What is an emerging market, anyway?

Antoine van Agtmael was an economist at the World Bank’s International Finance Corporation in the early 1980s. His mission was to raise a number of promising stockmarkets out of obscurity and so attract the investment they would need to prosper.

Armed with data on 10 such economies, Agtmael initially pitched the idea of a ‘Third-World Equity Fund’. The concept was met with enthusiasm, but early feedback suggested it might benefit from a better name.

Eventually, Agtmael came up with a term designed to fully capture a spirit of progress, uplift and dynamism. You may be familiar with it: emerging market.

This term has, of course, long since entered the everyday vocabulary of finance and investment. Yet even today it can be a source of controversy and confusion for investors.

The controversy most often revolves around the question of what an emerging market actually is – or, even, is not. For example, why is China, the world’s second-largest economy, still not recognised as a developed nation?

Meanwhile, the confusion most often revolves around the level of risk emerging markets can entail. Is it inevitable that investments in these countries are more perilous than those in their developed counterparts?

There are no definitive answers to these enduring puzzles. Yet investors at least need to understand why the emerging market space can represent such a broad church, and, crucially, why it can offer an equally wide array of opportunities.

What is an emerging market?

Despite Agtmael’s trailblazing work, the World Bank no longer maintains its own official list of emerging markets. It sold its database to Standard & Poor’s, one of several index providers that have assumed responsibility for bestowing or withdrawing emerging market status.

With the International Monetary Fund and a handful of academic institutions also weighing in, there are now numerous means of classifying an emerging market. They take into account factors such as incomes, life expectancy, economic growth rates, accessibility, regulation and the quality of financial systems.

As if to muddy the waters even more, the World Trade Organization (WTO) allows its members to self-identify as developed or developing. The latter can benefit from 'provisions', including preferential tariff (a tax imposed by a government on imports and exports) treatments that help make exports more competitive.

All this tells us the process of analysis and categorisation can be both objective (based on facts and evidence) and subjective (based on opinions or emotions). As a result, across-the-board agreement on how many emerging markets there are at any one time is rare, if not unheard of.

On the whole, though, an emerging market can be thought of as a nation undergoing a positive economic transition. Specifically, the journey is from a low-income, sometimes pre-industrial economy to a modern, industrial one.

In tandem, an emerging market can be viewed as an economy that is not only growing but becoming more integrated with global markets. This translates into increased trade volume and greater foreign investment.

Such a transformation should bring a higher standard of living. It is perhaps this consideration, above all, that ought to be kept in mind amid debates around whether some nations merely masquerade as emerging markets.

A mix of good and bad

Under the WTO’s self-identification regime, China classifies itself as a developing country. President Xi Jinping has even declared it will “always be a part of the developing world”.

This stance does not sit well with economic rivals such as the US. Lawmakers in Washington even introduced legislation intended to strip China of its emerging market standing.

“Lawmakers in Washington even introduced legislation intended to strip China of its emerging market standing”

Naturally, cynics point to state-of-the-art metropolises such as Beijing and Shanghai and ask what is remotely 'developing' or 'emerging' about them. They might ask much the same about Indian technology hotbeds such as Bengaluru and Mumbai.

But these nations are comprised of much more than a handful of cutting-edge super cities and global manufacturing centres. They are still home to a huge amount of poverty, especially in rural areas.

The World Bank has estimated 17.2% of China’s population lived on less than $6.85 a day in 2023 – not a statistic worthy of a truly developed economy. Similarly, 64% of China’s population and 37% of India’s population were reported to be living in urban areas in 2021. Yet each country has its own definition of 'urban', which further clouds the overall picture.

Investors must therefore accept emerging market status can be open to interpretation. It should not be regarded as a cast-iron indication of a country’s investment prospects.

Rethinking risk

This is most notably the case in relation to risk. Emerging markets have traditionally been regarded as significantly riskier than developed economies, but is this perception always warranted today?

The losses that followed Russia’s invasion of Ukraine underlined that some emerging market investments can still be extremely risky. In other instances, though, emerging markets might actually be seen as no riskier – maybe even less risky – than developed markets.

Take the automotive (motor vehicle) industry. China now makes more cars than any other country, is the top-selling manufacturer of electric vehicles (EVs) and has established itself as a leading producer of EV batteries. Analysts at UBS have predicted that by 2030, one in five cars sold in Europe will be Chinese.

“The losses that followed Russia’s invasion of Ukraine underlined that some emerging market investments can still be extremely risky. In other instances, though, emerging markets might actually be seen as no riskier – maybe even less risky – than developed markets”

Twenty-five years ago, when everyone was buying mobile phones, you would have invested in Motorola and Nokia. Today, of course, Apple and Korea’s Samsung dominate the market.

