more startup companies per capita than the U.S., Bloomberg Markets magazine reports in its March issue.
Yet by the standards of bond investors, Israel is still an emerging market, on a par with Brazil and Turkey.
Israeli bonds and the shekel are covered by emerging- markets strategists at Barclays Plc, Citigroup Inc. and Goldman Sachs Group Inc. JPMorgan Chase & Co. includes the country’s local-currency debt in its emerging-markets indexes.
The task of classifying countries as developed, emerging or frontier has gotten increasingly difficult in recent years, investors and fund managers say. A lot is at stake: More than $370 billion of assets were benchmarked to the MSCI Emerging Markets Index (MXEF) as of Feb. 7, according to Bloomberg data. Some $430 billion followed JPMorgan emerging-markets bond indexes as of Nov. 23, 2011.
Since the collapse of Lehman Brothers Holdings Inc. in 2008, rich countries have been traversing one of the roughest economic patches in decades. At the same time, emerging nations that were once considered hazardous bets -- from Argentina to Thailand -- by some measures are more stable than their developed counterparts.
When it comes to debt, for instance, some emerging markets are rated higher than developed nations. Among emerging markets, Standard & Poor’s rated the government debt of Chile as A+ and South Korea as A.
Spain also is rated A, while Portugal, with a BB, and Greece, which was downgraded to the junk level of CC on July 27, score lower. All three European markets are on the MSCI developed-nations list.
“Emerging markets were riskier in the past, but now the situation has changed at a very rapid rate,” says Mark Mobius, who helps oversee $40 billion as executive chairman of Franklin Templeton Investments’ Emerging Markets Group. “The whole rationale of why emerging markets were exciting was because the potential of growth was much bigger.”
The level of price swings and risk in emerging markets is becoming similar to that of developed markets. The volatility of the MSCI Emerging Markets Index, which includes 820 companies from the 21 developing nations, shrank to 22.3 in 2011 from 40.7 in 2008. That compares with 21.6 for the MSCI World Index (MXWO), which consists of 24 developed-market countries.
Volatility measures the relative rate at which the price of a security moves, using the annualized standard deviation of daily changes.
‘Blurring Going On’
“There’s a blurring going on,” says Peter Marber, chief business strategist for emerging markets at HSBC Global Asset Management, which manages $400 billion. While decreasing volatility means less risk, the downside is that investors whose funds try to mirror benchmarks may be reducing the potential for rewards, he says.
“People are viewing the world through these index goggles and not evaluating the countries for what they really are,” says Marber, who’s based in New York. “You may not be getting the exposure you need.”
Emerging markets have outperformed the U.S. and Europe for a decade. The MSCI Emerging Markets Index surged 189 percent to 916.39 in the 10 years that ended on Dec. 30, 2011 -- about 10 times as much as the MSCI World Index of developed countries and more than 20 times the S&P 500 Index’s 9.5 percent rise. In 2011, the emerging-markets index dropped 20 percent versus 7.6 percent for the world index.
Beating Developed Returns
In the debt markets, developing nations’ total return was 60 percent in the six years ended on Dec. 31 -- more than twice the 25 percent gain in advanced countries, according to data compiled by Bank of America Merrill Lynch and JPMorgan.
“It suggests emerging markets are no longer dependent on the developed markets,” says Komal Sri-Kumar, chief global strategist at Los Angeles-based TCW Group Inc., which manages $120 billion. “They are in a nice trajectory of their own.”
Becoming a developed market may have unintended consequences. After MSCI Inc. bumped Israel up to developed- market status in May 2010, there was a net outflow of $795 million from Tel Aviv shares by the end of the year compared with a $1.7 billion inflow in 2009. All investors tracking the MSCI index had to rebalance their portfolios as Israel was removed from the emerging-markets gauges.
That’s one reason the country isn’t lobbying for any change in its bond status. “One of our aims is to preserve both advantages: to be developed and emerging,” Israeli Finance Minister Yuval Steinitz says.
Middle East Risks
S&P says the conflict with the Palestinians, the Arab Spring revolts in Egypt and the turmoil in Syria negatively affect Israel’s credit rating.
