Emerging market rally as much about fleeing the US as finding value

Is this the year emerging market stocks finally turned the corner? At the start of 2025, the MSCI Emerging Markets Index, the main gauge of equities in developing economies, was near the same level it was at in September 2010. The benchmark S&P 500 index, by contrast, was up almost 500 per cent.\nFor the past 15 years, emerging market shares have underperformed their developed market peers. This is one of the most striking disconnects between economic heft – developing countries’ share of global economic output increased from 25 per cent in 2000 to 45 per cent last year – and investment returns.\nHowever, emerging market equities have risen for 10 straight months this year, their longest winning streak since 2004, according to Bloomberg data. The MSCI Emerging Markets Index has gained 30 per cent, its best year since 2009. The MSCI World Index, on the other hand, which tracks stocks in advanced economies, is up about 19 per cent.\nIn Bank of America’s latest monthly global fund manager survey, a net 27 per cent of respondents said they had an overweight position on emerging market stocks, the most bullish stance among the world’s main equity markets.\nHowever, it is not just stock markets in developing economies that are performing well. Signs of resilience across the entire emerging market asset class abound. Last week, China issued three- and five-year dollar-denominated debt at essentially the same borrowing costs as the United States, while spreads on a JPMorgan index of US dollar-denominated emerging market sovereign bonds are at their lowest level since 2014.\nMoreover, local currency bonds have returned more than 16 per cent in dollar terms this year, while flows to emerging market bond and equity funds are on track to end the year in positive territory for the first time in four years.\n\nThere are several factors at play. First, the US dollar had its worst first half of the year since 1973 because of the turmoil unleashed by US President Donald Trump’s trade and economic policies. A weaker dollar is a boon to emerging markets, easing financial conditions by making it cheaper to service dollar-denominated debts.\nSecond, inflation in developing countries is rising at a slower pace than in developed economies. According to data from JPMorgan, the average headline rate of inflation in emerging markets in September stood at 2.3 per cent, compared with 2.8 per cent in advanced economies.\nThird, the worst of the uncertainty over tariffs has passed. While Trump could renew his trade offensive anytime, the cat is out of the bag. His repeated climbdowns have undermined his credibility. Moreover, governments have learned how to deal with Trump, helping ease trade tensions.\n\n\nFourth, technology-driven economies in Asia are benefiting from the rise of generative artificial intelligence (AI). The main index of Asian tech stocks, powered by Taiwanese and South Korean shares, gained almost 50 per cent in the first 10 months of this year, more than double the increase in the tech-heavy Nasdaq Composite Index.\nFifth, and most importantly, emerging market stocks are significantly under-owned by global investors following years of underperformance. This year’s inflows have conspicuously lagged the rally. “Even a small pullback in foreign ownership [of US stocks] could unleash trillions in potential outflows. A modest shift of these outflows into [emerging markets] could have a significant impact,” Eastspring Investments said in a report.\nHowever, it is early days for the rebound in emerging market assets. The US dollar is strengthening again as bets against it unravel. Since September 16, the dollar index has risen 3 per cent, mainly because “the market is saying the ‘Trump shock’ is over. What else is there for President Trump to do to shock the market? We are struggling to come up with an answer ourselves”, said George Saravelos of Deutsche Bank.\nFor all its political, institutional and fiscal problems, the US economy has proved more resilient than expected. This is mainly because the fallout from higher tariffs and the crackdown on immigration has been offset by the AI spending boom.\n\n\nIt is not just that Trump has been lucky, but also that the US remains the “cleanest dirty shirt”, benefiting from the dominance of the dollar and US Treasury bond market. Provided that mounting fears about a bubble in AI-driven stocks do not lead to a sharp and sustained sell-off, sentiment towards the dollar should continue to improve, putting more pressure on emerging markets.\nEmerging market stocks tend to perform well only when their developed market peers are rallying. This is partly why Asian tech stocks are vulnerable. The tech-led sell-off on Wall Street this month has focused attention on concentration risks in Asian equity markets.\nWhile the top five tech stocks account for more than 27 per cent of the value of the US equity market, Taiwan Semiconductor Manufacturing Company alone accounts for 40 per cent of Taiwan’s stock market while Samsung Electronics and SK Hynix together account for 40 per cent of South Korea’s equity market.\nMoreover, growth prospects in emerging markets are not what they used to be. This is partly because of the structural downturn in China, but also because of the acute economic and geopolitical challenges facing developing countries.\nFifteen years of underperformance have left their scars. Most global investors see this year’s rebound in asset prices in developing economies as a timely opportunity to diversify away from the US rather than the start of a multi-year period of outperformance. Talk of an emerging markets renaissance is premature.\n