Press coverage and market sentiment have recently been bearish on investing in emerging markets. Despite some short-term concerns ranging from rising inflation to slowing growth and geopolitical tensions, strong economic fundamentals, combined with attractive valuations for assets in these markets, should allow experienced investors with longer-term horizons to generate attractive returns.

Fundamentals support investment attractiveness

• Emerging markets are expected to be the principal drivers of global economic growth over the medium term: the IMF projects that emerging markets’ GDP will grow on average twice as fast as that of developed markets, accounting for 74% of global GDP growth through 2017.
• Demographics will remain a key driver of economic development. According to UN predictions, emerging-market populations are expected to add close to 400m people between 2012 and 2017. These populations will remain relatively young, with an average age of 27 in regions such as the Middle East and the Indian subcontinent. Moreover, the UN predicts that while dependency ratios—the ratio of people younger than 15 or older than 64 to the working-age population (those aged 15-64)—across the developed world are rising to worrying levels, in emerging markets they will decline by 2% by 2020, resulting in an increasing economically active population able to support the growth of emerging economies.
• Lastly, the continued expansion of the middle class in emerging markets will result in sustained consumption growth as an increasing proportion of the population rises above subsistence levels and begins to enjoy discretionary disposable income, according to Angus Maddison at the University of Groningen in the Netherlands and Homi Kharas at the Brookings Institution in Washington, DC.

Attractive current valuations and capital under-allocation create long-term upside

According to the IMF and the Thomson Reuters Stock Market Ratios of January 29th 2014, emerging-market equities continue to be valued relatively cheaply compared with developed markets based on price/earnings to growth (PEG) ratios,[1] implying that growth is significantly cheaper to acquire in emerging markets than in developed markets.[2]

A recent survey of fund managers published by Bank of America Merrill Lynch noted that at the beginning of 2014 a net 15% of equity investors were underweighted in emerging markets. This market allocation trend is in line with the lows seen in 2001 (following 9/11) and late 2008 (during the global financial crisis) and is in stark contrast to the net overweight of 40% in early 2013. There is meaningful under-allocation of capital overall to emerging markets, and that is especially true of capital invested in private equity.[3] 

Allocations are likely to normalise over the coming decade, resulting in inflows of capital that will create growing competition for attractive assets in these high-growth markets, in turn driving increases in valuations and attractive returns for those who invested “at the right time”.

Unlikely repeat of the 1997 Asian financial crisis

In recent weeks emerging-market conditions have been compared to the 1997 Asian financial crisis (slowing growth, dropping currency rates, fleeing capital, etc). I don’t believe this will be the case, particularly because emerging markets have shown greater levels of monetary and fiscal responsibility in recent years.

Monetary policies have reflected lessons learned from 1997. Many countries have chosen to accumulate significant foreign-exchange reserves and have adopted floating exchange rates—eliminating currency pegs to the US dollar. As a result, the risk of a sudden collapse in currency exchange rates is significantly lower today. Emerging-market currencies have already experienced a gradual readjustment (a steady 28% decline since January 2010), reducing the odds of an abrupt adjustment.

IMF figures also confirm a long-term decline in external debt as a percentage of GDP from a peak of 41% in 1999 to 25% in 2013, which materially lowers the risk of a currency shock. These economies are further strengthened by the fact that many countries have had current accounts in surplus in recent years.

All in all, despite overall medium- to long-term optimism, investors today should remain cautious and watch closely for specific economic and political risks. There is no such thing as a single “emerging market” today, and opportunities as well as risks must be assessed on a country-by-country basis.

This interview is part of a series managed by The Economist Intelligence Unit for HSBC Commercial Banking.