Trading Emerging Markets: What Should You Know

The global economy stands on shaky grounds today. The US-China trade war escalation, economic difficulties in countries like Turkey and Argentina, dovish monetary policies of advanced economies and the impending Brexit, all seem to have contributed to a global slowdown since late 2018 and into 2019. But, according to a new report by the International Monetary Fund (IMF), published in April 2019, moderate expansion in the emerging economies could help stabilise global economic output at 3.6% in 2020 and beyond. The IMF further states that expansion in Chinese and Indian economies could help drive a global rebound after 2020.

An Important Link for Sustainable Global Economy

Since the 2008 financial crisis, the emerging markets have contributed around 80% of the global economic growth, creating a large number of jobs in advanced economies. Compared to many wealthy nations, they have witnessed a faster overall growth rate. According to a PwC report, by 2050, the emerging markets are likely to dominate the list of the world’s top 10 economies, in terms of GDP. In fact, they were half the size of the G7 economies in 1995, and by 2040, they could be double the size of these established markets.

There are plenty of factors that make these markets so attractive for investors, globally. But, before you invest, you should know a little more about the countries that make up the emerging markets.

The Emerging Markets

The World Bank defines the emerging markets as countries with less than $4,035 per capita income. Many of these countries originally had agriculture-based economies, from which they have transitioned into export-based economies, through rapid industrialisation over the years.

The MSCI Emerging Markets Index, which tracks the stock performances of major companies in specific regions, lists 24 major countries as emerging economies. These include China, Brazil, Malaysia, Argentina, Colombia, the Czech Republic, Singapore, the UAE, Thailand and South Africa. MSCI uses three major guidelines to classify a country as an emerging economy:

1. 25% above $12,476 income levels for 3 consecutive years
2. Local stock exchanges should list at least 5 companies, with approximately $3.2 billion market cap and have significant trading volumes.
3. The country should allow foreign direct investment, free capital flow and have stable and efficient market regulations.

Together, China and India, accounted for $32.6 trillion in economic output in 2017, which was far more significant than that of the European Union and the United States. These two countries are also home to a significant labour force.

Why Trade the Emerging Markets?

The first reason obviously is the growth potential. The emerging economies are growing at a faster rate than developed economies, many of which are already saturated. Lower per-capita income provides stimulus for faster economic expansion. This is important for an investor, since faster economic growth reflects in higher corporate earnings and appreciation in currency values.

Secondly, historically, these economies have shown resilience during times of global financial crisis, due to their strong fiscal discipline. They registered small GDP growth, particularly India and China, even in the tumultuous years between 2008 and 2010.

Thirdly, they are producers and exporters of major commodities across the world. Two decades ago, 62% of global bilateral trade occurred between countries like the US, Canada and Europe. By 2017, the figure had come down to 47%, while 53% of bilateral trade in 2018 included at least one emerging market.

Labour costs in the emerging markets tend to be low, driving manufacturing and exports. India and Brazil have the largest young working population, between the ages of 20 and 45 years. A huge amount of exports keeps the government debt levels low, while helping fund infrastructure and growth programmes.

Lastly, investing in these economies allows diversification. With liquidity expanding and plateauing interest rates in developed economies like the EU, UK and US, investors flock to the emerging markets in hopes of higher returns.

Risks Associated with Investing in Emerging Economies

Higher growth potential comes with higher risks too, which traders should remain aware of, such as:

• Geo-Political Instability: Wars, coups and internal conflicts tend to be common in these countries. This can give rise to economic instability and make the emerging markets very volatile. It may be possible that the currencies depreciate with respect to the US dollar, by the time you translate your earnings back home.
• Less Mature Capital Markets: Access to proper market information is difficult in many countries that have under-developed capital markets. However, rise in FDI in the last couple of years has made things better.
• Higher Investment Costs: The emerging markets tend to have higher processing fees, as compared to the major markets. This is why so many emerging market ETFs and mutual funds have high expense ratios, compared to their developed market counterparts.
• Regulatory Environment: Less matured capital markets mean lack of sound structure for corporate governance, transparency and accounting standards, in contrast to the developed economies. Many developing countries impose restrictions on business operations, which impacts profits.
• Financial Conditions: Growth can be undercut in many countries due to the absence of sound monetary policies. As a result, inflation could hurt the productivity of businesses and reduce the consumer’s purchasing power.

Some Popular Investment Strategies for the Emerging Markets

By analysing the markets properly and diversifying holdings by country and sector, many of the risks associated with the emerging markets can be tackled. Here’s a look at some popular investment options in this market segment:

Carry Trade

Traders try to capture positive interest rate differentials between a high-yielding and a low-yielding currency. The funding currency has the lower interest rate. Many traders resort to euro-funded carry trading strategies in the emerging markets, to limit their exposure to the effects of the US-China trade war. Leverage makes the difference between interest rates quite substantial, which is why carry trades are favoured by some experienced forex traders.

Emerging Market Bonds

JP Morgan EMBI Global reported that yield on emerging-market bonds denominated in US dollars was 5.54%, as compared to the 1% for 3-month treasury bills and 3.25% for US investment grade corporate bonds in 2017. Forex traders often invest in these bonds in local currencies, to hedge against currency risks.

Emerging Market ETFs

Major company stocks of the BRIC nations, such as Verizon, Sprint, Vonage, etc., are tracked by the MSCI Emerging Markets Index. The index has generated 10% annualised returns from 2008 to 2018, with respect to the broader index.

Energy sector ETFs have been performing well due to high energy demand in countries like India and China. They have remained stable despite inflationary pressures in recent years, and they move against the US dollar. So, investors find them useful to hedge against any appreciation in the US dollar.

How to Manage Risk in the Emerging Markets

• Research countries you wish to invest in, including their economic fundamentals and future prospects.
• Look into how ETFs pick individual stock holdings. Different funds have different investment philosophies regarding emerging stocks.
• Limit exposure to the emerging markets to only a small percentage of your portfolio.
• Use dollar-cost averaging to reduce risk and lower average cost per share.

Reference Links

• https://www.gfmag.com/topics/blogs/developing-economies-drive-fragile-economic-rebound-next-year-imf-says
• https://www.pwc.com/gx/en/issues/economy/the-world-in-2050.html
• https://www.thebalance.com/what-are-emerging-markets-3305927
• https://www.wsj.com/articles/yield-hungry-investors-revive-carry-trade-in-emerging-markets-11554724800