The emerging market conundrum

The emerging market (EM) equities region has been a perennial underperformer for many years now.  

What’s been behind this, and could this situation be set to reverse?  

Matt Brennan, Head of Asset Allocation at Scottish Widows, discusses the current state of play.

Track record

Although EMs have performed better than developed markets (DMs) since India and China came to the fore as equity investment markets in the 1980s and 1990s, they have been struggling on a relative basis since the global financial crisis. Indeed, over the 18-year period from end-April 2007 to end-April 2025, the FTSE Emerging Index posted an annualised total return of around 6% compared with over 9% for the FTSE Developed Index.

US strength

Part of the reason for this relative underperformance has been the market dominance of the US. The US has seen its weighting balloon in global benchmarks, helped by the performance of its major technology and other growth stocks like the now well known ‘Magnificent 7’, which includes NVIDIA, Apple and Microsoft.  

But what else has been holding EMs back?

EM struggles

Looking back over the last five years, there have been several major factors negatively impacting EMs.  

Shares in China – which makes up the largest part of major EM indices, at over 30% – have been a drag. Regulatory clampdowns by Chinese authorities against its large technology businesses and education providers knocked the overall market. Additionally, the country has struggled with a real-estate crisis as a result of high levels of leverage taken on by property developers.

China also had particularly strict Covid lockdowns that held back trade from several large cities, including major ports, for weeks at a time. However, amid supportive government stimulus measures, China’s shares soared in the third quarter of 2024 and caught up on some lost ground.  

Looking more broadly, supply chain issues and robust bouts of US-dollar performance have also held back EM returns. A strong US dollar tends to hinder EMs, in part because it increases the cost of dollar debt repayments for EM borrowers and makes key commodities and raw materials – like crude oil and others that are traded in US dollars – more expensive. EMs are more volatile than more developed markets, and this may have put off many international investors in a period packed with regional and global issues, including high inflation, elevated interest rates and geopolitical crises.

Why EMs could return to the fore: growth dynamics

EM growth is one of the key attractions of the asset class. Overall, the gross domestic product (GDP) growth rate of larger EMs, which therefore have greater impact on the total growth rate of the region, have slowed somewhat. In China, annual growth targets, set by its government and typically achieved by its economy, have dipped from over 7% just over a decade ago, to around 5% now.

Yet, as a group, the pace of EM GDP growth has continued to solidly outpace that of DMs over the longer term, and as such, EMs represent an ever-larger component of the global economy. EMs now produce around 41% of the world’s total output (based on GDP at current prices and excluding adjustments for purchasing power parity).¹ Looking at short-term estimates, the International Monetary Fund (IMF) predicts EMs will have robustly faster GDP growth compared with DMs for this year and next. For example, it is forecasting EM growth of 3.9% in 2026 and just 1.5% for DMs.¹

Despite the growth and overall size of EM economies, together they have a weighting of only around 10% in major global benchmarks. To give an idea of the scale of this imbalance, the combined market capitalisation of the ten largest stocks globally, which are all US-based, is double the market capitalisation of the whole EM region, as at the end of April 2025. It is worth remembering that by holding other markets, investors are potentially gaining strong indirect EM exposure.

Companies in, for example, the UK and Europe, particularly in sectors like luxury goods, food producers and autos, often have high sales and operational exposure to EMs, helping to drive their sales and profits. And overall, the sales exposure to EMs across other markets sits at around 20%.  

We believe this EM GDP growth outperformance is likely to continue over the longer term. Simply put, this will lead to expanding sales and profits for its companies and higher relative returns for EM equities in the long run, enabling them to develop into a larger component of global benchmarks.

Other EM attractions

As well as growth, there are other long-term attractions to investing in EMs, including access to dynamic, world-leading businesses across a range of industries. EM companies and governments tend to be less indebted than many of their DM counterparts. For example, EMs had a government debt to GDP ratio of almost 74% of GDP, versus 110% for advanced economies.²

EMs also have more favourable long-term population dynamics, with younger populations and ongoing growth in consumer wealth and demand. Despite the risks from lower levels of oversight, the long-term trend has been for improved regulation and stronger shareholder protection policies in EMs, which should help their standing in global benchmarks in the coming decades. EMs can also often present valuation opportunities. For example, EM dividend yields – an important component of total return – outstrip the overall dividend yields available from DMs, because DM yields are diluted by lower US dividends.

The current environment

We believe that EM equities are an important cornerstone of equity allocations and should help improve risk-adjusted returns as part of a diversified portfolio of assets. However, while the long-term opportunity presented by EMs is a strong draw, now is not necessarily the right time to express longer-term optimism with more positive, above-benchmark allocation, in our view.

The recent trade tariff announcements from the US administration were, on the face of it, a substantial challenge for EMs and global trade more broadly. So far, aside from initial volatility, these have not been too damaging for EM performance, not least given implementation delays. But we believe caution towards EMs is warranted for now as uncertainty persists, and speculation and any new tariff-related announcements could have a negative impact on equity and currency market volatility could also have a negative impact.

* All index data are shown in total return sterling.
Source: Financial Express. 

References:  

1. International Monetary Fund. 2025. World Economic Outlook: A Critical Juncture amid Policy Shifts. Washington, DC. April. 
2. IMF, DataMapper, April 2025.