Emerging Market equities have been the top performing asset class for over a decade and have the potential for rapid growth. However, with high profits, come higher chances of losses as well. Should you partake such volatility in your portfolio? If it can be carefully monitored and managed, then why not?
But, What Are Emerging Markets?
Economies that are still developing, but do not fully meet the criteria of a developed market, are known as Emerging Markets. Geographically, they can be border lined to most of Russia, Asia (except Japan), Africa, Latin America and Eastern Europe.
They are characterised by having made sufficient progress in improving the living standards, increasing economic and social stability, maintaining a presence in financial markets and unified currencies.
However, there are still certain issues that need to be tackled before they can be recognised as developed equity markets.
What Makes Emerging Markets Risky?
While emerging markets may have a low per capita income, moderate economic and social stability, a higher rate of unemployment; they have a much higher economic growth rate. The expected returns are much more as compared to developing countries, which also comes at the cost of a much higher risk.
Areas of vulnerability include liquidity, political stability and economic environment among many others. It gets worse with government policies that limit foreign investment and repatriation of assets.
Let’s have a brief look at some of the main areas of concern.
Emerging markets are less liquid as compared to developed markets, which results in increased levels of price uncertainty and high broker fees. The reason being, buying and selling of securities in emerging markets is not easy, due to the smaller size of the marketplaces.
Take, for instance, the total market capitalization of some emerging markets could be less than one entire company in a developed economy. Additionally, finding a position in some markets can be tedious; trying to sell the position when required, even more complex.
Political & Economic Risks
Unstable government and political uncertainty can be a major cause of concern. It can have a serious impact on the economy where the investors might find themselves in an unpredictable operating environment. Following are the political factors that make investing in an emerging market a risk – trade embargo or sanctions, the nationalism of assets, strikes, IP theft, corruption and bribery, sudden changes in policies, economic problems in host countries, unregulated markets, insufficient raw materials, high inflation, and unsound monetary policies.
Due to this, emerging markets follow uncertain distribution patterns that are under the process of constant change. Where in developed markets, economic forecasts can be made depending on historical information; the same cannot be said for emerging markets.
Federal Reserve Tightening
The change in the Dollar currency valuation has the power to influence everything right from corporate balance sheets to foreign reserves at global banks. Initially, many emerging markets took advantage of low-interest rates wherein they borrowed dollars and re-payed debts with stronger currencies. Now, the Federal hike could hurt the emerging market corporate bond.
Additionally, after the global economic crises of 2008, many emerging markets saw an increase in foreign investment, which the emerging markets got used to. The hike could subtract foreign investment and would have investors rushing back to the U.S, which could slow the economic growth of the emerging markets.
Emerging market currencies are extremely volatile. Hence, at any given time if the price of the currency falls it can have an adverse effect on the total return on investment.
The Bottom Line
Emerging markets offer a tempting opportunity due to their greater growth potential, higher expected returns, growing middle class and low debt levels. This can help them transition into developed economies.
However, failure to grasp this, combined with the higher expectation on long-term returns can turn out be particularly risky, especially because of their vulnerable economic environment and lack sector diversification.
Because of this, they are not completely independent and tend to fall back on other countries to support their economy. This can be contagious; i.e., if one country is going through rescission, it will quickly infect the depending emerging economy. Additionally, they are also dependent on the Federal Reserve decisions.
Therefore, it is advisable to not take a direct plunge in emerging markets without doing a background study. Before investing, thorough research on the government, population, market trends, inflate rate, traded goods and average income level is mandatory.