2025 – The Emerging Markets Investor

2Q2025 Emerging Markets Expected Returns

Emerging markets stocks outperformed the S&P 500 in the second quarter and first half of 2025 in a rare show of strength. China and Latin America led the way, while India sputtered.

Over the past year and decade, EM has underperformed the S&P 500 in a persistent and dramatic manner. Over the past 10 years, EM stocks have returned 4.8% annually in USD terms, compared to 13% for the S&P 500. Of the larger markets significant to EM investors, only India and Taiwan have delivered attractive returns.

The recent strength in international and emerging markets can be explained by hopes that a shift is occurring in the relative strength of growth away from the U.S. This has led to some dollar weakness and triggered capital flows out of U.S. assets, raising tentative concerns that a long period of U.S. “exceptionalism” may be faltering.

The strength of the S&P 500 over the past decade can be attributed largely to two factors: first, a remarkable decade-long expansion in profit margins, of which about 60% was driven by lower interest rates and globalization—two trends now clearly in reverse; and second, an expansion of earnings multiples, which has brought valuations to extremely high levels by most measures.

The valuation premium of the S&P 500 over the MSCI EM Index closed the quarter at elevated levels, surpassed only by the 2016–2018 and 1998–1999 periods. The rising valuation premium over the past three decades may reflect the U.S. market’s transition from being dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets—except briefly in China, until Chairman Xi curtailed the tech sector to “safeguard social harmony.” However, the valuation premium may have peaked and started to trend downward, as America’s tech titans have reached very high valuations and may face lower profitability in the future due to heavy investment in the highly capital-intensive and competitive AI sector.

The extraordinary profitability of America’s tech titans over the past decade drove profit margins and earnings to record levels. Meanwhile, many other companies in the U.S. and abroad have experienced a prolonged earnings depression. For example, as shown below, MSCI EM earnings in nominal dollar terms have not increased in about 15 years.

The chart below estimates the current expected returns for emerging markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity more recently through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted according to each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (April 2025).

As logic dictates, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns rely on two key assumptions: first, that current CAPE levels relative to historical averages are unjustified; and second, that over time, market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not over the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its current growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios. The same may be true for the Philippines.

The following chart shows MSCI EM country returns for the past 12 months in relation to the markets with the highest seven-year expected returns as of mid-2024. Among the markets with high long-term expected returns, Colombia, Chile, Peru, Brazil, and the Philippines currently exhibit strong momentum characteristics. The chart demonstrates that the CAPE ratio was not particularly predictive of performance over this one-year period, as is frequently the case. Over one- to three-year time frames, momentum, narrative, liquidity, and cyclical conditions have a much greater impact on performance than long-term valuation parameters. Nonetheless, when “cheap” markets on a CAPE basis show short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling.

Looking ahead, Chile, Colombia, Peru, and the Philippines may be well-positioned to perform over the next year, as they offer both attractive valuations and positive momentum, and are in the early to middle phases of their business cycles. Chile has the added attraction of an upcoming election, which may result in a more business-friendly administration. However, rising geopolitical tensions and sluggish global growth create an unfavorable investment environment. A continuation of U.S. dollar weakness could result in sustained capital outflows from U.S. assets, which would be beneficial for EM stocks.

Recovering America’s Control Over Naval Logistics: The Case of ZPMC

For decades, U.S. corporations have offshored manufacturing to take advantage of cheap labor, government subsidies, and lax environmental regulations, enabling them to build global value chains that maximized profits. Concurrently, China—through strategic planning and government support—methodically achieved global supremacy in a wide variety of manufacturing industries of strategic economic and military importance. Today, as the two countries find themselves in a “cold war” relationship, U.S. dependence on China for critical imports has caused alarm in Washington. The collapse of the port crane industry is illustrative of how the U.S. ceded a major strategic industry to China—and now deeply regrets it.

The United States emerged from World War II as the undisputed global manufacturing hegemon, particularly in military equipment and logistics. In the case of shipbuilding and port cranes, the U.S. maintained its dominance through the 1970s. However, in the 1980s, “Reaganomics” and its aversion to government intervention to support “inefficient” U.S. firms took hold. In 1981, President Reagan terminated construction differential subsidies (CDS) for the U.S. shipbuilding industry—measures that had enabled American shipyards to compete with foreign counterparts. The consequences were stark: by the end of the decade, the U.S. commercial shipbuilding sector had virtually collapsed. Heavily subsidized competition from Japan in the 1970s, South Korea in the 1980s, and China starting in the 1990s undermined the economics of shipbuilding in the U.S. Today, these Asian nations collectively dominate the global shipbuilding landscape, accounting for over 90–95% of new commercial vessel construction. In contrast, the U.S. share of the global commercial market hovers around 0.1%. Without the network effects, scale economies, and skill-building capacity provided by a robust commercial shipbuilding base, U.S. military naval shipbuilding capability has also been severely compromised.

