Emerging Markets stocks rally: here’s what’s behind it

Emerging Market (EM) equities have been a strong performer over the past six months (see chart below), so it’s worth taking a moment to assess what’s driving this trend.

In terms of valuations, Emerging Market equities have seen a pretty sharp re-rating over the past couple of quarters (see chart of the forward Price/Earnings ratio over time, which compares share prices to expected future earnings) as optimism on China and Emerging Market technology companies has risen. 

If we compare the valuation of Emerging Market equities to European equities, we see a similar re-rating, but Emerging Market equities are still cheaper than European equities on this metric.

Earnings and returns stay on track

Moving from valuations to current earnings, we can see that EM has held up pretty well. The chart below shows expected 2025 earnings growth for the US, Europe and Emerging Markets and how those expectations have changed over the past eighteen months. As we’ve noted before, expectations for European earnings growth for this year have fallen sharply, while expectations for the US and Emerging Markets have generally held up.

Turning to returns, we can see that EM stacks up reasonably well. The chart below shows the Return on Equity (ROE), which measures how much profit companies make for each unit of shareholders’ capital, for the US, Europe and Emerging Markets. As we’ve noted before, returns in the US have consistently exceeded the rest of the world, and we think that partly explains the higher valuations that investors are prepared to pay for US equities. But we also see that EM has usually generated a higher ROE than Europe and that’s currently the case today.

An outlier compared to history

So, when we compare Emerging Markets to Europe we still see stronger earnings growth, higher return on equity and cheaper valuations, perhaps partly reflecting political and geopolitical risk. All else equal, however, that should be a recipe for outperformance.

But looking back a little further, that hasn’t really been the case. The chart below shows the returns for various equity ETFs going back ten years. On these numbers, EM has performed slightly worse than Europe, while both have been dwarfed by the returns coming from the US. 

We think earnings explains at least part of the answer. Earnings from EM companies have generally lagged behind their global peers. The chart below shows trailing earnings over the past decade for a range of markets (US, UK, Europe and EM), with Emerging Markets firmly at the bottom. It seems that the relatively stronger earnings growth we’ve seen from Emerging Markets this year has been a bit of an outlier compared to history.

As you might guess, the performance of EM stocks is roughly (but not precisely) correlated with EM corporate earnings, as the chart below shows.

The Achilles’ heel of Emerging Markets

So where does that get us? We think the case for EM equities remains pretty solid. Decent earnings growth, reasonable valuations compared to some other equity markets (albeit higher than a year ago) and consistent profitability. 

In the past, earnings have been the Achilles’ heel of Emerging Markets, consistently lagging behind their global peers.

The outlook now may be a bit more optimistic, given improving signs on profitability in China, a decent macro environment in emerging markets generally, and a robust outlook for tech spending that should benefit a number of companies in Taiwan and Korea. 

But that’s an important assumption and one that we’ll continue to monitor. We continue to hold Emerging Market equities in most of our medium- to high-risk model portfolios.