Emerging markets rise driven by the AI boom

The emerging market (EM) universe is very diverse in terms of what drives individual economies. What does China have in common with India (other than being populous and in Asia) or either of them with Brazil? Yet they are treated as a block, and recent trends are stretching these contradictions further than ever.

A top-down investing strategy often involves assigning things to groups, then buying the most compelling groups or choosing the most attractive within a group. These groups can seem arbitrary – the difference between members can be as big as the similarities. Yet in the investment business, classifications that seem easy to understand can stick around well past the point where they make sense.

Standard rules of thumb for emerging markets would tell you that the last few months have been difficult. Many emerging markets are energy importers, so will suffer from higher oil prices. Markets also tend to be affected by inflows and outflows from foreign investors. If global investors get more nervous, they would be expected to cut emerging-market exposure first and take their money home. Yet the MSCI Emerging Markets index is up by 20% in sterling so far this year. How?

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AI stocks are over-represented in emerging markets indices

The explanation hinges on two points. The first is that two of the biggest markets in the index are emerging markets only in one very specific sense. South Korea and Taiwan retain certain restrictions, mostly around their currencies, that MSCI deems incompatible with being in the developed markets group. Yet in many respects, they are both wealthier and more advanced than many developed economies.

The second is that a few huge companies – Taiwan Semiconductor (TSMC), Samsung Electronics, SK Hynix – are huge beneficiaries of the AI boom and are driving their markets even more than the Magnificent Seven drives the US market. Those three stocks account for almost 30% of the MSCI Emerging Markets index. Taiwan and Korea together make up 50% of the index. In turn, TSMC is 55% of the MSCI Taiwan, while Samsung Electronics and SK Hynix account for 60% of the MSCI Korea.

These are eyebrow-raising numbers. They have worked out very well for any broad emerging-market investor. Still, we must remember that if the AI boom ends and the US market slumps, the emerging market index will do the same – it's been a play on the same theme.

If you want diversification, you will only find it in funds whose mandate does not bring in these stocks – BlackRock Frontiers (LSE: BRFI) or Barings Emerging EMEA Opportunities (LSE: BEMO), for example. Of course, these funds have lagged in recent months, held back by the lack of tech exposure or battered by the Middle East crisis. I would not say it is yet time to rotate out of broader emerging market funds. But it is something to keep in mind if the crisis passes and the AI boom falters.

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