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Should you invest in emerging markets?

From the early 2000s, emerging markets have remained popular. Since then, several new funds and instruments for investing in developing markets have been created. Emerging markets are a one-of-a-kind investing opportunity because they provide equal risk and profit. While investors can identify the correct emerging market investment to profit, the risks are often misunderstood and underestimated. Investment in emerging markets is not always set up for success. Real barriers might stifle economic progress and cost investors a lot, but should the market be favourable, the benefits of investing in an emerging market can outperform the risks.

This article will explain:

1. What are emerging markets?

Emerging markets refer to marketplaces that exist between developed and developing economies. These are nations that are increasing their manufacturing capabilities. When countries are in the emerging-market period, they see both rapid development and severe instability. When finding developing markets, investors and economists search for nations with low political or social upheaval and stable economic development. India, Brazil, Russia, China, and South Africa are among the current developing market economies in 2021. They are departing from their traditional economies based on agriculture and raw material exports and moving towards ICT based and cleaner energy sectors. They are quickly industrialising and transitioning to a mixed economy or free market.

2. How to identify emerging markets?

There are five characteristics of an emerging market that investors look for when identifying them.

These are:

  • Low income
  • Rapid growth
  • High volatility
  • Currency swings
  • High returns

Low income indicates a nation's per capita income is lower than average. It incentivises rapid expansion and societal change to make a swift transition to a more industrialised economy to stay in power and aid their people. For instance, major industrialised economies, such as the United States, the EU, and the United Kingdom, had their economies expand by 6.2%, 4.1% and 5.1%, respectively, in 2021. However, emerging and growing Asian nations, such as China and India, will have their economies grow by 8.2% and 7.5%, respectively, in 2021.

Rapid expansion and sudden societal change naturally lead to high volatility. It conflicts with many existing traditional policies and markets, such as agriculture. For example, when the US supported corn ethanol production in 2008, it significantly increased food and oil prices, causing unrest in emerging market nations. Investors investing in emerging markets must be prepared for high volatility.

Because emerging market countries are still in the early stages of development, they require a large investment. Currency swings describe exactly this notion. Foreign direct investment in emerging economies has a shaky track record. Information about corporations listed on their stock exchanges is sometimes difficult to get by. All of these elements increase risks but, if successful, can lead to higher rewards which is the final characteristic.

Investors may enjoy high rewards in emerging markets because many emerging countries pursue an export-driven strategy. They generate lower-cost consumer products and commodities for export to developed countries since they do not need them domestically. Profits will be made by the firms that drive this expansion. For investors, this engagement means greater stock prices. It also means a greater return on bonds. Emerging markets are appealing to investors because of this quality.

3. Risks of investing in emerging markets

Emerging markets aren't necessarily the best investments. The road to becoming a developed economy is not always upward. An emerging country needs to have low debt, a growing labour market, and a non-corrupt government to be successful. Emerging markets may be extremely volatile if their growth isn't consistent. Political turmoil or natural calamities may severely hinder a country's economic progress. Since the 1990s, Russia, for example, has alternated between being an emerging market and a developing economy. The fallout from communism and bad monetary management resulted in major debt default, dramatically depreciating Russia's currency, the ruble. The country was thought to be a bad investment for a long time. On the other hand, Russia has enormous oil reserves and mineral riches, making it quite possible to get back up again.

Another risk of emerging market investment is investing too late. China is an example of an economy formerly classified as an emerging market. However, by the time most people were aware of China's economic rise, the country was well on its way to becoming a global economic superpower. At its peak, investing in a developing market might be quite expensive and might come at a high price for eager investors.

Emerging markets' production is still limited compared to more established countries, even though they have come so far. Emerging markets account for nearly 75% of global economic development, but their stock market returns have lagged behind the S&P 500 for much of the last decade. Emerging markets have not fared much better in 2021, with the MSCI EM index up just 4.4% and the S&P 500 up 10.8%.

4. Pros of investing in emerging markets

If basic caution is followed, the benefits of investing in an emerging economy might exceed the risks. Despite their volatility, the fastest-growing economies will have the most growth and the highest-returning stocks. The twin drives of increasing international commerce and a more globalised production system have allowed a handful of emerging markets to achieve the highest GDP rates in the world over the last decade. The most successful emerging markets have been reforming fundamental societal principles that we take for granted in the developed world. Property rights, legal procedures, publicised regulations, and so on are examples of these.

Limiting your risks is the key to bringing growth from emerging economies to your portfolio. ETFs are a good alternative since they allow you to add a whole country or a group of nations to your portfolio. The volume and value of developing market-focused products such as exchange-traded funds (ETFs) have increased dramatically. It's worth noting that these goods are frequently enticing to retail investors. Retail investment has expanded dramatically since the outbreak of the epidemic, and it appears that this heightened interest has spread to developing markets as well.

5. Not all emerging markets are equal

Emerging markets are not all equal in terms of investment potential. Some countries have taken advantage of higher commodity prices to expand their economy since the 2008 global crisis. But not all of them utilised the price increase in the right way. The nations that suffered the most invested excessively in subsidies and new government positions. As a result, their economies flourished rapidly, their citizens purchased many imported commodities, and inflation quickly became an issue. Banks lacked local currency to help companies expand since their citizens did not save. By keeping interest rates low, governments could attract foreign direct investment. It was well worth it, even if it did assist in raising inflation. The countries gained tremendous economic development in exchange. However, commodity prices decreased in 2013. These governments had no choice except to reduce subsidies or raise their foreign debt. Foreign investments declined as the debt-to-GDP ratio rose. Currency dealers began dumping their assets in 2014. As currency prices dropped, panic ensued, resulting in huge currency and investment sell-offs.

The nations that benefitted from the crisis invested in infrastructure and workforce education. Furthermore, because the citizens of these countries conserved their money, there was plenty of local currency to support new firms. These nations were prepared when the crisis struck in 2014.

The Covid-19 epidemic is, unsurprisingly, a significant factor. As a result, the economic recovery remains shaky, and pandemic-related setbacks remain a severe threat in emerging nations. A good example is India, which still has many Covid cases every day.

The impact of inflation on developing markets is another factor to consider. Inflationary pressure might make it more difficult for emerging-market central banks to recover from the pandemic. Higher rates are also riskier to certain developing economies' fiscal positions, making riskier assets like growth and emerging markets equities less appealing. On the other hand, certain developing markets gain from increased prices because they are net exporters of some commodities.

Incorporating an emerging markets fund into your stock portfolio might broaden your worldwide diversity. The argument in favour of investing in emerging markets tends to lean towards the demographic and economic development of emerging market countries. On the other hand, emerging markets are subject to the same boom and bust cycles as developing markets. Indeed, because of their smaller size, emerging economies are more vulnerable to capital flight during difficult times, which may wreak havoc on their stock markets and currencies. While the dangers aren't ideal, that doesn't imply investors should ignore developing markets entirely. Greater risks, on the other hand, highlight the significance of diversification when investing in emerging economies.

Last update: 04/01/2022

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