Investing in Emerging Markets

‘Emerging Markets’ (EM) also known as emerging economies or developing countries is an umbrella label that describes economies which have begun to bare resemblances to developed nations, but are not quite there yet. Some of the best-known EMs are: Brazil, Russia, India and China (previously coined as the BRICs) but there are many others, for example, Hungary, Poland, the UAE, and Korea… myLIFE gives you a basic overview of the opportunities and risks associated with EMs.

Opportunities

Over the next 20 years, emerging markets (EM) are tipped to be the tour de force behind global growth. With growing populations and a rising middle class, a higher proportion of disposable income means that EM economies should continue to expand. McKinsey, a leading consultancy firm, projects that by 2025, overall global consumption will reach $62 trillion (twice its 2013 level), and half of this rise will come from the emerging world. In 2010, the “consuming class“[1] had 2.4 billion members – just over a third of the world’s population. By 2025, the consultancy firm foresees an additional 1.8 billion consumers globally, the vast majority of these living in emerging regions.

By 2013, EM already accounted for 59% of total demand for building materials, 57% for iron and steel, and 47% for machinery. But EMs are also systematically integrating themselves into the new digital economy. The Boston Consultancy Group finds that more than one-third of all unicorns[2] are from EM.

(…) not only do EMs offer an interesting structural investment case over the long-term, they offer investors the added advantage of diversification.

Naturally, this means that investment opportunities within these fast-growing nations are abound. And not only do EMs offer an interesting structural investment case over the long-term, they offer investors the added advantage of diversification. EM are typically are less affected by events occurring in the developed world and thus can, at times, offer some insulation against home market turbulence…

The problem for many investors, however, is siphoning out the lucrative opportunities from the duds, in what can at times be opaque and turbulent markets.

Risks

Investing in EM typically comes with more embedded risk than investing in developed markets. Generally EM don’t have the level of market efficiency, strict accounting standards and stringent securities regulation that advanced economies (such as the US, Europe and Japan) have. In fact, EM tend to have more volatile, less diverse stock markets and companies may have poorer levels of corporate governance.

EM have faced, and continue to face, unpredictable politics, unorthodox central bank policies and – at times – seemingly unsustainable levels of borrowing.

Currency fluctuations add another layer of uncertainty, meaning that investors have to be particularly attentive to the type of instrument they choose to buy.

Despite the various risks, EM are undergoing rapid changes and after a number of uncertain years, peppered with external vulnerabilities and economic headwinds, EMs are starting to look more sturdy.

Despite the various risks, EM are undergoing rapid changes and after a number of uncertain years, peppered with external vulnerabilities and economic headwinds, EMs are starting to look more sturdy.

The investment decision

Most investors recognize the potential of EMs, yet are perplexed when it comes to finding the right investment approach. EMs are highly diverse, traversing 4 continents, 20 time zones, and numerous currencies. An investor must thoroughly understand the local government, domestic nuances, economy and market of the EM they wish to invest in.

They must also be clued up on the investment vehicles available and their distinguishing features. There are four primary asset classes to consider when looking at EM are: EM equities, local currency bonds, hard currency bonds, Corporate bonds.

EM equities

EM equities offer the opportunity to buy shares of an expanding collection of companies across an array of sectors. The MSCI Emerging Markets index is comprised of 1,137 constituents in 24 countries. Emerging economies were once driven by commodity exports, but today, many of them are shifting towards service-based economies. Companies in the health care, technology and consumer sectors have become prominent, and the universe of EM companies has broadened significantly.

EM stocks have historically demonstrated higher volatility and deeper drawdowns than developed-market stocks, reflecting the inherent risks of the asset class. Yet, having a portion of one’s portfolio allotted to EM equities has historically helped improve overall risk-adjusted equity portfolio returns.

Whilst it is essential that investors in EM equities understand and appreciate the risks of the asset class (a task that seems daunting to some) the potential diversification benefits of investing in compelling companies located in some of the fastest growing economies in the world is not an opportunity that should be shunned without consideration.

Investors should also understand that EM equity is a different animal to what it was some years ago. Not only have country-specific factors became more important, sectorial allocation has radically changed due to the impact of the consumer-oriented boom.

EMD has historically offered higher long-term yields relative to the developed market equivalent in order to compensate investors for the additional risk inherent in this asset class.

EM debt (EMD)

Emerging market bonds are the bonds issued by the governments (sovereigns) or corporations of the world’s developing nations. EMD has historically offered higher long-term yields relative to the developed market equivalent in order to compensate investors for the additional risk inherent in this asset class. In addition to an enhanced yield, EMD offers a number of diversification benefits for investors, as the asset class has historically displayed a low correlation to developed-market debt. There are two key types of EMD – local currency, which is denominated in the currency of the EM in question, and hard currency – denominated in USD or another reserve currency (normally euros or yen).

Local currency (LC) EMD

Local debt markets are known to offer a very appealing yield differential. Local currency EMD can also provide long-term diversification benefits, as they offer exposure to local EM currencies. They are also less exposed to rising interest rates in developed nations. Local currency debt can, in the longer term, provide another way to capitalize on the strong economic growth and improving finances of EM countries but this if course depends on your individual risk tolerances, as EM currencies can be highly volatile.

Hard currency (HC) EMD

An investor buys HC EMD instruments in a reserve currency, therefore reducing FX risk. The yield is typically calculated as the US Treasury yield for the same maturity (for USD denominated bonds), plus a spread to compensate for the additional risk of investing in the EMD issuer. This means that a hard currency EMD portfolio’s performance is driven by a combination of both interest-rate movements and spread movements.

EM corporate bonds

Issuers of EM corporate bonds are located in multiple regions all over the world meaning that this asset class is subject to a diverse stew of political, regulatory and corporate environments. This results in much more diversity among the drivers of return.

Moody’s reports that from 1998 to 2017, the average annual corporate default rate for advanced economies was 2.4%, while it was 3.7% for emerging economies.

Whilst this asset class has typically been viewed as being at higher risk of default, what is interesting is that the default rate between EM economies and advanced economies is actually not that different. Moody’s reports that from 1998 to 2017, the average annual corporate default rate for advanced economies was 2.4%, while it was 3.7% for emerging economies. The difference, however, is largely attributable to several years at the beginning of the review period, when sovereign crises in emerging markets led to record default rates in those countries.

And despite the fact that EMD is often associated with credit and political risk, its low correlation to developed-markets bonds make these investments more immune to interest-rate risk and provide a useful diversification tool.

Conclusion

This article barely touches the tip of the iceberg in what is a complex and diverse market. Investors should make sure that they have the acumen in order to effectively assess their potential risks and returns on their investment and should also consider speaking with a subject-matter expert. An expert will also be able to make recommendations tailored to the individuals risk profile, objectives and investment time horizon. Another crucial consideration is how assets under consideration interact with other asset classes within an investor’s portfolio.

Investors may be well advised to consider a dynamic multi-asset class investment, across debt and equity markets, that harvests the most interesting opportunities from each. Investors should consider long-term opportunities to capture EM growth over the long run.

A final note of caution – though the opportunities in EM often seem to be abundant – on should keep in mind that often emerging market assets — both stocks and bonds — have always been among the first assets to suffer when things get volatile in global markets. Furthermore, it is important to remember that neither forecasts nor past performances are reliable indicators of future results or performances.

[1] People with disposable incomes of more than $10 a day.
[2] Firms that have $1 billion or more in market value based on private or public investment.