This blog post will unravel the benefits and risks of investing in transformative emerging markets, breaking down how exposure to EMs can enhance your investment portfolio's stability, diversification, and potential returns.

What Even Are Emerging Markets?

An emerging market economy is essentially the economy of a developing nation that's stepping up its game on the global stage. These countries aren't quite fully developed yet, but they're showing promising signs of growth and progress. Think of them as the rising stars of the economic world.

They're typically characterized by things like increasing economic activity, growing industries, improving infrastructure, and attracting more investment from abroad. As they continue to evolve, they become more intertwined with the global economy, with their local markets becoming more accessible to foreign investors and their regulatory systems becoming more reliable.

Some familiar names in the realm of emerging markets include India, Mexico, Russia, Iran, Saudi Arabia, China, and Brazil. These countries are on a journey from being low-income, less developed economies to becoming modern, industrial powerhouses with better living standards for their citizens.

So, for investors, diving into emerging markets can offer opportunities for potentially higher returns, albeit with more risk compared to fully developed markets. It's like investing in the future – exciting, but also something to approach with a discerning eye.

EMs At Large

While EMs are often not the main talk of town for many investors, the near and far future are likely going to change this trend. Despite their impressive run in the 2000s - the MSCI Emerging Markets Index almost quadrupled between 2002 and 2010, you might have been able to neglect them in the early 2010s when they failed to repeat their past performance and erased some of the gains made in the prior decade.

First, according to Goldman Sachs in 2022, EMs represented around 27% of total global market cap but around 45% of global GDP (measured in U.S. dollars).

Goldman Sachs Research predicts a significant shift in global equity market dynamics, foreseeing emerging markets' (EMs) stock market capitalization surpassing that of the U.S. and other developed markets. The forecast anticipates EMs' share of the global equity market to rise from 27% to 35% by 2030, 47% by 2050, and 55% by 2075.

This shift is attributed to favorable demographics, rapid GDP growth, and an equitization of corporate assets. However, rising protectionism and climate change are identified as potential risks to this optimistic projection.

Second, while the stock market is often the most followed by most investors when it comes to financial markets, it is by no means the biggest, with the global bond market totaling $133 trillion compared to the global stock market standing at $109 trillion in total market cap in 2022. Thus, you should not neglect this segment of the world economy and especially its components that have changed dramatically since the beginning of the millennium.

According to Amundi, the EM bond market has grown rapidly over the past 20 years. It currently accounts for around 20% to 30% of the global bond market, up from just 8% in 2003. This includes both sovereign debt and bonds issued by companies in these countries.

EM equities offer a valuable avenue for diversification away from the heavily skewed developed markets, particularly the US economy and its concentration in a narrow band of technology stocks.

The narrative of the last decade, with US earnings driving developed market outperformance, might not be the case in the future. Different markets dominate different time periods and one can easily make an argument for why EMs could rule the next decade.

Even without being certain, having exposure to EMs can be a reasonable move to make sure that you don´t miss out on the potential of future growth in these countries.

From a macroeconomic perspective, EMs appear relatively attractive. While the US grapples with a debt-to-GDP ratio of 112%, EMs maintain a more conservative 65%. Corporate dynamics tell a similar story, with the US boasting a net debt-to-equity of 77% compared to a more prudent 24% in EMs. Many US companies utilized debt for share buybacks, a trend that sustained market performance. However, the next catalyst for US market strength remains uncertain.

In contrast, EMs have exhibited a prolonged period of fiscal discipline, high real rates, and robust company balance sheets. Notably, EM central banks are positioned to cut rates ahead of their developed market counterparts, as evidenced by preemptive moves in countries like Brazil and Chile.

EM Risks

Why wouldn't everyone then invest their money exclusively in emerging markets, completely avoiding developed market assets?

After all, they seem to be attractive if they generate almost half of the global GDP but are only capitalized at 27% of the global market cap. The answer is simple, there is no such thing as a free lunch and these markets just like any other come with tradeoffs. The following are often the most cited risks that concern investors looking at these markets.

Political Risk

Political risk in emerging markets is characterized by greater instability compared to developed markets. EMs often exhibit less developed institutions and more flexible regulatory frameworks, heightening vulnerability to political uncertainties. The risk of civil unrest is also elevated in these regions.

Additionally, EMs face a higher susceptibility to sanctions, exemplified by restrictions imposed on Russia after its Ukraine invasion. Such sanctions can impede a country's debt repayment and hinder international trade.

Policies such as the “regulatory crackdown” on tech companies in China can harm investor confidence in the stability of these markets. In 2021 the regulatory storm aimed at curbing the dominance of Big Tech firms sparked concerns over the political reliability of China's stock markets.

China's tech giants have collectively lost over $1 trillion in value since the government's regulatory crackdown began three years ago. This crackdown not only diminished market value but also fueled US-China decoupling, shrinking China's tech companies significantly compared to their US counterparts.

Liquidity Risk

Emerging market bond markets face liquidity challenges due to smaller issuances and attracting fewer participants than developed markets. This can result in higher trading costs for investors, driven by unfavorable bid-ask spreads and increased broker commissions.

While liquidity has improved in recent decades, especially in the local EM bond market, corporate EM debt markets exhibit slightly higher liquidity risks. The opening of some economies to the West has contributed to enhanced liquidity, with EM local bonds gaining a greater share in global bond indices.

However, the choice of an EM bond index remains crucial for long-term performance and diversification, considering variations in liquidity levels among different EM bond sectors and countries.

