Emerging markets in developing countries have economies and financial markets that take on some of the characteristics of developed market countries while still offering a possibly greater profit potential. This greater profit potential comes from the emerging markets’ growth potential. As markets develop, they grow and expand at a much greater pace than the developed markets.
The downside to the greater profit potential is the equally greater risk. Emerging markets are often more susceptible to global market fluctuations than developed markets. With their markets still in development, emerging markets might not offer the same regulatory protection to investors that are common in developed markets. This adds to their risk.
Why Should We Be Concerned About Emerging Markets?
Even for investors who have not bought into emerging markets, the current risks to the economies of countries considered to be emerging markets should be of concern. The world’s financial markets have become more interconnected as emerging markets have grown and this interconnection will probably only increase in the future. A major downturn in one or more of the larger emerging markets could lead to a global downturn.
The term emerging markets can make one assume that these markets are smaller than the developed markets, but that is not quite accurate. China, for example, is considered an emerging market, and it has a Gross Domestic Product (GDP) of $12 billion US Dollars, making its economy second only to the United States, with its $19 billion US dollars GDP.
China is not alone as a large emerging market. The top four largest emerging markets, the countries of Brazil, Russia, India and China (known as the BRIC countries) hold over a quarter of the land on the planet and 40 percent of the world’s population. Combined, their economy tops that of the United States with a combined GDP of over $20 trillion. A significant downturn in one of these larger emerging markets will have a large effect on the economy of the world, as a whole.
Risk #1: A Strong US Dollar Could Lead To The Federal Reserve Raising Interest Rates
A strong dollar is generally a boon to the economy of the United States. It attracts greater capital investment into the US economy, but this can often come at the cost of greater inflation. To combat that inflation, the Federal Reserve can raise interest rates and, as of September 2018, the Federal Reserve announced that key interest rates would rise to 2.25 percent, the highest level in over a decade.
The strong dollar and higher interest rates pose multiple problems for emerging markets. As the US economy strengthens with the strong dollar, global investors are more likely to invest in the more stable and predictable US market over riskier, emerging markets. With less investment, these markets provide less profit, further pushing investors back to the developed markets.
Another way a strong dollar and the Federal Reserve’s rate increases can hurt emerging markets is related to the debt held by those governments and their citizens. When the dollar was weaker, such as it was in the first decade of the century, the governments of emerging markets borrowed heavily in order to stabilize their own economies. A stronger dollar threatens to depreciate the local currencies used in these emerging markets, making paying off these debts more expensive to the emerging market.
An example of the potential risk a strong dollar and rising interest rates can pose to emerging economies can be seen in the 2013 Taper Tantrum. In order to prevent inflation, the Federal Reserve tapered the amount of US dollars it was adding to the economy. This increased the yield of US bonds, making them a much more attractive investment and pulling money from the riskier emerging markets hitting the so-called ‘fragile five’ markets of South Africa, Turkey, Indonesia, India and Brazil hard.
Most likely, emerging markets will continue to outperform the developed markets (even with a stronger dollar in those markets), assuming that the interest rate rise is handled properly. A gradual and well-telegraphed rise in interest rates will prevent another taper tantrum by preventing a global shock to the markets that a sudden and steep increase could cause.
Risk #2: An Increase In Protectionist Measures Could Lead To Global Trade Declines
A robust system of global trade has proven to be beneficial to emerging markets. A study by the McKinsey Global Institute found that trade with and among emerging markets encompassed 20 percent of all global trade in 2016, up significantly from eight percent in 1995. Due to the increasing share of global trade involving emerging markets, the already elevated risk involved with investing in emerging markets can explode when global trade is threatened.
With the election of Donald Trump, and the United Kingdom exiting the European Union, protectionist measures against global trade have been on the rise. The United States pulled out of the Trans-Pacific Partnership, a proposed trade agreement among several countries in the Pacific rim, and started to renegotiate several other major trade agreements including the North American Free Trade Agreement, or NAFTA.
President Trump has additionally enacted several protectionist tariffs targeting specific industries, such as steel and aluminum, as well as tariffs targeting specific countries. China has been a large target, with billions of dollars in trade goods receiving tariffs. This has resulted in a trade war, with other countries enacting their own retaliatory tariffs.
These protectionist actions have already led the International Monetary Fund to revise its global economic forecasts. It has moved from estimating an expansion of the world’s economy at an increase of 3.9 percent downward to 3.7 percent this year. Emerging markets will probably be hit hardest by this decrease. The IMF’s predictions related to the Turkish economy are a good example of this. The Turkish economy grew 7.4 percent in 2017, but is forecasted to grow at only a rate of 0.4 percent in 2018.
Should these protectionist measures continue, or even increase, emerging markets will probably continue to under-perform and global trade itself could slow. On the other hand, the trade wars that the United States are currently in can provide interest opportunities in emerging markets. Due to the tariffs the Trump Administration enacted on Chinese goods, the Chinese enacted retaliatory tariffs on US products, including soybeans- one of the major US exports to China. Chinese firms have turned to soybean farmers in emerging markets, like Brazil and Russia, to avoid the tariffs on US soybeans.
Risk #3: A Stabilizing China Is Still Risky
China is undisputedly the largest of the emerging markets and it has used the size of its economy in the past to prevent downturns from harming its economy. It has depended on the growth of its economy to use debt and credit to keep the economy moving during global downturns. Because of this, China could avoid falling into a recession during the global financial crisis.
One of the largest industries China protected from recession was real estate. Given that China is home to more people than any other country in the world, real estate is a large industry on its own, but China’s real estate bubble resulted in the building of several “ghost cities,” or huge cities that could house millions of people, but remained empty for years. Many of these cities have finally attracted residents, but there is still some significant worry about bubbles in the Chinese economy.
The Chinese government has responded to these worries, and to the slowing growth of their economy, by attempting to stabilize it. The Politburo, comprising of the top leaders of the Chinese Communist Party which controls the government and economy of China, recently announced targeted measures aimed at stabilizing the Chinese economy. These measures include cracking down on the debt level and regulating high-polluting industries.
The stabilization of the Chinese economy is even more important today, given the great deal of uncertainty the current US-China trade war created. As the trade war continues, the growth of the Chinese economy will probably slow by up to two percentage points in 2019. This uncertainty makes investing in China even riskier.
Some of the reforms China enacted to stabilize their economy has opened the country up to greater foreign investment. While the continuing trade war with the United States brings uncertainty, the reforms that allow greater investments make China a tempting target for investors. If the reforms continue, and the Chinese government uses a softer hand to control its economy, China will be a great investment.
That said, the Chinese government’s current control of their economy potentially hides significant risk. They have taken actions in the past to keep their economy growing at a quick pace, which resulted in creating larger bubbles that will eventually pop. While China might emerge as the dominant economy of the world within the next 50 years, it could just as easily go the other way.
Emerging markets offer a great potential for profit, but that comes with an increasing amount of risk to investments. Given some of the recent global economic trends, these risks could be growing. Investors should keep these trends in mind when they choose to invest in emerging markets to ensure the greatest return on their investments.