The attraction of emerging markets is usually in two key areas: as a source of additional return (due to faster growth rates in those regions) and as a valuable diversifier from conventional developed market assets (due to the presence of different industries, different monetary and fiscal policies, and different political forces).
Emerging markets certainly have a tailwind from demographics and geography. Over 75% of the world’s people live in emerging or frontier markets; they cover over 75% of the world’s landmass and have over 60% of its natural resources. What’s more, population dynamics remain favourable – that is to say, the population pyramid is still “pyramid”-shaped rather than the “arrowhead” shape more often seen in mature, developed economies, including the UK. For example, 45% of the population of India is under 25 (in the UK it’s 29%); by 2027 India is projected to have the world’s largest workforce with over 1bn people aged 15-64. These favourable demographics mean policymakers can still focus on ‘growth’ projects instead of ‘cost reduction’ projects (especially costs associated with caring for the elderly, such as state pensions and healthcare).
Emerging markets have experienced strongly rising per capita GDP over the past 40 years, led by outperformance from China in particular, but also neighbouring countries like Indonesia, Malaysia and South Korea. In some cases annual growth in GDP per capita has exceeded 6% p.a. through the entire period, which has created an entire middle class that didn’t exist 40 years ago. With that comes urbanisation (over 90% of South Korea is urbanised for example), domestic consumption, and substantial opportunities not available in developed markets through companies providing products and services to these new customers. This maturing means emerging markets are increasingly trading among themselves and creating industries to service local customers, rather than simply manufacturing for developed market consumers.
And yet, emerging markets remain significantly underrepresented in global investment portfolios. If measured on a Purchasing Power Parity basis (which essentially seeks to normalise living costs across countries) emerging markets would constitute over 50% of world GDP while making up less than 10% of global market capitalisation. Some of that is down to global companies often being based in a developed country – i.e. their capitalisation counts towards developed markets even though they have large operations in emerging markets. More recently though we are beginning to see the opposite, where large emerging-market-based companies are becoming global leaders in their respective industries. Examples include Huawei in 5G networking and several middle eastern airlines.
Emerging markets have the advantage of a faster roll-out of technology and are less burdened by legacy investments. In other words, where a technology may be invented and v1 rolled out across a developed market (at considerable expense), the emerging market could directly implement v2 or v3 of the same technology. We also see a much greater take-up of technology within emerging markets. The use of mobile technology in China is well-known but it applies elsewhere too: 73% of Kenyans for example have a mobile payment account.
From an investment point of view, emerging markets have presented asset owners with consistently lower forward PEs and higher dividends, although volatility has historically been higher so some of those “premiums” are probably justified on a risk-aware basis. Many emerging markets remain opaque from an access point of view; for example, only over the last five years has the mainland Chinese equity market become readily accessible for foreign investors. Others remain largely closed (think Saudi Arabia). Still others (sometimes arbitrarily!) impose capital controls limiting the ability of investors to repatriate their funds at will.
Country-specific risks tend to be greater too than in developed markets. For sure there have been some developed market “shocks” of late – not least Brexit in the UK – but these tend to be uncommon and more easily absorbed by a better-managed financial and economic system. Emerging markets, often being smaller or more dependent on trade and external relations, can instead suffer longer periods of upheaval. Even the largest emerging markets can have specific issues; consider Russia, which despite its size, resources and population is still heavily dependent on the oil price, or the coronavirus outbreak currently underway in China.
Nevertheless, the emerging market indices have historically outperformed their developed siblings. On top of that emerging markets provide a valuable diversifier to a developed market portfolio. A recent study showed that if one had included 20% emerging exposure to a developed equity portfolio over the past 50 years the return would on average have been 1% p.a. higher and risk (volatility) 1% p.a. lower. Skill and care may be needed when allocating into emerging markets but for long-term growth-oriented investors that is a pretty attractive prospect.
Lars Hagenbuch, Consultant, RisCura
