Investing

Q15: What are emerging markets?

BRICS, and more… Ta!

Since the GFC in 2008, as developed market central banks around the world have tried to kick-start economic growth by printing more and more money — they prefer to call it Quantitative Easing  to make it sound more special — the returns on cash and short- and long-term bonds have fallen dramatically, as you can see from the chart below.

AU_Cash_10YB

Ever hungry for higher returns, investors were compelled to take on more risk in order to achieve their objectives. Stock markets roared into a bull run, Australian high-yield stocks such as the banks, Telstra and BHP also rose (Telstra has recently had other issues, unrelated to those that pushed its price up). In a previous post we looked at how risk and return are related, so what investors were having to do was to look for returns in investments that were further out the risk spectrum.

One place that investors looked to for extra return was in the so-called Emerging Markets (see map below). These are economies outside the traditional “developed” markets of Australia, Japan, Western Europe and North America that could be considered to be on their way to a higher level of economic development.

em_countries

Emerging markets often lack the standards of regulatory and accounting oversight of developed Western markets but they do possess typical financial infrastructure such as a unified currency, a stock exchange and a regulated banking system.

Financial people seem to enjoy giving names to things, and emerging markets are no exception. The five main emerging markets countries — Brazil, Russia, India, China and South Africa — have been given the imaginative title BRICS. Mexico, Indonesia, Nigeria and Turkey are called the MINTs. A Spanish bank has proposed the term EAGLEs for the Emerging and Growth-Leading Economies.

Regardless of the naming convention, emerging markets share some common characteristics:

  • low per-capita income
  • high economic growth
  • high volatility of returns
  • less mature capital markets
  • higher than average returns to investors
  • low correlation with developed markets

Low income can fuel high growth, as we’ve seen in China and India where growth has been well above 7%. Because the economies are in rapid transition they can be susceptible to economic shocks, such as those brought about by natural disasters. The economies are often reliant on agricultural production and can be affected by drought and flood.

Underdeveloped capital markets may also cause instability in these economies. Many emerging markets economies are reliant on offshore borrowings, so currency fluctuations, which can be rapid and large, can affect these economies greatly if debt is repayable in a foreign currency. It may also be harder to raise investment capital for entrepreneurs in these countries which can lead to a reliance on foreign investors.

Political instability in some emerging markets countries can pose additional risks for investors. In centrally-planned economies with a high degree of government control, such as China, the instability risk from government is smaller than for a country such as Venezuela but with less reliance on the rule of law there remains a risk that governments can change the rules for foreign investors with no notice, creating an additional layer of risk.

As with all investments, anyone considering a portfolio allocation to emerging markets should view these additional risks as providing the potential for higher returns. Investment theory indicates that there is a positive relationship between risk and potential return. This is the basis for an investment in emerging markets.

Major Contributor to Global Output

According to the International Monetary Fund emerging markets economies account for almost 60% of global GDP, with this set to grow into the future.

em_dm_gdp

But looking at the world’s equity markets the proportion of market value that comes from emerging markets only about 15%; this is well short of these countries’ contribution to global output. As these countries continue to develop economically, as their capital markets mature, and as reforms to corporate governance take shape investment in these countries and their share of the world’s equity market is likely to increase.

Red Flags Persist

It warrants a specific mention that there are significant risks in emerging markets. What makes them a candidate for investment may also potentially be their Achilles heel. Just a few of the areas of concern are

  • political instability
  • lack of transparency of information
  • lower regulatory oversight
  • currency exposure
  • unfamiliarity with local customs and practices

Due to these factors an investor’s ability to accurately gauge and assess the risks and returns in emerging markets may be compromised. Finding accurate information may be costly for an individual investor. These fees charged by professional managers will almost certainly be higher for emerging markets funds than for developed markets funds.

It also reinforces the need for diversification within an emerging markets allocation and for a broad allocation across many different countries and industries to avoid over-concentration. Many global investment firms offer passive or actively-managed emerging markets funds, with some offering specific exposures to Asia, Latin America or the Middle East.

Emerging Markets in a Portfolio

A well-rounded portfolio should contain allocations across and within asset classes. There’s a place for domestic and offshore investments in both bonds and equities dependent on an investor’s return objectives, time horizon and risk tolerance. Subject to these investor constraints and preferences there may be scope for an adviser to recommend some emerging markets investments to increase potential returns (being mindful of any additional risks). It could turn out that, in the fullness of time, an investment portfolio built on some BRICS could be flying with the EAGLEs.

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