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What you didn’t know about emerging markets

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

Emerging markets have become more stable and less volatile, although risks remain for investors.

Click to toggle accordion What you’ll learn:

What the hallmarks of emerging economies are.

Why emerging market equities remain riskier than shares in developed countries.

How to gain exposure to this sector.

In previous decades, the phrase ‘emerging markets’ was commonly associated with the word ‘crisis’. In the 1960s, 70s and 80s, many developing countries faced continuous political turmoil, hyperinflation and currency collapses.

As a result, emerging market assets were notoriously volatile. It felt like investments in shares, bonds or currencies could suffer from a market collapse, or be confiscated by a capricious local government, at any moment.

Today, many investors have noticed that matters have improved, and are paying more attention to these markets’ long-term potential. Large, young populations imply plenty of future workers and consumers, while many developing economies have become more closely integrated with the world economy.

Definitions of emerging markets vary, but they’re generally considered to be developing economies that are advancing rapidly. The countries most commonly associated with emerging markets are Brazil, Russia, India and China, but there are many others. The MSCI Emerging Markets index, an important benchmark for the sector, includes 19 other countries, including Poland, Peru and Taiwan.

Despite the progress that many of these countries have made in recent years, misconceptions about emerging markets still abound. So, many investors still have a skewed perception of the asset class. Here are three important points to bear in mind if you’re thinking about diversifying your portfolio by adding some exposure to emerging markets.

Remember that investing is risky and you may get back less than you invested. Past performance isn’t a guide to future performance, so if you’re unsure, seek independent advice.

1. Beyond commodities

One of the hallmarks of an emerging economy is a reliance on manufacturing or raw materials exports rather than services, which tend to be underdeveloped by Western standards. Emerging markets have traditionally been considered a way to profit from a growing global economy, which creates more demand for these materials. Commodities are key, with oil and industrial metals bolstering economies from the Gulf and Africa to Latin America and Asia.

Yet it’s no longer quite so simple. An analysis by specialist emerging markets investment manager Ashmore shows commodity producers now only account for 14% of the MSCI Emerging Markets index. That’s down from 30% in 2006.1 Companies that are highly sensitive to the economic cycle – these include industrials as well as energy and mining firms – in total comprise around 20% of the MSCI index.

By contrast, more than 50% of the MSCI Emerging Market index is made up of technology, telecoms, healthcare and consumer companies – firms that should underpin long-term, structural improvements in economies. Indeed, the tech component is heavier in the MSCI EM index than in America’s S&P 500 index.

2. The political backdrop is increasingly stable

Developing states’ reputation as a hotbed of political chaos also needs updating. Democracy has spread across the world since the 1970s.2 Research by the consultancy Capital Economics shows that the number of coup attempts in emerging markets fell from around 10 a year in the 1970s to three in the 2000s, which shows how political stability has spread in the past three decades.3

The spread of the rule of law has also been accompanied by gradual economic liberalisation, which is good news for investors. While populist leaders can undermine or halt this development, as we’ve seen in Eastern Europe of late, the broader trend remains encouraging. Investors have been especially impressed by South America recently,4 which was especially turbulent in the 1970s and 80s.

The impeachment of President Rousseff in Brazil has been followed by a shift towards liberalisation and business-friendly policies. Argentina has also turned its back on the era of populism under President Kirchner, when it was shut out of international markets after defaulting on its debt. The latest Peruvian presidential election featured two pro-business candidates.5

In Asia, the key trend of the past two decades has been China’s embrace of the free market, while Vietnam, India and Indonesia have done the same in the past few years. All this contrasts starkly with an apparent drift back towards protectionism and nationalism in the developed world, increasing the potential risk in their asset markets.

3. A stronger US shouldn’t sink emerging markets

One recurrent theme in discussions about emerging markets now is their vulnerability to developments in the US economy. Higher US interest rates, a result of a strengthening economy and rising inflation, imply a higher return on US assets. That makes them potentially more appealing than alternatives in emerging markets.

In these circumstances, then, money tends to flow out of traditionally risky assets and head back to the world’s biggest economy. As it does so, it pushes up the US dollar, reinforcing the attraction of US assets for global investors and drawing further capital away from emerging markets.

As the US often sets the tone for world markets, interest rates in bond markets in other developed states may also rise, which draws money away from developing states. It may nudge up interest rates in emerging markets too, tightening credit conditions there.

However, emerging markets may be less vulnerable to higher US rates and a rising US dollar these days for two complex, but important, reasons.

In the past, a large proportion of emerging market government debt was denominated in US dollars. When money left emerging markets and headed back to the US, their economies faced a double whammy. The interest rates on emerging market bonds would climb as investors sold up, lowering prices (bond prices move inversely to interest rates). And their currencies would fall against the dollar, increasing the size of the debt translated back into the local currency.

Now, however, that exchange rate risk has reduced. The World Bank points out that in 2000, debt denominated in local currencies comprised 55% of emerging market borrowings. By 2013, the share had jumped to almost 85%.6

Another facet of emerging market exposure to higher US rates is also less important than it used to be. A country with a high current account deficit, which measures its trading relationship with the rest of the world, is especially vulnerable to money flowing out.

An external deficit means that a country’s earnings in goods, services and investments abroad are smaller than what other countries earn from it. The gap is plugged by borrowing money from overseas.

The bigger the gap, the more vulnerable a country is to the removal of foreign capital. Less than five years ago, several emerging countries had current account deficits worth over 4% of their GDP,7 but deficits have shrunk since then. Now shortfalls of this level are rare.

Another concern is emerging markets’ exposure to the US dollar and their current account deficits, which could make emerging market equities fall sharply as US interest rates rise. However, a look at three previous US monetary tightening cycles suggests that emerging market stocks have tended to rise in the first 12 months after the US begins to hike.8

Of course, it’s important to remember that, even when all these factors are taken into account, emerging market equities remain even more risky than shares listed in developed markets, such as the US or the UK. This means there’s a greater risk that your investments could fall in value, and you may get back less than you invested.

As with any investment, past performance isn’t a guide to future performance. If you’re unsure, seek professional advice.

How Barclays can help

Emerging market assets remain high risk, volatile assets, and they should only be held as a small part of a widely diversified portfolio, which includes exposure to other parts of the world. But in recent years, emerging markets have become more diverse and less dangerous than their reputation can imply, and investors should consider these changes too.

You could gain exposure to emerging markets through the Stewart Investors Global Emerging Markets Leaders fund (GB0033874545), or the Investec Emerging Market Equity fund (GB00B8HWDL62), both of which are included in the Barclays Funds List.

Bear in mind that our referring to emerging markets and emerging market stocks or bonds doesn’t constitute advice or a personal recommendation to invest in these or any other investment.

Investments can fall as well as rise and you may get back less than you invested. Past performance is not a reliable indicator of future performance.