Emerging markets refer to economies of developing countries with high growth rates. This is in contrast to developed countries that are characterized by high per capita incomes with well established capital and equity markets, industrialization, efficient regulatory organizations, and stable economies.
While emerging countries do not have all the characteristics of developed economies, they are in transition and show significant progress on many economic fronts. The emerging economies usually grow at a much faster pace than developed countries and resultantly become more integrated with global economies over time.
According to Ashmore Group, emerging countries constitute around 60% of the world’s GDP and around 80% of the global GDP growth rate, yet their share of the global market capitalization is barely 10%. Around 85% of the world’s population lives in countries categorized as emerging economies.
These stats show immense potential of developing countries and the room for further growth as economies like China and South Korea make huge strides in global trade. Due to their high economic growth rates, emerging markets can provide attractive opportunities for investors in the form of higher returns in equity and debt markets albeit at potentially higher risk.
Companies in emerging economies are often underpriced compared to the valuations of similar corporations in the U.S or other foreign markets. This is partly due to less coverage of the local companies by foreign brokerages. The robust growth of emerging economies may warrant active investment from foreign firms to benefit from the lucrative returns the stocks might offer.
“Emerging markets investing doesn’t have to be a rollercoaster. They are often perceived as plays on world growth and commodity prices. But we have found companies across Asia, Europe, Africa, the Middle East, and Latin America that have both domestic and international focus, and which demonstrate persistent cash-based profitability.” -- Mark Hammonds for Forbes.com
Some investors also invest in emerging markets as a way to diversify their portfolios and improve the overall return from their holdings. Many of the developing countries, such as China and India, have favorable economic outlook, and investing in their financial markets can help amplify the portfolio’s overall returns.
However, there are some potential risks unique to most emerging countries that foreign investors must consider before investing in the financial markets of such countries. Some of the developing countries have weak currencies, which can reduce the returns generated on investments when converted back to the home currency. Additional costs related to currency risk hedging might make it impractical to invest as the costs and uncertainty exceed the potential benefit of investment.
Some other potential risks that could be detrimental to investments include political uncertainty, geo-political risks, volatile or illiquid financial markets, and relatively weak regulatory institutions.
Despite the emerging economies forecasting higher growth rates than developed economies, the representative returns of their equities as determined by the MSCI Emerging Markets Index have been lackluster in comparison with those of the S & P 500 index. The MSCI Emerging Markets Index in USD terms in 2024 stands at roughly the same point as it was ten years ago in 2014, which is a significant underperformance compared with the S&P 500 index. However, since 1999, the MSCI Emerging Markets Index has roughly generated an annualized growth rate of 7.77% compared to 7.4% of the S&P 500 index.
“Emerging markets serve as a daily, constant reminder that we won’t win unless everybody wins. We’re looking at the challenges in these markets and making sure that we stay close to them to understand what those challenges are.” -- Michael Miebach, Mastercard CEO
Many hedge funds offer emerging market funds to investors who wish to gain exposure to equities or debt of different emerging economies. For example, Fidelity Advisor Emerging Markets Discovery Fund - Class A, PIMCO RAE Emerging Markets Fund, and T. Rowe Price Emerging Markets Stock Fund are some mutual funds available for investment in the equity or debt markets of developing countries. Investors who want to invest in equities of a particular company, say India or China, can invest in country-specific ETFs, like VanEck India Growth Leaders ETF (GLIN), iShares MSCI China ETF, Columbia India Consumer ETF (INCO), and iShares MSCI India Small-Cap ETF (SMIN).
Pro Tip: Use the trading simulator at TradingSim to analyze and backtest your performance on these ETFs before investing real money.
Investors also have the option to invest in ETFs that track the MSCI Emerging Markets Index (EEM), a selection of stocks from 25 emerging market companies. Some examples of emerging markets include Brazil, South Africa, India, China, Turkiye, South Korea, Poland, Saudi Arabia, Indonesia, among others.
Investors who want to invest in the bond market can consider buying units of bond market funds such as M&G Emerging Markets Bond. Depending on the type of fund, investors can get exposure to both corporate as well as government bonds.
Monetary policy is the central bank’s most important function. Central banks all over the world primarily have three goals: maximum employment, price stability, and moderate interest rates in the long-term. To achieve these goals, central banks manage money supply with the help of monetary policy.
The three tools central banks use as part of their monetary policy are open market operations, the discount rate, and reserve requirements. The central bank keeps a close eye on the GDP level, GDP growth rate, inflation rate, and other important economic statistics and devises monetary policy accordingly.
Let’s find out how central banks use each of the three tools of monetary policy to manage money supply to achieve its desired objectives:
Open market operations (OMO) is the most widely used tool of monetary policy to manage money supply and short-term interest rates. A central bank’s buying or selling of government securities, such as T-bills and bonds, is referred to as open market operations. The counterparties to the central bank in the open market operations are commercial banks.
When the central bank buys government securities from commercial banks, it pays cash to the selling bank. As a result, the bank’s reserve with the central bank increases. The resultant increase in commercial bank’s reserves enables it to lend more, which increases the money supply.
In contrast, when the central bank sells government securities from commercial banks, it gets cash from the buyer bank or deducts cash from the bank’s reserves held by it. This causes the commercial bank’s reserves to decrease, thereby reducing its ability to lend. The end result is a reduction in money supply.
Central banks set a target interest rate and then use open market operations to meet that target. When the commercial banks need cash to meet their reserve requirements, they borrow funds from other commercial banks. The interest rate which the banks charge each other for the funds is called the fed funds rate and the amount borrowed or lent is called the fed funds. It is the open market operations fund rate that is often quoted in the media as central bank raising or decreasing interest rates.