A similar decline occurred in the port crane manufacturing sector—a key component of transportation logistics with significant military relevance. U.S. firms dominated port crane technology and markets throughout the postwar decades, but by the early 1980s they were facing strong competitive pressure from Japanese and Korean firms. One by one, American companies either went out of business or were absorbed by foreign competitors, so that by the early 1990s, the industry was controlled by Asian firms.

The Chinese firm Shanghai Zhenhua Heavy Industries Company (ZPMC), established in 1992 with an aggressive international focus, quickly won contracts with major ports including Vancouver, Oakland, Miami, Houston, Long Beach, and Los Angeles. By the mid-2000s, ZPMC had secured over half of the global market for quay ship-to-shore cranes. Over the past twenty years, ZPMC has captured more than 70% of the global market and 80% of the U.S. market. Including other Chinese port crane manufacturers, China’s global market share is estimated at approximately 80%, with the remainder held by Japanese, Korean, and a few highly specialized European firms.

ZPMC is a formidable global competitor and has only grown stronger as it has achieved greater scale and technological expertise. It routinely outbids competitors on price, delivery time, and customization—often pricing at less than half the cost of rivals and offering significantly faster delivery.

ZPMC is a major state-owned enterprise in China, directly overseen by the Assets Supervision and Administration Commission (SASAC). Numerous U.S. officials, intelligence agencies, and congressional committees have expressed serious concerns about ZPMC’s ties to the Chinese military.

The company benefits from extensive state support. In addition to its close collaboration with the Chinese military, it receives substantial tax breaks, subsidies, and access to cheap credit from government funds and state-owned banks.

Despite its commanding market share both globally and within China, ZPMC delivers poor financial performance. Over the past 15 years, revenues have nearly doubled, but earnings have not kept pace. The company has maintained a net profit margin of only around 2%. Its return on equity (ROE), despite a highly leveraged balance sheet, has averaged just 3% over the past nine years—a level of profitability unacceptable to private enterprises in Western markets.

As is common for most state-owned companies listed on Chinese stock exchanges, ZPMC’s stock has languished.

Today, the global port crane industry is dominated by a company that functions as both a ward and an instrument of the Chinese state and is a major beneficiary of comprehensive financial and regulatory support. As the political mood in Washington shifts, the absurdity of this situation has become increasingly apparent. Policymakers are now coming full circle—proposing steep tariffs of up to 100% and financial support for alternative suppliers, similar to those eliminated by Reagan in 1981.

The End of the Global Debt Cycle and the Return of Financial Repression

The world economy has experienced a long debt cycle under the fiat, dollar-centric monetary system in place since 1971. The process of debt accumulation was slowed by the Great Financial Crisis of 2007–2008 but then resumed its upward path, propped up by deflationary forces, Federal Reserve intervention, and financial repression policies. However, recent market trends point to limits to further debt accumulation.

Since President Nixon severed the link between the U.S. dollar and gold in August 1971, the dollar has depreciated by 98% relative to gold and by 87% in purchasing power. Nevertheless, beginning in the late 1970s with the Volcker Fed, a new phase of monetary stability was achieved, and the “great financialization” of the neoliberal revolution began, fueled by a multi-decade-long decline in interest rates.

The chart below, from the IMF’s Global Debt Monitor, shows the evolution of world debt levels in the post–World War II period. From 1950 to 1980, the world debt-to-GDP ratio increased at a tepid pace—from 97% to 108%. From 1980 to 2000, during the heyday of dollar hegemony and monetary stability, global debt ratios soared, reaching 195%. Since 2000, debt levels have continued to rise, though at a slower and more uneven pace, reaching 250% of GDP in 2020.

The Bank for International Settlements (BIS) provides another, more granular, source for global and country debt levels. The BIS’s total world sample for 2001–2024 is shown below. World debt-to-GDP levels peaked near 300% in 2020 and stood at 250% in September 2024.

