Many talking heads, pundits and portfolio managers these days will say that every investor should at least consider allocating some part of his or her portfolio to emerging markets. While the term emerging markets seems obvious at first, a closer look shows that it’s not as simple as it may seem. What exactly defines an emerging market? Are their varying degrees of emerging? And how do we know when a country has stopped emerging and has…well, emerged.
Today in Asia, the traditional emerging markets are Indonesia, India, China, Thailand, Malaysia, Pakistan and Philippines. However, it was no that long ago that the “developed” nations of Asia like Singapore, Taiwan and South Korea were in fact emerging. In 1984 an economist at the World Bank named Antoine W. van Agtmael wrote a book called Emerging Securities Markets. The premise of his book was that due to the spread of technology and the adaptation of equity markets in underdeveloped countries, investors could no longer ignore these emerging markets. In addition, he wrote “The frontiers of international investment are beginning to push toward the major emerging markets and this trend is likely to continue”. The term “emerging market” had entered the financial lexicon.
Before World War II there was no obvious roll for equity markets in developing countries. Instead these countries relied on debt financing. It was far easier for these nascent economies to negotiate loans with a few major banks than go through the arduous process of establishing the institutions and rules necessary for a viable stock market. However, sentiment began to change during the later part of the 1970’s when many Latin American countries borrowed vast sums of money, mainly for infrastructure programs. In 1975 total sovereign debt in the region was about $75 billion, and by 1983 it had reached $315 billion. This was compounded by the fact that global interest rates were on the rise during this time and debt servicing started to become much more expensive. Mexico eventually defaulted on its debt. Overtime these countries began to realize that equity financing might be a better way to generate capital.
When it comes to investing, a good rule of thumb is that in general, bonds are more conservative and less risky than stocks. However, if you are on the other side of the transaction it is the opposite. Imagine you own a business. If you borrow $1 million you have to pay that back plus interest. If you sell a portion of the company as stock and generate $1 million, you don’t have to pay back the money. Equity financing provides permanent capital, while debt financing provides temporary capital.
In addition to the new found interest in equity financing, emerging markets also got help from the easing of capital controls in developed nations. Before the 1980s many mature economies had restrictions or quotas on foreign investment. The free-market attitude championed by Ronald Regan in the US and Margret Thatcher in the UK chipped away at these restrictions during the 1980’s. The amount of international investments in US pension funds for example doubled every 2-3 years during the last half of that decade. And the pattern was the same for emerging markets: In 1984 institutional investors had about $500 million in securities domiciled in developing countries; by 1991 that figure had ballooned to $25 billion, and was close $100 billion by 1999.
One common challenge all stock markets face whether they are young or mature is regulation. Many of the earliest emerging markets like Brazil, Taiwan, South Korea or Mexico all struggled early on to maintain an efficient market. As a result, many of the newcomers experienced severe stock market bubbles. South Korean and Taiwan’s markets were especially inflated.
The important thing to remember about emerging markets is that they are volatile. While the potential returns are attractive, the risk levels can be high. Talk with your advisor to see if they are an appropriate investment for your portfolio.