Given high valuations and sluggish growth among the developed markets, many investors are looking to the emerging markets for potential returns. Yet we believe popular market capitalization-weighted emerging market indexes dilute the high-growth opportunities in the emerging markets that investors are seeking. One cause for this “dilution” is due to the fact that market cap-weighting schemes tend to overweight the countries that have already experienced periods of rapid growth and are now decelerating as they mature into middle-income economies.
For example, as of December 30, 2016, the BRICs (Brazil, Russia, India, and China), South Korea, and Taiwan made up nearly 73% of the MSCI Emerging Markets Index but demonstrated an average GDP growth rate of just 1.5% during that same year.1 At the inception (1988) of the MSCI Emerging Markets Index, the average GDP growth rates for these six countries was 8.2%. The 5-year rolling average GDP chart below shows that since the late 1980s, these countries have experienced a downward trend of economic expansion.
Source: Knoema, 2017. GDP data from to 2016.
While traditional emerging market indexes may be overexposed to these slowing economies, it’s possible that investors could consider two alternative approaches in an effort to zero-in on the higher growth potential opportunities that remain within the emerging markets:
- A broad approach that focuses on the less advanced developing markets – the next emerging and frontier countries; and
- A targeted approach that isolates specific sectors within the larger emerging markets, such as the Chinese consumer and technology sectors.
A Focus on Less Developed Countries: The Next Emerging and Frontier Markets
Many investors prefer accessing a variety of emerging markets simultaneously to help mitigate the idiosyncratic risks associated with any one economy. In order to maintain broad exposure to the emerging market asset class, while increasing its growth potential, investors might consider shifting their focus away from the largest emerging markets and focus in on the less developed emerging and frontier markets. This strategy, which is the basis for the Global X Next Emerging & Frontier ETF (NYSEARCA:EMFM), avoids 6 major middle-income economies: Brazil, Russia, India, China, South Korea, and Taiwan (‘BRIC + ST’). EMFM solely focuses on the less developed category of the ‘next’ emerging & frontier countries (‘Next EM + FM’).
The next emerging & frontier markets make up only 27% of the MSCI Emerging Markets Index (0% of which are frontier markets portion), but often have attractive characteristics, such as large, growing populations, vast natural resources, and low market capitalization to GDP ratios.2
The combined population in the Next EM + FM countries are the largest in the world and forecast to expand at twice as fast as the BRIC + ST countries and four times as fast as developed economies. Coupling these demographics with 37% lower labor costs than the BRIC +ST countries, it’s possible that the Next EM + FM countries could benefit from a demographic tailwind, which might accelerate their growth.
Source: Global X Research based country data from OECD, Numbeo, 2017.
While the Next EM + FM countries tend to have lower amounts of fixed assets and capital than their more developed peers, they are often rich in natural resources. Exporting these commodities to developed markets attracts foreign capital that can be used to improve public services like education and healthcare, to develop better infrastructure, and to import new technologies, for example. Over time, reinvesting this capital can help to help close the economic gap between the Next EM + FM countries and the rest of the world.
Source: Global X Research based country data from UNCTAD, 2016.
The Next EM + FM countries demonstrate the lowest market cap to GDP ratio, which is a measure about which Warren Buffett once said, “(is) probably the best single measure of where valuations stand at any given moment.”3 This ratio tends to move towards 100% as a country’s capital markets mature and become fully priced. Given the comparatively low market cap to GDP ratio, the capital markets in the Next EM + FM could be on a track to expand with additional IPOs and rising market caps.
Source: World Bank, 2016.
Target Sector Exposures: China Consumer and Technology
Rather than entirely eliminating the BRIC + ST countries from an emerging market allocation, investors could opt to target just the higher growth segments of these economies. For example, while China’s broad economic growth is generally slowing, the country is in the midst of a substantial transition from its ‘old economy,’ characterized by often inefficient state-owned enterprises and investment in fixed-assets, to a ‘new economy’ led by domestic consumption. This transition could create a substantial opportunity within the consumer and technology sectors, which have the potential to benefit from the rising spending power of Chinese consumers/shoppers.
In 2015, household final consumption accounted for approximately 37% of China’s total GDP. This figure is well below the 54% average for similar middle-income countries (see chart). If Chinese household consumption numbers are on a path to match other similar middle income countries, consumption as a % of GDP will likely increase. 2016 demonstrated that this trend underway as retail sales expanded 9.6% during the year, exceeding the country’s total GDP growth of 6.7%.4
Source: World Bank, 2015, Trading Economics, 2017.
The power of China’s shopping is seen in areas as varied as transportation, entertainment, cell phones, and luxury goods. Today, China is the world’s largest automobile market and has charged ahead as the biggest purchaser of electric vehicles.5 Moviegoers in China contributed 17% of total box office receipts in 2016.6 They also represent one third of global luxury retail sales, and they are making many of these purchases online.7 E-commerce purchases grew by 26% percent last year in China, as 15.5% of total retail purchases were made online.8 Part of this online retail push is attributable to China’s massive market for smartphones, which is now the largest in the world.9
Broad market cap-weighted exposures to the emerging markets can dilute exposures to larger potential growth opportunities. To achieve more precise exposures to these opportunities, investors could be well suited to either focus on next emerging and frontier markets or more targeted exposures within the BRIC + ST countries.
Global X offers the Global X Next Emerging & Frontier ETF (EMFM) for broad access to developing markets while excluding the BRICs, South Korea and Taiwan. In addition, Global X offers the Global X China Consumer ETF (NYSEARCA:CHIQ) and the Global X NASDAQ China Technology ETF (NASDAQ:QQQC) for targeted exposure to segments of the Chinese economy that potentially stand to benefit from rising spending.
1. Bloomberg, 2017.
2. MSCI, December 30, 2016.
3. Fortune, “Warren Buffett on the Stock Market”, Dec 2001.
4. China Daily, “China retails sales grow 9.6% in 2016”, “Jan 2017.
5. Quartz, “China is selling more electric vehicles than the US- and it’s not even close,” May 2017.
6. Box Office Mojo, 2017.
7. Financial Times, “Chinese shoppers begin to buy luxury brands again – at home,” Jan 26, 2017.
8. PYMNTS.com, “China Online Shopping Jumps by 26.2% in 2016,” Feb 2017.
9. Fortune, “How China’s Smartphone ‘Big Four’ are Fighting for Global Customers,” Jan 2017
Investing involves risk, including possible loss of principal. International investing may involve risk of capital loss from unfavorable fluctuations in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Frontier markets generally have less developed capital markets than traditional emerging market countries, and, consequently, the risks of investing in foreign securities are magnified in such countries. These countries are subject to potentially significant political, social and economic instability, which could materially and adversely affect the companies in which the Fund may invest. EMFM invests in securities and markets that are susceptible to fluctuations in certain commodity markets. Commodities represent a significant portion of the Latin American and Middle Eastern economies. Any negative changes in commodity markets could have a great impact on these economies. Unlike most exchange-traded funds, EMFM intends to effect all creations and redemptions partially for cash, rather than in-kind securities. As a result, an investment in EMFM may be less tax-efficient than an investment in a more conventional ETF.
Securities focusing on a single country and narrowly focused investments may be subject to higher volatility. Investments in securities in the Technology sector are subject to rapid changes in technology product cycles; rapid product obsolescence; government regulation; and increased competition, both domestically and internationally, including competition from foreign competitors with lower production costs. Technology companies and companies that rely heavily on technology tend to be more volatile than the overall market, and are also heavily dependent on patent and intellectual property rights.
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