In this note, the Panama Savings Fund (“FAP” or “Fund”) explores what emerging markets are (hereinafter, “EM”), their potential value for investors and some of the most common ways to invest in they.

Key points of note:

  • EMs can have high long-term growth potential, so investments in EMs can be valuable within portfolios.

  • Investors can access investment in EMs through capital markets.

  • Investors should consider all the key aspects of investing in EMs before doing so.

1. What are Emerging Markets?

Investments in EM represent those asset classes (eg, bonds, stocks, etc.) issued by countries (and companies within them) that have a high potential for economic growth (measured by Gross Domestic Product or “GDP” ) or that are currently in full economic development. This economic growth is identified by high direct foreign investment, advances in industrialization, urbanization, strengthening of its regulatory bodies, fiscal transparency, and an ascending middle class. Despite the diversity among them, EMs share some of the following pillars to be classified as emerging.

  • High consumption potential;

  • Accelerated economic growth compared to developed countries (“G7”);

  • Per capita income below the world average;

  • Underdeveloped labor market;

  • Susceptibility to exchange risk of its currency, volatility of raw materials or external economic shock; Y

  • High sensitivity (volatility) due to political instability or natural disasters.

 According to the MSCI Stock Index, the top five (5) EMs are: Brazil, Russia, India, The People’s Republic of China (“PRC”) and South Africa.

2. Capital Flows to EMs

A widely used variable to measure investment capital flows to a foreign country is Foreign Direct Investment (“FDI”). In the particular case of EMs, this economic indicator has become relevant due to its impact on the acceleration of economic growth and globalization.

 Currently, the main FDI agents are multinational companies, which generally have the following motivations to invest in EMs: a) obtaining raw materials; b) low cost labor; c) mergers / acquisitions; d) access to consumer markets; e) diversification of investments; and f) potential returns.

 In practice, FDI to MS contributes to generating employment, increasing productivity, and transferring specialized and technological knowledge. FDI is therefore one of the main sources of financing for EMs.

 We can see how the FDI / Nominal GDP ratio of EMs increases from the 90s (Data 2). This phenomenon is closely related to the application of a set of reforms suggested by the International Monetary Fund to countries hit by the financial crisis in the 1980s. This package of measures involves the reduction of investment in the public sector and trade / financial liberalization.

Data 2: FDI / Nominal GDP ratio of EMs (2001-2019)

Also in Data 2, it can be observed that there is a negative correlation between the FDI / Nominal GDP ratio of EMs and the yield of US Treasury bonds with a maturity of 10 years (“Treasury10”). This means that, historically, EMs tend to receive more capital flows when interest rates are at low levels in the US; the cause of the search for higher returns by EM investors.

3. Investment in EMs

Here are some of the vehicles that investors generally use to invest in EMs:

A. Emerging Fixed Income (Bonds)

It groups together those debt issues that governments and corporations of EMs carry out to finance their regular operations and investment projects.

From the perspective of profitability opportunities, and despite the inherent volatility of EMs, fixed income markets (bonds) focused on EMs are attractive to investors from the point of view of the potential yields they offer and its power of diversification.

It is also important to highlight the liquidity component provided by market markers such as: insurers, pension funds, banks, private investors and family offices; that individually maintain a different degree of risk sensitivity (risk aversion).

An important fact is that, at the end of 2019, the PRC fixed income market amounted to USD 13.5 trillion, which led it to be categorized as the second largest fixed income market in the world, only after The USA.

Data 3: Fixed Income Market Size and GDP Ratio

The importance of RPC within the international fixed income markets is gaining more value every day. For this reason, in 2018, Bloomberg LP announced the incorporation of fixed income instruments denominated in Renminbi (“RMB”), the official currency of the PRC, within the Bloomberg Barclays Global Agg (“ Barcap ”) index . The Barcap is a benchmark widely used by institutional investors, including the FAP, for investments in diversified global fixed income.

A widely used indicator to measure the profitability potential of EM fixed income instruments through the spread / premium between the return that investors demand from US Treasuries (risk-free) and the return required from the bonds of any other country is called Sovereign Spread . The main indicator used to measure this spread / premium in relation to EM is the Emerging Market Bond Index (“ EMBI” ), which is calculated by the JP Morgan financial institution.

In financial markets, the EMBI is widely used as a variable to measure sovereign risk. This spread is expressed in basis points (“bps”). A measure of 100 bps means that the government would be paying one percentage point (1%) above the risk-free bond yield. Riskier bonds pay higher interest, therefore, the spread of these bonds relative to US Treasuries is higher. This implies that the higher return that a risky bond has is the compensation for having a greater probability of default (“ default” ).

Data 4: EM Sovereign Spread (EMBI)

In addition to the above, the lower the EMBI , the lower the country risk. In other words, the market perceives a lower probability of defaulting on its financial obligations with respect to sovereign debt. This indicator also takes as a reference the credit rating granted by rating agencies such as Standard & Poor’s , Moody’s or Fitch Rating .