What’s so exciting about emerging markets and why does everyone want to invest in them?

Investments in securities of developing countries have the potential to have higher returns and help protect the portfolio from the risk of getting stuck in investments in countries with low economic growth. At the same time, they are subject to greater volatility and risks of deep drawdowns. We’ve prepared a quick guide to emerging markets that will help you figure out why they are loved and whether they are worth investing in.

The term «emerging markets» was coined by economists in the early 1980s to generically refer to an entire asset class for investment. Although this concept is widespread, there is no single definition of emerging markets, but the general meaning is as follows:

Experts say that the characteristic features of emerging markets are high rates of economic growth, active development of trade, as well as the country’s participation in international and global processes. The BRIC countries (Brazil, Russia, India and China) are examples of emerging economies that have shown explosive growth over the past decade. By the way, China is the largest EM market with 37.4% of the iShares MSCI Emerging Markets ETF. Therefore, the dynamics of the Chinese economy has a dominant effect on EM yields, both directly and indirectly. As the saying goes: «when China sneezes, the whole world has a runny nose» (all parallels with the pandemic are accidental).

Another important developing economy is India. From 2013 to 2018, India was the fastest growing economy in the world, even outstripping the growth rate of China. At the end of 2020, India is the third economy in the world in terms of GDP, its share in world GDP is almost 7% (according to the IMF). Despite such a scale of the economy, the Indian stock market in global capitalization has a modest 1.44% and is only in 11th place in the MSCI ACWI Index.

Due to the lack of clarity in terminology, investment companies and index providers create and maintain their own criteria and methodologies by which countries (respectively, and shares of companies in these countries) are classified as “emerging markets”.

Prospects for growth.

Market capitalization — 1899 vs. 2021

Incidentally, this chart is a cautious reminder to investors that diversifying their investments is very important over long horizons: leaders tend to change, and Argentina is a prime example of this. So, at the beginning of the 20th century, Argentina was on a par with France and Germany in terms of per capita income, had a strong economy (mainly due to the abundance of natural resources, as well as a favorable geographic location) and a high level of education. As an economically developed country, Argentina once attracted millions of immigrants from Europe, but after the Great Depression, there were decades of inactivity. As a result of numerous political and economic crises, by the 21st century Argentina moved into the third dozen countries in terms of nominal GDP, and today almost no one remembers its past successes and development prospects.

Dynamics of GDP of developed and developing countries

The main drivers of rapid growth in emerging markets are China and India. Only for these two countries

Drivers of world GDP growth,%

In the opinion

Diversification.

Another argument for portfolio diversification is its declining correlation with the broader US equity market. Over the past 20 years, the correlation between the S&P 500 and MSCI Emerging Markets has slowly declined and is now 0.73.

Correlation of S&P 500 and MSCI Emerging Markets, 2000-2021

Attractive in terms of value.

Nevertheless, we find this indicator to be very useful. Historically low CAPE values foreshadowed periods of economic growth, while high CAPE values warned of possible market downturns. According to Bloomberg, the CAPE of the MSCI Emerging Markets index is 19.42, while the S&P 500 has a value of 35, that is, almost 2 times higher. More information about the CAPEs of some developing countries can be found in the table below. But it is necessary to be careful when comparing CAPEs by country with each other — at least this indicator can be influenced by differences in accounting rules and other factors.

Shiller CAPE selected emerging markets (as of 30 September 2021)

While there is ample room for diversification, the history of high growth potential has proven to be less reliable. Comparative dynamics in emerging and developed market (DM) stock returns is actually mixed.

Developed and Emerging Markets Dynamics, 1900-2020

Over the past 10 years, the index monitored by the FXDM fund has surpassed the MSCI Emerging Markets Index, showing an average annual return of 6.52% in dollars (versus 5.19% for the MSCI index). At the same time, the volatility of emerging markets over the past 10 years has been on a par with developed countries: 15.45% for emerging markets and 14.78% for developed ones. The same conclusion was reached by the authors of the annual review of Credit Suisse: they

Динамика MSCI Emerging Markets Index и Solactive GBS Developed Markets ex United States 200 USD Index NTR, 2011-2021, USD

Emerging markets have relatively high volatility. The additional risk is offset by a higher premium. But often political, economic and currency risks are unreasonably high, as in the last 10 years (when developed markets have brought higher returns). According to the American political scientist Ian Bremmer, «emerging markets are countries in which politics is no less important to the market than the economy.»

Emerging markets currency risk is associated with the fact that the currency itself does not have an intrinsic return, therefore, in the long term, it has a strong impact on the volatility of returns. Scott Donaldson, Victor Zhu and their colleagues at Vanguard in their work

Average annual market volatility over the past 50 years

Analytical departments of large investment companies — BlackRock, Invesco, Research Affiliates and others — help to navigate future estimates of profitability for various asset classes. Their capital market assumptions model almost always features emerging markets. Below we have summarized their forecasts in one table.

10-year expected return on emerging markets (USD)

This level of expected average annual dollar returns is truly impressive. Most investment firms estimate that EM looks very attractive compared to other asset classes. In general, the combination of high expected returns with moderate correlation between emerging and developed markets suggests that the allocation of some assets to emerging markets is justified.

As Research Affiliates founder Rob Arnott writes, “Diversify. But set aside 10 to 20% for your least favorite segment of the market: emerging economies. ”

We, in turn, remind you that the choice of asset classes is an individual matter, and investment decisions should be made based on your risk profile and investment horizon.

The information in the text does not constitute an individual investment recommendation.