For investors, emerging market performance has been quite weak over the last decade – especially when compared to developed country indexes. That is exactly why investors may want to consider the asset class going forward. Emerging market asset prices have historically experienced periods of underperformance followed by periods of outperformance.
Emerging economies have all suffered as a result of the Covid-19 pandemic – but this means the valuations are even more attractive when compared to other asset classes. In this article we highlight some of the factors to consider when investing in emerging markets, as well as seven countries to consider as a starting point.
- Why invest in emerging markets?
- Risks of investing in emerging markets
- How to manage emerging market investment risks
- Checklist for investing in emerging markets
- Top 7 emerging markets for the next decade
Why invest in emerging markets?
One of the reasons stock market indexes have an upward bias over the long term is that companies benefit from economic growth. When an economy grows, the number of people with disposable income grows. This leads to a growing potential market for many companies. Since emerging market economies tend to have higher growth rates, they offer an opportunity for investors.
Most emerging markets have young populations and a growing middle class. Both of these attributes are also growth drivers for an economy as the number of people earning an income continues to grow. Another growth driver for developing economies is infrastructure development. For an economy to continue growing, infrastructure related to transport, energy and communications must be built. Policy makers also use infrastructure projects to create jobs and stimulate further growth. These projects also create opportunities for investors and lenders.
Finally, many of the countries with developing economies are also resource producers. This means they benefit from global growth as well as the growth of their own economy. Emerging markets give investors access to a much larger pool of commodity producing companies. Besides the investment potential of developing economies, emerging market stocks and bonds perform an important role in asset allocation. Developing and emerging markets tend to cycle between periods of out-and-underperformance. By owning stocks of both developed and emerging economies, portfolio volatility can be reduced.
Over the last few years, the US stock market has outperformed, driven primarily by tech stocks. However, their current high valuations may put them at greater risk now. As we pointed out in the article on the megatrends of the future, tech stocks may well continue to lead the way. But their extremely high valuations imply volatility is almost certain. This is where diversification into other asset classes including emerging markets, commodities and hedge funds may become important.
Risks of investing in emerging markets
On balance, investing in an emerging nation will come with more risks than investing in a developed nation. But, investors are paid for taking risks, so the higher risk is not a reason to avoid emerging markets. Typically, the prices of emerging market assets will reflect a certain amount of risk. As an investor, your job is to work out what the risks are, and how much risk has been priced into the market. These are some of the most common risks emerging market investors face:
- Currency risk is most often the reason for underperformance from emerging market assets. When you make a foreign investment, you are also exposed to another currency. Currency weakness can be caused by unsustainable debt, a weak current account balance and political instability.
- Political risks increase when a country has weak democratic processes, or populist leaders introduce unsustainable policies. Political risks can lead to rising uncertainty and possible capital flight.
- Insufficient regulation of companies and financial markets can lead to investors being defrauded by companies and intermediaries.
- If corporate governance is poor, there is a greater chance of fraud and of a company being heavily fined.
- Liquidity can also be a problem in emerging markets with lots of small companies. Poor liquidity tends to compound the effects of other risks.
How to manage emerging market investment risks
The first thing you can do to reduce risk is to avoid the riskiest markets. If you stick to the largest 10 to 15 emerging economies, you should not have problems with liquidity and transparency. You will also find it easier to access the information you need to make investment decisions.
Diversification across sectors, regions and countries is always an effective means of portfolio hedging. Your emerging market investments should be spread across at least 15 stocks in at least 5 different countries. You can also use investment funds or ETFs as the core of an emerging markets portfolio.. The iShares MSCI Emerging Markets ETF (EEM) holds over 1200 securities from 43 countries. There are also more sophisticated emerging market ETFs you can use to further reduce risk. These funds start with an emerging markets index and then remove the riskiest stocks. This is done using quantitative investing techniques like factor investing and ESG investing.
