Diversifying across emerging countries
Investing in the emerging markets (EM) is a bit like buying a box of assorted chocolates. Emerging countries are not all the same. They are not a homogenous group, but because they are grouped under the emerging markets category, investors can misunderstand the nuances of the region and subsequently miss opportunities to diversify.
As emerging nations continue to show signs of stronger fundamentals compared to a decade ago, it may be time for investors to reconsider these misconceptions about EM.
Individuality across regions
Emerging markets are made up of multiple countries that speak different languages. Each country is run by individual government structures and has its own unique identity, culture and economy. These differences impact the market dynamics and associated risks of investing in each country.
As each country is undergoing different changes, investors can benefit from EM assets in multiple EM countries. Here we explore several major regions and the countries that are drawing investor attention.
Asia has become well-known for rapid change and expansion. This has naturally drawn global investors who are eager to find the next big economic machine. But Asia is marked by a breadth of countries that may have more differences than similarities. In addition, many Asian countries have been experiencing positive progress in their own ways.
There are many headlines on China. While there remain debates about the country’s prospects, there are some aspects of the nation that are hard to ignore. China’s financial technology (fintech) has come very far in a short timeframe. The Chinese online-payment industry already accounts for about half of global transactions.
Alipay, which is operated by Alibaba’s financial unit, is the current market leader. Chinese consumers are using mobile technology for more than payment. They are also using it to borrow and invest, spurring such industries as peer-to-peer lending and business-to-business finance, filling the gaps left by cautious state-owned banks.
Indian Prime Minister Narendra Modi has adequate support from his people as he works on major reforms. Several large initiatives have already been set into motion. Demonetization of the two highest value rupee notes, as well as the introduction of the Goods and Services Tax (GST), are important steps in moving the Indian economy into a new era. Although there were challenges in implementing these reforms, they were notable feats.
India also recently completed Aadhaar, which is a national database that verifies citizens’ identities by connecting each person’s biometric data (such as fingerprints and iris scans) with an original 12-digit number. It is a voluntary process but has become routinely required for many processes, from signing up for a mobile phone contract to claiming free lunch. It has already helped improve recordkeeping and rooted out some types of corruption.
Like India, Indonesia has also made strides to pass key reforms. Since becoming prime minister in late 2014, Joko Widodo, or Jokowi, has passed a number of initiatives with varying degrees of success, including a tax amnesty program and cuts to fuel subsidies. The Bank of Indonesia has been supportive of the nation’s economy by helping keep inflation sufficiently low and stable. Other factors, such as a manageable current account balance, improving fiscal deficits and increased infrastructure development have made the country more appealing to investors.
Because of historically low correlations to developed-market bonds, Indonesian bonds can be powerful diversifiers within a portfolio that are not as sensitive to the potential for a rising rate environment in much of the developed world. Additionally, Indonesia is less dependent on the U.S. for trade, which means any protectionist stance in America may do little to impact its progress.
When the U.S. elected Donald Trump in November 2016, the Mexican peso plunged. There were fears that Trump’s call to build a Mexican border wall and do away with the North American Free Trade Agreement (NAFTA) could dampen the Mexican economy. But the peso seems to have recovered. Mexico’s central bank, Banco de Mexico, has responded by raising interest rates several times in order to fight inflation caused by a weaker currency.
However, investors should keep a close eye on how politics could impact the country and the Latin American region as a whole. Nearly two out of three Latin Americans are going to undergo political change in 2018. If populism takes root, it could create shifts within the countries, and investors should be prepared.
FrontierFrontier countries are countries that are even less developed than emerging ones. They are also generally too small to be considered an emerging country. However, investors who are looking to expand their portfolios to include a range of developing countries should take note of frontier nations.
Like emerging markets, frontier markets are marked by individual countries with a unique set of characteristics. Although frontier nations face challenges, they provide a diversification tool and avenue for equity and fixed income investors to allocate to a further range of countries that are experiencing growth from various factors.
Kenya’s economy has had about 6% annual growth, which was supported by lower energy costs, investment in infrastructure and a strong agricultural industry. A lower oil price helped narrow the current account deficit. Inflation has managed to stabilize, and the government is committed to further spending cuts. Despite Kenya’s large twin deficits, the International Monetary Fund (IMF) has extended a $1.5 billion package to the government to support Kenya’s structural and economic reforms.
Within the next decade, Vietnam could be one of the fastest growing markets globally with GDP growth forecasted at between 6% to 9% per year. The country has increasingly opened up to free trade, which could benefit the country’s industries and corporate sectors.
Nigeria has a relatively well-developed pension plan industry and other local investors who have been attracted to long-dated bonds out to 20 years. Nigeria could be an appealing foreign market for offshore investors if they were to allow for a market-determined exchange rate, rather than trying to micromanage the currency.
Countries as a bottom-up diversification tool
Diversification within emerging markets, as evidenced by these examples, is not as simple as deciding to make an EM allocation. Countries and their individual traits are worth consideration and can influence the risk profile of EM assets, including sub-asset categories.
This emphasizes the importance of understanding the individual nuances of EM countries, and a case for how investors may be missing important diversification avenues within emerging markets.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.