In general, economies are classified into two broad categories: developed economies and emerging economies. To answer the question, “what are emerging markets?” one first needs to understand developed markets.
Developed economies have higher standards of living, well-developed infrastructure, and more mature capital markets. Most developed market economies can be found in North America, Western Europe, and Australia.
Emerging market economies (EMEs), on the other hand, are those that are still in the process of becoming developed economies. Emerging markets are ones that are beginning to institute regulatory bodies, seeing rapid growth, and increasing amounts of money flowing through their stock markets.
EMEs make up the majority of the global economy—up to 80%, in fact. India, China, and Russia are just a few large countries that fall into this category.
What Are Emerging Markets?
In essence, an emerging market refers to an economy that has the potential to become a developed, advanced economy in the near future.
Investors tend to see these countries as potential cash cows because their economies resemble that of an established yet still young startup company. The infrastructure and blueprint for success has already been laid out, things just need a little more time before the economy can really take off.
If an investor selects an emerging market economy accurately, the payoff could potentially far exceed most investments in already advanced economies that have already experienced their most substantial stages of growth.
China is an interesting example of an emerging market. The country is quite advanced in many ways, with a large manufacturing base, plenty of technological innovation, and the largest population of any country in the world. China is the second-largest economy in the world by gross domestic product (GDP) and accounts for 16.38% of the entire global economy. So why is it considered an emerging market economy?
China has a few characteristics that are typical of an emerging market, in particular, having an economy that relies heavily on exports. India is another economy that is advanced in some ways, yet has a low per capita income that is typical of an emerging market.
Correctly identifying emerging markets isn’t exactly scientific. Not everyone agrees on which countries are emerging markets and which countries are not.
On the list are some large countries like China, Russia, Brazil, Korea, Mexico and others, in addition to smaller countries like Qatar, Poland, Peru, United Arab Emirates, and the Philippines.
Other financial institutions, like the International Monetary Fund, the S&P, Russell, and Dow Jones have their own lists that aim to help investors understand the question “what are emerging markets?”
How Investors Recognize Emerging Markets
While there are some differences among these lists, there is also a general theme. Certain indicators tend to be included time and again among those trying to differentiate emerging market economies from developed ones.
Here are seven tips for recognizing emerging markets, in addition to how to invest in emerging markets, the pros and cons, and why someone might want to invest in this area.
An emerging market economy is one in a state of rapid expansion. There is perhaps no better time to be invested in the growth of a country than when it enters this phase.
At this point, an EME has laid much of the groundwork necessary for becoming a developed nation. Capital markets and regulatory bodies have been established, personal incomes are rising, innovation is flourishing, and GDP is climbing.
Lower Per Capita Income
The World Bank keeps a record of the gross national income (GNI) of many countries. For the fiscal year of 2021, lower-middle income economies are defined as having GNI per capita of between $1,036 and $4,045, while upper middle-income economies are defined as having GNI per capita between $4,046 and $12,535.
The vast majority of countries that are considered EMEs fall into the lower-middle and upper middle-income ranges. India, Pakistan, and the Philippines are lower-middle income, for example, while China, Brazil, and Mexico are upper-middle income. All of these countries are referred to as emerging markets despite the considerable differences in their economic progression.
For EMEs, volatility is par for the course. Risk and volatility tend to go hand in hand, and both are common among emerging market investments.
Emerging market economies are often rife with conflict, political turmoil, economic upheaval, and booms and busts. Some of these countries might see violent revolutions, political coups, or become targets of sanctions by more powerful developed nations.
Any number of things could happen that threaten to throw an EME into disarray at a moment’s notice.
Political and Economic Instability
One of the reasons that developing economies can see a lot of volatility has to do with their inherent trend toward instability.
This can come from any source, including the type of situations mentioned in the last point.
Another potential point of conflict can come in the form of natural disasters, which can hit export-heavy nations hard. If a country relies on agricultural exports for a large portion of its trade, a tsunami, hurricane, or earthquake could derail a lot of related commerce.
Instability could result through either social unrest, economic devastation, political upheaval, or related factors.
A currency crisis can sometimes be accompanied by a political crisis. When people lose faith in the leadership of a country, they might also lose faith in the currency of that country.
When this happens, a currency can enter freefall. When currencies lose value rapidly, prices for consumer goods start going up faster and faster.
