with Eli Remolona and Jimmy Shek
When global investors go into emerging markets or get out, how do they differentiate between the different economies? Has this behaviour changed since the crisis of 2008 to reflect a “new normal”? We consider these questions by focusing on sovereign risk as reflected in returns on credit default swaps (CDS). Tests for breaks in the time series of such returns suggest a new normal that ensued around October 2008. Dividing the sample into an old normal period and a new normal period and applying factor analysis, we find that a single global factor drives most of the variation in CDS returns, and it does so more strongly in the new normal. This factor is highly correlated with VIX, a measure of implied volatility in the U.S. equity market. To our surprise, when we take the country-specific loadings on this factor and regress them on the countries’ economic fundamentals, we find little influence of the usual fundamentals. Instead we find that the single most important explanatory variable is simply an indicator of whether or not the economy is designated as an emerging market. Again this is especially true in the new normal.