Emerging Markets: Key Differences and Risk Analysis

The views in this Global Market Outlook report are subject to change at any time based upon market or other conditions and are current as of October 5, 2019. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed.

Special credit to the CFA Institute's "Capital Market Expectations" and "Managing Investment Portfolios: A Dynamic Process" for broad reference points

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Now that we have taken a quick look at some of the economic factors such as GDP and its components related to emerging markets, we move on to certain characteristics that we must consider, both regarding frequently seen differences between emerging and advanced economies, and how we can best analyze certain risk factors.

Frequently seen differences between emerging and developed economies: As an introduction, these are by no means exclusive, and many of these are also closely intertwined, but these should provide a useful framework for analysis of a given economy and why the relevant factor matters.

Foreign investment: In contrast to more developed economies, emerging economies often require high rates of external investment in both physical assets such as capital equipment and infrastructure, and also increasing human capital via education and sill building.

-Why important: Since these economies are still developing, they often lack sufficient domestic savings to invest themselves, making foreign investment necessary. While these can be mutually beneficial in the long-term, we must also be aware of potential short-term concerns with political pressure, for example countries taking on too much debt and thus being under the sway of foreign investors. On the other side of the coin, emerging markets with strong revenue streams can use these revenues to efficiently invest in their own countries & diversify their economies (more below), such as Norway's Government Pension Fund, and this can be a strong positive for an emerging markets investor

2. Concentrated economies: Many emerging markets often have concentrated economies; for example, oil in Venezuela or the Middle East, mining in Africa; with that said, this is not exclusive to emerging markets and can in fact be seen in major cities - for example, entertainment in Los Angeles or business services in New York City or London.

-Why important: Concentration makes the economy more vulnerable to adverse changes often out of their control, for example the oil price moving from $100+/barrel to current levels around $50. For economies centered around one major industry, this can be catastrophic to their budgets as they will not have the necessary revenues to fund spending. In contrast, diversified economies are better positioned to weather economic pullbacks, and often have both cyclical and noncyclical industries to better balance their economies, so finding emerging countries who have diversified their economies can be very attractive.

3. Potential political and social uncertainty: While by no means exclusive to emerging markets, and with some emerging markets in fact having more favorable political and social situations than some developed nations, this is nonetheless something to consider

-Why important: Closely tied to the required foreign investment, this can lead to potential issues if one government enters into a deal with a foreign investor (whether sovereign or corporate), but a successor government wants to renegotiate or even nationalize the prior deal. Domestically, this can lead to major internal issues, such as Venezuela's ongoing disputed presidency and economic collapse not even two decades removed.

4. Required structural reform: Closely tied to the potential political and social uncertainty risk is the need to undertake structural reform in order to fully transition along the spectrum from emerging to developed, especially if governments are protecting vested interests who are already established. This in turn leads to external groups like the IMF (focused on global monetary & financial stability) and World Bank (helping to provide financing to developing countries) needing to get involved, as well as developing criteria - more below- to evaluate the emerging country's progress in meeting targets.

-Why important: This both helps the country obtain the funding necessary to grow, while also providing useful criteria to better gauge their progress as they move from emerging to advanced.

Emerging Market Risk Analysis: Now that we considered have a few essential differences between emerging countries, we must consider a risk analysis framework to better gauge how attractive the emerging market is

How sound is fiscal and monetary policy: Given that emerging markets need to finance development, deficits are an area to closely watch, particularly the ratio of fiscal deficit to GDP, with a persistent ratio over 4% being concerning. 2-4% one to keep an eye on, and below 2% generally safer. Related, emerging markets may take on debt to fund deficits, with a general ration of debt/GDP above 70% being concerning.

-Why important: Given that many emerging countries need external financing, yet have volatile growth, this can be a concern if revenues do not grow as fast as planned, for example the collapse in oil prices affecting many countries' budgets, and is certainly a risk worth watching closely as most investors will shy away from an overleveraged situation where repayment is unlikely

2. Economic growth prospects for the economy: As discussed earlier, one of the major attractions to emerging markets is the growth potential, which can often be in the 4-5% range vs. the 1-2.5% seen in emerging companies.

(https://www.imf.org/en/Publications/WEO/Issues/2019/07/18/WEOupdateJuly2019)

Why important: While slowing growth is to be expected as the emerging market matures and the GDP base is higher - i.e, doubling GDP from $1B to $2B requires $1B of incremental revenue, but doubling GDP revenue from $4B to $8B requires $4B in additional revenue - slowing growth before this maturation can be a concern. A helpful resources is the Economic Freedom Index (www.freetheworld.com), which analyzes indicators such as tariffs, tax rates, the cost of doing business, etc. and can give a better sense where a nation stands vs. others

3.Currency competitiveness: This is a concern both as an overvalued currency can dissuade investment and lead to debt. Financing a current deficit via debt can lead to depreciation and economic slowdown.

-Why important: If investors perceive the currency as overvalued, they may avoid the opportunity as they will give up some of their investment gains as the currency exchange rate normalizes, forcing the country to perhaps take on debt on less favorable terms. Conversely, a country with an undervalued currency that also has other positive factors can be very attractive, as the investor can benefit from both returns on investment and currency appreciation.

4. External debt under control: While some debt is certainly ok as this debt can be viewed as an investment that will be repaid several times over with GDP growth, this must be done in a sustainable manner. One indicator is foreign debt to GDP, with 25-50% considered ambiguous, and 50%+ a concern. Debt to current account receipts are similar, with a 200% ratio being a concern but ones below 100% being okay.

-Why important: Similar to the fiscal and monetary policy factor in (1) above, countries with excessive debt may find it hard to borrow necessary funds as lenders become wary of repayment, thus also affecting liquidity (more below) as capital flows out

5. Liquidity: This is not in regard to the bid-ask spreads mentioned earlier, but rather to foreign exchange reserves relative to trade flows and short-term debt. Reserves/short term debt over 200% are good, while those below 100% are a concern

-Why important: As mentioned, excessive debt can lead to a liquidity crisis where the country does not have sufficient reserves, leading to a potential default. In contrast, a liquid country has far greater flexibility and will be more attractive to outside investors

6. Do politics support the required reforms and policies. As alluded to above, reforms are often necessary to achieve the desired growth. Some areas to watch are fast overall GDP growth, effective policy, low debt, and high reserves; however, countries in more precarious positions may have multiple areas lacing and thus flash a warning sign.

-Why important: This ties in the criteria we have discussed in depth above and provides a great way for emerging countries to benchmark their progress not only internally, but also against peer economies and more advanced economies. For countries not meeting their goals, this can be a warning sign that scares off investors; for countries that are making good progress, this can make their economies more attractive for investment