Understanding emerging markets
Emerging markets – economic growth and market returns?
Emerging markets have surprised many over the past couple of years, with strong sharemarket returns and resilient economic growth.
And this growth looks set to continue, with emerging markets forecast to be the primary driver of world economic growth.
The big question is: can continued economic growth translate into continued sharemarket returns?
The promise of growth (and hope of returns)
Economic growth, or gross domestic product (GDP) growth, is entwined in the emerging markets story. Since 1994 emerging markets have increased GDP around 4% faster per year than developed markets.
But, despite what you might logically think, statistical studies released last year found few links between GDP growth and sharemarket returns over extended time periods, suggesting more complex factors may be at play.
For example, because the economic growth prospects of a country are well known, there’s evidence to suggest a year of high sharemarket returns will actually precede a year of strong GDP growth, as markets quickly incorporate positive growth forecasts into share prices.
Investors therefore need to build their emerging markets investment strategy on more than the shaky assumption that future GDP growth will generate future sharemarket returns.
Strong fundamentals
The fundamentals currently driving emerging markets are strong. These markets cover around 46% of the world’s land mass, holding valuable deposits of natural resources such as oil and gas, and account for over 70% of the world’s population.
Levels of disposable income are increasing, fostering a rising middle class. These newly cashed-up consumers are fuelling high levels of domestic demand, leading to less reliance on exports (and hence the global economy) to drive economic growth.
Most emerging market economies came out of the GFC in a much better position than their developed market counterparts. Low levels of public debt in emerging markets enabled governments to maintain expansionary fiscal and monetary policies to stimulate their contracting economies during the crisis without borrowing excessively.
The risks remain
Keep in mind, emerging markets investments carry a high degree of risk. While they tend to outperform developed markets in upswings, they more often than not also underperform in downturns. Their ‘risky’ perception means foreign investors tend to oversell when times get tough.
Political risk is typically much higher as well. And corporate governance standards, though improving, are still not as comprehensive or well regulated as those in developed nations.
Currency risk, ever present in international investing, will also affect the performance of an emerging markets investment. Adverse movements in the exchange rate between the Australian dollar and emerging market currencies can eat into returns, and implementing a currency hedging strategy can be expensive.
Looking forward
Looking at the fundamentals, it’s clear emerging markets are well positioned to be a driver of future world economic growth. They’re also an increasingly large and important component of world financial markets.
However, as we’ve seen, the relationship between economic growth and sharemarket returns is murky at best. And, in an increasingly globalised world, emerging markets are far from immune to the prospect of another global downturn.
Taking a long-term view, though, the outlook looks promising for emerging markets. A reasonable allocation in a well- diversified international investment portfolio should allow an investor to benefit from the often impressive upside, while minimising any downside impacts.
The investment overview and risks presented here are not all- encompassing, and have not considered specific emerging markets investments or your personal financial situation. As always, before making any investment decision, talk to your financial planner to discuss whether the investment is suitable for you.