Emerging Markets - Higher Growth, Higher Risk
Emerging markets represent roughly 40% of global GDP and are home to over 85% of the world's population. The growth differential between emerging and developed economies has been a consistent feature of the global economy for decades. While the United States grows at 2-3% per year in real terms, China has averaged roughly 6% over the past decade, India roughly 7%, and Vietnam above 6%. Faster GDP growth translates into faster revenue growth for companies operating in these markets, which is the fundamental attraction. The MSCI Emerging Markets Index, which covers large and mid-cap stocks across 24 emerging market countries, has delivered long-term returns competitive with developed markets but with significantly higher volatility and deeper drawdowns.
The higher risk in emerging markets is not a vague abstraction. It manifests in specific, identifiable forms: currency crises, sovereign debt defaults, capital controls, political instability, regulatory unpredictability, corruption, and weaker rule of law. Between 1994 and 2024, emerging markets experienced the Mexican peso crisis (1994), the Asian financial crisis (1997), the Russian default (1998), the Argentine default (2001), the Turkish lira collapse (2018), and the Sri Lankan default (2022), among others. Each of these events wiped out 30-80% of equity market value in the affected countries within months. Investing in emerging markets without understanding these risks is speculating, not investing.
The Growth Story
The case for emerging market investing rests on demographics, urbanization, and convergence.
Demographics. Emerging markets have younger populations and faster labor force growth than developed economies. India's median age is approximately 28, compared to 38 in the U.S. and 49 in Japan. A growing working-age population expands the labor supply, increases consumption, and generates the domestic demand that drives GDP growth. Countries with favorable demographic profiles can sustain higher growth rates for decades because they have more workers entering the economy than retirees leaving it.
Urbanization. The shift from rural to urban living drives productivity gains as workers move from low-productivity agriculture to higher-productivity manufacturing and services. China's urbanization rate rose from roughly 26% in 1990 to over 65% by 2024, and each percentage point of urbanization contributed to GDP growth through increased productivity, infrastructure investment, and consumer spending. India, Southeast Asia, and Sub-Saharan Africa still have significant urbanization potential.
Convergence. The convergence hypothesis holds that poorer countries grow faster than richer ones because they can adopt technologies and practices already developed elsewhere, rather than inventing them from scratch. A developing country building out telecommunications can leapfrog to mobile technology without laying copper landlines. This catch-up growth has been the primary driver of the emerging market growth premium over the past 30 years.
The growth story is real, but it does not automatically translate into stock market returns. Between 2010 and 2020, the MSCI Emerging Markets Index returned approximately 3% annualized while the S&P 500 returned approximately 14%. Chinese GDP roughly doubled during this period, yet Chinese equities underperformed U.S. equities by a wide margin. The disconnect between economic growth and stock market returns is one of the most important lessons in emerging market investing.
Why Growth Does Not Equal Returns
Several factors explain why faster GDP growth does not guarantee better equity returns.
Dilution. When an emerging market economy grows, the growth may come from new companies going public, new share issuance, or government-directed investment in state-owned enterprises rather than from earnings growth at existing listed companies. If the economy grows 7% but listed companies issue new shares equal to 3% of market capitalization, per-share earnings growth for existing investors is only 4%. These concepts are explored further in the economics guide.
Valuation starting points. If emerging market growth expectations are already priced into high valuations, the actual growth may only justify those valuations rather than generating excess returns. In the late 2000s, MSCI Emerging Markets traded at a premium P/E to the S&P 500, pricing in the growth differential. When that premium evaporated, returns underperformed despite the growth materializing.
Governance and minority shareholder risk. In many emerging markets, controlling shareholders (often founding families, conglomerates, or governments) can extract value at the expense of minority investors through related-party transactions, dilutive capital raises, and opaque corporate structures. Earnings that appear strong on paper may not flow to public shareholders.
Regulatory risk. Government intervention in business operations, pricing, and capital allocation is more common in emerging markets. China's regulatory crackdown on technology companies in 2021, which wiped out more than $1 trillion in market value from companies like Alibaba, Tencent, and DiDi, demonstrated that state action can override business fundamentals overnight.
