The definition of an emerging market has evolved strongly over time, says Stephen Dover in his essay on finews.first. That’s also why the expert sees numerous investment opportunities in those countries in 2017.
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The way investors think about emerging markets has been evolving – along with the markets themselves. One can’t consider emerging markets as one asset class; the opportunities are very differentiated between regions, countries and markets, with different fundamentals shaping them.
I think emerging markets are appropriately named – they are indeed emerging and have changed over time. With these changes, I believe the way people both think about and invest in the asset class also should evolve.
One example of the evolution we have seen is in regard to market capitalization (market cap). In 1988, when the MSCI Emerging Markets Index was first launched, just two of the 10 countries in the index – Malaysia and Brazil – represented more than half of the index’s market cap. At that time, the entire market cap of the index was about $35 billion, representing less than 1 percent of the world’s equity-market capitalization.
If we fast-forward to 2016, there were 23 countries in the index, and the market cap had grown to $4 trillion, representing about 10 percent of world market capitalization. The mix of countries in the index has also evolved over time. In terms of country weights, today, India represents 8 percent of the MSCI Emerging Markets Index and China – which wasn’t represented at all in 1998 – is nearly 27 percent of the index today. Meanwhile, Brazil’s representation is much less today, at only 8 percent.
«It really boils down to how one defines emerging market»»
What constitutes an emerging market has also changed significantly over time, but the waters in emerging markets have not always been very clear.
South Korea has been the subject of some debate in this regard. MSCI includes South Korea in the emerging-markets category, while another index provider, the FTSE Russell, considers it a developed market. This issue is quite important, as which countries are in which category and at what percentage in the indexes help determine how many investors position their portfolios. We have seen countries shift in and out of emerging-market status over time. For example, in 2013, MSCI reclassified Greece from developed to emerging-market status, and in 2016, MSCI announced Pakistan will be reclassified this year as an emerging market from frontier status.
It really boils down to how one defines «emerging market», and there is some disagreement about exactly what the criteria should be. MSCI and FTSE have their own criteria for inclusion in a particular index, including explicit requirements for market size and liquidity, a country’s openness to foreign ownership, foreign exchange and other aspects.
If you were to follow the World Bank’s standards as to which countries are classified as «high-income» to determine developed-market status, you’d wind up with a very different set of constituents than the index providers—for example, Qatar’s per-capita income ranks above that of Australia, Denmark and the United States.
«Emerging markets have also undergone structural changes»
While emerging markets currently represent at least 10 percent of the world’s stock-market capitalization (based on MSCI indexes), in our various discussions with investors, we have found most have a smaller percentage of their portfolios invested in emerging markets. And worth noting, the 10 percent figure represents the traditional MSCI indexes—other measures of emerging-market capitalization show emerging markets more broadly represent an even higher percentage.
Looking at other measures, we can see just how important emerging markets are to the global economy. Today, emerging markets represent nearly 50 percent of the world’s gross domestic product (GDP) measured in nominal terms (nearly 60 percent when using purchasing-power parity) and account for nearly 80 percent of global GDP growth.
Emerging markets have also undergone structural changes. Over the past three decades, emerging markets largely achieved their phenomenal growth through exports – and many people have associated these markets with commodities.
While many emerging-market countries still rely on exports, these economies are radically changing. As recently as 2008, commodities and materials stocks constituted 50 percent of the components of the MSCI Emerging Markets Index. Today, that category represents about 15 percent of the stocks in the index. To me, what’s really exciting about this shift is that it opens up many more investment opportunities that are focused on consumption and services.
«It is really not accurate to say emerging markets are pure commodity plays anymore»
Many investors may not realize that some very sophisticated information technology companies are based in emerging markets. In 2008, information technology (IT) companies represented about 7 percent of the MSCI Emerging Markets Index, and today, the sector represents 24 percent of the index – in fact, the top four constituents by weight are IT companies. Consumer/consumption-oriented stocks represented 7 percent of the index in 2008; today their weighting is 17 percent. So it is really not accurate to say emerging markets are pure commodity plays anymore, even though many people still consider them to be driven by the whims of commodity prices.
The weakness we have seen in many emerging-market currencies is something I think also strengthens the investment case. The dollar is at a 15-year high and some predict it could strengthen even more as the Federal Reserve is expected to continue to raise interest rates as inflation picks up. In my view, emerging-market currencies have been quite weak – in some cases, unjustifiably so.
I see this as supportive. Mexico, Argentina, Colombia, Indonesia and Malaysia are all examples of countries with currencies trading at what could be considered distressed levels – priced as if those economies are in great crisis. The fundamentals tell a different story. I believe the fundamentals in these countries look much better than their currency prices are reflecting.
«History has shown us that in general, a strong US economy is positive for emerging markets»
Additionally, I believe inflation appears poised to drop in many emerging-market countries, including Brazil, Russia, Colombia and Nigeria, and this allows their central banks to pursue more accommodative monetary policy, which could stimulate local equity markets.
Despite some uncertainties, I see opportunity in emerging markets in 2017 and I am optimistic many investors will see value in making greater allocations to them. GDP growth is expected to outpace that of developed markets, with the International Monetary Fund projecting growth of 4.5 percent in emerging and developing economies versus 1.9 percent in developed markets this year.
I see evidence that earnings growth in emerging markets could likely be higher than in developed markets, too. Emerging markets have been lagging in regard to earnings growth, but 2016 marked the first time in more than five years they outperformed developed markets. I think there’s still quite a bit of room for emerging markets to further catch-up.
And finally, the United States is near full employment and President Donald Trump’s administration has proposed some policies that appear stimulative for economic growth, including potential tax cuts and fiscal spending. History has shown us that in general, a strong US economy is positive for emerging markets. Even if we do see some reduction in trade on a marginal level, I think an expansion in the global economy is likely to help emerging markets. And, as noted, emerging markets that are more domestically driven should be more insulated against global shocks in other markets.
Emerging markets are in fact, emerging, and I see many opportunities ahead in 2017.
Stephen H. Dover is CFA Managing Director Chief Investment Officer Templeton Emerging Markets Group and Franklin Local Asset Management.
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