The chart below shows the persistent rise in the U.S. debt-to-GDP ratio from 1980 to 2011, broken down by government, households, and corporations. Total U.S. debt-to-GDP rose from 130% in 1980 to 255%, while the government’s share increased from 32% to 103%.

Following the GFC, U.S. debt levels stabilized at around 250% of GDP, as private debt from households and corporations was offset by rising government debt. This was a long period marked by deflationary tendencies: first, declining oil and commodity prices; second, a strong dollar; third, an influx of cheap immigrant labor; and last but not least, a flood of imports from Asia, primarily China. This deflationary environment, enhanced by financial repression (negative real interest rates, yield curve control and quantitative easing), facilitated large fiscal deficits. Over the 12-year period from 2011 to August 2023, real annualized rates on 2-year Treasury bonds were low to negative, averaging –1.4%. During the four years of the Biden administration, annual fiscal deficits averaged over 8% of GDP, enabled by persistently negative real rates, which reached as low as –6% in 2022.

As the chart below shows, the world has changed since 2022, when 10-year Treasury yields rose from 1.5% to over 4%. Since August 2023, interest rates have again turned positive on 2-year Treasuries. With the “free lunch” of financial repression over, the rising cost of financing the debt has raised alarms in Washington and financial markets over the sustainability of fiscal deficits. Interest payments on the national debt increased by $251 billion in 2024 to $1.12 trillion—well above defense spending—and are expected to rise further as debt is refinanced at higher rates. Both Fed Chair Jerome Powell and the Congressional Budget Office (CBO) have warned that the U.S. is on an “unsustainable fiscal path.”

The dilemma faced by the United States is shared by several other countries that also benefited from financial repression in recent years but must now adapt to higher interest rates.

For example, the UK successfully reduced its government debt-to-GDP ratio from 140% to 89% between 2021 and 2024. However, its 10-year Treasury borrowing rate has now risen to 4.5%, compared to near zero in 2020.

Japan, the champion of financial repression, has seen its 10-year Treasury yield rise from –0.5% to +1.5% since 2020, increasing the cost of financing its enormous government debt.

Brazil is another country facing a significant challenge. It enjoyed a period of negative real interest rates in 2020–2022, which helped reduce debt ratios. However, real rates near 10% have returned with a vengeance, and debt is rising again. Fiscal deficits are expected to remain very high in the coming years (in the order of 7–8%, according to IMF forecasts), while GDP growth remains low. Brazil is experiencing “fiscal dominance,” a condition in which monetary policy is constrained by the growing weight of interest expenses on fiscal expenditures. The last time Brazil experienced a surge in debt levels (1998–2002), it was able to reduce them thanks to a fortuitous economic shock brought about by the China-fueled super-commodity cycle (2002–2012). The chart below shows how the combination of strong economic growth, capital inflows, and currency appreciation reduced debt levels during this period. Unfortunately, a repeat of these circumstances is unlikely. It is far more probable that Brazil will have to resort to yield curve control measures and higher inflation to bring debt levels under control.

Turkey is a recent example of a country that has successfully deleveraged through financial repression. The latest IMF Staff Report on Turkey outlines the measures adopted: monetary expansion to inflate prices; suppression of government bond yields to artificially low levels; interest rate caps on loans; mandated holdings of government bonds at below-market rates; limits on offshore swaps; and export surrender requirements (i.e., capital flow management measures). The result of these anti-market policies of financial repression has been a significant reduction in debt ratios, creating the conditions for an eventual new credit cycle.

China stands out for its continued rapid debt accumulation in recent years. While much of the world successfully implemented financial repression policies during the pandemic years, China faced a deflationary environment caused by a collapse in real estate prices and an oversupply of manufactured goods. According to the BIS, the total debt-to-GDP ratio is approaching 300%—a figure that would be considerably higher if Chinese GDP were measured in line with Western standards. China appears to be following the path of Japan—growing government debt and exports to compensate for weak domestic demand—a model that will likely cause rising trade tensions.

The chart below shows BIS debt data on most of the world’s prominent economies.

Countries highlighted in red are those that have accumulated debt quickly to excessive levels, either at the government level or across the entire non-bank sector (government, households, and corporations) and are expected to see further increases in debt-to-GDP ratios over the next five years (according to IMF estimates).

Countries in black may have experienced rapid debt accumulation but still have the capacity to increase debt and are not expected to run large fiscal deficits in the future.