Currency Risk
Currency depreciation is one of the most consistent sources of return erosion for international investors in emerging markets. The MSCI Emerging Markets Index in local currency terms has consistently outperformed the same index in U.S. dollar terms, with the difference attributable to emerging market currencies weakening against the dollar over time.
The reasons for structural currency weakness are multiple. Higher inflation rates in emerging markets erode purchasing power relative to the dollar. Current account deficits require capital inflows that can reverse during risk-off episodes. Central banks in emerging markets often lack the credibility of the Fed or ECB, leading to higher inflation expectations and currency instability.
Currency crises are the most dramatic manifestation. When capital flees an emerging market (due to political crisis, debt concerns, or contagion), the local currency can depreciate 30-50% in a matter of weeks. The Argentine peso lost roughly 80% of its value against the dollar between 2018 and 2024 through a combination of inflation, default risk, and capital flight. For a U.S. investor holding Argentine equities, even a 100% gain in local currency terms would translate to a significant loss in dollar terms.
Hedging emerging market currency risk is expensive because interest rate differentials between emerging market currencies and the dollar are typically 3-8 percentage points. The cost of the hedge (which reflects this differential through forward points) can consume a significant portion of the expected return.
Political and Institutional Risk
The quality of institutions, the rule of law, property rights, and regulatory transparency all affect the risk-adjusted returns available to foreign investors. Markets with strong institutions (South Korea, Taiwan, Chile, Poland) tend to offer more predictable investment environments than markets with weaker institutions.
Political regime change can transform the investment landscape. The election of a market-friendly government can trigger a rally as investors anticipate deregulation, privatization, and improved fiscal discipline. The election of a populist or interventionist government can trigger a selloff as investors worry about nationalization, capital controls, or fiscal excess.
Capital controls represent the most direct political risk. If a government restricts the ability of foreign investors to withdraw their money, the investment becomes illiquid regardless of its fundamental value. Malaysia imposed capital controls during the Asian crisis. Argentina has maintained various forms of capital controls intermittently for decades. China's capital account is still partially closed, limiting the ability of foreign investors to freely move money in and out.
Emerging Markets in a Portfolio
The case for including emerging markets in a diversified portfolio rests on diversification benefits, long-term growth potential, and periodic valuation opportunities.
Diversification. Emerging market returns have historically had lower correlations with U.S. equity returns than developed international markets, though correlations rise during global crises. The diversification benefit is real during normal times but diminishes precisely when it would be most valuable.
Valuation. Emerging markets periodically trade at significant discounts to developed markets on P/E, price-to-book, and price-to-sales ratios. These discounts reflect real risks (currency, governance, political), but when the discounts become extreme, the risk premium more than compensates. The MSCI Emerging Markets P/E ratio at its lowest point during the 2022 selloff was roughly 9x forward earnings, compared to 17x for the S&P 500. Investors who bought at those valuations captured significant returns as the valuation gap partially closed.
Country and sector selection. Emerging markets are not a monolith. The investment case for Taiwan (semiconductor manufacturing dominance, strong rule of law, TSMC) is completely different from the case for Brazil (commodity exports, demographic challenges, political instability) or India (demographic dividend, digitalization, but bureaucratic friction). Country-specific analysis is more important than broad EM allocation.
Access vehicles. U.S. investors can access emerging markets through broad ETFs (VWO, IEMG, EEM), country-specific ETFs (EWZ for Brazil, EWY for South Korea, FXI for China, INDA for India), and American Depositary Receipts of individual companies. Each approach involves different levels of diversification, currency exposure, and expense.
The practical allocation to emerging markets for most U.S.-focused portfolios ranges from 5% to 15% of equity exposure. The lower end is appropriate for investors with low tolerance for volatility and currency risk. The higher end is appropriate for investors with long time horizons, comfort with drawdowns, and the willingness to analyze country-specific conditions.
Emerging markets reward patience, selectivity, and an understanding that the growth premium comes bundled with risks that do not exist in developed markets. Capturing the growth while managing the risks is the defining challenge of international equity investing.
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