6 min read 27 Apr 22
While you’ve probably heard of ‘emerging markets’ before, the investment proposition they offer can often be misunderstood. Here are five points to think about to help you decide if they could be a good fit for your investment portfolio.
There is no denying that China has a huge economic importance. As at March 2022, it is the world’s second-biggest economy as measured by gross domestic product, and almost one in every five people on earth is Chinese. As such, China’s economics really matter, but it’s not always the best place to invest.
Chinese companies may suffer from too much state interference and are sometimes run for the benefit of the desired social outcomes in China, rather than for the benefit of company shareholders. In recent years, there have been cases where vast sums have been invested inefficiently in unprofitable businesses and local government projects.
China’s sheer size can sometimes overshadow other emerging markets (EMs) that offer a wide and diverse opportunity set, such as the commodities of Latin America, or the information technology of India. India’s growth rate is similar to that of China and it additionally has the advantage of a large English- speaking population. Brazil is Latin America’s largest economy and a large oil producer, whilst South Korea has managed to weather the storm of the COVID-19 crisis and proved to be resilient to the lockdowns which affected its Asian neighbours.
PwC’s The World in 2050 report, predicts that by this date the top three largest economies will be China, India and in third place the United States.
Fundamentally, emerging economies are those which - in times when the economy is doing well and there are no geopolitical, environmental or health-related challenges - are expanding rapidly towards an advanced stage of development. They are typically in the throes of industrialization, producing goods for the global market and developing their own consumer markets.
The Morgan Stanley Capital International (MSCI), a benchmark index of emerging market performance, categorises 24 economies as ‘emerging’. The stand-out ones in there are China, Brazil, India and the United Arab Emirates. It also includes relatively wealthy countries such as South Korea alongside the likes of Mexico and South Africa.
The differences between various economies show that EMs are not one and the same. The process of economic development is not linear and each EM has its own investment characteristics. For example, East Asia, with its close connection to China’s economy boasts very different investment opportunities and economic challenges to European Union-linked Eastern Europe.
Frontier markets are typically less developed economies whose stockmarkets might be less regulated or liquid – meaning it may be harder to sell unwanted investment assets. These countries may not even have a stockmarket on which to trade investments. Among those that MSCI deems to be frontier markets are Croatia, Nigeria and Pakistan.
A distinction can therefore be made between emerging and frontier markets, as highlighted in the map below.
What makes EM countries attractive is their fast growing economies. EMs typically grow by 6%-7% a year as compared to less than 3% for developed market (DM) countries. They tend to have cheap labour costs, a higher proportion of young people in the workforce, and relatively fewer elderly people to take care of. This is a direct contrast to the demographics within developed economies – although China is likely to be the big exception to this rule, as its population is ageing rapidly.
Furthermore, as EM countries travel rapidly towards an advanced stage of development they are propelling their populations into the middle classes; these newly minted urbanites are also new consumers and are powerful drivers of future economic development.
That said, fast economic growth is not the same thing as strong stockmarket growth. It’s well-run companies that generate good investment opportunities and consequently drive the stockmarket.
In the past, EM companies relied on their cheap and plentiful labour to mass-produce cheap goods and undercut the products of companies in DMs. As these companies have learned to compete in the global market, they have also learnt that this strategy does not lead to long-term profits. Therefore, they have pivoted to higher-quality goods and invested in research and development in order to keep innovating and to future-proof their businesses.
An example of this is the South Korean electronics producer Samsung, which over recent years has moved from being a small export business to becoming a preeminent supplier of high-quality semiconductors, mobile phones and other household electrical items.
The opportunities presented by the rapid growth of EM countries act as an initial draw to investors. But despite the appeal, it’s important to remember that these countries are more vulnerable to political headwinds, as demonstrated by the recent conflict in Ukraine.
In March 2022, the result of international sanctions caused the Russian ruble to collapse, which then had the knock-on-effect of causing markets to fall in Asia and Latin America. These type of ‘shocks’ do have a tendency to affect the EM economies as a group, however, governments are starting to build buffers to act as a protection against these events, such as holding large reserves for foreign exchange.
Unfortunately, the COVID-19 pandemic drained some of these resources, which did leave these economies more exposed than would have otherwise been the case.
On the other hand, EMs do not necessarily move in the same way as DMs, and as such can provide diversification to your portfolio. For instance, Latin America has proven to be an unlikely ‘safe haven’ during this crisis due to the many commodities which it can export, such as oil.
It is possible to invest directly in individual companies listed overseas, but it may be easier to achieve effective diversification by investing in a professionally managed fund that holds a range of EM assets. It cannot guarantee against losses, but diversifying your investments should reduce the negative impact of individual failures on your portfolio’s value.
Taking a fund approach, with your money pooled alongside that of other investors, can offer exposure to large assets such as EM government bonds that might not be otherwise accessible to individual investors. Active fund managers can also confer professional expertise and due diligence.
As an alternative to investing in EM assets you can also gain exposure by investing in equity (shares) or debt (bonds) of DM companies whose businesses are skewed towards EMs.
There are several UK-listed companies that derive most of their revenues – and revenue growth – from DMs.
When you’re deciding how to invest, it’s important to remember that the value and income from a fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. Emerging markets tend to have larger price fluctuations than more developed markets, as they are generally smaller, less liquid and more sensitive to economic and political factors.
Past performance is not a guide to future performance.
The views expressed in this article should not be taken as a recommendation, advice or forecast. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.