Redefining 'emerging markets'

Levy- Yeyati: "The performance of a new group of Advanced Emerging Markets will likely look better in five years than what past data suggests."

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NEW YORK (Fortune) -- The news that Dubai World may default on $60 billion in loans has reawakened investors' suspicion towards emerging markets.

But experts say certain Latin American and East Asian countries have proven their economic mettle during this global recession and are unlikely to catch Dubai's contagion.

That's why Barclays strategists say they deserve a new label: Advanced emerging markets.

FTSE Group, which creates stock indices, has already given that title to six countries with high national income levels or developed market infrastructures: Brazil, Hungary, Mexico, Poland, South Africa, and Taiwan.

Barclays strategist Eduardo Levy-Yeyati would add countries such as India, Korea, Singapore, and Chile to the list, and leave out the United Arab Emirates, which he says lacks the "financial depth and policy track record." China, he says, is in a different asset class altogether because of its sheer size.

Financial advisors usually tell investors to keep a minority of their stock portfolio in international equities and a fraction of that amount in emerging markets. About 15% of the MSCI All Country World Index -- which tracks stocks from 45 countries -- comes from emerging markets.

Levy-Yeyati expects that to expand over the next few years. "The weights in the benchmark don't fully represent the economic upside of emerging markets," he says.

Some investors are apprehensive of emerging markets, according to Levy-Yeyati, because they fear a reprisal of the catastrophic episodes that occurred in the 80's and 90's, like Brazil's bout with epidemic inflation.

"Skeptics used to say the next crisis would show that [emerging markets] were no different from how they were before," he says. "But this time, they showed: 'We're different.'"

While the Brazilian and Indian stock markets fell further than the S&P 500 in 2008 -- and rebounded higher -- those countries' economies were hardly shattered by the global recession. In fact, the IMF estimates that all will post GDP growth topping 3% next year, while the U.S. is expected to achieve growth of just 1.5% (the IMF's projections are conservative by most analysts' estimates).

In a recent note to investors, Levy-Yeyati and his team marveled at advanced emerging markets' ability to reduce risk while maintaining growth. The analyst attributes the phenomenon to structural changes, many of which he says were implemented after the economic crises of the 90's.

Local governments, he says, have become more stable, using liquidity gained in boom times to build war chests, or reserves. "Fiscal consolidation and monetary credibility are here to stay."

Because of those fundamental changes, advanced emerging markets were able to cut interest rates and implement government stimulus over the last year without causing currency runs or credit sell-offs. While there was once a contagion effect -- if one market crashed, the others recoiled -- emerging market credit barely reacted when Ecuador defaulted last year. Following the Dubai incident, emerging market stocks and bonds faltered slightly, but are already bouncing back.

"Ultimately, these structural changes gave many E.M. countries the ability to enact countercyclical policies in bad times for the first time since the creation of the E.M. label," Levy-Yeyati wrote.

So what's keeping advanced emerging markets from becoming fully developed? "There are three aspects in which they're lagging," he says. "Currency convertibility -- many already have that -- income distribution, and institutional progress. For example, there's more uncertainty about the length and cost of investments and bureaucratic processes in these countries."

Levy-Yeyati says the second factor, income distribution, could take the longest to achieve. But now that these markets have achieved "macroeconomic stability," he says, they're closer to that goal.

The recent stabilization of emerging markets doesn't mean that they have decoupled from the G8 economies -- economic indicators still show a strong correlation between developing countries and the rest of the world. But that correlation, says Levy-Yeyati, has skewed heavily towards China, which is why many advanced emerging markets have rebounded.

"Empirically, it's very simple," he says. "China is increasingly the most important global factor."

Because China has become the main trading partner of Latin American and East Asian countries -- where most advanced emerging markets are based -- the country now drives their business cycles, he says. Eastern Europe and Mexico are still exceptions, yoked respectively to Europe and the United States.

Given many analysts' optimistic forecasts for China, it isn't surprising, then, that Levy-Yeyati expects advanced emerging markets to surpass expectations. "Indeed, because of the backward-looking nature of financial markets, the structural improvements ... have been only partially reflected in asset prices," he wrote. "The performance of a new group of Advanced Emerging Markets will likely look better in five years than what past data suggests."

As a result, he says, if investors take an overweight position in emerging markets now, they'll be ahead of the curve.