Emerging markets are well-known for their volatility compared to developed markets like the United States or Europe. While some risks are difficult to predict, four significant factors are affecting emerging markets on an aggregate basis. Understanding these factors can help international investors avoid dicey situations and help predict the long-term movements of emerging markets relative to other asset classes.
Read about the four major factors affecting emerging market performance, and learn what they mean for international investors.
- Emerging markets often evolve from exporting to developed countries due to the demand for their cheaper labor and products.
- Emerging markets may evolve from domestic demand due to a large population and then begin exporting goods and services.
- Emerging markets often use debt issued by developed market countries, which devalues their currency if the developed country experiences a rise in its currency value.
- Globally, many commodities come from emerging markets; market fluctuations in the importers of their commodities affect the emerging market.
Developed Market Demand
Many emerging market countries manufacture products and/or sell services to developed market economies. For instance, China makes all kinds of goods for the United States and Europe, while India has become a leading exporter of information technology services. A downturn in developed economies can, therefore, have a negative impact on emerging markets that rely on demand to bolster their economic growth.
Since the 2008 financial crisis, many developed countries have struggled to return to normal growth rates. However, things have turned around globally following the pandemic. The Organisation for Economic Cooperation and Development (OECD) projects that global nominal gross domestic product (GDP) will hover between 4% and 5% throughout 2022.
Domestic Economy Performance
Many emerging market countries are driven by domestic demand rather than export demand. For example, exports (goods and services) to the U.S. account for just $87.4 billion of India’s $2.9 trillion (nominal) economy in 2019—or less than 1% of its total economic output. Also, China’s $634.8 billion in exports (goods and services) to the U.S. account for less than 1% of its $14.1 trillion (nominal) economy in the same year. Domestic factors—like consumption and politics—have a big influence on these emerging markets.
Growth rates have generally stayed the same since 2011, demonstrating a continuance of emerging market performance.
Often, emerging market economies evolve from an export-driven economy to a domestic-focused economy. China’s transition has taken growth rates from more than 10% in 2010 to less than 3% by 2020. The upshot is that domestically powered economic growth is widely viewed as more stable than export-driven growth since it doesn’t depend on external factors.
Currency Market Dynamics
Many emerging market countries have unstable local currencies and must issue debt in dollar-denominated bonds. When the U.S. dollar value rises, these debts may become costlier to service for emerging markets that earn revenue in local currency. A higher dollar valuation also implies higher interest rates, which tend to draw capital away from emerging markets and makes it more expensive for emerging markets to raise future capital.
For example, the U.S. dollar has been experiencing a long-term increase in purchasing power parity (PPP, measured in national currency per U.S. dollar ) in emerging markets (Brazil, Russia, India, China). There has also been a decrease or flatline in developed markets (Germany, Canada, the UK, Denmark) over the long run.
An increase in purchasing power parity makes it harder for emerging markets to raise funds via debt instruments, because their currency is losing purchasing power compared to developed markets.
Many emerging market countries are net exporters of commodities, which makes them sensitive to changes in commodity prices. For example, Russia is a large exporter of natural gas to Europe. Brazil exports iron ore, soybeans, coffee, and crude oil to China and the United States. A downturn in these commodities could have a dramatic impact on the revenue generated by state-owned and private enterprises in these countries.
Commodity prices have dramatically fallen since 2011 due to slower end-market demand, but the global economic recovery is slowly boosting demand. Since 2016, many metal commodities have experienced growth that has helped many emerging markets. Copper and palladium prices have been strong performers since first half of 2017, which has helped offset weakness in crude oil and natural gas prices.
Consider Investing in Emerging Markets
Emerging markets are a great way to diversify any portfolio. An understanding of the underlying performance drivers can help investors time the market. International investors holding emerging market-related investments have certainly felt the impact of their underperformance since 2011, but these trends could be turning around as long as the U.S. economy continues to grow. Those without emerging market holdings may want to consider adding the asset class as these trends play out.