Emerging Markets: What You Should Know
July 27, 2012
- Emerging markets tend to have higher growth than developed markets.
- We'll look at some sources of that growth, a representative list of countries, the benefits and risks of emerging-market investments, and options to consider.
- Helpful information for investors looking to diversify.
Emerging markets—countries undergoing rapid economic growth and industrialization—are becoming bigger players on the world stage. These countries make up 82% of the world's population1 and 36% of the world's economic output.2 And they are growing fast. Emerging market economies are expected to grow an impressive two to three times faster than their developed counterparts, according to an April 2012 International Monetary Fund (IMF) estimate.
Indeed, these countries deserve to be noticed. Consider China: Despite its status as the world's second-largest economy, China is still defined as emerging due to low household income levels, which are nearly one-tenth of those in the United States.3
To shed some light on this important category of international investing, we'll cover the following:
- What are emerging markets?
- Which countries are considered emerging markets?
- Emerging markets of the future
- Why consider emerging markets?
- What's enabling emerging market growth?
- What are some of the risks?
- Is it possible to reduce the risks?
- How could I get started?
An important note before we get started: Like most high growth investments, the risks involved with investing in emerging markets can be significant and major short-term price fluctuations can occur.
Also known as "developing" markets, emerging markets tend to be countries whose economies are experiencing rapid economic and household income growth and industrialization. They differ from their "developed" market counterparts in four main ways. They have:
- Low household incomes
- Structural changes occurring, such as modernization of infrastructure or moving from a dependence on agriculture to manufacturing
- Economic development and reform programs under way
- Stock and bond markets that are less mature in functioning, rules of conduct, and liquidity
To get a better sense of the difference between emerging and developed markets, take a look at the table below. Three of the countries in this table, Brazil, China and India, are considered to be emerging markets, while South Korea is being considered for a move to developed status. You'll notice that emerging markets have lower income per person (GDP per capita) than the developed, or "advanced," markets, such as the United States, Canada, Germany and Japan.
You can also see how two countries, China and India, account for 38% of the world's population but only 12% of the world's economic output (GDP). Contrast that to the United States, which has 5% of the world's population and 21% of the world's economic output.
As of June 2012, MSCI (Morgan Stanley Capital International), the industry standard for measuring foreign market performance, listed these countries as emerging: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Peru, the Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, and Turkey.
A few countries are in transition: South Korea and Taiwan have been under review by MSCI for a couple of years for a potential move to developed status. Morocco is under review for a potential downgrade to frontier market status.
MSCI uses the guidelines below to categorize emerging vs. developed countries. To move up from emerging to developed status, countries need to meet these criteria:
- Economic development: The country must have income levels 25% above $12,276 (the World Bank high income threshold) for three consecutive years.
- Size and liquidity requirements: The local stock exchanges must have at least five companies with market capitalizations of roughly $1.8 billion each and the amount of trading volume must be significant.
- Market accessibility: The country must be open to foreign ownership, allow capital to flow freely, and have stable, efficient markets.
Another subset of international investing is "frontier" markets, which may be the emerging markets of the future. They tend to be even less-developed and have higher levels of risk than emerging markets. MSCI has Qatar and the United Arab Emirates under review for moves to emerging market classification.
Growth potential. Emerging economies are expected to grow an impressive two to three times faster than developed nations, according to April 2012 IMF estimates. As an investor, this is important because corporate revenues have the potential to grow faster when economic growth is higher. However, it's important to keep in mind that bottom-line profits also depend on keeping expenses low.
Another benefit is diversification. By investing in emerging markets, you help diversify your portfolio, as emerging markets can perform differently than developed markets.
Yet another benefit is the potential to discover up-and-coming companies. This is because emerging markets tend to have less-efficient markets where information is not as readily available and there are fewer stock analysts. Diligent investors who are willing to research and invest directly in individual companies (see How could I get started?) may be able to find investments with the potential for higher returns.
While there are country-specific differences, compared to developed economies, emerging market economies as a group have:
- Young working-age populations. This tends to add to economic growth, while retiree populations generally subtract from growth due to less economic output, higher health care costs and the need for government services. For example, India and Brazil have high ratios of working-age to retired populations.
- Export strength. Labor costs tend to be lower in emerging markets, driving growth in manufacturing and exports. For example, the Philippines has developed electronics manufacturing and call center industries based on its labor resources.
- Low levels of government debt. Emerging nations tend to produce more than they buy, resulting in trade surpluses. Large state-owned companies involved in exporting are often sources of government revenues, keeping government debt levels low, and funding infrastructure spending or programs to help raise living standards.
- Low levels of consumer debt. Debt at the consumer level is also low in many emerging nations. For example, China has strong foreign trade and a low government deficit, as well as low debt levels at the consumer and business level.
- Growing household income. Rising household incomes afford consumers the ability to have income available for discretionary purchases, resulting in the emergence of a middle-class consumer sector. Indonesia and the Philippines are examples of countries with strong domestic economies and growing consumer classes.
- Natural resources. Emerging market countries have a disproportional share of natural resource wealth (although exceptions exist, such as Australia, Canada and Norway). Countries rich in natural resources tend to benefit as emerging markets industrialize. For example, Brazil should continue to be self-sufficient in oil over the longer term and has the largest farmable area in the world.
