Emerging Markets
Emerging markets (EM) are economies that are transitioning from developing to developed status—characterized by rapid GDP growth, industrialization, and rising per-capita income, but still exhibiting significant vulnerabilities including political instability, institutional fragility, less developed capital markets, and susceptibility to external shocks—occupying a middle position between developed economies and frontier (least developed) markets.
Key takeaways
- Major EM indices (MSCI EM) include countries like China, India, Brazil, South Korea, Taiwan, South Africa, Russia (suspended), and approximately 24 other countries.
- EM economies typically exhibit faster GDP growth than developed markets but with higher volatility, driven by commodity dependence, demographic trends, and catch-up industrialization.
- EM assets offer diversification benefits to developed market portfolios but are subject to 'sudden stop' crises when foreign capital withdraws rapidly during global risk-off episodes.
- The EM investment thesis has evolved: early EM investing focused on commodity-linked growth; modern EM includes technology-driven economies (China's internet sector, India's IT services) with different risk/return dynamics.
- Currency risk is a major consideration in EM investing: local currency returns can be dramatically different from USD-hedged returns, particularly during EM currency crises.
Explanation
The concept of 'emerging markets' was popularized by World Bank economist Antoine van Agtmael in 1981 as a more optimistic rebranding of 'third world' countries undergoing economic development. The term now encompasses a diverse group of approximately 20–25 countries (by major index provider definitions) representing the world's major developing economies, including China (the world's second-largest economy), India, Brazil, South Korea, Taiwan, and others.
The fundamental EM investment thesis is based on three economic propositions: convergence theory (developing economies grow faster than developed economies as they adopt existing technologies and institutional frameworks, closing the per-capita income gap); demographic dividend (younger, growing populations expand labor forces and consumer markets faster than aging developed economies); and natural resource abundance (many EM countries are major commodity producers, benefiting from global commodity demand growth). These structural tailwinds support higher long-term nominal GDP growth in EM versus DM, which should translate to higher earnings growth and equity returns over long horizons.
However, the EM investment experience is complicated by recurring vulnerabilities. The 'original sin' problem—EM governments and corporations borrowing in foreign currencies (USD, EUR) while generating revenues in local currencies—creates financial fragility. When global risk appetite deteriorates or the U.S. dollar strengthens, EM currencies weaken, increasing the local-currency cost of external debt service and potentially triggering sovereign debt crises (Asia 1997, Russia 1998, Turkey 2018, Argentina chronically). These 'sudden stop' episodes—rapid reversal of capital flows as foreign investors simultaneously exit EM assets—create correlated drawdowns across EM equity, credit, and currency markets.
Institutional quality differentials between EM and DM significantly affect investment outcomes. Weak property rights, unreliable legal systems, corruption, and political interference in economic policy create persistent discounts to EM asset valuations relative to developed market equivalents. The 'EM discount' in equity valuations (EM typically trades at 10–15 P/E versus DM at 15–20 P/E) reflects both genuine growth premium and governance/risk discounts. ESG analysis in EM must account for significant variation in corporate governance standards, environmental regulation, and social practices across the EM universe.
For institutional investors and hedge funds, the EM allocation decision involves both strategic (long-term strategic asset allocation) and tactical (cyclical tilts based on valuations, risk appetite, macro conditions) dimensions. Strategic EM allocations are increasingly driven by index composition (MSCI EM weight has historically ranged from 10–15% of MSCI ACWI), while tactical tilts may increase or decrease EM weight based on valuations, dollar strength, commodity cycle positioning, and geopolitical risk assessment.
Example
An institutional investor with a $10 billion portfolio maintains a 15% strategic allocation to emerging markets ($1.5 billion) across equities, bonds, and currencies. The portfolio's EM equity sleeve ($700M) tracks the MSCI Emerging Markets Index with heavy China weight (approximately 30%). In 2021, China's regulatory crackdown on technology companies, real estate developers (Evergrande crisis), and private tutoring companies caused MSCI China to fall approximately 25%, dragging EM equity returns to -2.5% for the year versus +20% for MSCI World. The investor's EM fixed income sleeve ($500M) in local currency bonds benefited from yield differentials but suffered when EM currencies weakened against the USD. The remaining $300M in EM macro positions (via hedge fund allocation) generated positive returns from currency trading, partially offsetting equity and bond underperformance. This example illustrates both the diversification benefits (EM macro provided positive returns when EM equity declined) and concentration risks (China's weight in EM indices creates single-country exposure) of EM investing.
Related terms
Asset Allocation Bond Convergence Diversification Dividend Equity Frontier Markets Hedge Fund Inflation Natural Rate Of Interest Premium Reversal