The value of a country’s currency is an important factor to keep in mind when investing in emerging markets.
Sometimes it can look like stock prices are soaring, but in reality, the currency that those stocks have their values measured in is declining.
If a stock goes up by 50% in a month, but the national currency declines by 90% during the same period, investors will still see a net loss, although they might not recognize it as such until converting gains to their own native currency.
For example, Venezuelan stocks have soared against the Venezuelan Bolivar during the last five to ten years as the currency has entered hyperinflation, although those same stocks have collapsed in value against the US dollar.
Heavy Reliance on Exports
Emerging market economies tend to rely heavily on exports. That means their economies depend in large part on selling goods and services to other countries.
A developed nation might house all the needs of production within its own shores while also being home to a population with the income necessary to purchase those goods and services. Developing countries, however, must export the bulk of what they create.
One of the biggest defining factors of an emerging market economy might be its potential for high growth.
These are countries that have shown a determination to join the developed world and have already laid most of the groundwork for achieving that.
So, the theory goes that if such a country were to continue progressing, its industry would flourish, its population would grow and earn higher incomes, and as a result related investments would outperform those in most other markets.
Why Invest in Emerging Markets?
Emerging markets are generally thought of as high-risk, high-reward investments.
They are also yet another way to diversify an investment portfolio. Having all of a portfolio invested in the assets of a single country puts an investor at the mercy of that country’s circumstances. If something goes wrong, like social unrest or revolution, a currency crisis, or widespread natural disasters, that might damage related investments.
Being invested in multiple countries can help mitigate the risk of something unexpected happening to any single economy.
The returns from emerging markets might also exceed those found elsewhere. If investors can capitalize on the high rate of growth in an emerging market at the right time and avoid any of the many potential mishaps, they stand to profit.
Over the period of 2000-2010, for example, the S&P 500 gave investors an annual return of -0.95%. At the same time, the MSCI Emerging Market Index returned 16% during that period.
Pros and Cons of Investing in Emerging Markets
Let’s recap some of the pros and cons associated with EME investments.
• High profit potential: Selecting the right investments in EMEs at the right time can result in returns that might be greater than most other investments. Rapidly growing economies provide ample opportunity for profits.
• Global diversification: Investing in EMEs provides a chance to hold assets that go beyond the borders of an investor’s home country.
This creates a kind of diversification that can’t be had any other way. Even if an unforeseen event should happen that contributes to slower domestic growth, it’s possible that investments elsewhere could exceed expectations.
• High volatility: As a general rule, investments with higher liquidity and market capitalization tend to be less volatile because it takes larger capital inflows or outflows to move their prices.
EMEs tend to have smaller capital markets combined with many uncertainties, making them vulnerable to exceptional volatility.
• High risk: With high volatility and uncertainty comes high risk. What’s more, that risk can’t always be quantified. The situation might be even more unpredictable than usual due to conflict, political turmoil, economic upheaval, and natural disasters.
All investments carry risk, but EMEs bring with them a host of fresh variables that can twist and turn in unexpected ways.
• Low accessibility: While some emerging market funds do exist, it’s not always easy to gain access to these kinds of investments. There may not be a ticker symbol to select in a brokerage account, as is the case with most domestic securities.
While liquid capital markets are a characteristic of emerging markets, that liquidity still doesn’t match up to that of developed economies.
It may be necessary to consult with an investment advisor or pursue other means of deploying capital that may be undesirable to some investors.
When contemplating how to invest in emerging markets, there is no one correct answer that works for every investor.
Emerging market Exchange-traded Funds (ETFs) might invest in different assets within a single country or spread their investments throughout multiple countries. The more countries included in a fund, the more diversification it will achieve. As usual, greater diversification can limit risks but also tends to limit rewards.
Bonds can also play a role in an emerging market portfolio. Many countries with developing economies have used the issuance of new debt to borrow money to build out their infrastructure. That means some emerging market economies could offer bonds with attractive yields.
Investors with low risk tolerance might choose to limit their exposure to emerging markets. Not only are related investments often volatile and high-risk, but the risk can be difficult to assess.
Whether playing it safe or taking a risk in emerging market stocks, SoFi Invest® has all the tools a new or experienced investor might need, including a cutting-edge trading platform and free financial advisors at your fingertips.
If you’re interested in learning more about emerging markets and other investment options, check out SoFi Invest.
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