Prudent investors are generally "risk-averse," and thus, seek to avoid uncertainty. This is a major reason why equity markets of developed countries attract more capital than emerging markets. But with traditional powerhouses of the world – the United States, Western Europe and Japan – each now facing their own economic uncertainties, is now the time to look to emerging markets to pick up the slack? Will the meek finally inherit the Earth?
Emerging nations make up roughly 90 per cent of the world's population, and now represent more than half of world GDP (at purchasing power parity). The emerging world is vastly underrepresented by capital markets though, making up only approximately 10 per cent of the global equity market.
In financial theory, over the long-term, GDP growth is the only determinant of growth in the overall stock market. Let me explain. Stock prices are determined by corporate profits. Profits rise as GDP rises, or if corporate profits as a percentage of GDP rises. This cannot persist in the long run though, because the people employed by corporations won't continue to work for a smaller share of these profits (in the form of salaries and wages). True, stock prices can rise in the absence of increased earnings when price-to-earnings multiples increase. But this is only a short-term phenomenon as investors will not pay ever higher prices for the same level of earnings. Therefore, again, in theory, GDP growth is the sole determinant of long-term appreciation in stock prices. With that in mind, we look to GDP growth projections across the world.
The chart below shows GDP growth forecasts, in percentage terms, from Thomson Reuters economic polls. The polls aggregate estimates provided by a number of contributors like banks, think-tanks, ratings agencies, etc. It is quickly apparent that the lines at the top of the chart correspond to emerging (and frontier) market countries, while developed countries are clustered toward the bottom.
Four of the world's five most populous countries are emerging nations. As the political landscape grows troubling in the developed world (Brexit, U.S. election, etc.), there are encouraging signs to be found in these emerging giants. In China, the Communist Party continues to move toward a more free market-based economy, and is shifting away from manufacturing toward domestic consumption as the main engine of growth.
In Brazil, President Dilma Rousseff, who oversaw a gross mismanagement of the economy, has been suspended and faces impeachment over her alleged role in a massive corruption scandal. In reaction, Brazil's stock market is up an incredible 31 per cent so far this year.
In Indonesia (the world's fourth-most populous nation) leaders have traditionally come from the political and military elite. In 2014, Joko Widodo – a former entrepreneur from humble beginnings – was elected Prime Minister to break this trend. He became popular, especially with the country's youth, because of his reputation as a "clean" politician and his promises to curb corruption, as well as his platform to improve the economy and boost small businesses.
The most promising of all emerging nations however, is perhaps the world's largest democracy.
Roughly half of India's 1.25 billion people are under 25. They are entrepreneurial and place tremendous importance on education. In 2014, Narendra Modi was elected Prime Minister in a landslide victory in an election with the single biggest voter turnout in human history. He won on a promise to fix the economy and provide opportunity for the hundreds of millions of hopeful and ambitious young Indians.
The potential is great. India is very poor, with a GDP per capita about half that in China and a third of Brazil. Low oil prices, which can be crippling for oil exporters like Venezuela, are a blessing for India as it imports 80 per cent of its oil. The economy has, for most of recent history, been strangled by bureaucracy and graft, but Mr. Modi has promised to cut red tape and stamp out corruption. Beyond these more tangible factors, India's rich culture now has a worldwide influence and provides soft power (a persuasive strength) in international relations. The stock market has been steadily growing, the rupee is firm and the economy appears stable. This may be the beginning of something truly momentous.
As with any investment, greater growth potential accompanies greater risk; and the emerging world may not be appropriate for those with a shorter time-horizon or less tolerance for volatility. For those on the other hand, with the patience to watch emerging nations actually emerge and join the world's historically affluent, it provides a truly compelling story.
Vanguard's emerging markets ETF (VEE-TSX) tracks the FTSE emerging markets all cap index, and provides equity exposure to China, Taiwan, India, South Africa, Brazil and others for a management fee of only 0.23 per cent. BMO's India Equity ETF (ZID-TSX) replicates the BNY Mellon India select DR index and has the highest possible Lipper rating (five out of five) for both total return and consistent return.
Hugh Smith, MBA, works in the financial and risk unit of Thomson Reuters and specializes in wealth and asset management.