Emerging Markets Valuation Considerations. Now, historically, emerging markets have offered high rates of return and high risk or volatility, but why? And we'll take a look at some of the reasons behind that. First of all, on the return side, we want to talk about growth. The main reason behind the outsized returns coming from emerging markets is because of growth. Emerging markets are expected to grow about three times faster than developed countries like the US, creating the potential for high returns. Now, what drives the growth? There are a couple of key characteristics of emerging markets that we should point to. First of all, population. Emerging markets tend to have a younger demographic, and this adds to economic growth. While retiree populations generally subtract from growth due to less economic output, higher healthcare costs, and the need for government services, younger workers do not in general have those issues to deal with. And for example, India and Brazil have high ratios of working age to retired populations. Next, high export levels. Labor costs tend to be lower in emerging markets, driving growth in manufacturing and therefore exports. Next, growing household incomes. Now, rising incomes afford consumers the ability to have income available for discretionary spending, resulting in an emergence of middle class consumer sector, which is a positive to economic growth. Indonesia and the Philippines are examples of countries with strong domestic economies and a growing consumer class. Next, natural resources. Emerging market countries have a disproportional share of natural resources in general and the wealth that comes along with it. Of course, there are exceptions like Canada and Australia and to some extent the US, but countries rich in natural resources tend to benefit as these emerging market countries industrialize. One example is Brazil. They should continue to be very self-sufficient in oil over the long term, and they have the largest farmable area in the world. And lastly, there are some other factors like low debt at the government and consumer level, creating opportunities for spending and growth, and the potential for expansionary fiscal policy. Now, as a result of the higher expected economic growth, emerging markets are accounting for a growing share of the global economic output or GDP. And if you look at the graph here, that share is expected to continue to increase for the foreseeable future, as estimated by the International Monetary Fund. Well, of course, higher expected returns do not come for free. They come with additional risks, and there are various emerging market risks that we should discuss. First, volatility. Now, prices on emerging market investments, both stocks and bonds, can be more volatile, and trading can be less liquid. Emerging market investor sentiment can shift quickly with changes in global growth forecast, for example. And this magnifies price movements both on the upside and the downside. Next, liquidity risk. Emerging market investments tend to be less liquid than developed market investments. And a major consideration for investors in emerging markets is that liquidity, or the ability to get out of investments quickly at a low cost. Next, political risk. Emerging market governments are generally less stable politically than developed markets, and events like external conflicts, or coups, or internal tensions between political parties can create a difficult operating environment for companies within that market. Next, financial risk. Emerging market countries may not have sound fiscal or monetary policies in place and are subject to a lot of the risks that come along with that. Inflation, for example, has been a large problem in some markets. Next, currency or FX risks. Now, there's FX risk for all non-domestic investments because there's a possibility that the currency of your investment will fall relative to your local currency, lowering your return, of course. Now, this risk is even higher for emerging markets investments because their currencies are more volatile. Regulation. Now, the rules and regulations of emerging market countries tend to be less developed, and as a result market regulation, corporate governance, transparency, accounting standards may not be as reliable or even as mature as developed markets. Some countries even have restrictions on how freely businesses can operate, and of course that's gonna impact their ability to earn profits. And lastly, higher costs. Investing internationally can bring additional fees, and emerging markets tend to have even higher fees relative to the broad foreign universe. And this is why most emerging market mutual funds or exchange credit funds cost investors a bit more in terms of expense ratios than the broad international universe or domestic counterparts.
