Emerging markets must deliver growth

There are two obvious points to make about emerging markets at a time like this. One is that the idea of emerging markets as a single type of investment feels nonsensical and has done for a long time. The emerging-market universe covers a huge range of economies that have far less in common than the developed-market universe, which is already diverse enough. The other is that – regardless of the above argument – one rule still holds: when the US dollar goes down, emerging markets are much more likely to go up.

We have seen the same pattern playing out again this year. The MSCI USA is up by about 7% since the beginning of January, while the MSCI Emerging Markets is up by almost 16% in US dollar terms. Currency moves play a part here, but they are not the whole story: the index is up by almost 13% in local currency terms. This does not mean that every emerging market is doing well. India is notably weak. So is most of Southeast Asia. The mainland China A share market is unimpressive. Still, Hong Kong-listed shares, Korea, Eastern Europe, most of Latin America and the Middle East (excluding Saudi Arabia) have all been fair to outstanding.

Will emerging markets outperform others?

The natural explanation for why a weaker dollar and stronger emerging markets go together is down to capital flows. The dollar is weaker because money is flowing out of US assets (or at least no longer flowing into them) and instead going elsewhere. That money is not only heading into emerging markets, but economies that do not have deep pools of domestic institutional investors are very sensitive to foreign flows and so small shifts can make quite a difference.

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The question then is whether this short-term rally can turn into a longer-term bull market. Certainly, the MSCI Emerging Markets looks cheap on a forward price/earnings ratio of about 13. The differential between this and the USA (on a forward p/e of around 23) is far wider than it was a decade ago. The caveat here is that emerging markets looked even cheaper back then (when the forward p/e was about 11). Yet subsequent returns were disappointing, which was in part because earnings growth was weak, though emerging economies grew faster (on average) than developed economies.

This will need to change for the rally to run – and there are signs that it may. Earnings per share for the MSCI Emerging Markets rose 10% last year and JP Morgan forecasts are for a further acceleration to 17% this year (although in this environment, forecasts should be treated as even more uncertain than usual). If so, this should turn into a virtuous circle: better results from emerging markets encourage more investment, more spending and lead to more growth. Note too that even though emerging markets have had a strong 2025 so far, they have actually lagged behind European markets. That feels natural at this stage, since pessimism about Europe has been extreme. However, if the rotation away from the US continues, one would expect them to ultimately outperform.

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