Understanding emerging market equity risk premia: Industries, governance and macroeconomic policy uncertainty

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Abstract

The average equity risk premium (ERP) in emerging markets is well-known to be significantly higher than in developed markets. But, key reasons for this remain unclear, contributing to investment strategy uncertainty. Here, we use industry-level data for 19 emerging market countries across three regions of the world to first examine the contribution of each industrial stock market to the extra premium paid by emerging markets to international investors from 1995 to present, and then to explore the relative importance of country-level governance and macroeconomic policy uncertainty in explaining both national and regional industry-by-industry ERP behavior. We conduct separate analyses for the emerging market crises period of 1995–2002, and the post-crises period of 2003–2012. Based on both static and dynamic approaches, we find that some industries indeed perform consistently better than others. In particular: (i) the healthcare and basic materials industries mostly contributed to the extra premium paid by the Asian stock market; and (ii) the East European and Latin American stock markets’ extra performances were largely driven by the utilities and consumer services industries, respectively. However, our cross-sectional analyses suggest that country-level governance indicators are not strongly correlated with either national or industry-level returns, with the exception of the consumer goods industry. Lastly, using both rolling-window and DCC-GARCH frameworks, we find that correlations between industrial stock market excess returns and a measure of global economic policy uncertainty are consistently negative, and follow similar patterns. Our empirical evidence as a whole suggests that industrial stock markets are more highly related both within and across countries and regions than has been suggested previously. Contrary to much existing empirical work, our results therefore suggest there is currently little space in emerging markets to exploit cross-industry portfolio diversification benefits.

Graphical abstract

Panel A reports the dynamic unconditional correlations between the world equity portfolio excess return and the emerging regional industry portfolio excess returns and the US industrial stock market excess returns. Panel B reports the dynamic unconditional correlation between the regional industrial stock market excess returns and the US economic policy uncertainty index.

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Section snippets

Introduction and motivations

During the last three decades the emerging market asset pricing and international finance literature has largely focused on the following five issues: (i) the behavior of the emerging markets ERP (i.e. performance measurements); (ii) the predictability of emerging stock markets excess returns (i.e. local vs global information variables, country effects vs industry effects); (iii) the effects of financial liberalization on emerging stock prices, cost of capital and expected returns; (iv) the

The stock excess returns

We download ten industrial stock market indices from Datastream Global Equity Indices (DGEI) for 20 national markets. The sample includes 19 emerging countries (see Table 1), as well as the United States, which we use for comparisons in some of our analyses. Emerging countries follow the IFC country classification (see IFC, 1999).9

The world CAPM: a static analysis

The Capital Asset Pricing Model (CAPM) has been widely used in the financial literature during the last two decades for a range of applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. The CAPM also represents a standard approach for estimating the risk of a national stock market with respect to a “market index” (e.g. world market index), and this is the approach that we use in our analysis here to determine the industries which

Country-level governance and ERP variation

Governance issues feature prominently in the global finance literature as explanatory variables for a range of market and firm-level performance outcomes, hence a brief assessment of the role of country-level governance in explaining industrial excess returns is also warranted here. Much existing empirical work around governance has demonstrated that the quality of governance in a country affects its ability to benefit from foreign direct investments (FDI) and international capital flows. In

Implications for portfolio diversification: assessing the role of macroeconomic policy uncertainty and global co-movements

Our results in Section 3 suggest that certain industries drive the higher observed emerging market ERP, although the particular industries vary by region. On the surface, this finding could suggest a potential portfolio performance benefit towards industry diversification in a risk-return framework (rather than country diversification). To explore this further we augment our earlier analyses with an assessment of the extent to which emerging market industries’ returns are independent of each

Conclusion

Over the last twenty years, and especially after liberalization,31 emerging stock markets have captured the attention of many scholars as well as many practitioners. Emerging markets’ empirical regularities are well known (e.g. high returns, high volatility, time-varying moments). Using industry-level data for 19 emerging stock markets across three regions and over two different sub-periods (i.e.

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    We thank Thomas Lagoarde-Segot (the editor) and an anonymous reviewer for their helpful comments and suggestions. All remaining errors are our own.

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