23rd August 2010
Many of the traditional risks associated with emerging markets have fallen away.
Latin America has moved away from its reputation for corruption and economic free-wheeling. Asia has moved away from its reputation for excessive debt. Political instability occasionally rears its head in places such as Russia or Thailand, but many ‘emerging market' problems have now become developed market problems – excessive debt, political interference in markets, potential defaults.
However, it is important not to dismiss risk in emerging markets altogether. They are, by their nature, still developing and that in itself brings risks.
Here are five risks that investors should be alert to when investing in emerging markets:
It is very easy to get caught up in seductive GDP growth figures without considering how much this is reflected in the price of emerging market companies.
This article from The Guardian reflects a niche view, but shows why investors should be cautious on valuations. In general, investors can protect themselves by being wary of markets that have seen huge rises.
For example, recent figures from HSBC Asset Management show that the Russian market is trading at a 40% discount to its Global Emerging Market peers. The Indian market, in contrast, is trading at over double that of Russia.
Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management, says: "Domestic consumption growth is imperative for much of the emerging world that if they are going to continue to grow relative to developed markets." The assumption that a new consumer will emerge in emerging markets is built into many predictions about growth. Fortunately, all the signs are that it will happen with the majority of emerging markets seeing good consumption growth. In Brazil, for example, consumption is predicted to rise 20% in 2010.
Emerging markets are less liquid than developed markets. In general they have fewer domestic investors and are therefore often subject to the whimsy of international investors.
This has been the big worry in China and India and this blog from the World Bank explains why it is such a concern. China's property sector, for example, has certainly attracted excess capital. Wage growth is being seen across many emerging markets, but particularly in China. These can generate inflation. However, equities will often do well, at least in the short-term, in inflationary periods.
Emerging markets cannot exist in a vacuum. Some, such as India, are more self-sustaining, but export-dependent countries such as Taiwan will suffer if the global economy weakens. Commodities also suffer, so countries such as Brazil can see growth fall. China can pick up some of the slack, but can't compensate entirely. Nevertheless, if this weakness does happen, it won't be much fun in developed markets either so emerging markets may still look – relatively – the better option.