Credit Risk

Credit risk in emerging markets varies based on the type of bond, with hard currency bonds subject to the regulatory jurisdiction of the currency-issuing country. For instance, defaults on US dollar- or pound sterling-denominated bonds are adjudicated by courts in the US and UK respectively.

Conversely, local bonds operate under local regulations, with defaults managed by local courts. This distinction implies that foreign investors might have less legal protection in local bonds, contributing to an additional risk premium.

However, in practice, governments are often hesitant to aggressively restructure local bonds, given their substantial ownership by domestic banks or pension funds, offering a degree of reassurance to both domestic and foreign investors.

Currency Risk

Currency risk, often referred to as exchange rate risk, is a concern for investors when they hold assets denominated in a foreign currency. Essentially, it's the risk that changes in exchange rates can negatively affect the value of investments.

For example, if you invest in a foreign stock and the currency of that country weakens against your home currency, the value of your investment in terms of your home currency may decrease, even if the stock price remains the same.

This risk arises because currency values fluctuate due to various factors such as economic indicators, geopolitical events, and central bank policies.

To manage currency risk, investors can use strategies like hedging or diversifying their investments across different currencies. You can read more about currency risk and currency hedging in our blog How Much Does Currency Hedging Cost Today?.

Emerging markets are exposed to market and currency risks influenced by local economic factors, particularly inflation. Inflation plays a pivotal role in shaping monetary policy and consequently affecting exchange rates in EM countries.

The inherent volatility stems from the heavy reliance on commodity exports in many EM economies, making them susceptible to global supply and demand fluctuations.

Notably, the inflation baskets in EM economies often include a larger share of volatile items, such as food. Rising inflation typically prompts an increase in interest rates to counteract its effects, potentially impacting total returns adversely. Conversely, falling inflation is expected to result in lower interest rates, potentially boosting total returns.

Both inflation and interest rate moves cause currency values to change as higher interest rates tend to increase value since investors can earn a higher interest on their deposits and inflation causes the currency to hold less value in terms of purchasing power parity.

This intricate interplay of market and currency risks underscores the challenges and opportunities inherent in navigating the dynamic landscape of EM investments. However, you should note that this risk is not unique to EMs and thus should not be a reason on its own to avoid EM assets.

Why You Should Not Sleep on EMs

Emerging market (EM) equities, particularly small caps, stand as a rich and underappreciated asset class in the global financial landscape. Despite driving 65% of the world's economic performance over the last decade, EM equities remain underrepresented in global indices by market cap, partly due to a structural bias towards domestic markets and the perception of being a 'risky' asset class.

However, investors overlooking EM small caps may be missing out on significant opportunities. The main point here is, that just like in the case of developed markets, you should diversify across different assets within EMs, be it according to market cap, sector, or region. Diversifying might be able to help you strike the right balance between both the risk and opportunity of EM assets.

Investors should consider an allocation to EM companies for several reasons. Firstly, the broad and diverse nature of this universe mitigates concentration risk, providing resilience in the face of global economic uncertainties.

Secondly, the sheer number of companies in this space presents ample opportunities for uncovering hidden gems that may outperform developed market counterparts. Additionally, investors can benefit from smaller EM companies that are often more closely tied to domestic markets, they can offer a unique way to capitalize on the local economic growth of specific EM countries.

The graph above demonstrates the fact that different markets dominate different timelines. The 2000s saw the S&P have lackluster performance and virtually no growth for years while the MSCI EM Index almost quadrupled.

As time went on the S&P500 began to grow, eventually outperforming the MSCI EM Index and becoming the dominant force in today’s market. The point here is that by owning both, you would avoid losing out on the opportunities presented by both markets – this, however, goes for both the UPs as well as the DOWNs.

Note that even when looking at EMs, you should always look closely at the type of EM Index you choose to invest in. Just like in any other market, differences between small, middle, and large caps will exist.

Notwithstanding, one should not shy away from looking at companies outside of the large cap universe. For instance, while the MSCI EM Index is often dominated by China, the MSCI EM small cap Index showcases a more diversified landscape, with India featuring prominently.

Thus, being invested in all small, mid, and large cap companies once again might provide a degree of safety regardless of where the growth might occur. In the face of geopolitical tensions between China and the US, India emerges as a strategic choice for investors seeking long-term opportunities with reduced geopolitical risk.

Sector-wise, the EM large-cap index is often tilted towards financials, whereas the small-cap index emphasizes industrials and real estate firms. By investing in both, you can gain exposure to a multitude of sectors and diversify your portfolio.

Investing in EMs can not only help investors diversify across sectors and market-cap spectrums but also provides global investors access to high-growth markets like India, Taiwan, and South Korea.

Conclusion

In summary, investing in emerging markets (EMs) offers both challenges and exciting opportunities. Despite facing issues like political uncertainties and liquidity risks, EMs have the potential for fast growth and diversification.

According to Goldman Sachs Research, EMs are expected to become even more significant in global markets, with India and China leading the way. While it's crucial to be aware of the risks, the rising importance of EMs and improving liquidity create unique chances for smart investors.

Understanding the ins and outs of politics, liquidity, and markets is key. As EMs take a more central role, making well-informed investment choices can unlock the untapped potential of growing economies, adding strength and prosperity to diversified investment portfolios.

At Finax, all Intelligent Investors can benefit from the exposure to emerging markets, as our portfolios aim to reflect the world stock and bond market capitalizations. This way we make sure that our investors participate in the potential returns of assets across the globe.