Seven questions and answers for understanding how emerging markets work

Investing through investment funds can be an alternative for entering into these markets, which are becoming increasingly important due to the demographic growth they are experiencing.

Creand Wealth Management, the private banking specialist, has drawn up a guide to emerging markets, covering what they are and how they work. The document explains the main aspects of investing in them, the advantages and risks faced by an investor, the investment options in the current scenario and future trends.  

What are the characteristics of an emerging market? 

Emerging markets are countries whose economies are in the midst of economic development and rapid growth. As such, they are likely to offer investment opportunities with attractive returns compared to other markets.

These markets are attractive from an investment point of view due to their demographic growth, which generates a favourable environment for the creation of new wealth models, thanks to increased consumption resulting from internationalisation. In turn, this boosts economic relations and opportunities for investment, as well as improvements in infrastructure and other elements that help lay the foundations for increased productivity. They are countries with national GDP growth expectations well above those of more developed economies, and with lower debt ratios.

The main emerging markets are China, India, South Korea, Brazil, Turkey, Taiwan, South Africa and Mexico, but it is important to differentiate between other “frontier” markets. The latter are also developing but are not considered emerging because they have a lower growth potential and are less accessible to investors, such as Argentina, Croatia, Romania and Morocco.

What are the advantages and main risks involved in these types of markets for investors?

As these markets are less mature, they offer greater opportunities for identifying undervalued companies that could bring value to investment portfolios. In recent years, investors have become better informed about the economic situation of these countries, providing them with tools to gauge the risks of investing in them. The major advantages in finding investment opportunities in these regions include the expected growth in the years to come, due to demographic growth, young populations and a boost in domestic demand, combined with increasingly stable political landscapes and interest in opening up internationally.

In terms of the risks involved in investing in emerging markets, it is important to note the political instability in these countries, their lack of legal certainty—which results in a lack of protection due to deregulation in many areas—and the recurrent liquidity problems they face. Currency factors must also be taken into account, since these countries’ currencies suffer severe fluctuations and frequent episodes of inflation.

How do you invest in emerging markets?

Generally speaking, an attractive alternative for investing in this type of markets are active investment funds, as well as taking advantage of the growth of these markets by investing in European or American companies whose businesses are highly exposed to these countries.

Other options include direct investment through company equity and debt, the use of indexed funds and ETFs to invest in the region as a whole, and investing in active investment funds to take advantage of specific markets and trends.

As these markets are less well known, they create more inefficiencies that can be exploited, making investment through active investment funds, which are well versed in the specificities of each region, more appropriate than indexed funds or ETFs, for both equity and fixed income investment.

As is the case globally, investment in emerging debt is currently more attractive to us than equities, given the risk/return trade-off. In addition, some emerging countries have more moderate inflation records than the rest of the world, making the monetary policy of their central banks much more favourable for debt investment.

To give an example of how these investments have changed, bonds of Latin American issuers used to be reserved for the most daring or specialised portfolio managers in the region; today, any investor has some Latin American bonds in their fixed income portfolio. According to the Bank for International Settlements, the value of outstanding international debt of non-financial corporations in Latin America and the Caribbean has more than quadrupled in the last decade. Furthermore, investment grade Latin American issuers are 30% less leveraged than North American companies.

What are the most favourable macro and market scenarios for investing in emerging markets?

In general terms, risk-taking scenarios will always be the most favourable for finding investment opportunities in emerging markets, especially in more established markets, where investors can find an interesting risk-return ratio to diversify their investments.

In recession or economic slowdown scenarios, investing in emerging markets is usually not the best option, as they have a higher “beta” than developed markets and, in such scenarios, equities fall and credit spreads widen. Although the current starting point is an attractive valuation in these markets, emerging equities would fall further and credit spreads would widen more than those in developed markets.

That said, in the current scenario, there are some elements that favour investment in emerging markets: financial conditions are easing and credit markets have reopened with new issues. However, it should be noted that the rise in interest rates in the US and Europe affects the financing of companies and emerging markets themselves, and the strength of currencies like the dollar or the fall in oil and other commodities tend to be negative factors for investment in these countries.

Are they an investment alternative for all profiles?

Historically, investing in emerging countries in general has been more volatile than investing in developed countries, in both equities and bonds. Considering that emerging countries suffer from greater political and legal instability, it is only logical that this would remain the case. As such, investing in emerging markets should only be appropriate for less conservative investors.

Where can you find investment options in emerging markets today?

China could be an option for the medium and long term, as it starts from an attractive valuation and its companies enjoy good fundamentals, but macroeconomic deterioration may weigh in the short term. There is some weakening that has led the Chinese central bank to cut interest rates and raise expectations of further stimulus to ailing industries, such as the real estate sector, which is also being directly affected by the Evergrande crisis.

There are also good prospects for India, already the world’s most populous country, with consumption potential on the rise, thanks to growth three times that of other economies.

It is interesting to see the yields offered by the debt of countries such as Mexico or Brazil, where a great effort has been made to lower inflation levels, and which now have very high real interest rates. This situation leaves them in a very favourable position from a debt point of view as long as their economies do not falter, which does not seem likely in the short term. Interestingly, for the first time Mexico is exporting more than China to the United States.

What are the main trends for the future?

We would highlight three major trends. Firstly, the reconfiguration of these countries in terms of trade in a context of intense disputes between great powers and emerging countries, as evidenced by the trade war between the US and China. Secondly, the geopolitical restructuring and shifting balance of power that will occur in the aftermath of the war in Ukraine. And finally, demographic pressure, as such countries will increasingly have a higher demographic weight compared to Europe or the US, where growth is much lower.

In terms of sectors, technology will undoubtedly play a fundamental role, thanks to the development of innovative businesses in the financial and insurance sectors. Also of importance will be the boost to industries that have so far had very little influence in these markets, such as pharmaceuticals and others related to the health sector, in addition to the growing interest in the real estate sector, fuelled by the growth of the middle class in many of these countries.