In recent years there have been some notable changes in the relationship between measures of investor sentiment towards risk and emerging markets equities. Our work suggests that there has been a significant shift in historical relationships between Latin American equity markets (as summarized by the IFC Latin America Investable index) and, on one hand, US Treasury bond yields and, on the other, various credit spread measures.

Specifically, there has been a noticeable strengthening of the correlation between the IFC Latin America index and US Treasury yields since the start of the second (and more intense) leg of the recent emerging market crisis, which we date from October 1, 1997 (following the initial start of the crisis in July that year, as Thailand devalued the Baht). From October 1997, there was a marked deterioration in investor psychology and attitude toward risk in emerging markets.

From the early 1990s until October 1997, the
relationship between Latin American equities and US Treasury yields was weak. Conventional wisdom held that lower yields on US Treasury securities implied abundant global liquidity, which was generally associated with rising Latin American equity markets. Figure 1 shows that the correlation between the two series from January 1992 to September 1997 was just 0.18.

That all changed, however, in October 1997.

The intensification of the Asian crisis at that time was symbolized by the 10% collapse in the Hong Kong equity market (Hang Seng index) on October 23. After the US equity market (DJIA) itself plunged by 7.2% on October 27, there was another sharp fall in the Hong Kong market of 14% on the following day. By October 31, the IFC Composite had fallen by 16.5% during the month of October, with Latin America down by 18.7%. From its peak for the year on October 21 (a gain of 47.5%), the IFC Latin America index had fallen by 21% by the end of that month.

This major equity market sell-off was accompanied by a substantial rise in emerging market debt spreads, as investors completely lost their appetite for risk.

Since October 1997, the positive relationship between US Treasury yields and Latin American equities has become much stronger, as investors have increasingly ‘sought quality’ in US government securities in the face of volatility and crisis in the emerging markets.

Since October 1997, the correlation between US Treasury yields and Latin American equities has increased dramatically to 0.84; this implies that falling US Treasury yields have become much more strongly associated with downward movements in emerging market equity indices. This shift signals a clear flight to quality. Liquidity poured out of Latin America securities, amid extreme volatility in emerging markets, as investors sought the safety of higher quality, dollar-denominated Treasury bonds, the yields on which, therefore, fell sharply. The US 10-year Treasury yield fell from around 6% at the time of the collapse in equity markets in October 1997 to a low of just under 4.4% in the immediate aftermath of the Russian default and devaluation crisis of August 1998.

Interestingly, this trend of risk aversion since October 1997 was not limited to the emerging markets world; the same flight to quality was also evidenced in the divergence of US government and corporate bond yields, reflected in widening corporate yield spreads.

It is logical, therefore, that the trend of higher correlations with Latin American equities is not limited to US Treasuries. In fact, even stronger relationships have emerged between the IFC Latin America index and US corporate bond yields, as measured by spreads over the US 10-year Treasury yield. Again, Figure 1 illustrates that these correlations have strengthened considerably since October 1997. As would be expected, however, in this case the relationship is sharply negative (rising yield spreads are associated with falling stock prices).

From January 1992 to October 1997 the correlation coefficient between IFC Latin America and Moody’s AAA index yield was -0.57; however, since then, it has jumped to a very tight -0.84. When more speculative-grade bonds are incorporated into the analysis, the relationship is even more pronounced. After exhibiting a correlation with Latin American equities of -0.71 from January 1992 to the end of September 1997, the spread of the Merrill Lynch Corporate Master index yield over 10-year Treasuries has seen an increased correlation with the IFC Latin America index of -0.91.

These data suggest that, in recent quarters, corporate bond spreads have become a strong indicator of investor sentiment in Latin American equities, given the remarkable increase in correlation since October 1997.

Corporate Bond Spreads-A Risk Proxy
So why do corporate bond spreads appear to be an increasingly good indicator of the direction of Latin American equities? For one, by definition, they look beyond trends in benchmark US Treasury yields to gauge prevailing market risk premia. By being a strong indicator of investors’ willingness to hold risky assets, corporate bond spreads have become closely linked to the peformance of Latin American equity markets.

Again, this was most noticeable during the Russian crisis of August 1998, which induced a massive flight to quality, not only away from emerging markets, but within US financial markets also. US government bond yields collapsed as investors poured out of risky assets, with corporate bond yields skyrocketing, even in the case of investment-grade corporate bonds but, in particular, for higher risk bonds. Corporate spreads rose to levels not seen since 1991.

At the same time, the close (inverse) relationship between emerging market debt spreads and emerging market equities has been well-documented in recent months. As would be expected, therefore, a close (positive) relationship has developed between Latin Brady spreads and US corporate spreads.

Short-term Outlook for Spreads Unfavorable
So what does this imply going forward? The evidence of this work is, to the extent there is any causality at all, that an ability to predict US corporate bond spreads as well as emerging debt spreads should increase the possibility of calling the Latin American equity markets.

Our US economists have taken considerable notice recently of corporate bond spreads, noting that real corporate yields (inflation-adjusted) have recently risen to levels not seen since the late-1980s. Financial market conditions are tightening in the US, something which is not fully discernible simply by looking at US Treasury yields (although these have risen also now to a new high for this cycle of 6.25% on 30-year yields). There appear to be several factors behind this recent widening of credit spreads and our view of little significant narrowing in the short-term:

? Expectation of further Fed tightening is fueling a wave of new issuance. This increased supply of corporate bonds may maintain upward pressure on corporate bond yields and spreads.

? The recent (late-July) announcement of a new plan to ‘buyback’ US Treasuries, to maintain the average maturity of the debt, in the face of current budget surpluses, should further reduce the stock of Treasury debt relative to corporate bonds.

? In the run-up to the end of the millenium, Y2K jitters may prompt another flight to quality, which is bullish for Treasuries relative to corporate bonds.

In our view, however, there is little indication that corporate bond spreads will narrow again in the short-term, as the above factors continue to dominate. Near-term, therefore, there is unlikely to be much help at all for Latin American equity markets from the evolution of various credit spreads (including emerging market debt) as indicators of investor risk aversion.

Brighter Longer-term Prospects
However, while the short term is uncertain, the medium- to long-term outlook should be brighter. Despite the worryingly long period (now close to two years) of much higher risk aversion, it is likely that the relationship between US government bond yields and Latin American equities will eventually cease to exhibit such a strong positive correlation as investor appetite for risk and, therefore, for emerging markets recovers. As the global economy steadily rebounds, including a pick-up in GDP growth in Latin America from an estimated contraction of 0.5% in 1999 to +3.1% next year (boosted also by rising commodity prices), the increased aversion to risk that has gripped emerging market investor sentiment should gradually subside. In time, we expect the recent closer relationship between Latin American stock markets and US Treasury yields to weaken again. However, while corporate bond spreads continue to be a proxy for risk, they will remain closely linked to Latin American equity markets.

Conclusions
? Latin American equity markets have been particularly closely correlated with corporate debt spreads since October 1997.

? In the short-run, there is unlikely to be any help for Latin American equity markets from narrowing corporate spreads. Indeed, with the Fed in mid-August set to tighten further, issuance currently high (as rising yields cause concern amongst borrowers that the cost of bond finance is set to rise sharply) and Y2K a constant worry now, corporate spreads could even widen further over the next few weeks, putting further pressure on Latin American equity markets.

? Longer-term, however, particularly as economic growth in Latin America turns positive next year, as Y2K worries subside and as the Fed ends its tightening campaign, investor appetite for risk should increase again from recent historically low levels, which is likely to support higher equity valuations in Latin American markets.

Geoffrey Dennis is Latin American equity strategist at Salomon Smith Barney