Countries in green have accumulated debt at a moderate pace and still have room to increase debt ratios.

The first two columns show the increase in debt ratios over the past ten years; the next two columns show debt ratio levels as of Q3 2024; and the final column shows IMF estimates of the annual increase in government debt ratios over the next five years.

China, Brazil, Japan, France, and the United States are the countries with the most concerning public sector debt dynamics and are, therefore, the most likely to engage in financial repression.

Mexico, Indonesia, Germany, Poland, and Turkey have sound debt dynamics and are less likely to resort to financial repression.

The United States and the United Kingdom have both successfully used financial repression to stabilize debt ratios. However, they still have high debt levels that are expected to increase in the coming years. As the chart from Lynn Alden (https://www.lynalden.com/) shows, the United States has largely repeated the path it followed between 1920 and 1950. That period was followed by a long phase of high growth and low deficits, which significantly lowered debt ratios. Today, optimists foresee a tech-driven productivity boom that could lead to a similar outcome over the next decade. Pessimists, however, point to poor demographics, disappointing productivity trends over the past twenty years, and rising obligations for defense, healthcare, and social security, all of which suggest a much bleaker outlook.

A New Cycle for International Markets

American stocks have experienced a stratospheric rise since the Great Financial Crisis, while foreign stocks have languished. This long period of “American Exceptionalism” was marked by enormous inflows of foreign capital into the U.S., which boosted the value of the dollar and U.S. assets to altitudinous levels. However, recent political shifts and new market trends point to a tidal change that could lead to a sustained reversion in U.S. asset prices and a relative outperformance of international assets.

In recent American financial history, periods of “American Exceptionalism” have been followed by bouts of “American Malaise.” These cycles—from euphoria to despair and back—are typically marked by the relative GDP growth of the United States compared to the global economy. During periods of American Exceptionalism, strong U.S. GDP growth relative to the global economy is usually driven by political and technological trends. Conversely, during periods of American Malaise, relatively weak U.S. growth is typically driven by a reversion of previous trends and by the rise of foreign economic powers, such as Germany in the 1970s, Japan in the 1980s, and China and emerging markets in the 2000s. Importantly, these cycles have significant effects on monetary flows, currency valuations, and asset prices. During periods of American Exceptionalism, capital is attracted to the United States, driving up the value of the dollar and U.S. asset prices. During periods of American Malaise, capital flows out of the U.S. into foreign markets, driving their currencies and markets higher.

Since the mid-1960s—a period that includes the turbulence of the final years of the Bretton Woods dollar/gold fixed exchange rate system and over five decades of a U.S. dollar-centric fiat currency global monetary system—the U.S. has experienced three full cycles of sentiment, moving from pessimism to exuberance and back. Conveniently, these cycles can be marked by the rise and fall of the dollar in a fiat currency system such as the one we’ve had since 1971. The chart below highlights these four phases:

Cycle 1

American Malaise (1966–1980)
By the mid-1960s, both Europe and Japan had recovered from World War II, and the U.S. began to run current account deficits, leading some countries—such as France—to decry the “exorbitant privilege” enjoyed by the U.S. and to repatriate gold. This led President Nixon to end the convertibility of the dollar to gold in 1971, breaking the Bretton Woods system established in 1944. The collapse of the dollar and the stagflation of the 1970s ensued. This period of American Malaise was marked by the rise of Germany as an economic power and the embrace of the Deutsche Mark and gold as alternative “safe haven” assets. In 1979, President Carter’s famous “Malaise Speech” expressed a general feeling of national frustration and pessimism following Vietnam, Watergate, and the Iranian Revolution. He warned that “the erosion of our confidence in the future is threatening to destroy the social and political fabric of America.”

American Exceptionalism (1979–1986)
President Reagan (1981–89) embodied American Exceptionalism with his “Morning in America” rhetoric and his vision of America as a “shining city on a hill,” a moral lighthouse to inspire the world. An extremely hawkish monetary policy, executed by Fed Chairman Paul Volcker, triggered debt crises in Latin America and Eastern Europe, collapsed commodity prices, and set off huge capital inflows into U.S. assets, driving the dollar upward. The Plaza Accord in 1985 aimed to weaken the dollar through coordinated market intervention. Reagan also restrained Japanese car exports (1981), requiring automakers to build factories in the U.S. to maintain market share.

