Invest in Emerging Markets: Risk vs. Potential Returns
Investing in Emerging Markets – Yea or Nay? This is a question that every investor has to answer individually. Although they sometimes have high potential for returns, this needs to be carefully weighed against the risks.
Emerging markets, also known as newly-industrialized countries, are markets that are progressing. Whereas developed countries are now seeing only slow growth, there is much more potential in these countries. Industrialization in the emerging markets is spurring GDP. At the same time, the population is increasing. This ensures that there are plenty of employees and that labor expenses remain low. As such, production is affordable for companies and they can generate large returns.
This population growth also boosts consumption, since the younger generation is eager for consumer goods as well as luxury goods. An example of this can be seen in China. Companies that produce consumer goods are not the only ones to benefit from this. Broadly speaking, consumption also promotes the economic growth of the country.
High Returns and Interest Rates Appealing in Emerging Markets
Economic growth is reflected in the financial markets. Large returns can be obtained on the stock exchange. The interest rates for government bonds are significantly higher, as well. This is because due to the growth, these governments and companies have significant cash needs while also having lower credit ratings than many industrialized nations.
So it makes sense that investors want to partake in the boom occurring in emerging markets. Private investors can invest in equities or bonds. Another option is found in funds that focus on such investments or that track an emerging markets index. Many emerging markets have also opened up more for foreign investors in recent years.
Investments in Emerging Markets Are Associated with Risk
The risks involved need to be considered, however. This is because in emerging markets, it is not just the returns that are greater, as is the case for all developing countries; the risks are also greater. One reason for this can be found in their political development, which often lags behind their growth. This can lead to political and economic instability, which halts further development and puts legal certainty at risk. In the worst case scenario, companies could even be nationalized, including expropriation of the shareholders.
Unlike in more advanced countries, the market is less transparent in emerging markets. These countries place fewer requirements on companies. The guidelines on the information that they need to provide to shareholders are very different. This can mean that investors do not receive all the key information needed for making a sound decision to buy or sell a security.
Currency Risk Can Reduce Returns
In addition, currency risk should not be overlooked, particularly inflation. If inflation gets out of control, it will stifle growth. Even though governments try to keep currencies stable, they fluctuate drastically in the emerging markets. Inflation rose so high last year in Venezuela that even toilet paper became a rare commodity.
If a currency depreciates, it is not just growth that falls. The real value of the investment drops, as well. Although investors can hedge against currency risks – which can be useful for emerging market debt, for instance – this hedging is expensive and thus cuts into the return.
Bottom Line: Carefully Weigh the Opportunities and Risks
Each investor must decide individually whether it is right to invest in emerging markets. This is an opportunity to obtain higher returns than in the Western world. At the same time, growth is not guaranteed and there is even potential for losses. Depending on your investment strategy, however, investments in emerging markets can be used to make a high-risk investment of part of your portfolio and thus, to diversify it.
Aside from emerging market debt, the consumer goods industry is also worth considering. This does not necessarily have to include companies in developing countries, however. Corporations that export to emerging markets can also benefit from the boom.