Well known reasons to invest in emerging markets are diversification and high-risk premiums. While these reasons seem pretty straightforward, the factors to consider when investing are not always that obvious. Currently, slow vaccine rollouts in some developed countries and expected higher inflation are hot topics. With these two risks mentioned, the question is if now is the ideal moment to invest in emerging markets. More and more investors seem to answer this question with a yes.
Last year, the number and value of emerging market focused products such as exchange traded funds (ETF’s) have risen significantly. Noteworthy is that these products typically are appealing to retail investors. It is known that retail investing has increased a lot since the start of the pandemic, and it seems that this increased interest has also found its way to emerging markets. The capital flow into the asset class can be seen as the most significant sign of interest in the past decade. Moreover, the global output of emerging countries has doubled in dollar terms this decade.
Although emerging markets provide about 75% of economic growth, stock market returns have been less than the return of the S&P 500 for much of the past decade.
There are however two aspects that nuance this story quite a bit. Firstly, it has to be considered that although the global output of emerging economies has grown to 40% of the total output, this is still relatively small compared to the 80% of the world population that lives in these countries. Secondly, the increase in gross output does not necessarily translate into stock market returns, while at first glance this would seem logical. When emerging markets catch up with the developed world, they grow more quickly and higher returns on investments could be expected. However, although emerging markets provide about 75% of economic growth, stock market returns have been less than the return of the S&P 500 for much of the past decade. 2021 has not been very promising either for emerging markets, with the MSCI EM index up just 4.4% and the S&P 500 up 10.8%
To anticipate the future returns of emerging markets we have to consider the following factors. Unsurprisingly, an important factor is the Covid-19 pandemic. While in most developed countries the vaccine rollout is going quite smoothly, the opposite is true for a lot of emerging economies. Economic recovery therefore stays fragile and pandemic related setbacks remain a serious risk in emerging markets. A valid example is the emerging country India, which still has a lot of Covid cases every day.
Then, there is the influence of inflation on emerging markets. Inflationary pressure and higher US rates can complicate the efforts of central banks of emerging economies trying to recover from the pandemic. Higher rates are also a threat to the fiscal position of some emerging markets and make riskier investments such as growth and emerging markets stocks less attractive. On the other hand, there are emerging markets that benefit from rising prices of some commodities since they are net-exporters of these goods.
US policies and the US dollar are always important to keep in mind, because of their universal influence. We often see that when the US dollar is weak and US growth is low, investors take on more risk. This also translates to the higher risk emerging markets which then offer attractive returns. Since the US economy seems to recover quite well from the pandemic, the question is when and how much US inflation and interest rates will rise. If US yield suddenly become more attractive again it could be that capital flows out of emerging markets.
Each emerging market has different risks and opportunities and it is potentially beneficial to analyze country-by-country.
If an investor finally has decided to invest in emerging markets one final question remains, which emerging market is worth investing in? Each emerging market has different risks and opportunities and it is potentially beneficial to analyze country-by-country. However, most investors lack the liquidity and time to effectively implement such a strategy, which limits these investors to ETF’s and mutual funds. All thing considered, the outlook for most emerging markets remains uncertain. The economies that flourished before the pandemic and managed quite well could be rewarded with new investments.