Emerging markets offer compelling long-term return potential, but continue to present risks that every investor should understand. NORIKO KUROKI, of the emerging markets equity team at J.P. Morgan Asset Management, discusses the risks inherent in emerging markets and looks at the effect they have had on economic and investment performance.

There are two macroeconomic trends – globalisation and urbanisation – which mean that, for long-term investors who are aware of the risks, there is considerable reason for optimism about emerging markets. The fundamentals driving emerging market equities First, it is worth restating the two fundamentals driving the development of the emerging markets asset class. The first is the rebalancing of the world economy from the extreme concentration of economic power typified by the creation of the G7 (the group of seven industrialised nations) in 1976, which meant that by the end of the Cold War in the early 1990s the developed world of North America, western Europe, Japan and Australasia, about 12 per cent of the world’s population, represented 77 per cent of global GDP. It is this extreme degree of economic imbalance that is unusual, not the more balanced world we are moving back towards (see Exhibit 1). The second key driver is urbanisation – the continuing move of population from the countryside to cities–which drives both productivity and consumption. About 50 per cent of the world’s 6.8 billion people currently live in urban areas. However, more than 95 per cent of the population of developed countries is already in urban areas. In consequence, close to 100 per cent of the productivity and consumption growth derived from urbanisation lies in the emerging world, sustaining faster economic growth.

Strategic risks to monitor Having described the key positive drivers, the risks should be examined, and specifically at why many of the emerging nations of 100 years ago are still emerging today. There are two key reasons: revolution (or political upheaval) and inflation. Exhibit 2 lists the 10 largest emerging markets and highlights their experience with these two destructive phenomena. The economic consequences of political revolution are clear, with the Russian and Chinese examples of the 20th century not requiring further elaboration. Many countries in the emerging world have witnessed less well-known but equally damaging political upheavals, which make political and legal institutions less reliable and predictable than in the developed world. The impact of inflation is less obvious but more pernicious in preventing development and especially in perpetuating poverty. Over the last 100 years, Brazil has grown on average at 4.9 per cent in real terms. This is considerably better than the US, which grew at 3.5 per cent over the same period. However, Brazil remains an emerging market, while the US is the world’s leading economy. Unlike most of the top 10 emerging market countries, Brazil, despite periods of military rule, has not suffered from political revolutions, partition or war. Consequently, it should be a candidate for graduation from emerging to developed status. The reason that Brazil has not emerged is inflation.

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