- Recent events including inflation and the pandemic slowed down the growth of emerging economies, dropping its index by 40% last year.
- Yet, nearly $1 billion has been pouring into emerging markets daily since the beginning of the new year.
- While the rebound of emerging markets is present, it does come with its risks.
Money has poured into emerging markets, almost breaking a record. Entering 2023, nearly $1 billion has flowed into stocks and bonds every day in the week. As inflation is falling and China is reopening, investors are turning towards emerging markets.
Emerging markets experienced turbulent times, with the MSCI Emerging Markets index tumbling more than 40 percent between February 2021 and October last year. However, since its fall through a few months ago in October, the MSCI EM index has increased by nearly 21 percent – typically indicating a bull market, which explains the increase in appeal for investments in these markets. But will this persist, and if so for how long? Will they be the leaders of the next decade?
Crash Course Emerging Markets
Before diving deeper into this topic, it first comes in handy to do a quick crash course on emerging markets – establishing what an emerging market economy is when a market is considered an emerging market and which countries fall under it.
While there is no official definition of an emerging market, simply put, emerging markets (EM) are part of an economy of a growing developing country that is increasingly becoming involved in global markets. An EM country has some characteristics of a developed country, such as steady economic growth, liquid equity and debt markets, rising income levels (but still lower than Western norms), or that it is accessible for foreign investments. Hence, as an EM economy evolves, it may have increased liquidity in local debt and equity markets and more involvement in foreign direct investment (FDI).
EM can be classified in different ways by different observers. For instance, the IMF and the S&P classify 23 countries as emerging markets while Morgan Stanley Capital International (MSCI) classifies 24 and Dow Jones classifies 22. The IMF, for example, identifies an emerging market by considering systemic presence (economy size, nominal GDP, exports), market access (share of external debt in global external debt, global indices) and income level. Overall, the 5 most prominent EMs are Brazil, China, India and South Africa – the GDP of these countries has augmented continuously since 2000.
In other words, emerging markets undergo a transformation from a low-income, less-developed economy to a modern and industrial economy.
Why Emerging Markets Now?
Inflow into EMs might not come as a surprise. EMs can make attractive returns since their GDP growth is rapid compared to more mature markets. And, recently, investors are turning to EM stocks and bonds, nearly at a record rate. This especially emphasizes the big shift after a dull performance for developing markets last year. Figure 1 shows the rebound emerging market stocks are making from their recent grim levels.
Figure 1: EMs Stock Rebound
Source: Financial Times, FactSet
So why the rise? The reason for this is that falling inflation, lifting of Covid lockdowns, and reopening of China’s economy attract these inflows. The falling global inflation is especially a benefit for emerging markets as it is predicted that the central banks of developed markets will halt raising interest rates; as the Fed’s tightening is ending soon, the dollar is ceasing to appreciate which alleviates foreign-denominated debt of EMs, making them a better investment environment. Moreover, the fear of recession has slightly faded as the US economy grew by nearly 3 percent, more than anticipated, at the end of last year.
Undoubtedly, China’s zero-Covid policy influenced its own economy and emerging economies. The impact of lifting this policy was tremendous. As stated at the beginning, emerging markets have seen a $1bn inflow in emerging markets daily. And, according to the Institute of International Finance, 80% of the daily inflow in EMs is destined for China, while other developing markets are profiting from this too.
The rise in inflows is also thanks to the expectations investors had in EMs: outperforming advanced economies. JPMorgan anticipates the GDP of emerging economies in 2023 to augment by 1.4 percentage points more than the rate in mature economies.
Figure 2: US equities lagging behind and EM equities progression
Source: Financial Times, FactSet
Over the last 20 years, emerging markets equities have progressed, being a source of investment opportunities. Liquidity has deepened and investor interest has grown. In figure 2, it can be seen that the S&P 500 lags behind Europe’s Stoxx 600 with a growth of around 4 percent and 8.5 percent respectively, while the MSCI’s EM index is catching up and has gained nearly 8 percent.
Thus, despite the downfall in economic growth – a consequence of the pandemic, the invasion of Russia in Ukraine and financial restrictions to overcome inflation as mentioned before – EMs would still experience superior growth over developed markets and recovery in 2023. According to a report from Lazard Asset Management, much capital left EM the last few years and thus parts of the asset class are under-owned and consequently valued attractively with high financial productivity.
It does come with risks
Well now the question comes down to, what about its future? While the growth in EM is looking positive, it does not come without risks. For emerging markets particularly, these include political risk, infrastructure, currency volatility, unregulated markets and so forth. Moreover, debt cannot stay low indefinitely. As stated by the International Monetary Fund in figure 3, even when debt is incurred in local currency, the share of domestic debt held by foreigners makes the domestic financial market volatility and a potential driver for financial shocks.
Figure 3: Share of domestic debt held by foreigners
Source: International Monetary Fund, Working Paper 14/29
While many have a positive outlook on emerging market economies, some doubt future growth despite the recent rebound. Paul Greer, Fidelity International:
“Rising levels of debt, greater fiscal strains across much of the developing world and the increasingly negative impact of demographics would reduce potential growth”
What to take away?
Well, are emerging markets the new investing trend? It seems like for the near future, looking at the near-record rate inflows. Even though investing in emerging markets has its risks, previous emerging market performances and its recent rebound shows that the outlook is positive with a more supportive global ground. And as this year's Lazard report states, they “should monitor risks but anticipate ample opportunities for above-market returns”.