Emerging markets continue to play only a minor role in global stock indices. The share of the emerging countries in global economic output has almost doubled over the past 40 years. Investors should give more weight to emerging markets in their portfolios. Future markets, growth markets, emerging markets, new markets, emerging markets, emerging countries – the dictionary knows a whole range of translations for the term emerging markets. But they all have the same core: emerging markets are economies on the way up.
Index providers classify emerging markets
There is no general definition according to which countries can be divided into emerging markets and developed markets (developed economies). Economists generally orient themselves towards the criteria of the International Monetary Fund (IMF), which focuses on the development of real economic indicators. For example gross domestic product (GDP) per capita as an indicator of prosperity and the degree of diversification of exports.
For investors, on the other hand, the classification of the leading index providers MSCI, FTSE Russel and S&P is decisive. Although their criteria catalogs differ, their emerging market indices contain the same countries with a few exceptions. While MSCI still classifies South Korea as an emerging market, FTSE Russel and S&P list it as a developed industrial country. FTSE Russel also granted Poland this status. The other two large index providers, however, continue to classify the Eastern European country as an emerging market.
In contrast to the IMF, the financial markets are particularly decisive for the stock index constructors when categorizing individual countries. Important factors are, for example, the size of the stock markets, the liquidity of the stocks, the accessibility of the markets for foreign investors, the proportion of free float in the market capitalization and legal security.
The $ 25,000 rule
Among the diverse and various sets of rules, there is a basic criteria that has made it very easy to grasp the segmentation of index providers in the past: countries with a per capita GDP of more than 25,000 US dollars are developed economies. However, since the Gulf states were included in the emerging market indices, this rule of thumb is no longer as accurate. Because in these countries the GDP per capita is over 25,000 US dollars. But because the Gulf States do not meet important financial market criteria, the index providers classify them as emerging markets.
The MSCI Emerging Markets Index currently contains a total of 26 countries (as of June 2019). The countries with the largest equity markets in terms of investable market capitalization (free float) include China, Korea, Taiwan, India, Brazil, South Africa, Russia, Thailand and Mexico.
The share of global economic performance in emerging markets is increasing
In the past 40 years, economic growth in the emerging countries has been significantly higher on average than in the industrialized countries. This resulted in a larger share of global GDP. The exact amount of this share depends on how economic output is measured.
However, since exchange rates fluctuate considerably in some cases, these results are distorted. For example, if the Brazilian real appreciates against the US dollar, Brazilian GDP will rise without more production. In addition, the price level and purchasing power in the individual countries are not taken into account. To avoid such distortions, economists use what is known as GDP adjusted for purchasing power to compare economic performance in different countries. It is based on a special exchange rate, the so-called purchasing power parity dollar, which results from the comparison of price levels. Economic performance can then be measured on the basis of the resulting purchasing power. According to this procedure, the emerging countries are far better off than on the basis of current exchange rates. Adjusted for purchasing power, their share of world GDP has climbed from 25 to 49 percent over the past 40 years.
Emerging markets are often considered (too) risky
Most investors, however, are likely to shy away from portfolio weighting based on GDP adjusted for purchasing power. The label “extremely risky” still sticks to the emerging markets in the collective consciousness. The main reason for this is the turbulent 1980s and 1990s. These two decades were marked by a multitude of crises: bank collapses, drastic currency devaluations, inflation shocks, defaults on government bonds and stock market crashes kept investors in suspense.
The fear of contagion is also deeply rooted in investors. Many believe that if a crisis occurs in one emerging country, it quickly spreads to other emerging markets. But the data speak against this thesis. According to calculations by Dimson, Marsh, and Staunton, the correlation of local stock markets was below average when crises in emerging markets occurred. By contrast, crises in industrialized countries are more dangerous. They are much more likely to have the potential to drag on other stock markets in developed and emerging countries, the researchers’ figures suggest.