With developed markets currently confronting rising debt, stubborn inflation and political uncertainty, investors have, almost by default, been forced to reconsider the notion of emerging market (EM) risk with a view to capitalising on the greater return prospects they’re now offering.
It’s not just EM equities that have been luring investors, with EM debt having also performed well over the past five years compared to their developed market peers.
It’s low debt and fast GDP growth that appear to be underpinning EM outperformance, with debt forecast to be 60% lower than developed markets in 2025, while emerging market bond yields are 70% higher.
Interestingly, the risks now being ascribed to developed markets coincide with stronger investment opportunities now evident across emerging markets.
This year, EMs have outperformed the U.S. with a one-year return of 21%, and the bulk of this performance has surprisingly occurred since the U.S. ‘Liberation Day’ tariff announcement on 2 April 2025.
Drivers of EM outperformance
In addition to geopolitical shifts, Stefan Magnusson, EM portfolio manager at fund manager, Orbis in Hong Kong, believes there have been two primary drivers for this outperformance.
One is the enhancements made by Korea to its corporate governance framework, while the other driver Magnusson points to is a move by Chinese investors away from property and savings into equities.
On a cyclically adjusted basis, U.S. shares on average trade at 34 times earnings, a near-record, while in contrast, shares in EMs trade at a 60% discount.
Given that they typically don’t look beyond the benchmark index and/or do not look too closely at valuations, Magnusson reminds investors that they may have largely overlooked this.
While EMs have outperformed world markets since the inception of the first benchmarks in 1988, over the last 15 years, they have underperformed the U.S. significantly as investors focused on the rise of the headline-grabbing mega-cap growth stocks, well-illustrated by the rise of the so-called ‘Magnificent Seven’.
But during this same period, Magnusson also reminds investors that EM countries have been transforming and becoming more self-reliant and more central to global growth.
Many have also become more fiscally disciplined and, in several cases, surpassing their developed market peers.
Developed markets mask underlying risks
What irks Magnusson is that while the evolving backdrop of global macro and geopolitical events presents challenges for all markets, much of the risk ends up being ascribed to EMs by default.
As a case in point, given that Taiwan manufactures a dominant portion of the world’s most advanced semiconductor chips, any disruption there would likely impact the Magnificent Seven stocks negatively.
However, such risks do not seem to be priced into these stocks.
While some developed countries, notably the U.S. under the Trump administration, are seeking to re-industrialise and onshore more of their manufacturing - to reduce exposure to geopolitical risk - many aspects of globalisation, such as the setup of existing supply chains into Asia and other EMs, are likely irreversible.
However, what’s not fully appreciated in the West is that while onshore manufacturing may reduce some geopolitical risk, it is also likely to be far less profitable for participants, while China and other EM are extremely competitive in many industries.
However, Magnusson suspects one country that may be the exception to this is Australia.
“With its geographic proximity to Asia and its close trading ties, it appears to have a more nuanced view about the opportunities in China, India, and Southeast Asia,” he notes.
“Many Australians know Asia well, which offers these investors an opportunity to uncover great prospects in markets that are situated on their doorstep.”
Be selective
Meantime, while he believes EMs are a rich hunting ground for uncovering mispriced long-term investment opportunities, Magnusson also warns investors that a passive approach to investing that overlooks business fundamentals - popularised by the rise of indexing - risks missing the alpha opportunity in EMs.
For disciplined investors, he believes EMs represent a rich hunting ground for uncovering mispriced long-term investment opportunities.
“From a diversification standpoint we would encourage investors to look deeper into emerging markets with the mindset that they could be an opportunity rather than a risk,” said Magnusson.
“Selective ownership of high-quality emerging market businesses trading on low valuations run by able and aligned owner-management with integrity could help improve portfolio resilience and potential long-term returns.”
