International | 10:30 AM
Global market dynamics are changing, and to the potential benefit of Emerging Markets, reports Ernest Yeung, Portfolio Manager, Emerging Markets Discovery Equity Strategy at T. Rowe Price.
- Extreme dominance of US equities puts focus on alternatives
- Valuations in Emerging Markets remain relatively attractive
- Comparatively light investor positioning adds to EMs attaction
- US dollar weakening tends to benefit EMs
After a decade defined by US exceptionalism, the most important market signal today may not be a new technology trend or an election cycle, it may be the direction of capital itself.
Emerging markets (EM) have delivered a strong run over the past year. Initially, the rally appeared tactical: valuations were discounted, the US dollar softened, and investors sought opportunities beyond an increasingly concentrated US market.
But the narrative is evolving. What began as a rebound may be developing into something more structural, powered by capital flows, currency dynamics, and a macroeconomic cycle that increasingly favours parts of the developing world.
US equities now account for roughly two-thirds of global equity benchmarks, an extraordinary concentration.
When allocations are that skewed, even modest adjustments can have meaningful consequences. A one-percentage-point reallocation away from US equities can translate into a proportionally significant inflow into EM simply because the asset class is smaller.
What feels incremental in the US can feel amplified elsewhere, both in equity prices and currencies.
Dollar weakness over the past year has already encouraged investors to deploy capital outside the US, lifting Europe, Japan, and emerging markets. But Europe and Japan have enjoyed multi-year rallies and positioning there appears increasingly crowded.
Emerging markets, by contrast, have rallied for only about 12 months. Valuations remain relatively attractive and investor positioning is still comparatively light.
There is also growing unease, particularly among European and UK allocators, about concentration risk in US assets. This is not a wholesale retreat, but portfolio shifts often begin at the margin.
At the same time, US-based investors are responding to the same currency signal: when the dollar weakens, international assets become more attractive in home-currency terms. Different motivations may be leading to the same outcome, with capital gradually rotating outward.
If that rotation persists, EM could become a higher-beta beneficiary.
The structural case extends beyond flows. Since the pandemic, developed and emerging economies have followed different policy paths. Developed markets maintained fiscal support and accommodative monetary policy for longer, contributing to persistent inflation and limiting policy flexibility.
Many emerging markets, by contrast, tightened earlier and more aggressively.
Brazil’s policy rate, for example, reached the mid-teens. Several EM central banks acted decisively, bringing inflation under control sooner. As a result, much of the emerging world now has greater scope to ease policy if growth slows, flexibility that developed markets may lack.
If the Federal Reserve begins cutting rates, some EM central banks could ease more assertively, creating room for positive growth surprises.
Unlike previous cycles, when developed and emerging markets moved largely in sync, today’s trajectories appear increasingly distinct. Developed markets look late-cycle and inflation-constrained; parts of EM may be earlier in their recovery phase.
That divergence may strengthen the argument that this is more than a valuation trade.
Artificial intelligence (AI) remains the dominant global equity narrative, and some investors question whether rotating away from the US means giving up exposure to that theme.
In reality, EM offers differentiated participation. Taiwan and Korea, the two largest emerging equity markets, sit at the heart of the global semiconductor supply chain.
The current earnings impulse in AI hardware runs directly through these markets, where capacity tightness and pricing power have supported strong performance. In recent months, select Korean semiconductor names even outperformed headline US technology stocks.
China presents a more nuanced opportunity. While property and heavy industry remain under pressure, privately owned internet and technology platforms are building a ring-fenced domestic AI ecosystem.
Many are perceived to combine reasonable growth expectations with strong balance sheets and potentially meaningful shareholder returns through dividends and buybacks. Unlike segments of the US AI complex, where concerns about overinvestment and stretched valuations are rising, China’s domestic ecosystem operates under different competitive dynamics.
The broader point is that diversification into emerging markets does not require abandoning technology exposure; it simply changes its expression.
At the same time, selectivity is essential, particularly in China, where dispersion between sectors is wide. Outcomes vary meaningfully among state-owned enterprises, private technology firms, exporters, and domestic consumption franchises.
In such an environment, active management can materially influence results.
Beyond technology, structural global spending on defence, infrastructure resilience, and supply chain security is supporting commodity-linked emerging economies across Latin America, South Africa, and parts of Southeast Asia. These markets were overlooked for much of the past decade, but firmer commodity prices, improving fiscal discipline, and supportive currency trends appear to be rebuilding momentum.
Risks remain. A forceful resurgence in US growth that strengthens the dollar could slow or reverse capital flows. A sharp unwinding of the AI cycle would affect technology-heavy markets such as Taiwan and Korea. A broad global slowdown would weigh on export-oriented economies.
Trade policy is also worth monitoring, although many emerging markets have diversified supply chains in recent years, reducing vulnerability relative to prior cycles.
Ultimately, the direction of the US dollar remains the central variable. Emerging market cycles have historically turned on currency dynamics, and that remains true today.
The recent rally began as a tactical response to discounted valuations and early signs of dollar weakness. The structural case now rests on reinforcing pillars: capital rotating away from historically concentrated US allocations, a softer dollar supporting EM financial conditions, and macro as well as earnings divergence favouring select emerging economies.
There is also a simple portfolio-math reality at work. When one market dominates global benchmarks to an extraordinary degree, even modest rebalancing can have outsized effects elsewhere. Capital flows rarely shift dramatically at first.
They drift and then they compound.
For investors increasingly uneasy about concentration risk and late-cycle developed markets, emerging markets may represent more than a cyclical catch-up trade. They may signal a broader rebalancing of the global equity landscape.
If the dollar remains supportive and allocations continue to normalise, EM’s smaller size could magnify the impact. That combination of flows, valuation, and earnings breadth does not appear often.
When it does, it is usually worth considering.
Re-published with permission. Views expressed are not by association FNArena’s.
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