Emerging Markets: A Growing Global Force

Jose Zepeda, IMS Trader
September 21, 2016

Emerging markets are a group of countries that are in a transition phase: They have maturing financial and regulatory systems, are open to foreign investment and trade liberalization, and are gearing toward becoming industrialized nations.

The opening of these economies to global capital, technology and talent over the past couple of decades has resulted in GDP growth rates that have outpaced developed economies, creating a new middle class in many cases and, thus, a vast new market of consumers.

 

Changing Populations and Global Trends

In the past, emerging markets have been associated with being a homogenous block that has been difficult to predict, but this is no longer the case. These economies are breaking away from the trends that used to define them and are creating new opportunities. According to the International Monetary Fund (IMF), emerging economies represent 85 percent of the world’s population and together account for nearly 60 percent of global GDP.1 These figures are significant, especially when population trends are changing, and developed/developing nations are experiencing aging populations, while poorer countries are experiencing increases in younger demographics. Many of these countries are seeing explosions in economic growth and a growing middle class that is beginning to demand more of the goods and services enjoyed by developed economies, which means that U.S. companies will need to look abroad more than ever in order to expand their prospects for growth.

One of the basic models of economic growth, the Solow-Swan model, predicts that income in poor countries will catch up with the advanced economies through increases in labor, capital deepening and, the main ingredient, the exchange/adoption of technology from those advanced economies. Take a look at India, for example: The liberalization of foreign direct investment in 1991 decreased government intervention in business, discouraged public sector monopolies, and paved the way for foreign direct investment to encourage growth in the services and technology sector, which helped make India the second largest emerging economy (behind China).

What does this mean for the U.S. consumer? According to the U.S. Department of State, India’s market offers U.S. exporters of goods and services tremendous opportunities. India is on track to have the largest population on the planet by 2030 and the largest economy by 2050. The population is expected to contribute 1.2 billion consumers to the global market, consumers who, according to former Principal Assistant Secretary of the Bureau of South and Central Asian Affairs Geoffrey Pyatt, have “growing aspirations and the disposable income to act on their aspirations.”2

 

3 Reasons to Invest in Emerging Markets

 

Diversification

Diversification helps to prepare for the uncertainties the market holds by spreading risk through the use of various investment vehicles. Market volatility can’t be avoided, but diversification can help ensure the survival of your investments during severe market disruptions so that long-term objectives can be achieved. Emerging markets are an important component of a well-diversified portfolio, and when used strategically, investing in emerging markets can help reduce risk due to low correlation to U.S. indices.

According to U.S. economist and Nobel laureate Harry M. Markowitz, Ph.D., “To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other.”3 Correlation measures the relationship between two asset classes — a correlation of 1 means the two assets move in tandem with one another, and a negative correlation means they move in opposite directions. The lower correlated assets are the better diversifier since a decrease in one asset class could mean an increase or a smaller decrease than another. Markowitz theorized that investing in a basket of securities whose movements moved in tandem with each other offered as little protection as investing in a single security.

Valuations

Emerging markets have faced a number of headwinds during the past five years, the most recent in our minds being the strengthening of the U.S. dollar, the slowdown of the Chinese economy and the commodity supply glut from which we’re just starting to see a relief. These headwinds have caused large outflows of capital from emerging markets as a result of investors not seeing the returns needed to justify the riskier assets. These headwinds are still factors for caution; however, valuations for emerging markets are low, especially compared to U.S. markets, which have been in a bull market for more than seven years. The cyclically adjusted price-to-earnings (CAPE) ratio, a valuation measure for emerging markets, is 10.6 and 20 for developed markets,4 which shows that emerging markets have attractive valuations compared to the developed world. The table below shows similar valuation with emerging markets at significantly lower valuations than the S&P 500.

 

Underweighted

According to Morningstar Advisor, the average U.S. investor has a 3–4-percent allocation in emerging market equities and less than 1 percent in debt.6 Given the recent underperformance of emerging markets and the lower valuations as compared to developed markets, there is a higher growth potential. These considerations, along with the benefit of adding diversification in the form of low correlation — not simply adding more eggs into different baskets — make emerging markets a valuable tool that can help portfolios take advantage of economic growth cycles, offering the potential to weather the storms we can’t see coming.


Conclusion

The growing influence of emerging market economies in the global market can no longer be ignored, and when investors allocate appropriately, they allow their portfolios to participate in this growth. Understanding the ingredients necessary for constructing a properly diversified portfolio is important in allowing the participation in the positive attributes of the long-term growth potential of various asset classes — in this case, emerging markets. Furthermore, the U.S. market has been in one of the longest bull markets, which tells us that we may be at market highs. Given the growth potential when capital begins to move to emerging markets once again, the lower valuations will make this asset class more attractive. While most investors may have the same goal of portfolio growth, the path taken to get to that goal is different based on each individual’s situation and varying objectives. A successful portfolio is constructed by having honest conversations with your advisor so that the end result best reflects your objectives and expectations. During your next portfolio review, it would be wise to discuss your allocations so that you are taking advantage of all of the components of a diversified portfolio.


1 IMF: The Role of Emerging Markets in a New Partnership for Global Growth
2 Geoffrey Pyatt, “The Importance of U.S.-India Business and Economic Relations.” June 24, 2011

 

Definitions of Indices

The S&P 500 Index is a free-float market capitalization index of 500 large publicly held U.S.-based companies, capturing 75-percent coverage of U.S. equities. It is often used as a proxy for the American stock market.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity performance of 22 developed markets, excluding the U.S. and Canada. The MSCI EAFE Index is commonly used as a benchmark for equities representing the developed world outside of North America.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity performance in the global emerging markets.

Disclosures

Asset allocation/diversification of your overall investment portfolio does not assure a profit or protect against a loss in declining markets. Investing in a non-diversified fund that concentrates holdings into fewer securities or industries involves greater risk than investing in a more diversified fund.

Investing in emerging markets involves greater risks as well. Such risks include currency exchange rates, political and economic upheaval, lack of information about companies, poor liquidity, and differences in accounting standards.

All opinions expressed and data provided are subject to change without notice.

Some of these opinions may not be appropriate to every investor.

Securities offered through 1st Global Capital Corp. Member FINRA, SIPC. Investment advisory services offered through 1st Global Advisors, Inc.

1st Global Capital Corp. is headquartered at 12750 Merit Dr., Ste. 1200 in Dallas, Texas 75251; 214-294-5000. Additional information about 1st Global is available via the Internet at www.1stGlobal.com.

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