- Prudent fiscal policies. Many emerging market countries have endured economic crises in the past, instituting strong fiscal discipline well before the 2009 global recession. For example, Brazil has made major strides since 1994, with inflation falling from triple-digit levels to an average of 5.4% over the past five years, and decreasing government debt levels have resulted in an investment-grade credit rating.
As a result of higher economic growth, emerging markets account for a growing share of global economic output or GDP. See the graph below.
Emerging Markets Are Becoming A Larger Share of Global GDP
Source: FactSet and International Monetary Fund as of June 29, 2012.
In contrast to the developed world, emerging market economies as a whole have the flexibility to expand fiscal policy, while growth in most advanced economies is likely to be constrained by reduced government spending and tax increases. Additionally, growth in Europe in the near term may be hampered by a contracting banking sector which is likely to reduce lending.
In addition to the higher growth potential, emerging markets also have higher risk. As you'll see, emerging markets share the same risk categories as developed markets, but risk levels tend to be heightened and include:
- Potential for political instability. Emerging market governments can be less stable politically, and events such as external conflicts, coups, and internal tensions can create a difficult operating environment for companies.
- Financial conditions. Emerging market countries that do not have sound fiscal and monetary policies are subject to a number of risks. For example, growth can be undercut. Inflation can rear its head—impairing the ability of companies to keep up with input price trends, hurting consumer's purchasing power and potentially destabilizing the country's currency.
- Currency fluctuations. There's the possibility that the currency of your investment will fall relative to the US dollar, lowering the return after it's translated back into dollars.
- Regulatory environment. The rules and regulations of emerging market countries tend to be under development. As a result, market regulation, corporate governance, transparency and accounting standards may not be as reliable or mature as in developed countries. Some countries have restrictions on how freely businesses operate, impacting their ability to earn profits.
- Volatility. Shares on emerging market exchanges can be more volatile and trading can be less liquid (fewer shares changing hands). Emerging market investor sentiment can shift quickly with changes in global growth forecasts, magnifying performance on both the upside and downside.
- Higher costs to invest. Investing internationally can bring additional fees and emerging markets tend to have higher fees relative to the broad foreign universe related to processing trades. This is the reason most emerging market mutual funds and ETFs cost investors a bit more (via higher expense ratios) than their broad international or domestic counterparts.
When investing in emerging markets, investors need to gauge their ability to tolerate risk because significant short-term price fluctuations can occur. There are a number of steps you can take to help reduce the risk:
- Have a long-term perspective. Investors should be willing to invest for a long time horizon to ride out short-term price moves.
- Diversify your holdings by country and sector. An individual country index may have a high concentration in a particular sector or company. For example, the Russian MICEX Index has more than a 50% weight in energy as of June 30, 2012. This, in addition to company-specific risk, is one reason we believe investors should have a diversified portfolio when investing internationally.
- Limit exposure. We recommend that aggressive investors limit their emerging-market exposure to a maximum of 5% of the stock portion of their portfolios. In addition, you also might want to review your foreign mutual funds, as many allow allocations to emerging markets as part of their fund objective. You can find this information in your fund's prospectus.
- Use dollar-cost averaging. Investing a fixed amount at regular intervals or dollar-cost averaging can potentially help you reduce risk and lower your average cost per share. Note that transaction costs will dilute returns, and investors should not spread investments too thin, as transaction costs can have a significant impact on small investments.
If you're considering emerging-market investments, the first step is to see how your current asset allocation stacks up against your target allocation. For more details, clients can use the Schwab Portfolio Checkup tool.
Schwab provides a multitude of resources for investors to help manage international portfolio allocations: exchange-traded funds (ETFs), mutual funds and individual stocks. Clients can find out more about specific countries on the international research pages.
Go to Regions & Countries, and select a country. Here you'll find economic data, research, news, allocation guidelines and investment options, including the ETFs and mutual funds with the largest exposure to each country.
You can invest in individual international stocks, but you'll need a high risk tolerance and time to devote to in-depth research. Read Managing an International Equity Portfolio Using Schwab Equity Ratings to learn about our recommended research process for creating and managing an international stock portfolio.
Schwab clients can get the Schwab Equity Ratings International Report on a particular stock—it's in the Ratings Summary box on a stock's summary page under the Research tab. The report provides information to help you evaluate the investment potential of a particular stock. It includes insights into a stock's rating along with valuation, earnings and fundamental metrics.
Investors trading foreign ordinary shares in the US OTC (over the counter) market using our online and automated trading platforms can contact Schwab's Global Investing Services team at 800-992-4685 for more information.
1. The United Nations, as of June 2012.
2. The International Monetary Fund, December 2011.
3. The International Monetary Fund, December 2011.
For funds, investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses.You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Schwab Equity Ratings International grades are assigned to approximately 4000 stocks issued by companies headquartered, incorporated, and traded in certain foreign nations. In a limited number of cases, a company may be headquartered and conduct its business operations in one country and trade on a stock market in another country. In such cases, Schwab will generally rate the stock within the country where the company maintains its headquarters and conducts its primary business operations. Not every foreign equity market will be represented.
The Schwab Equity Ratings International model utilizes third-party data in the forming of a rating. While Schwab believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness. Third-party information is subject to change without notice.
Diversification and dollar cost averaging strategies do not assure a profit and do not protect against losses in declining markets.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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