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Emerging Markets: What You Should Know

Emerging markets—countries undergoing rapid economic growth and industrialization—are becoming bigger players on the world stage. These countries make up 59% of the world's population1 and 40% of the world's economic output.2 And they are growing fast. Emerging market economies are expected to grow faster than developed economies, at 4.8% in 2020 versus 3.6% for their developed counterparts, according to an April 2019 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 just 15% of what they are in the United States.3

To shed some light on this important category of international investing, we'll cover the following:

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.

What are emerging markets?

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

The table below illustrates the differences between emerging and developed markets. Three of the countries in this table, Brazil, China and India, are considered to be emerging markets. 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, Germany and Japan.

You can also see how two countries, China and India, account for 36% of the world's population but only 22% of the world's economic output (GDP). Contrast that to the United States, which has 4% of the world's population and 28% of the world's economic output.

Emerging countries have lower incomes per person

 

Population

(millions)

GDP

(billions)

Income

per Person

Share of

World

Population

Share of

World

GDP

U.S.

326

$14,527

$46,900

5%

21%

Germany

83

$4,000

$48,264

1%

6%

Japan

126

$4,972

$39,306

2%

7%

Brazil

209

$1,868

$8,968

3%

3%

China

1,386

$13,407

$9,608

18%

18%

India

1,339

$2,717

$2,036

18%

4%

Source: IMF-WEO Database, April 2019, World Bank. 2018 GDP and income per person (GDP per capita), 2017 world population.

Which countries are considered emerging markets?

As of June 2019, the industry standard for measuring foreign market performance Morgan Stanley Capital International (MSCI), will include these countries as emerging: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Pakistan, Peru, the Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, South Korea, Taiwan, Thailand, Turkey and United Arab Emirates.

Kuwait is under review for a potential upgrade from frontier market to emerging market status.

MSCI uses the guidelines below to categorize 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 $12,476 (the 2016 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 $3.2 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

 

What are frontier 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 Kuwait under review for a potential move to emerging market classification.

Why consider emerging markets?

First, for their growth potential. Emerging economies are expected to grow faster than developed economies, at 4.8% in 2020 versus 3.6% for  their developed nations counterparts, according to April 2019 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.

The last 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 do I get started investing in emerging markets?) may be able to find investments with the potential for higher returns.

What's enabling emerging market growth?

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. 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. 

Emerging markets are becoming a larger share of global GDP

Source: International Monetary Fund as of April 2019.

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.

What are some of the risks?

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:

  • 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.

Is it possible to reduce the risks?

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 46% weight in energy as of March 31, 2019. 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 12% 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 known as dollar-cost averaging, can help you reduce risk and lower your average cost per share. Note that transaction costs will reduce returns, and investors should not spread investments too thin, as transaction costs can have a significant impact on small investments.

For clients: How do I get started investing in emerging markets?

Step 1: Review your asset allocation 

Use the Schwab Portfolio Checkup tool to see how your current asset allocation stacks up against your target allocation.

Step 2: Do your research

Visit the international research pages for economic data, research, news, allocation guidelines and investment options, including the ETFs and mutual funds with the largest exposure to each country.

Step 3: Invest

Most investors can purchase emerging market ETFs or mutual funds in their IRA or brokerage account.

1. The World Bank, as of 2017.

2. The International Monetary Fund, April 2019.

3. The International Monetary Fund, April 2019.

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Important Disclosures

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