The words “emerging markets” conjure different images for different investors. Where some think of emerging markets as an exciting category where high risks go hand-in-hand with potentially high rewards, others picture an exotic world that is best left to professionals.
But investors shouldn’t get hung up on the name. Far from being a niche where the normal rules don’t apply, emerging markets play an important role in financial markets and the global economy. They account for more than half of the world’s economic output, 80% of its population and 10% of global stock market valuation.1
Adding exposure to emerging-market investments to your portfolio offers the potential for growth and diversification. Here we’ll take a closer look at this sometimes misunderstood segment of the investing world.
What’s in a name?
In general, “emerging markets” are low- or middle-income countries that are on the path to developed-country status. These countries typically have rapidly rising per capita income and economic growth. They also generally have fairly large and liquid financial markets. On the continuum of market designations, emerging markets are less mature than developed countries, but more mature than poorer and far riskier “frontier markets.”
The category encompasses a very diverse group of economies. Perhaps the most famous group of emerging markets was identified roughly 15 years ago when an analyst coined the term “BRICs” to recognize the economies of Brazil, Russia, India and China, which were growing fast at the time. Other well-known emerging economies include Mexico, Indonesia, South Africa and Turkey. MSCI, which assembled the benchmark MSCI Emerging Markets Index in the late ’80s, also considers relatively sophisticated economies such as South Korea and Taiwan to be emerging markets.
In recent years, growth has slowed in many emerging markets, at least compared with the rapid rates during the BRICs era around the turn of the century. However, these economies still typically offer more rapid economic growth than developed economies such as the United States, Japan and many European countries.
Several factors are at work here. First of all, emerging markets have the potential to rise quickly as they develop. At the same time, many of them have young populations, which bodes well for consumption, especially if you compare them with those developed countries where aging populations will eventually lead to a decline in the number of consumers.
Many emerging markets have tidied up their fiscal situations after being upended in a series of crises in the ’90s. Their debt is lower relative to the size of their economies, and their citizens tend to save more than those in developed economies. In addition, emerging economies have flexible exchange rates and larger foreign-currency reserves than they once had.
Over the longer term, emerging markets could be the source of the most significant global demographic change for investors: the rise of the global middle class. The World Bank estimates that by 2030, 93% of the global middle class will be in emerging market countries. This will likely be a major investment theme of the coming decade.
Global providers of household products, autos and many other categories may benefit from the middle class megatrend. At the same time, demand for services from finance to health care is also likely to rise.
Emerging markets also provide investors with diversification because they can perform differently than developed markets. As you can see in the chart below, there have been periods over the past decade when emerging market stocks have performed significantly better than those in the U.S. and other developed markets, as well as periods when they have significantly underperformed.
Emerging markets may be on the path toward developed-country status, but they still have work to do to get there. That means they may come with their own set of risks.
For example, their corporate governance—the framework or set of rules under which companies operate—is generally regarded as being poorer than that of developed countries. There can be restrictions on how freely businesses operate as well as their ability to earn profits. It can also be difficult for investors to research emerging market companies.
In addition, geopolitical or social unrest might spur political change in some emerging markets, potentially ushering in instability. Trade and fiscal deficits may cause some emerging market countries to struggle if the Federal Reserve begins to hike interest rates. Also, China, the largest emerging market, has launched economic reforms that may slow growth.
At the same time, some investors may be concerned that the strong U.S. dollar—which set record highs against some emerging market currencies within the last year—dims the appeal of emerging markets stocks. A rising dollar is a drag on any investment not denominated in U.S. dollars. Some emerging market companies could struggle to service their dollar-denominated debt, as they could find themselves having to make payments with a weakened currency.
Part of a well-balanced portfolio
All investors, but mostly those with moderate to higher risk tolerances, might want to consider adding emerging market stocks as part of a diversified portfolio.
Even as emerging markets continue to contend with sluggish global growth, they will likely produce much faster growth than developed markets, which investors prize in a world where growth is scarce.
1Global output and population data from the International Monetary Fund’s World Economic Outlook as of April 2015. Global stock market valuation from MSCI as of 12/31/2014.