But the top three Chinese phone manufacturers – Huawei, Vivo and Honor – now sell more units in China than Apple and are gaining a larger foothold in the UK and in Europe¹.

In one respect it does not matter which brand wins the battle of the smartphone. As the 'factories of the world', emerging market nations are home to remarkable investments further down the supply chain that provide vital products and services to manufacturers.

Value matters as well. Particularly in China, risk is reduced by the fact that many stocks trade at deep discounts to their peers in the developed world.

It may also be worth remembering that developed economies are themselves nowadays far from risk-free, as evidenced by everything from the lingering impacts of Brexit to the threat of a US civil war after the forthcoming presidential election.

Diversification

One aspect of emerging markets it is worth exploring is the role they can play in diversifying portfolios.

In four of the past six years, global equity has been the best-selling net sector among end investors in the UK, according to the Investment Association.

The MSCI All Country World Index (a global stockmarket containing developed and emerging market companies) has more than 63% of assets in the US. China, the world’s second-largest global economy, has less than 3%. Fifth-largest India is somewhere in the 'other' part of the pie chart.

Technology companies Microsoft, Apple and Nvidia each represent more in the index than the whole of China. Many global funds reflect that asset allocation, too.

Historically, emerging market countries have been very dependent on the health of the US for their own wellbeing. Not for nothing was it said that when the US sneezes, the rest of the world catches a cold.

But one of the results of the global financial crisis and more recent tensions between the West and emerging markets was that governments in China and the rest of Asia made the decision to be cushioned from demand shocks in future.

Self-sufficiency is building – they are trading more with each other than historically. They are becoming less dependent on the US².

“Historically, emerging market countries have been dependent on the health of the US for their own wellbeing. Not for nothing was it said that when the US sneezes, the rest of the world catches a cold”

This means that though a major slowdown in the US will have knock-on effects in many emerging market countries, it could be less than we would have historically expected.

Arguably, then, having a portion of a client’s portfolio in emerging markets may mitigate concerns you may have about valuations in the US and particularly the extent to which a handful of companies now dominate many portfolios.

Opportunities

The great excitement over emerging market companies when they first captured the popular investor imagination was the opportunity for strong growth. These companies were in regions of rising wealth.

As we have seen, they often had a part to play in areas of secular growth (driven by a permanent change that is not affected by short-term factors), such as the rise of the smartphone and more recently the electric car.

Many companies have become global giants, such as Korea’s Samsung. Artificial intelligence has created huge demand for high-quality chips. TSMC – the Taiwan Semiconductor Manufacturing Company – is one of the most successful and is responsible for manufacturing many of Nvidia’s chips. Kia Motors – part of the Hyundai group – produces more than 1.4 million vehicles a year³.

Manufacturing quality has improved substantially. So has corporate governance (the system of rules, practices and processes used to manage and control a company) in general. And an added attraction is how surprisingly high some dividends (income paid to shareholders) are today.

Asian company management teams have learned the hard way to be conservative. We see little evidence of reckless expansion or merger-and-acquisition (combining or taking over companies) activity. Instead, many companies have little debt and are using strong cashflow (the money left over after all liabilities have been met) to deliver dividends or to buy back shares – a smart move when share prices are depressed.

We cannot deny that in the past five years many emerging market strategies have disappointed, and the index has lagged developed market indices. I am a strong believer in active management in this area.

“Asian company management teams have learned the hard way to be conservative. We see little evidence of reckless expansion”

Since April 2015, the MSCI Emerging Markets GBP index has delivered 50.4 per cent (to May 31 2024); the IA Global Emerging Markets sector average has made 57.5 per cent; our fund is up 101.9 per cent⁴.

It has been a challenging decade for emerging market equities and many areas such as Brazil, Korea, South Africa and Turkey look cheap⁵. Within each of these countries it is possible to find stable, high-quality businesses at depressed valuations.  

I believe the asset class is on the cusp of a recovery, with several growth drivers, including government support packages and falling interest rates, that should offer powerful support to demand. 

The mission Agtmael embarked on 40 years ago continues today. Earlier this year the World Bank published a new raft of data in a bid to “provide transparency and inspire investor confidence” in emerging markets.

Investors would do well to look beyond all the nuances and disputes over the terminology of what constitutes an emerging market. It is also time, perhaps, to challenge some of their own preconceived ideas and prejudices.

This is a sector that is currently rich in opportunity for the selective investor.