The term “emerging markets” was coined in 1981 by Antoine van Agtmael while working at the World Bank, to create a more aspirational description of approximately 80% of the world’s population previously referred to as the “third world”. 

There’s no precise definition of what constitutes an emerging market (EM), but they’re generally categorised as economies with low to middle income per capita, that are in the transitional phase towards becoming developed economies that generally have a higher per capita income and are well integrated into the global economic system. 

The countries that constitute “emerging” are not uniform in nature and exhibit different levels of economic and social development. They also exhibit different growth and risk profiles and exposure to different market sectors. 

As investors and consumers, we all have direct or indirect exposure to investments or products and services from emerging markets. 

Many large companies from the developed world derive significant portions of their revenues from emerging markets. BHP Group (ASX: BHP) for example, generates over half of its revenue from sales to China.  

In terms of trade, some of Australia’s most significant partners hail from emerging markets most notably China, our largest trading partner, and South Korea, our fourth largest. 

Brands such as Samsung and Hyundai are household names and most of us would be using products that contain microchips manufactured by Taiwanese company TMSC - Taiwan Semiconductor Manufacturing Company Limited, which dominates the production of semi-conductors used by brands such as Apple. 

In addition to these global EM players, there are many domestic companies seeking to grow as emerging economies evolve and per capita income increases, leading to a rise in consumer demand for a range of goods and services.
 

Why invest in emerging markets

From an investment perspective, one of the primary reasons for considering investing in emerging markets is gaining exposure to the strong economic growth they’ve historically generated and could generate into the future, in Fidelity’s opinion.

For the past 20 years, the GDP of emerging market economies has grown by 5.3% compared to developed markets which have grown by 1.7%, according to Fidelity analysis. GDP growth for emerging markets for the coming five years is expected to be 4% compared to 1.6% for developed markets, according to Fidelity analysis.

As part of this growth, the world has seen household income transition from low income to lower/middle income, upper/middle income through to high income (households earning more than $40,0000 per annum).

If Fidelity looks at India as an example, this transition from the lower income bracket is expected to gain momentum over the coming years with the lower income brackets declining and most noticeably the upper/middle income bracket rising strongly by 2030. 

This effective growth of the “middle class” is expected to see an increase in the market penetration of certain goods and services as households have more money to spend. 

As an example, the number of vehicles per thousand people is 59 in India compared to 890 in the USA. Likewise, 3% of Indians have credit cards versus, China at 22% and the USA at 69%, according to Fidelity analysis. As income levels grow, demand for goods and services is anticipated to increase, providing significant opportunities for companies within these sectors. 

Aside from the opportunity to access growth, emerging markets are currently trading at a valuation discount to developed markets, as the chart below shows.

When Fidelity considers financial metrics such as price-to-book ratio, for example [which compares a company’s market value to its book value], emerging markets have been trading at a significant discount.
 

EM index trades at deep discount relative to history

Source: Fidelity International, Refinitiv DataStream, 31 July 2023. P/B = Price to Book ratio

Generally, investing in assets when they’re trading at a discount is positive for long-term returns, in Fidelity’s opinion. 

[Editors’ note: Buying assets at a valuation discount is no guarantee of investment success. Some companies trade at a large discount to their historical average because of market concerns about their prospects or the market’s assessment of potential risks in that investment].
 

Risks of emerging markets

Assets also generally trade at a discount for specific reasons. In the case of emerging markets, the lower relative prices may reflect the additional risks associated with investing in these regions such as geopolitical risk, poor governance, liquidity risk, or that economic performance in certain countries is below expectations. 

Each country will be exposed to their own specific risks. In the current market, for example, there are geopolitical concerns regarding tension between China and the US over Taiwan. 

Conversely, if we look at the Indian market, many companies are tightly held by the founding families of the business, and issues relating to governance may need to be considered.

As part of the investment research process, analysts will generally factor in risk considerations in their return assumptions. The return an analyst will expect for taking on a higher level of risk will be incorporated into the price they’re willing to pay for investing in a company exposed to certain risks. This means the hurdle for investing in a higher-risk investment will be higher than that of a lower-risk investment.

Historically, emerging markets have exhibited greater volatility than developed markets, hence the trade-off with potentially higher returns. This is an important point when considering an allocation. EM equities have a longer-term investment horizon and for investors concerned about short-term fluctuations, this may not be appropriate. 

On the other hand, for investors with a longer-term view, seeking a higher level of growth, emerging markets could be an addition for a diversified portfolio of growth assets.

To conclude, emerging markets provide exposure to a diverse range of countries, sectors and companies that can complement other equity exposures within a portfolio. The sector provides exposure to a range of economies that are rapidly evolving, expanding their GDPs and have burgeoning middle classes who will demand access to goods and services, providing opportunities for companies to tap into this changing dynamic. 

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