What are emerging markets and what are their investment risks?

What are emerging markets?

Emerging markets are countries that are playing catch-up with developed economies, usually in terms of gross domestic product (GDP) per capita. But GDP per capita isn’t the only criterion taken into consideration. While there’s no single definition for an emerging market, characteristics such as export diversification and the degree of participation in the global financial system are usually important factors.1 Emerging markets are also more established and advanced than frontier markets.

As of December 2021, MSCI, the provider of the most popular emerging market equity index, listed 25 emerging markets, with China, India, and Taiwan representing the largest weights. Based on MSCI’s country classification, emerging markets account for 37% of the world’s GDP, versus 54% for developed markets and 9% for the rest of the world.2

Emerging markets (ex-Qatar) lag developed economies in terms of GDP per capita

List of emerging markets according to MSCI, ranked by GDP per capita (U.S. dollars)

Bar chart ranking emerging markets by GDP per capita (in USD). Qatar has the highest GDP per capita and is the only emerging market with a higher GDP per capita than the developed markets' average. United Arab Emeriates, South Korea, Kuwait, and Czech Republic complete the top five.

Source: Manulife Investment Management, World Bank, and Macrobond, based on data available as of Dec 22, 2021. Developed countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, United States, and the United Kingdom.

Today’s emerging markets are also quite different from what they were 20 years ago, at least from an economic standpoint. In the past, they were commodities-oriented economies, relying heavily on the energy and materials sectors to fuel growth. Although those sectors are still playing a key role in their economies, emerging markets have become increasingly tech- and consumer-focused, thanks to an environment that’s more favourable to innovation and a fast-growing middle class propelling consumer demand.

Emerging markets have diversified away from commodities

MSCI Emerging Markets Index combined sector weightings (%) for selected industries

Emerging market equities: a shift from commodities-oriented sectors toward faster-growing tech and consumer sectors

Source: MSCI Inc, 2021. The MSCI Emerging Markets Index tracks the performance of publicly traded large- and mid-cap emerging-market stocks. It is not possible to invest directly in an index.

Risks of investing in emerging markets

Emerging markets are vital for the world’s economic health and growth, from playing a key role in supply chains to being at the centre stage of the clean energy transition. In an investing context, emerging markets can also be a key asset class for many investors to meet their financial objectives. On an absolute return basis, for example, emerging markets have provided higher equity returns than developed markets over the past two decades, generating an annualized return of 10%.3

Emerging markets have delivered strong absolute returns

Investment growth of $100,000

Line chart showing the investment growth of $100,000 invested in the MSCI Emerging Markets Index and in the MSCI World Index (developed markets), from January 2002 to December 2021. After the 20-year period, the value of the MSCI Emerging Markets Index investment grew to $680,569, about $218,000 more than that of the MSCI World investment.

Source: Manulife Investment Management, Macrobond, as of December 2021. Developed markets are represented by the MSCI World Index. Emerging markets are represented by the MSCI Emerging Markets Index.

Investing in emerging markets, however, is not without risks. 

Political risk

Governments in emerging markets tend to have greater decision power and intervene more in the market than policymakers in developed countries. For example, in some emerging countries, there’s a lack of central bank independence, something which is considered critical for long-term economic stability. Political risk also refers to the probability of war, regulatory changes, and runaway inflation.

In emerging markets, there’s also a greater risk of nationalization of corporations or expropriation of their assets, which can significantly impact both the company that’s taken over and its investors. For example, in 2007, Venezuela seized control of multiple oil fields managed by foreign companies like Total, Exxon, and ConocoPhillips.

Currency risk

Currencies in emerging markets tend to be more volatile than those of developed countries, which can hurt performance. Although currency risk is mitigated by the fact that there’s some diversification across the different currency movements of the 25 emerging markets, it can still be a headwind for foreign investors. To eliminate that risk, investors can opt for a currency-hedged strategy.

Liquidity risk

The equity markets of emerging economies are, in general, less liquid than those of developed economies, which could lead to more volatile price movements, especially when there‘s panic in the markets and transaction volumes decline.

COVID-19 risk

The COVID-19 pandemic—and the way each country is dealing with it—created a new risk for economies around the world, not just for emerging markets. However, populations in developed countries are largely vaccinated, which helps reduce the probability of future lockdowns, contrary to emerging markets for which vaccination rates are still problematic.

Considering the risks and rewards is key before committing to an allocation in emerging markets. As with any investments, it’s critical to talk to your financial advisor to assess whether they can be a good long-term investment for you.

 

1 https://www.imf.org/external/pubs/ft/weo/faq.htm#q4b. 2 Manulife Investment Management, World Bank, as of December 2021. 3 Manulife Investment Management, Macrobond, as of December 2021

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