Another way to manage risk is to wait for a stock market crash before investing. Buying when prices are low reduces the potential downside and increases the potential upside. You can compare several valuation metrics for a market index to their historical average to get a sense of how expensive a market is. This isn’t the same as market timing, but simply a case of investing when valuations are lower. Finally, you will need to consider the potential currency risk and the country’s growth potential, which we cover in the next section.
Checklist for investing in emerging markets
Before you begin stock picking, you need to consider the countries you want to invest in. There are three questions to consider regarding emerging market countries:
- Is there sufficient regulation and investor protection?
- Is growth robust and sustainable?
- What are the chances of a currency or debt crisis?
Is there sufficient regulation and investor protection?
Investors should avoid countries with poor records on regulation and corporate governance. Fortunately, most of the 15 largest emerging economies do have reasonable oversight. The Financial Freedom Index combines three indexes related to investor protection for each country. The scores range from 0 to 1, with any score above 0.4 being reasonable. The prominent emerging markets with lower scores are China, Russia, and Vietnam.
One way to reduce risks related to poor investor protection is to invest in companies that list their stocks on exchanges in a developed foreign market like the US or Germany. These exchanges demand greater levels of disclosure and accountability before a company can be listed.
Is growth robust and sustainable?
The potential for rapid growth is the main drawcard for emerging markets. Ideally a country should be consistently growing its economy by over 3% a year, and preferably at over 5%. The economy should also be growing faster than the rate at which government debt is increasing. If it is not, GDP growth may be unsustainable. Low growth does not mean there will be no investable opportunities. But it does mean you need to be more selective about the stocks you choose. You should also avoid stocks that require growth to accelerate – unless you are sure growth will accelerate.
What are the chances of a currency or debt crisis?
Both of these can lead to a significant decline in the value of the currency, which will in turn affect asset prices. To do this, some fundamental analysis of the economy is required. Two ratios to consider are the debt to GDP ratio and the current account to GDP ratio. Emerging economies generally have debt worth between 15 and 80% of their GDP. A ratio below 50% is considered sustainable. If the ratio is higher than 50%, GDP growth really needs to be sustainable to avoid a possible debt crisis.
The current account, or balance of payments, reflects the trade balance as well as other capital flows. Essentially it tells you whether money is flowing into or out of a country. Persistent current account surpluses result in structurally strong currencies. On the other hand, persistent current account deficits can result in structurally weak currencies. The current account to GDP ratio will tell you whether it is positive or negative, and the magnitude relative to GDP. This will give you an idea of whether the currency is structurally strong or weak. If the ratio is negative and widening, the chance of a currency crisis increases.
If the currency looks vulnerable, you can also look at the ratio of foreign exchange reserves to GDP. The higher the ratio, the better the chance that the central bank will be able to defend the currency. A weak currency is not necessarily a bad thing. Exporters (which includes most resource producers) benefit from weakening currencies as their revenues increase when measured in the local currency. For companies that do not export, a weak currency is negative. The same applies to bonds. Weak and volatile currencies can result in uncertainty and capital flight, which is negative for all assets.
Top 7 emerging markets for the next decade
The countries listed below are seven of the most attractive, or most promising emerging markets for investors to consider. The following overview considers economic performance over the last decade, but before the effects of the Covid-19 pandemic were felt. This is to give an indication of the longer-term prospects, rather than the current recessions which should be temporary.
China has been the most significant emerging market story of the last two decades and remains an important market. There are several reasons that China has been a key economy for investors. In the last few years, China’s middle class has grown from a negligible number to hundreds of millions of people. This growth has resulted in the greatest increase in consumer spending in history.
The number of people with disposable income has occurred at the same time that profitable technology platforms Alibaba and WeChat have emerged – we covered this in detail in our article on China’s tech giants. One of the advantages for investors considering China is that many of the best companies are listed on US and European exchanges. Companies like Alibaba and Tencent are uniquely positioned to benefit from the growth of the middle class. But you may also want to consider some of the less exciting companies like China Mobile and China Life Insurance which trade on lower valuations.
