The New Emerging Markets

Technology is fundamentally reshaping both business and society in ways that were inconceivable just a few years ago. Its transformative potential remains largely untapped, revolutionizing how we gather information, manufacture goods, engage with businesses, and access products and services. In emerging markets, technological advancements present a unique opportunity to both empower underserved communities by reducing costs and barriers to entry for entrepreneurs and businesses. This fosters the development of innovative business models and enables the enhancement of traditional technologies. Private sector innovations are key in alleviating poverty and promoting shared prosperity, with AI playing a pivotal role in driving these structural advancements.

Emerging markets are generally defined as economies with low to middle per capita income that are experiencing rapid growth. The primary measure for this classification is wealth, often expressed as Gross Domestic Product (GDP) per capita. Organizations like the International Monetary Fund maintain lists of Emerging and Developing economies, while the World Bank classifies countries as low-income, lower-middle income, or upper-middle income. However, these static definitions fail to capture the dynamism and pace of development within emerging markets. Simply put, not all emerging markets are created equal, and the emerging markets of the past will not be the emerging markets of the future.

Across the most renowned economic theories, three primary forces are essential for a country to achieve sustained economic growth: population growth, capital, and technological advancement. Emerging markets have historically benefited from the first two—population growth and capital. Now, artificial intelligence (AI) has the potential to provide the missing ingredient: technological advancement.

AI’s impact on emerging markets could be akin to the mobile phone revolution of 20 to 30 years ago. Mobile phones allowed these countries to bypass the need for widespread, expensive communication infrastructure, dramatically improving productivity and connectivity. This leap forward opened up rural areas that were previously isolated, contributing to broader economic development.

Today, emerging markets are poised for robust growth. The International Monetary Fund (IMF) projects a real GDP growth rate of 4.3% for emerging markets, compared to a more modest 1.9% for advanced economies. Individual countries like India are expected to see real GDP growth of 6.5% in 2025, while Brazil is projected to grow by 2.4%. Additionally, many emerging market countries have demonstrated fiscal prudence and maintain stable debt levels relative to their GDP, further bolstering their growth prospects.

Lower exposure to emerging markets could prove costly if emerging market equities come back into favor. The MSCI ACWI Index, widely regarded by financial professionals as a representation of the global equity market, captures large and mid-cap companies across 23 developed and 24 emerging market countries. However, because the index is market-capitalization-weighted, it allocates more weight to larger equities and countries over time. As a result, the representation of emerging markets within the MSCI ACWI Index has decreased, currently holding a 7% weight, down from 10% in the 2010s. Emerging markets are now positioned to benefit from several major global trends. From a valuation standpoint, both emerging market equities and currencies are attractively priced—a characteristic that has often been the norm. However, what sets this period apart is the combination of attractive valuations with strong growth metrics at the equity level and the potential for emerging market currency strength, particularly if the U.S. dollar weakens. This unique setup offers a favorable backdrop for emerging markets that hasn’t been seen in recent economic cycles.

Major structural trends are increasingly favoring emerging markets as the global economy shifts towards a more de-globalized model. Developed countries are focusing on securing their supply chains, which will increasingly link emerging market nations to major developed economies. A key example of this is multinational companies reshoring manufacturing operations away from China, which is set to benefit countries like Mexico, India, Indonesia, and Vietnam. This shift is already evident, with Mexico recently surpassing China and Canada as the United States’ largest trade partner.

Another significant theme is the global infrastructure build-out, whether for AI, sustainable energy transitions, or general domestic and international infrastructure projects. The worldwide demand for commodities is expected to surge, especially given the structural underinvestment in the hard economy in recent years. This anticipated ramp-up in demand stands to benefit emerging market countries significantly. Latin America, for instance, offers a diverse set of economies with substantial exposure to commodities, all at relatively low valuations. Brazil, in particular, remains a commodity powerhouse, exporting gas, iron ore, oil, proteins, soy, and other products globally.

Moreover, emerging markets have evolved considerably with the rise of the middle class and urbanization. Many of these countries are now increasingly self-sustaining, driven by robust domestic demand. For example, India has made significant strides in the technologization of its economy, more than tripling the number of internet users in the last three years. This domestic growth, paired with strategic global positioning, underscores the growing importance of emerging markets in the new economic landscape.

While emerging markets present an attractive investment landscape, we believe that successful investing in this space requires specialized expertise.

Most emerging markets are highly inefficient, creating opportunities for alpha potential. Equities and debt from these regions offer unique risks and opportunities that can complement a globally diversified portfolio. Over the past decade, emerging market equities have shown a correlation of 0.70 to the S&P 500, while emerging market debt has a correlation of 0.68. This lower correlation highlights the potential diversification benefits of including emerging markets in a global portfolio.

When building an allocation to emerging markets, selecting the right manager or product is crucial. Active management is often recommended in this space due to the potential for generating alpha through strategic views and tilts. However, conducting thorough due diligence and understanding the manager’s strategy is essential.

ETFs have democratized access to institutional strategies and improved liquidity in emerging markets, benefiting the global financial system. For those willing to embrace the risks of emerging markets, choosing the right type of ETF is the next step.

One approach is to select a broad market ETF, which typically offers lower fees and a diversified portfolio, reducing the risk of overexposure to any single company or country. The indexing methodology is important here; for example, FTSE indexes do not consider South Korea an emerging market, whereas MSCI indexes do.

Another approach is to consider rules-based ETFs. Systematic active strategies, such as those offered by Avantis and Dimensional Fund Advisors, usually start with a broad market cap-weighted portfolio and then quantitatively tilt towards companies with strong value and quality factors. These strategies may take country and sector tilts based on their quantitative approach but generally provide diversified EM exposure.

Discretionary and exclusionary ETFs form another category. Discretionary strategies, often managed by firms with ‘boots on the ground’ like Capital Group, focus more on qualitative research. These strategies tend to be more concentrated and may exclude certain countries, companies, or sectors deemed unattractive. Exclusionary ETFs, which have gained popularity recently, are typically quantitative and index-agnostic, excluding specific countries or companies such as state-owned enterprises.

Finally, investors may also consider currency hedging. For those looking to hedge currency exposure, firms like Xtrackers offer a suite of international ETFs that hedge 100% of the currency risk.

Navigating the complexities of emerging market investing requires careful consideration and a well-thought-out strategy to maximize potential returns while managing risks.

In conclusion, the evolving landscape of emerging markets presents a compelling opportunity for investors willing to navigate their inherent complexities. The intersection of artificial intelligence, favorable valuations, and structural global shifts underscores the transformative potential these economies hold. As emerging markets continue to evolve with advancements in technology and infrastructure, they offer a diverse array of investment opportunities, from equities to debt, each with unique risks and rewards. With the global economy increasingly characterized by de-globalization and regional realignments, strategic investments in these markets, supported by thorough research and a clear understanding of the various investment vehicles available, could prove advantageous. While emerging markets may present significant opportunities for growth and alpha generation, they require a nuanced approach and careful consideration of market dynamics and investment strategies.

*Earnings Growth Chart: (ETFs used as proxies for investable universe, SPY, ACWX, EEM, MCHI, INDA, EWT, EWY, EWZ, EZA, EPOL.  Earnings growth definition: Morningstar’s estimated growth over the next 5 year)

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