Emerging markets are those transitioning from the “developing” to “developed” phase. The biggest emerging markets in the world are Brazil, Russia, China, and South Africa. As emerging market economies grow, they become more engaged with the global market and foreign investment. Foreign capital investments into emerging markets since the 1980s have contributed to a sizeable reduction in poverty levels and the growth of the middle class globally.
The three characteristics of emerging markets
Emerging markets share characteristics with developed markets but have not yet unleashed their potential and lack some of the traits of developed markets. The main characteristics to identify emerging markets are as follows:
- Market volatility
Market volatility may stem from a number of sources, including political tension, external price movements, or crises like natural disasters. Investors must consider this, as they can be exposed to fluctuations in foreign exchange rates and overall market performance.
- Growth and investment potential
Emerging markets are generally associated with fast growth and potentially higher returns than in developed markets, along with an increased risk profile. The transition to becoming a “developed” market from an agriculture-based economy typically requires foreign investments. Currently, the difference between the growth rate of emerging and advanced economies is set to reach its lowest level this century. The usually higher growth rate of emerging economies made them attractive to investors, who were willing to accept the higher risk with the hope of higher returns. However, in the current climate, investors may not be willing to accept this risk for the comparably low return advantage. Figure 1 Below outlines this issue.
Figure 1 (Graph by Financial Times, Source: IMF World Economic Outlook)
- Government and central bank policies
Governments and central banks of emerging markets tend to implement policies to further industrialization and encourage fast economic growth, simultaneously leading to higher income per capita and lower unemployment. Developed market economies tend to experience lower rates of growth, as they are already industrialized.
The effect of the pandemic
Due to the pandemic, many emerging markets have faced severe hardships. Loss of revenue from tourism, stagnation in international trade, the impact of low vaccination rates on public health, and monetary policy to address high inflation levels have significantly impacted economies. Many emerging economies were forced to increase interest rates aggressively to avoid hyperinflation, slowing down economic growth.
Emerging economies generally had a higher inflation rate than developed countries, as shown in Figure 2 below. These factors have contributed to downgrading the debt of affected countries, and scaring potential investors, mainly due to the risk of default. In 2020, the rating agency Fitch issued debt downgrades affecting 27 out of 80 emerging markets, including large economies like Turkey, Mexico, and South Africa.
Figure 2: Difference in inflation rate in emerging and developed economies based on CPI
Is a positive outlook justifiable?
Emerging markets can have significant opportunities, especially as the world enters its post covid stage. Economic recoveries, for example in fixed income, are likely to be reflected in asset pricing. These recoveries reflecting real economic progress can often be explosive in nature. Investment in emerging markets will also have a long-term positive economic effect, as the consumer class develops, leading to a larger marketplace. Many emerging markets currently have an account surplus.
Emerging markets, primarily in sub-Saharan Africa, that export commodities and other goods have profited from the notable price rally practically all commodities experienced during the pandemic, cushioning the blow of lockdown measures and scrutinized public health. A further sell-off by investors of emerging market assets can be deemed unlikely, since many have already divested. Prices may be low enough to spark interest in the eyes of investors once again, possibly justifying a positive outlook on the near future of emerging markets.
The effect of interest rates
Increases in interest rates are known to have a deflationary effect, slowing down economic growth and typically decreasing asset valuations. While the US Treasury is set to up rates in March of this year, central banks of many emerging market economies, including Brazil and Russia, have already done so last year and have therefore already experienced the economic dent. This has led to a combination of high interest rates and low inflation, attractive to fixed income investors because of the high yields of currency bonds for example.
Emerging economies in 2022.
In 2022, the “MSCI Emerging Markets Index” ended 2021 down 2.5%, underperforming the developed market equivalent, the “MSCI World Index” by approximately 24%. Whether this trend may continue in 2022 is ambiguous for now. Global economic growth expectations have declined over the past months, particularly due to China’s slowing growth, attributed to supply chain issues, its zero-Covid policy, an affected property sector, along with decarbonization efforts. In January alone, stocks and bonds of emerging markets (with the exception of China) saw an outflow of $7.7 billion of foreign capital.
What is the estimated future of emerging countries?
Emerging markets behold a lot of potential. 20 years ago, emerging markets made up only 24% of global GDP, while today that number stands at around 43%. Many investors see emerging markets assets as essential in their portfolio on the basis of diversification. Nonetheless, the market faces some major obstacles. Output growth in China is slowing down, negatively impacting other emerging markets like Brazil, which benefitted from Chinese growth as it required numerous commodities.
In addition, lowered developed markets growth projections imply lower demand for manufactured goods than in 2021. The level of government debt in emerging market economies has significantly increased in 2020 (See Figure 3 below), to provide support to businesses and citizens during the pandemic.
The median level of government debt to GDP in 80 emerging markets rose from under 50% in 2019 to more than 60% in 2020, a tremendous difference in just a year. Emerging market economies that service a lot of foreign currency debt are particularly vulnerable to the possibility of the Fed raising interest rates soon, as a rising dollar relative to local currency would increase the cost of debt.
Figure 3: The rise of emerging market government debt in 2020 (Graph by Financial Times, Source: Fitch)
Emerging markets will continue to face some key difficulties, many caused by, or associated with the Covid pandemic. Inflation, stagnating growth, political uncertainty, and increased debt levels will be key factors to monitor throughout 2022. Currently, fixed income assets of emerging markets are priced relatively cheaply but are accompanied by the aforementioned risks and rising volatility.
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