The case for emerging markets

US investors always face some macro challenges, and the current moment is no exception. Over the short-to-medium term, the US economy is contending with elevated inflation and heightened recession risk. Over the longer term, the impacts of high levels of federal debt, an aging population, and sluggish productivity gains¹ could weigh on growth potential.

These headwinds are no reason to throw in the towel on US stocks, which still make sense as a core portfolio position for many investors (learn more about creating an appropriate investment strategy). But challenges at home may make it all the more important for investors to maintain a broadly diversified portfolio, by considering non-US investments to provide potential growth.

A brighter growth outlook

One fertile hunting ground for long-term growth potential is emerging markets. Although past performance is no guarantee of future results, as a group these economies have generally grown at a faster pace over the past decade-plus than the US and other developed nations,² while providing some portfolio diversification benefits.

"Three percent GDP growth is high for the US, whereas many emerging markets have been growing faster than that," says Xiaoting Zhao, manager of the Fidelity^® Emerging Asia Fund (). For example, the US economy grew at an average annual pace, after inflation, of about 2.1% from 2015 to 2022, compared with an average annual pace of 3.9% for emerging and developing economies.³

Some populous emerging markets, such as India, Indonesia, and Brazil have continued to experience faster population growth than many developed economies, implying an expanding labor force to help support growth. Many of these economies still have substantial "catch-up potential"—the capacity for faster productivity gains and economic growth as living standards rise.⁴ And while exact estimates vary, emerging markets broadly—and economic powerhouses China and India in particular—are projected by some to account for higher proportions of total global economic output in coming years and decades.⁵

An increasingly diverse bunch

Emerging markets were never homogenous, but the differences seem to be widening.

"Emerging markets used to be mainly an urbanization, growing middle-class story—which is still true in India, Indonesia, and Vietnam," says Sam Polyak, co-manager of Fidelity^® Total Emerging Markets Fund (FTEMX). But now, he adds, the more developed markets like Taiwan, South Korea, and China are producing world-class technology products and services—with a level of innovation that arguably bests some more-developed economies.

Taiwan Semiconductor Manufacturing Co. (TSM) has been illustrative of this phenomenon. TSMC is the world's largest chip-making foundry, with a global market share of more than 50% and a lock on the most advanced chips, according to Zhao. The second largest foundry is Samsung Electronics Co., of South Korea, which is also the world's largest memory-chip producer and the biggest mobile-phone maker.

Zhao says that Korean and Taiwan manufacturers such as these have the twin advantages of a low-cost production base and proximity to large markets like China.

Rapidly moving upmarket

It may seem hard to believe, but China, with a population of more than 1.4 billion,⁶ has a shrinking labor force.⁷ This has led toward a focus on increased automation and a push into higher value-added industries.

"China doesn't have a demographic tailwind," says Polyak, "but it does have a lot of innovation, spending on research and development, technology, new products, and ecommerce, which helps to differentiate it from other emerging markets."

Two examples of internet giants in China are Tencent Holdings () and Meituan (). Tencent is the nation's largest company by market capitalization, with a market value of more than $400 billion as of June 2023. The company has a potent position in online businesses ranging from advertising and social media to fintech services and video games. Meituan is the country's dominant food-delivery company, and its app is also used for movie ticketing and restaurant booking.

Polyak says that "premiumization" of domestic Chinese brands has been another powerful theme. "Local brands have caught up in quality, technology, innovation, and marketing," and in some cases are taking market share from foreign manufacturers, he says.

Haier Smart Home (),⁸ which acquired GE Appliances in 2016, has illustrated this trend. The company is a world leader in the production of refrigerators, freezers, and washing machines. And its high-end home appliance brand, Casarte, leads the premium appliance industry in China currently, which Polyak says is expanding at a multiple of the country's overall large-appliance market.

Zhao cites Shenzhen Mindray Bio-Medical Electronics⁹ as an example of a domestic medical equipment maker that has dramatically improved product quality and now competes directly with old, established European and American suppliers—but with a much lower cost structure. Mindray, which invests about 10% of revenues on research and development,¹⁰ makes equipment such as endoscope cameras, ventilators, and ultrasound and defibrillation systems.

Strong tailwinds

Like China, India has a population of more than 1.4 billion.¹¹ But it is less economically developed than China, with a per-capita income that is just a fraction of that of its neighbor.¹² This changes the opportunity set of investments for India, which has been growing faster and has a much younger demographic profile.¹³

"I believe that India in the next 20 years could be in a sweet spot for growth and rising affluence that is very much like the last 20 years in China," says Zhao, who notes that India's per-capita gross domestic product (GDP) today is comparable to China's around the turn of the millennia, when the Chinese economy boomed.

India's infrastructure has received lower levels of investment than that of China, but therein lies a potential opportunity, says Polyak. For example, he estimates that India's cement and power consumption are only about 10% that of China, a situation that is likely to change as India grows more urbanized—a typical outcome of economic development.

Companies that provide infrastructure-related products and services could see a potential benefit from increases in infrastructure investment. For example, Larsen & Toubro (LTOUF)¹⁴ makes heavy machinery for construction, engineering, mining, and plant-building.

Not surprisingly, India's rapid economic growth has been swelling the ranks of the middle class with disposable income to spend. Zhao cites Zomato as an example of a domestic company that has benefited from rising consumer affluence. Zomato, the leading food-delivery company, operates across India connecting restaurants and delivery partners with a burgeoning number of customers.

Worth a look

To be sure, with greater growth potential can come greater risk. It's important to remember that foreign markets can be more volatile than US markets. And risks can be heightened in emerging markets, compared with developed markets. For that reason, it may make sense to keep exposures to emerging markets well diversified, and to place overall limits on their role in a portfolio.

But with growth outlooks somewhat subdued in the developed world, investors might be remiss to ignore the potential offered by emerging markets.