The Surprising Rise of Emerging Markets - Are These Countries the Future of Global Investments?

As I delve into the world of finance, one trend that has caught my attention is the surprising rise of emerging markets. These countries, often overlooked in the past, are now positioning themselves as the future of global investments. Let's explore why this shift is happening and what it means for investors.

The New Phase of Growth

Emerging markets have long been associated with the rise of a global middle class, driven by younger populations and increasing per capita incomes. However, the current phase of growth, often referred to as "EM Boom 2.0," is significantly different from the previous one. This new boom is not just about China's rapid industrialization, but it encompasses a broader range of emerging market nations.

India, for instance, is at the forefront of this new cycle. With its ongoing infrastructure boom, significant investments in roads, bridges, and trains, India is experiencing a steep rise in gross capital formation and surging private sector new project announcements. The country's young, English-speaking population, inherited banking system, and diverse economy make it an attractive destination for investors.

Beyond China: A Diverse Landscape

While China was the focal point of the first emerging markets boom, the current phase is more diverse. Countries like Brazil, Chile, and South Africa are benefiting from the global push for decarbonization, which has increased demand for raw materials. Vietnam, Indonesia, and Mexico are capitalizing on supply chain diversification as companies seek alternatives to China.

The Gulf states are also leveraging their strategic location and resources to diversify their economies away from fossil fuels. This diversification is integrating more of the world's developing economies into the global economy, creating a vast and dynamic investment landscape.

A Changing Global Landscape

The current emerging markets boom is fundamentally different from its predecessor. Unlike the previous boom, which was largely deflationary due to the influx of cheap Chinese goods, the new boom is likely to have an inflationary impact. This is due to the sheer scale of economic activity and investment across multiple regions.

Another significant trend is the formation of a "parallel economic ecosystem" outside of the U.S. In the past, capital generated from trade often flowed back into the U.S. economy. Now, money is heading back into domestic markets, funding entrepreneurial dynamism across emerging markets. This shift means higher investment into domestic economies, leading to higher productivity.

Resilience and Fiscal Discipline

The resilience of emerging markets during recent economic challenges has been impressive. Many emerging market economies entered the pandemic with stronger financial discipline and lower levels of borrowing compared to Western nations. As a result, they emerged post-pandemic with improved fiscal positions, stronger balance sheets, and lower external vulnerabilities.

This fiscal discipline, combined with relatively low currency valuations, has made emerging markets more competitive. Low currency valuations act as a "cheat code" for national economies, attracting capital and driving higher growth. This virtuous cycle is a key factor supporting the outperformance of emerging markets.

Growth Opportunities and Diversification

Emerging market equities offer exposure to fast-growing economies and key drivers of global growth. Many companies in these markets are relatively inexpensive compared to their developed market peers, providing a margin of safety and potential for higher returns.

Investing in a wide range of emerging market stocks, including both household names and lesser-known small- and mid-cap securities, gives investors broad diversification and the potential to generate alpha. Over the past two decades, a portfolio blending emerging and developed markets indices has generated higher risk-adjusted returns than a portfolio comprised solely of developed markets.

Global Influence and Spillovers

Emerging markets, particularly those in the G20, are exercising greater global sway. Growth spillovers from domestic shocks in these markets have increased over the past two decades and are now comparable to those from advanced economies.

Countries like India, Brazil, Russia, and Mexico play significant roles in their neighbors' economic performance. Positive growth surprises in these markets can boost the revenue growth of foreign firms, especially in sectors reliant on demand from these markets.

However, faster growth in emerging markets can also lead to increased competition in sectors like textiles and chemicals. This import-competition effect from lower-wage countries is a factor investors need to consider.

Structural Opportunities

Looking ahead, emerging markets are on the cusp of a significant growth cycle driven by structural factors such as favorable demographics, increasing incomes, and deepening economic integration. India stands out as a structural growth opportunity, boasting the world’s largest youth population, high literacy rates, and a market-friendly government.

Brazil is another attractive option, with its equities trading at undemanding valuations and offering a strong margin of safety. The country's prospects for positive earnings revisions and its dividend yield make it an exciting investment opportunity.

The Role of the U.S. Dollar

The performance of emerging market equities is often inversely related to the U.S. dollar. Historically, emerging market equities have gained roughly 4% for every 1% downward move of the USD. This correlation is due to the inverse relationship between the USD and commodity prices, as well as the fact that many emerging market countries have funded their growth prospects with USD debt.

A weaker U.S. dollar, driven by the likely peak of the U.S. monetary policy cycle, could signal healthier balance sheets, lower interest expenses, and higher earnings revisions for emerging market companies. This makes emerging markets an attractive option for investors seeking growth in a world where interest rates might be tapering off.

Urbanization, Innovation, and Geopolitics

Emerging markets are also driven by trends such as innovation, urbanization, and shifting geopolitical and global trade dynamics. Urbanization is leading to the growth of a consumer class, driving demand for goods and services. Innovation is transforming industries, from technology to healthcare, creating new investment opportunities.

Geopolitical shifts, such as the nearshoring and friendshoring of the global supply chain, are benefiting countries in Latin America and Southeast Asia. These changes are positioning emerging markets as critical components of global value chains.

Managing Risks and Opportunities

While emerging markets offer compelling growth opportunities, they also come with risks. Investors need to be aware of challenges such as underdeveloped economies, political instability, and less well-established legal and regulatory regimes.

However, many emerging economies have recovered quickly from the COVID-19 pandemic and are now in a better fiscal situation compared to past crises. Structural reforms, particularly in labor markets and business regulation, can help sectors benefit from reallocation due to spillovers from G20 emerging markets.

Conclusion

The rise of emerging markets is not just a trend; it's a fundamental shift in the global economic landscape. These countries are no longer just peripheral players but are now central to global growth and investment opportunities.

As an investor, it's crucial to understand the nuances of this new phase of growth. From India's infrastructure boom to Brazil's cyclical opportunities, and from the impact of the U.S. dollar to the role of urbanization and innovation, emerging markets offer a wealth of opportunities.

While risks are inherent, the potential for outperformance and the structural advantages of these markets make them an exciting and potentially rewarding investment destination. As we look to the future, it's clear that emerging markets are not just the future of global investments; they are already shaping the present.