Emerging markets - a problem of definition

(AF4, FA7, LP2, RO2)

We all love to group things. Young children learn to put similar coloured blocks into stacks. Teenagers split off into cliques defined by music, sport or fashion. Even adults will often arrange their weekends (and sometimes their whole lives) around the sports team or political party that they support.

Grouping is helpful – it makes things easier to categorise and therefore think about. However, care is required. Sorting construction materials by colour, instead of tensile strength, might not be a useful approach to building bridges.

Of course, there are few fields that better exemplify our preference for grouping things than finance. The passive index industry, for example, exists solely to put assets that share certain characteristics into convenient buckets for investors to think about as a whole. As long as those common characteristics are the most important, for investment purposes, this approach makes sense. For the most part, finance gets it right, but there are a few obvious anomalies.

The collection of emerging markets is one of those anomalies, and it is one of the most important to try and understand – particularly given the recent events in Argentina and Turkey, as well as the global impact of a US-China trade war.

As a term, investors are at odds on what defines an ‘emerging’ market. Classification by GDP growth doesn’t work. That’s because although some emerging markets are currently growing faster than say, the United States, a whole bunch of others are not. So while China is growing at 6%, Brazil is barely at 2%. We also can’t use wealth per capita, because that puts resource-rich nations such as Qatar, Kuwait and the United Arab Emirates above a decent chunk of Western Europe. Using metrics such as current account deficit or debt to GDP tend to lead to similar problems – the UK would be an emerging market based on its deficit, and most countries in the world have a lower debt to GDP than Italy…

This problem of definition has led to a bizarre situation in which the composition of the group of ‘emerging markets’ changes depending on who you are talking to. Even the world’s two largest index providers can’t agree – MSCI treats South Korea as an emerging market, and it has a weight of around 14% in their emerging market index. Conversely, the London Stock Exchange Group (the parent company of FTSE Russell) defines South Korea as ‘developed’ and thus omits it from their emerging market index entirely.

In short, the term is just too broad and this is important from the investor’s viewpoint. The investment opportunities and corresponding risks in Russia are very different to those in China or Brazil or Turkey, and yet investors tend to view these markets as a homogenised group. As an asset class, emerging markets have experienced a summer sell-off based on crises in Argentina and Turkey (one is already on IMF life support, the other is very close), both of which have a domestic flavour.

Should a domestic political issue in Turkey change your view on India? Or China? Or Mexico even? There may be tangential impacts, given the nature of globalisation, but at a high level, large scale ramifications are unlikely. Grouping mentality, however, means that trouble in one emerging market leads to a view that there is trouble in all, and we end up with a situation where, as long as there is no systemic global crisis, lots of countries have seen their stock markets and currencies punished unfairly, because of their classification.

Another way to look at it is that a number of these markets seem a lot more attractive now than they did a few months ago. When thinking about emerging markets we like the definition used by Ian Bremmer, the founder of Eurasia Group (and one of 7IM’s independent research providers), which references "a country where politics matters at least as much as economics to the markets".

We accept that political risk is a function of emerging market investing – it is one of the reasons why the return profile is more attractive – but each country must be analysed on its individual merits. As long as we believe that the global economic expansion is going to continue, or that markets may grow due to their own domestic demographics, there are likely to be some decent opportunities for those willing to look beyond the group-think and focus on the investment fundamentals.

Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority and by the Jersey Financial Services Commission. Member of the London Stock Exchange. Registered office: 55 Bishopsgate, London EC2N 3AS. Registered in England and Wales No. OC378740.