Can the rally last? The shift away from the US has helped emerging markets
At a time like this, there are two clear things to say about emerging markets. For one thing, it has long felt absurd to think of emerging markets as a single investment category. The developed market universe is already sufficiently diverse, whereas the emerging market universe encompasses a vast array of economies that share virtually nothing in common. Another is that, notwithstanding the aforementioned argument, one principle remains true: emerging markets are far more likely to rise when the US dollar declines.
This year, we have witnessed the same pattern unfold once more. In terms of US dollars, the MSCI USA has increased by roughly 7% since the start of January, while the MSCI Emerging Markets has increased by nearly 16%. The index has increased by nearly 13 percent in local currency terms, but currency fluctuations are not the only factor at play here. Not all developing markets are doing well, though. India is a very weak nation. The majority of Southeast Asia is also. The share market on the Chinese mainland is not very impressive. Nevertheless, shares listed in Hong Kong, Korea, Eastern Europe, and the majority of Latin America and the Middle East (apart from Saudi Arabia) have all performed fairly well.
Will new markets perform better than others?
The correlation between stronger emerging markets and a declining dollar can be explained naturally by capital flows. Money is leaving US assets (or at least not entering them anymore) and moving abroad, which is why the dollar is depreciating. This money is not only going to emerging markets; economies without sizable domestic institutional investor pools are particularly vulnerable to foreign flows, so even minor changes can have a significant impact.
Therefore, the question is whether this brief rally has the potential to develop into a longer-term bull market. Certainly, with a forward price/earnings ratio of roughly 13, the MSCI Emerging Markets looks cheap. Ten years ago, the difference between this and the USA (on a forward p/e of about 23) was much smaller. The warning here is that, at the time (when the forward p/e was around 11), emerging markets appeared even more affordable. However, even though emerging economies grew faster (on average) than developed economies, the subsequent returns were disappointing, partly due to weak earnings growth.
Emerging markets for MSCI.
This must be changed in order for the rally to proceed, and there are indications that it might. Last year, the MSCI Emerging Markets' earnings per share increased by 10%, and JP Morgan predicts that this year's earnings will accelerate even more to 17% (though forecasts should be viewed as even more uncertain than usual given the current climate). If this is the case, it should become a positive feedback loop whereby improved performance in emerging markets stimulates increased investment, spending, and growth. It should be noted that despite their impressive start to 2025, emerging markets have historically underperformed European markets. Given the extreme pessimism regarding Europe, that seems normal at this point. However, they should eventually outperform if the rotation away from the US continues.
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