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Can Emerging Markets continue their unexpected rally?
Despite trade wars and global headwinds, EM stocks are outperforming. But is it sustainable, or just a fleeting moment? Here's what investors need to know about the evolving landscape of emerging markets.
Beyond commodities, a new EM profile
For years, emerging markets were viewed as commodity-driven economies, highly susceptible to price swings. Yet, the MSCI Emerging Markets Index has gone through significant changes in recent years.
Energy and Materials, once 25% of the index in 2005, now make up only 10%. IT has surged from 17% to 24% over the same period. Include internet-related companies from Communication Services and Consumer Discretionary, and the tech and internet exposure jumps to a commanding 37%.
This means EM returns are far less dependent on the commodity cycle than they used to be, and this makes EM stocks more appealing for long-term investors.
EM's Unexpected Resilience
It's important to note that EM stocks have outperformed the S&P500 so far this year (which doesn’t happen often), by far - even with ongoing trade tensions, particularly those targeting China. A similar scenario unfolded in 2017 during a previous administration's trade policies.
A potential driver for this unexpected strength is low sentiment going into the year, coupled with stronger-than-anticipated global growth and a weaker US dollar.
China: Stimulus and Consumer Confidence
The EM universe is far from a single entity. Four countries dominate the MSCI EM Index, accounting for 76% of its weight as of last month: China (28.4%), Taiwan (18.9%), India (18.1%), and South Korea (10.7%). Each has distinct drivers.
China's economy benefited from companies pulling forward shipping to avoid future tariffs in the first half of 2025. If growth slows in the second half, expect fiscal stimulus. Ironically, more tariffs could lead to more stimulus.
Consumer confidence in China remains a major hurdle, stemming from the property market slowdown, slower income growth, and longer work hours. Reforms addressing childcare, pensions, healthcare, and property issues need to happen to significantly boost consumer confidence.
Taiwan: The Semiconductor Powerhouse
Taiwan's market is heavily concentrated in technology, and in just a single company (perhaps the most important company in the world), with Taiwan Semiconductor (TSMC) making up 54% of its index. Its performance is closely tied to global demand for semiconductors and advancements in AI, making them positioned very well for the future.
However, investors should be wary of geopolitical tensions - if China invades Taiwan, no one really knows what could happen to TSMC, but it won’t be pretty, nor will it be easily accepted by the US.
India: Domestic Drivers and Rate Cuts
In India, domestic consumption drives nearly 70% of its GDP, making it less reliant on global factors. After a six-month slump, lower interest rates and reduced inflation following the Reserve Bank of India's rate cuts could spur growth.
This renewed growth in India would directly benefit its Financials and Consumer Discretionary sectors, the two largest weights in the MSCI India Index.
South Korea: Tech and Corporate Reforms
South Korea's market also has significant tech exposure (40.8%). Like Taiwan, its performance is linked to global growth and the electronics industry. Critically, Corporate Value-Up reforms are improving corporate governance.
These reforms are already yielding results, with an increase in dividend payouts and stock buybacks, making Korean businesses more attractive to outside shareholders.
The Path Forward: Diversification and Dollar Weakness
Looking ahead, emerging markets could continue to thrive in 2025 if global growth reaccelerates, particularly in China and India, and if the US dollar continues its weakening trend. A weaker dollar translates to better returns for US investors that are investing in foreign markets, with foreign currencies.
A diversified portfolio of emerging market countries offers exposure to potential long-term, sustained economic growth and innovation. While volatility remains a factor, the evolving nature of EM suggests a measured allocation within a broader international stock portfolio can be a wise move, providing some much-needed diversification from US-only portfolios.