Comparing Sovereign Credit Risk and Stock Market Risk

by: Erik Dellith

I recently caught an IMF working paper titled “Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis”. The authors find that there are spillovers associated with changes in sovereign debt ratings. The extent of the spillover depends on various factors. While those authors focused on short-term impacts of the current European debt crisis, the paper made me wonder about the general trend of credit risk and how it might relate to stock market risk, where do we stand, and where are we likely going.

Measures of Risk

In Country Betas: Risk and Convergence, I discussed some of the dynamics associated with the MSCI country indices for Developed, Emerging, and Frontier Markets. I used those betas for this analysis, as well.

For comparison purposes, I took the relationship of the emerging market risk metric to that of the developed market. For instance, rather than simply look at how beta changed over time, or the spread between the average betas, I took the ratio of the average Emerging Market beta relative to the average Developed Market beta (EM beta/DM beta). Numbers below unity (1.00) suggest that the Emerging Market group, on average, is less risky than the Developed Market group; numbers above indicate more volatility.

I examined the sovereign credit ratings available on the Fitch Ratings website. I did not look at interest rate spreads, which could, potentially, be distorted by the loose monetary policy of the world’s central banks in recent years. Instead, I focused on relative credit rating. In other words, I assigned a numerical value to Fitch’s credit ratings; the better the credit rating, the higher the number. The ratings ranged from RD = 1 to AAA = 29.

I calculated the average credit ratings for the MSCI Developed Market and Emerging Market groups. I similarly took the ratio of Emerging Market ranking relative to the Developed Market ranking (EM average rank/DM average rank).

Where Do We Stand?

Although relatively volatile, we have seen some convergence in recent years between the average betas for countries in the Developed and Emerging Market groups. Though by a considerably smaller degree, we have seen average credit ratings in the Developed and Emerging Market groups converge over the last decade or so. These relationships are seen in the graph below (click to enlarge images):

Click to enlarge

This raises various questions. Does this suggest that emerging markets are becoming less risky? Or does it indicate the enhanced volatility in the Developed Market that resulted from the most recent financial crisis?

Perhaps the answer is choice C: Both of the above.

Average credit rankings in the Emerging Market group have effectively stabilized after trending slightly higher. Meanwhile, the average credit ranking for the Developed Market group has taken a bit of hit, as countries such as Greece, Ireland and Portugal have seen their ratings deteriorate. This relationship is seen in the graph below.

Click to enlarge

Where Are We Going?

It is likely that, in coming months, we will see further compression between the average credit rankings. Fitch cut its rating on Greece’s debt again on Friday. And we cannot forget about how austerity budgets could hamper growth, not just in Greece, but also in some of the smaller EU economies. While Germany will likely continue to power the EU region to some degree, weakening conditions exist there. A downturn in the euro zone could put further pressure on already strained federal budgets. Do not be surprised to see further deterioration in the average credit rating for the Developed Market group.

This does not necessarily mean that investors should just plow into the Emerging Market group. As I discussed in "Country Betas" (see link above), there are risks associated with investing in foreign, particularly emerging, markets.

Still, if investors are looking for exposure to Emerging Market areas that have been upgraded recently, then they may want to take a look at Chile. Fitch upgraded Chile’s rating from A to A+ in February. Further, according to my calculations, the rolling five-year beta on the MSCI Chile Index has been under 0.50 since August last year, so picking up the iShares MSCI Chile Index ETF (NYSEARCA:ECH) could provide exposure to this emerging market while also offering some insulation from volatility in the global equity markets. Further, as Econ Grapher noted in the article “Should You Invest in Chile?” the IMF is forecasting solid growth and reasonable inflation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.