Why are investors drawn to emerging markets, and what makes them tick?
Countries like India, Vietnam, and Brazil are gaining attention for good reason - they’re full of potential.
I like to think of emerging markets as the promising underdogs of the global economy. They have young, growing populations with untapped industries and undervalued assets that make them attractive.
And with the right conditions, these regions could drive some of the biggest economic shifts ahead, especially as global divides - like East vs. West - continue to deepen.
And while I like this space, it’s not smooth sailing since emerging markets come with serious challenges and risks.
So, the question is: does investing in these markets offer more upside, or downside?
Here's my two cents.
The Good: Emerging Markets Look Relatively Undervalued
One major draw of emerging markets is their valuations — aka the cost to buy shares in their companies.
These 'price tags' are often lower than those in the U.S. or Europe, especially in recent years
Remember, this doesn’t mean they’re bad investments; rather, it can signal more room for growth.
Think of it like investing in an interesting startup versus a big-name tech giant. The established company may grow more slowly since it’s already near the top (going from 1 to 2 is a 100% gain, but from 2 to 3 is only 50%, and it declines further and further). Emerging markets are like these startups - they're relatively riskier but with the potential for rapid growth and higher returns.
What makes this even more appealing is that, historically, emerging markets are deeply discounted compared to the U.S.
Over the past two decades, the price-to-earnings (P/E) ratio of emerging markets has consistently trailed that of U.S. stocks. This means investors are paying far less for the same dollar of earnings. As this discount has grown, emerging markets now look like an even better deal when compared to the S&P 500. With these lower valuations, they may offer substantial growth opportunities in the years ahead.
It’s times like this when I remember: there’s no such thing as good or bad risk - just the price you pay for that risk.
- Put simply, risk is always there. It’s neither good nor bad - it's about what you paid to take on that risk. When something’s overpriced, the downside is bigger because you’re paying a premium that might not hold. But if you buy something riskier at a low price, the downside is smaller. Even if things go wrong, you’ve paid less and have less to lose.
Because of this, emerging markets may offer more upside relative to the downside on a corporate earnings basis.
Or said another way, the cheap valuations may justify the added risk.
The Bad: Too Many Shares Issued Have Dragged Down Emerging Market Returns
So, while emerging markets offer discounted opportunities relative to U.S. markets, there are some caveats.
Companies in these regions keep issuing more shares. And the more they make, the less each one is worth. Too much supply drags down the value - it’s simple supply and demand.
Thus, even as these companies grow profits, issuing new shares to expand or pay off debt shrinks each piece of the pie, making each share’s profit worth less
- Without all the extra shares, emerging markets would have had a 12.3% return each year. But because of share issuance (blue bar in the image below), that return dropped to 6.1%. This shows just how much these new shares can cut into the gains.
For countries like China and India, this trend is a big deal – and one to be wary of.
So, if you’re investing in emerging markets, watch out for this ‘share dilution’ risk.
The Good: Growing Populations and the Youth Factor
Another positive difference in emerging markets is the people - especially young people.
As I shared with you in April when I wrote – ‘They Say Demographics Are Destiny: If So, Things May Look Pretty Bleak’ - many developed countries (like Japan, Canada, and Europe) have serious population imbalances. Meaning they have rapidly aging populations combined with plunging fertility (birth) rates. This can slow down growth and cause serious economic issues – such as deflation, huge government deficits, and anemic workforce.
But in emerging markets, the story is a bit different.
Young people bring fresh ideas, energy, and, most importantly, more hands in the workforce. This drives productivity, raising the standard of living, increasing spending, boosting corporate profits, and keeping the economy lively and growing.
This single factor is a huge tailwind for emerging markets compared to the developed world.
The Bad: Not All Demographics Are Equal in Emerging Markets (Yes, I’m Looking at You China)
Did you know that China – the second-largest economy in the world and a key source of growth for many emerging markets - is facing a massive demographic crisis?
This will likely weigh on China’s economy for decades.
And while I don’t personally consider China an emerging market (it’s already the world’s second-largest economy), this will dramatically impact the emerging market sector – since most get a good amount of growth from China.
For example:
- Influence on Commodity Prices - China’s twenty years of above-trend economic growth saw a surge of imports - from oil and metals to crops and timber – thus pushing up global commodity prices and shaping the fortunes of resource-rich emerging markets that depend on exports.
- Consumer Demand - China’s growing middle class (which grew from roughly 40 million people to 700 million between 2000 and 2018)4 drives demand for goods from other emerging economies – such as luxury goods from South Korea, apparel and shoes from Vietnam, and beef and wine from Brazil and Argentina.
- Investment and Infrastructure Projects - through its Belt and Road Initiative, China has poured billions into infrastructure across Asia, Africa, and Latin America. This boosts local economies, creates jobs, and builds vital trade routes throughout emerging markets (albeit has created some worrying ‘debt traps’ for select countries).
- Source of Capital Flows – Many Chinese companies invest abroad, bringing capital through direct investments, joint ventures, and loans from Chinese banks to emerging market businesses.
So, while emerging markets generally enjoy positive demographic trends, the real question – or rather the “300-pound panda in the room” - is whether they can withstand the ripple effects of China’s aging and shrinking population.
Time will tell.
Conclusion: A Balancing Act Between Optimism and Caution
As I mentioned in the beginning, I am fond of this space. Because in the end, emerging markets present an enticing mix of growth with young, dynamic populations and undervalued markets.
Meanwhile, they stand to benefit from an expanding middle class and promising economic development.
For investors, this could mean attractive opportunities.
But as always - with opportunity comes risk.
Emerging markets can be unpredictable, affected by China’s slowing growth, a strong U.S. dollar (as I’ve detailed before – read here), and political instability. These markets bring both upside and downside.
And for those willing to ride the waves, the payoff could be big - but remember, in these waters, you’ll need both a sober mind and a solid plan.
Sources:
- Point of View | Emerging market stocks appear attractive | Northern Trust
- Mapped: Top 10 Countries Driving Future Population Growth - Visual Capitalist
- China to raise retirement age for first time since 1950s
- How Well-off is China’s Middle Class? | ChinaPower Project
Disclosures:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. All examples are hypothetical and are for illustrative purposes only.
Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information. This document is provided for information purposes only and should not be considered as investment advice.
Index Definitions
MSCI Emerging Markets Index - The MSCI Emerging Markets Index captures large and mid-cap representation across 24 Emerging Markets (EM) countries*. With 1,278 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI World Index - The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries*. With 1,409 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
You cannot invest directly in an index.
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA/SIPC. Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc.