In recent weeks the markets have exhibited rocky performance, and emerging markets have played a significant role in the volatility. For those of you unfamiliar with the term, an emerging market (also known as a developing market) refers to the economy of a country that is less developed than that of a developed country or region but is well on it’s way to becoming developed. For comparison's sake, Mexico, Brazil, India, and Russia are all developing markets, while the U.S., Japan, and the Eurozone are all developed markets. An emerging market is often characterized by lower per capita GDP (average annual salary per citizen), but higher GDP growth, meaning the country’s economy is growing at a faster pace than other developed nations. A prime example of an emerging market is China who, while not quite as stable and efficient as the U.S., has exhibited very high growth in the past several decades and is progressing towards becoming a developed economy.
Emerging markets have historically been an attractive investment because they have a high growth potential; however, because they are often less stable, they tend to be more risky, as we’ve observed in recent months. You can invest in emerging markets in a variety of ways, most obviously through purchasing stocks or bonds in a company headquartered in an emerging country or through directly purchasing bonds issued by the government of that country. To better understand what makes an emerging country a good investment, we believe it’s a good idea to look at the fundamentals – key political, social, and economic behaviors that a country exhibits. The CFA Institute categorizes these traits as follows:
A healthy emerging economy is one in which individuals are not only able to save money, but are also able to invest it. This allows the individuals to grow their wealth, but it also allows companies access to capital, which allows them to grow, which in turn allows the country’s overall economy to grow.
In order for individuals to invest, an emerging economy needs a stock market with intermediaries such as banks who connect investors with companies. For the financial market to be effective, it must have high standards and transparency, otherwise, the investors may not trust that they will get their money back, which could prevent them from investing.
A stable government and defined property rights are important elements of economic growth. In order for individuals to engage in entrepreneurship, they require the security of knowing that their property will not be stolen or confiscated. Countries with corrupt governments cause distrust among their citizens, which inhibits business development and hinders growth.
One of the most crucial elements of a healthy economy is access to good education and healthcare. The best way to grow business is to have healthy, intelligent employees. Countries with inadequate healthcare suffer from lower life expectancy rates as seen in certain parts of Africa where diseases such as AIDS and Ebola have wiped out large portions of the working population.
Another important aspect of economic health is having tax and regulatory systems in place that maintain the right balance of raising enough revenue to provide for government expenditures without limiting business growth. A good example of poor taxation and regulatory systems is Greece where an initially loose tax system with minimal accountability and a poor regulatory environment caused a ballooning debt burden. Unfortunately, Greece has catapulted to the other extreme and has levied so many taxes that economic growth is now stunted, creating a vicious cycle of growing debt and the inability to pay it back due to a lack of economic growth.
Free trade is key to economic growth because it allows individuals and countries to focus on doing what they do best, which allows them to grow. If one country is good at growing apples and another is good at growing oranges, while they could both grow both fruits, it makes the most sense for them to each focus on growing what they are good at growing and then trade. When a country is unable to trade, due to economic sanctions or a political riff as we’ve recently seen in Russia, the negative impact on its economy can be great.
Here at Cedarstone, we believe that by focusing on the fundamentals of whatever we are looking to invest in, whether it’s emerging markets or developed markets, we can better understand where there is value to be found. If you’d like to learn more about how we invest, check out some of our other articles or give one of our advisors a call today.
CFA Institute. 2015 CFA Level II Volume 1 Ethical and Professional Standards, Quantitative Methods, and Economics. Hoboken: Wiley, 2015.