Seoul, South Korea. Photo by Minyoung Choi.
Times change, and language changes with it – but not always at an equal rate. So the term “emerging market” persists, even though it is, at best, outdated.
In current usage, an “emerging market” is generally a country that shares some but not all of the characteristics of “developed” markets, with the potential for growth. Coined in 1981 by economist Antoine van Agtmael, the term “emerging market” replaced “less developed countries,” the common term in the 1970s for markets that lagged the U.S., Western Europe and Japan. It was also intended to replace “Third World” as a shorthand descriptor. As van Agtmael told The Economist in 2008, he had tried to start a “Third-World Equity Fund” while working at the International Finance Corporation, but he had trouble developing interest among investors. “Racking my brain, at last I came up with a term that sounded more positive and invigorating: emerging markets,” van Agtmael said. “‘Third world’ suggested stagnation; ‘emerging markets’ suggested progress, uplift and dynamism.”
The phrase “emerging market” solved an image problem but created a meaning problem. It was meant to signify some middle ground between “developing” and “developed,” but the criteria vary depending on whose metrics you used. In 2009, economist Vladimir Kvint defined an emerging market as
“a society transitioning from a dictatorship to a free-market-oriented-economy, with increasing economic freedom, gradual integration with the Global Marketplace and with other members of the GEM (Global Emerging Market), an expanding middle class, improving standards of living, social stability and tolerance, as well as an increase in cooperation with multilateral institutions.”
Today, some people use “emerging” as shorthand for any significant economy not included in the Group of Seven. Others mean a country that is included in a specific index. The disagreement about what the term means, as well as the debated distinction between an “emerging market” and an “emerging economy,” already suggest part of the reason we should leave the term behind. Economists and fund managers cannot seem to agree on what it means. Still, by the late 1980s “emerging markets” had overtaken “Third World countries” in financial circles. Even casual usage of “Third World” has dropped since the end of the Cold War, with “emerging market” mainly on the rise.
Early proponents of investing in these economies emphasized that they offered diversification and potential for faster growth than “industrialized” or “developed” markets. The Templeton Emerging Markets Fund, launched in 1987, initially focused on Hong Kong, the Philippines, Singapore, Malaysia and Thailand. In the waning days of the Cold War, those five economies had a market capitalization just below $100 billion. Today, their collective market capitalization exceeds $2.5 trillion. The Morgan Stanley Capital International Emerging Markets Index – the most popular emerging market fund – started with 10 countries in 1988, but now includes 26.
This raises the question of when, if ever, a market has finished emerging. A particular index or company may move a country from emerging to developed – or in the other direction. But there is no consensus on when such moves should happen. Factors could include economic growth, market size, liquidity, accessibility or some combination of these. What is the regulatory environment like? How hard or easy is it for foreigners to own stocks? Because the definition of “emerging” is so broad, the process of evaluating a country can yield strange results.
Many markets labeled emerging are doing just fine by most measures. Consider South Korea. In terms of gross domestic product per capita, the country has outpaced markets including Italy and Portugal that are generally considered developed. Yet many mutual funds that track emerging markets still include South Korea. What is the country missing to join its developed peers? Because each fund or index sets its own criteria for what makes a market emerging or developed, there is no blanket answer.
Beyond the oddness of “emerging” or “developed” as they apply to individual markets, it is worth considering whether it is useful to continue to group economies this way. If an index includes South Korea, Greece and Mexico (as MSCI does), what is the index tracking? Not to mention China, the “panda in the room,” as Michael Power put it in an opinion column for the Financial Times.
Part of the rationale for investing in emerging markets as a class was the rise of globalization. Many investors assumed these markets would continue to grow as the world got smaller and trade became freer. Today, it is much less obvious that globalization is inevitable. Brexit has created waves of uncertainty in Europe. Trade tensions between China and the United States created negative effects for some emerging market countries and positive effects for others. In the past decade or so, some emerging markets have done well, while others have faltered, making discussion of their behavior as a bloc increasingly difficult. Grouping them together, or even describing them with a single term, makes less sense in 2019 than it did in 1981.
People have been asking whether the term “emerging market” has lost its meaning for at least a decade. But it stubbornly persists. It may be that investors are simply accustomed to the category, or there may be subconscious biases that incline investors in Western Europe and North America to perceive qualitative differences where none exist. But whether it is a matter of inertia or misperception, the term hangs on. Investors should be cautious.
This skepticism for the emerging market label does not mean I think investors should always avoid countries to which it is currently applied. It only means that grouping them together under one umbrella is not useful. At Palisades Hudson, we do not invest in funds that focus on emerging markets as a group. Instead, we favor funds that invest in geographic regions. For instance, the “BRIC” countries – Brazil, Russia, India and China – are often grouped together. But given their respective risks and opportunities, it makes much more sense to invest in them separately, if at all. Given China’s growth (and opacity), even some emerging market index boosters have suggested that it makes sense to separate Asian markets from other emerging markets. This would, at least, reduce some of existing problems with the label.
If the definition and use of the term emerging market was purely a question of semantics, we could leave it to economists and academics. But for investors who want to meaningfully identify a fund or an asset class, it is past time to let this vague catch-all go.