“It’s in the Middle East, and it’s perceived as more of a risky play,” Michael Ganske, head of emerging-markets research at Commerzbank AG in London, says of Israel. “The local politics are very difficult, which creates fear and volatility.”
Not everyone agrees that the politics are a reason to downgrade the country. “It’s ludicrous that Israel is still considered an emerging market,” says Benoit Anne, head of emerging-markets strategy at Societe Generale SA in London. “Stanley Fischer isn’t exactly an emerging-markets central banker.”
Fischer, 68, became Bank of Israel governor in 2005. He earned a doctorate in economics at Massachusetts Institute of Technology in 1969 and taught there during the next three decades, serving at one time as thesis adviser to Ben S. Bernanke, the Federal Reserve chairman.
Anne says South Korea also doesn’t belong with the emerging group, a view that other investors echo. The country’s growth averaged 3.3 percent annually from 2009 to 2011, while its policies and regulations met developed-market-status expectations, he says.
How to Get Upgraded
Winning an upgrade from frontier or emerging status isn’t easy. One criterion that MSCI uses to define a country as developed is whether gross national income per capita is at least 25 percent above the World Bank’s high-income threshold -- $12,276 as of 2010 -- for three consecutive years.
MSCI also looks at liquidity and the accessibility of the country’s markets to foreign investment: “At least some” openness to foreign investment qualifies a country as a frontier market, “significant” as emerging and “very high” as developed.
Qatar and the United Arab Emirates failed last year to secure an upgrade to emerging-market status from frontier.
Status of Greece
“The upgrade should really be done forever unless there’s some sort of extraordinary event,” says Sebastien Lieblich, vice president of research at MSCI. “We don’t want to see markets flip-flop from one universe to another.”
MSCI upgraded Greece to developed-market status in 2001. The nation’s benchmark ASE Index (ASE) was the world’s second-worst performer in 2011, falling 52 percent, behind the Cypriot General Index, which dropped 72 percent. Still, the Greek market is open to foreigners.
“Equity market accessibility hasn’t been impacted, so there’s no reason for us to downgrade,” Lieblich says.
Even some rich countries would welcome being considered as emerging. Jerome Booth, who helps manage about $60.4 billion as head of research at Ashmore Investment Management in London, recalls arguing with a banker in Iceland who tried to get Booth’s developing-markets fund to invest in the nation’s debt.
“We got into this argument of yes-we-are, no-you’re-not an emerging market,” Booth says.
Iceland’s GDP per capita for 2010 was estimated at $38,300. After its banks defaulted on $85 billion of debt in 2008, Iceland completed a 33-month International Monetary Fund program in August. As of Jan. 20, it cost less to insure against an Icelandic sovereign default than it did to hedge against a credit event in Europe’s single currency bloc, according to credit-default-swap prices from data provider CMA, a unit of CME Group Inc.
“We appear to be in the early days of a major transition,” says Jim O’Neill, chairman of Goldman Sachs Asset Management, who coined the term BRIC for the rapidly growing economies of Brazil, Russia, India and China.
While returns are now shrinking in the BRICs, O’Neill says he’s optimistic about countries that he calls growth markets. He says the next big spurt may come from places that are somewhere between emerging and developed, such as Indonesia, Mexico, South Korea and Turkey.
Sometimes, the best way of spotting a market that’s on its way up is through old-fashioned, on-the-ground observation. Marber recalls the first time he visited Warsaw, back in the 1980s: “The weather was gray; the buildings were gray; women’s makeup was gray,” he says.
Returning in 1994, he was struck by the changes: a gleaming, new airport terminal and a driver in a Mercedes taking him to his hotel, where he read in a flier that the local branch of Pizza Hut Inc. offered to deliver piping hot pies within 30 minutes -- and it did.
“It was the ka-ching factor,” Marber says. “You could just hear the sound of the cash registers because of the amount of business that was going on.” He boosted his holdings of Polish assets after that trip.
To contact the reporter on this story: Tal Barak Harif in New York at firstname.lastname@example.org
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