SSgA strategist says despite tight correlations now with developed markets, he's expecting those ties to widen as conditions improve. George Hoguet is a global investment senior strategist specializing in emerging markets at State Street Global Advisors. Prior to joining the firm in 1998, he worked in London and Boston with Baring Asset Management. Hoguet has also worked at the Frank Russell Co., where he consulted with large institutional investors. On Friday, he reviewed major investment trends for the coming year in emerging markets with IndexUniverse's Murray Coleman. Here's an excerpt of that conversation. IU: What do the major emerging market indexes show about volatility levels now? Hoguet: Emerging markets have been and will continue to be much more volatile than developed markets. However, if you look at emerging markets in a portfolio, a modest allocation amount can help reduce overall risks since they're not perfectly correlated with developed markets. IU: Do you think emerging markets noncorrelation qualities will return? Hoguet: In the intermediate term???over the next five years or so???correlations are likely to increase. In the very long term, China will become less correlated, as will much of the rest of emerging markets. In about eight or nine years, China should surpass Japan as the second-largest economy in the world. IU: Then for long-term-oriented investors, you're still bullish on emerging markets? Hoguet: Investors should have a strategic allocation to emerging markets, which represent about 9% of the world's float-adjusted equity capitalization. Currently, emerging markets face substantial headwinds. But the MSCI Emerging Markets Index has significantly outperformed the MSCI World Index over the past seven years. And for the 18 years ending Aug. 30, 2008, the MSCI Emerging Markets Index had outperformed the S&P 500 by more than 76 basis points per year. IU: Over longer periods, hasn't the U.S. in particular outperformed? Hoguet: That's true if you go back to the turn of the 20 th century, because of the disruption of World War I and World War II. Also, the confiscation of assets by communist regimes meant that people lost everything and stock markets were closed in some countries. The point is, when you talk about the U.S. having above-average returns, that relates to the fact that in the 20 th century, we've never had a period where assets were confiscated on a large scale and markets were closed indefinitely. IU: Then how do you measure the U.S. stock market versus the world? Hoguet: There are a lot of methodology issues such as survivorship bias. Many companies have gone bankrupt. But what you can say is that the U.S. has been characterized by a relatively high degree of political, economic and social stability. IU: As an investable theme, what does this mean? Hoguet: The reason the U.S. represents roughly 45% of the world's market capitalization and emerging markets about 9% is precisely because of the political and economic risks involved in emerging markets. So the question with investing in emerging markets is whether that risk is being properly priced. And the question is over the long term, how much should emerging markets outperform developed markets? IU: What are some of the short-term negatives? Hoguet: Those would include the reality of a global recession. They'd also include increased financing costs and credit contraction in global markets. Investors are still deleveraging across the world and are much more risk-averse these days. Commodity prices are declining and, in some cases, countries are facing prospects for continued currency weakness. Then there's the contagion factor, which means a sell-off in one market could lead to a sell-off in other markets. IU: Don't all markets face these same problems in varying degrees? Hoguet: Yes, but it's a very broad dispersion. Some countries are much more dependent on commodities and natural resources, for example. China, with its large foreign exchange reserves, is in a better relative position than a country like Turkey. It runs a substantial current accounts deficit and its corporations are major borrowers on external markets. So if they can't obtain financing or if so, on unfavorable terms, they could face rollover risk. But those are just two examples. It can vary from country to country a lot. IU: So you think correlations tightening between emerging and developed markets is a short-term occurrence? Hoguet: I wouldn't put it that way. There are two trends at work. The first is a secular, long-term trend which is based on the fact that in general, investors are holding more diversified portfolios. That's reducing home biases, and emerging market companies are becoming more integrated into the world. The second factor is cyclical. We're seeing a deleveraging take place and a shock in the U.S. that led to a significant drop in the U.S. stock market last year. Investors have been lowering their risks and selling emerging markets. In the current environment, these two factors have led to increased correlations. What I'm trying to suggest is that in the very long term, as China becomes the second-largest economy in the world, global business cycles won't be as synchronized. Right now, we've got a synchronized slowdown in markets across the world. That's forcing correlations to become much tighter. IU: This year, what trends do you see? Hoguet: The returns are extremely tied to progress in the world economies. For emerging markets to rally on a sustained basis, investors need to see significant progress towards normalization in credit markets. Right now, we're still on a downward path, as growth continues to disappoint. Investors will have to also see a reduction in volatility. IU: How can individual investors monitor those factors? Hoguet: What they should look at is volatility in developed equity markets, which likely will have to fall before anything happens in emerging markets. The consensus is that the U.S. economy will start to recover by the third quarter of 2009. But risks are to the downside. And there's a question mark to the path this year of the Chinese economy. IU: What challenges does China face in coming quarters? Hoguet: The question is how much growth will slow in China and how much its exports to the U.S. and the rest of the world will be offset by domestic demand. Chinese GDP growth below 6% would signal a sharp enough slowdown to further reduce the world's rate of growth. My feeling is that by the end of the year, emerging markets are likely to finish higher. My reasoning is that credit markets will have stabilized and improved enough to support growth and that the world economy will no longer be on a downward path.