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After much contemplation about the deficiencies of emerging markets as a concept and what would be required in a more useful descriptor, I believe referring to these investments as Asteriscs, or assets tied to economies of risky countries, does a better job.
The catchy term emerging markets has been a marketing success. It has also been a poor guide for investors. Above all, it is confusingly inconsistent.
The term describes characteristics of the actual market: a nascent market with low liquidity. It can also refer to a country: an asset class of an “emerging” country. Problematically, the term is often used in both ways simultaneously. Yet, a country can have several markets (equities, bonds, currencies, real estate and others) with different characteristics.
The concept of emerging markets can be misleading. Do markets or countries have to undergo positive transformations to be “emerging”? Occasional sarcastic references to “submerging” markets are understandable.
Furthermore, the term emerging markets may make us take too much comfort from its counterpart, developed markets. “Developed” implies a stable equilibrium. Can developed markets regress? Recent debt crises in several developed countries indicate this question is not theoretical.
The description of emerging markets as nascent markets fails to provide their defining characteristic. Lower liquidity is not always characteristic of emerging markets, nor is it an attribute exclusive to them.
More recently, a different label — frontier markets — has appeared to describe less liquid emerging markets.
Defining EM country risks
A country’s wealth is a good starting point for defining an emerging country. It bundles together many attributes, as per capita national income exhibits a strong, yet not perfect, correlation with other characteristics of interest to investors: institutional stability, rule of law, economic competitiveness, creditworthiness.
We can thus start by thinking about emerging markets as a collection of asset classes affected by developments in non-rich countries.
Viewed this way, the appeal and risks of emerging markets become clearer. The appeal is based on a promise that economies of emerging countries can grow at higher rates than those of their developed counterparts. This promise is embedded in the very definition of an emerging country. A non-rich country is starting with a lower base and has more room to catch up.
The definition also warns us about main investment risks in emerging markets. There is information in the fact that these countries are not rich.
However, some rich countries facing geopolitical threats, regime-shattering political risk or severe debt problems could be still classified as emerging.
We need a more comprehensive definition of an emerging country using the presence of relatively high country risk as the differentiating criterion. Regardless of their specific nature, country risks share a common characteristic — the potential to affect performance of all asset classes with strong ties to that country.
Of course, recognising high country risk is easier after the event than before it. Still, at least one of the following characteristics is present in all cases of elevated country risk:
● A country’s wealth below the high income threshold
● A geopolitical threat
● Impaired creditworthiness
● A non-democratic political regime
A geopolitical threat needs no explanation, with wars and lesser types of military conflicts constituting important risk factors. Impaired creditworthiness, as reflected for example in a speculative-grade credit rating, is a country risk because default on public debt is a systemic event that undermines investor confidence, damages the financial system and raises the cost of capital. Last, democracies institutionalise uncertainty as elected governments are constantly changing. Yet it is precisely the flexibility of a democratic system that mitigates the risk of a more sizeable political upheaval present in non-democratic regimes.
In a world enamoured of acronyms, we can thus conceptualise emerging markets as Asteriscs — assets tied to economies of risky countries.
In other words, emerging markets are asset classes with an asterisk next to them which should remind investors that, in addition to traditional risks which vary by asset class, they are also taking on an elevated country risk.
Empirical research highlighting the importance of country risks in emerging markets supports this approach.
Thinking of emerging markets as Asteriscs illuminates their two roles in a portfolio. First, by taking on elevated country risks, emerging markets can potentially enhance returns. Second, Asteriscs may also diversify the country risk levels within a portfolio.
This is a potentially significant benefit, considering the home bias of many portfolios. It also makes accommodation for the fact that some developed economies are moving fast in the direction of becoming Asteriscs.
The author is head of emerging markets at Standish, an asset management company