Indonesia, with the fourth largest population in the world, is often overlooked by investors. However, it has some of the best growth drivers with a population that is younger and faster growing than most Asian countries. Indonesia’s economy was hit very hard during the Asian financial crisis in the 1990s. But the country learnt from the experience and has managed its debt and current account quite well since then – while growth has ranged between 3 and 6 percent.
The Indonesian market has again come under pressure during 2020, with the result that prices are back to 2009 levels. Telkom Indonesia (which is listed on the NYSE) often comes up as top emerging market pick. Other stocks to consider are pharmaceutical giant, Kalbe Farma, and Unilever Indonesia. Two ETF, the iShares MSCI Indonesia ETF (EIDO) and VanEck Vectors Indonesia Index ETF (IDX) are also worth considering.
Much of the focus over the last two decades has been on China. But India’s growth has been almost as impressive, and it also has a large population. India’s per capita GDP is still a lot lower than China’s suggesting more upside in the future. There are still high levels of poverty – but at some point a large middle class will emerge. This will result in rapid growth in disposable income.
India does have a lot of debt and a fairly large current account deficit. So, as an investor you will need to make sure these numbers have stabilized when you look to invest. Stocks to consider include Reliance Industries, Infosys, and Britannia Industries – all listed on US exchanges. For investors who want to dig deeper, India has a very active local market with over 5,000 listed stocks.
Malaysia has been one of the most reliable economies in Asia that is still considered an emerging market. Growth has ranged between 4 and 6% over the past decade, and the debt to GDP ratio is falling. Malaysia also has a relatively strong currency and a current account surplus. With a diverse economy, Malaysia is well suited to ETF investing. The iShares MSCI Malaysia ETF (EWM) holds the stocks of the 41 most valuable companies in 9 sectors.
There are lots of reasons for investors to avoid Brazil. The country seems to move from one crisis to the next, with high levels of debt, unemployment and inflation, and ongoing political uncertainty. However, Brazil is also rich in natural resources and has the sixth largest population in the world. For the most part, investors should focus on Brazil’s exporters, companies that benefit from a structurally weak currency. These include commodity producers like Petrobas and Vale, and food exporters like Brasil Foods.
For more active investors, Brazil may also offer an opportunity due to the weak performance of its stock market. The combination of political uncertainty and the Covid-19 pandemic means that in USD terms, Brazil’s stocks are trading at the same level they were in 2006. The companies to consider are banks, utilities, and tech companies.
Chile is regarded by many as the top emerging market in South America. The country has seen steady growth averaging around 3% over the past decade. Although it has a current account deficit, debt is low, and the currency risk is relatively benign.
Chile has a relatively stable economy and exports a diverse range of products including copper, lithium, wine, and wood pulp. There are some excellent companies to consider, including Banco Santander, Enersis and Vina Concha y Toro. You can also invest in the entire Chilean market with an ETF like the iShares MSCI Chile ETF (ECH).
Poland has been one of the most successful emerging market countries outside of Asia for three decades. In fact, some analysts now consider it a developed market. Poland’s economy is well integrated with that of other EU countries, most notably Germany’s. The fact that Poland still uses its own currency the Polish Zloty is also an advantage as it retains more control of its finances.
Growth over the last decade has average 3% and risen as high as 5%. Poland’s balance sheet is also in good shape with manageable debt and a positive current account balance. ETFs are a good way to invest in Poland – though there is now just one fund available to investors. The iShares MSCI Poland ETF (EPOL) holds 36 stocks, and weights are capped to reduce concentration risk.
Conclusion – Emerging market investing
This list of emerging economies is by no means complete. Some other more established emerging economies include Thailand, Russia, Mexico, Argentina, and South Africa. Other countries that come with higher levels of risk and require more research are Vietnam, Nigeria, Pakistan, and Bangladesh.
Often, investing in emerging markets becomes a three-way trade-off between risk, potential reward, and the amount of information you can access. Fortunately, information is becoming available on more companies in more countries. Investor protection is also improving, so the number of emerging market opportunities available to investors should continue to grow.