Reserve requirements are the funds that a commercial bank must keep as a reserve either with the central bank or in its vaults. The central bank sets the reserve requirements as a percentage of bank deposit. For example, if the central bank sets a reserve requirement ratio of 10%, it means that banks must hold 10% of their total deposits as cash with the central bank.
If the central bank wants to increase the money supply in the economy, it can decrease the reserve requirement percentage, which would increase the bank’s lending capability and create additional money. If the central bank wants to reduce the money supply, it can increase the reserve requirement percentage, leaving banks with lesser money to lend.
If the banks can’t borrow funds from other banks, they can borrow from the central bank at the interest rate called the discount rate. The discount rate is usually higher than the funds rate charged by the banks for lending money to one another, so banks usually utilize this discount rate option as a last resort.
Similar to the other monetary policy tools, if the central banks lower the discount rate, banks would find it convenient to borrow money from the central bank, which would increase their lending capacity. Consequently, the money supply will increase. The reverse also holds true. If the central bank increases the discount rate, banks would borrow less due to higher borrowing costs, resulting in a reduction in new money creation.
The policies of a country’s own central bank has definite impact domestically. However, due to the United States’ global dominance in the monetary system, the policy decisions of the Federal Reserve Bank of the US not only impacts the United States but also indirectly affects global markets. Let’s discuss the impact of the Fed’s policies on emerging markets.
Monetary policy tightening, or contracting monetary policy, means that the Fed hikes the interest rates to reduce money supply and curtail demand by making it costly to borrow money. The Fed’s decision is taken in the best interest of the domestic economy, but it has spillover effects on other economies as well. For example, the monetary tightening and the resultant high interest rates will make the UW treasury securities lucrative for foreign investors because of their high yields and might result in capital flight from emerging countries to the US provided the interest rates are lower domestically in the emerging markets.
Capital flight from emerging economies towards the US can depreciate their currency against the US dollar. When the domestic currency depreciates, it dissuades foreign investors from investing in the emerging economy because of the reduction in real returns in the US dollar after accounting for domestic currency depreciation.
Further, the weaker domestic currency against the US dollar would increase the country’s foreign debt in terms of US dollars, which could cast further strain on the country’s economy.
Monetary easing or expansionary monetary policy refers to a reduction in interest rates to spur demand and alleviate recessionary pressures on the economy. Interest rate cuts in the US can affect the emerging markets in the following ways:
Low interest rates in the US could persuade US investors to look elsewhere for higher returns as domestic, low-risk US securities no longer offer attractive returns. In such a scenario, if the interest rate on government securities is high, it might attract foreign investments in government bonds, resulting in a strengthening of the domestic currency. The foreign portfolio will benefit investors as well as companies with foreign direct investment in the country from the domestic currency appreciation, which could attract further investment. The country’s USD-denominated debt would also decrease because of currency appreciation against the U.S. dollar.
The United States Federal Reserve has been keeping the policy rate, the federal funds rate, unchanged at 5.25%-5.5% over the past one year (eighth consecutive monetary policy meeting). As of July 2024, the interest rate in some of the major emerging markets are:
Apart from China, the rest of the countries mentioned above have interest rates higher than that of the U.S. Theoretically, we could gauge the impact of the Federal Reserve’s monetary policy decisions if we isolate the variables in play. However, in reality, factors like emerging country’s foreign exchange reserves, current account balance, inflation, size of economy, the GDP mix, and many other factors together determine the relative impact of Fed’s actions on emerging countries, which makes it difficult to determine.
Analysts predict that the Fed will cut interest rates by up to 75 basis points, starting from September 2024. The anticipation of rate cuts is because of subdued upside inflation risks and growing confidence that the inflation level will be sustainable at the 2% target rate. Speaking at the FOMC Press Conference on July 31, 2024, the Fed’s Chairman Jerome Powell said,
"Economy continues to expand at a solid pace, job gains have moderated, and the unemployment rate has moved up but remains low. Rate cuts could be on the table in September. We are getting closer to being at a point to reduce rates."
Various emerging countries are also expected to cut rates, and given the expected rate cuts by the Fed in the coming months, investors might consider emerging markets debt markets, provided the real interest rates make economic sense.
Central banks, in particular the Federal Reserve, wields significant influence globally due to the US’s economic might and the position of the USD as a currency for international trade and a dominant reserve currency. Emerging markets can provide overseas investors with profitable opportunities in equities as well as debt markets due to their high growing economies and potentially undervalued stocks. However, high economic growth does not always correlate with or translate into higher equity returns, as we saw that most emerging markets funds could not beat the returns generated by the S&P 500 or the NASDAQ. Similarly, investing in the debt market to earn returns because of positive interest rate differential comes with its own set of risks.
Despite all the potential downsides of investing in emerging markets, still there are some feasible options available to investors. For example, investors can consider investing in stocks of particular countries like China or India by buying units of country-specific ETFs. Alternatively, they can also consider investing in debt ETFs of particular countries. This is where Tradingsim can help. In order to test your investing and trading strategies in these ETFs, take advantage of our simulator to see what strategies will maximize your returns before you actually invest real money.
With the majority of central banks forecasted to cut interest rates to spur demand, investors are likely to switch to equities instead of the debt markets. As always, consult your licensed financial advisor before making any decisions in the market. Risk is very real in the market, especially with emerging markets. Do your due diligence.