Cycle 2

American Malaise (1986–1992)
During the second half of the 1980s, Japan was heralded by magazines and best-selling books as the new economic power threatening U.S. hegemony. Japanese companies—such as Toyota, Sony, Panasonic, and Honda—were believed to be outperforming U.S. competition by being more efficient, more innovative, and offering better quality. This aura of Japanese dominance was punctuated by a wave of Japanese acquisitions of Western trophy assets, such as Rockefeller Center, Pebble Beach, and iconic Western artworks. Moreover, this was a period of strong recovery for emerging market economies, which once again attracted significant speculative capital. America’s despondency was further punctuated by the First Gulf War and a rise in oil prices, which drove the U.S. economy into recession and led to the election of President Clinton.

American Exceptionalism (1992–2001)
President Clinton (1993–2001) presided over a remarkable period of American Exceptionalism. The Cold War ended in 1991 with the collapse of the Soviet Union. Francis Fukuyama’s book The End of History (1992) expressed the widely held belief that Western liberal democracy and capitalism had permanently won the battle of ideas. The “peace dividend” allowed Clinton to cut defense spending from 6% of GDP to 3% and, along with tax increases, run fiscal surpluses from 1998 to 2001. The 1990s saw a productivity boom driven by the Information and Communication Technology (ICT) revolution—computers, software, and networking technology—and a stock market boom, particularly in tech and internet companies. Concurrently, emerging markets suffered a long series of financial meltdowns, beginning with Mexico in 1994, Asia in 1997, and Russia in 1998.

Cycle 3

American Malaise (2002–2012)
Clinton’s deregulation of the financial sector (the repeal of Glass-Steagall and deregulation of derivatives) laid the groundwork for the dot-com and housing bubbles, which burst in 2000 and 2007, respectively. The stock market crash and the Great Financial Crisis brought forth unorthodox monetary policies, which undermined the dollar and revived interest in gold. The accession of China to the WTO (2001) and the launch of the euro (2002) also sparked dollar outflows. China’s economic miracle (2000–2012) caused a commodity super-cycle and enormous inflows into emerging market assets, which created massive stock market and credit bubbles.

American Exceptionalism (2012–2024)
The GFC left most of the global economy in a semi-depressed state, including China, which was burdened with excess debt, a housing bubble, and diminishing returns on infrastructure investment. However, starting in 2012, the U.S. experienced a relative resurgence based on four pillars: (1) a rising dollar, (2) the shale oil revolution, (3) the remarkable success of its winner-take-all global tech titans, and (4) a cycle of fiscal expansion and debt accumulation. These factors led to massive inflows of capital into American financial assets and a singular “wealth effect” for America’s moneyed classes.

Cycle 4

American Malaise (2025–?)
President Trump has articulated a darkly negative vision of a country mutilated by elites—both domestic and foreign—who have “sold out the country” and caused “an American carnage” of crime, poverty, and decaying infrastructure. He aims to dismantle both domestic institutions (public programs, the courts, universities) and the American-led world economic order—its liberal foundations and its system of alliances—which has long buttressed American leadership and soft power. Unsurprisingly, Trump’s wrecking-ball tactics are unsettling investors and raising questions about the reliability of the U.S. as a partner in military, financial, business, and educational matters.

Initial reactions to Trump’s second-term agenda point to the start of a new phase of American Malaise. A weakening dollar, rising long-term interest rates, declining U.S. stock prices, and a surge in the price of gold indicate significant capital outflows from U.S. assets. Moreover, the drivers of the past decade of American Exceptionalism appear tired. First, the administration is ambivalent about the dollar’s reserve status and is considering measures (e.g., a new Plaza Accord) to bring it down from its high level. Second, the shale revolution appears to have peaked, with output now expected to stabilize. Third, high valuations, saturated markets, deglobalization costs, regulatory hurdles, and increasingly capital-intensive business models for the tech titans point to more moderate return prospects. Fourth, bond markets are showing low tolerance for further fiscal largesse.

A phase of American Malaise can be expected to last 5–10 years. Outflows from U.S. markets into foreign markets drive the dollar lower, raise commodity prices, and unleash credit, boosting GDP growth and asset prices outside the U.S. These flows create a virtuous cycle of rising confidence, growing liquidity, and higher asset prices abroad.

Expected Returns in Emerging Markets Q1 2025

Emerging markets stocks outperformed the S&P 500 in the first quarter of 2025 in a rare show of strength. China and Latin America led the way, while India sputtered.

Foreign markets are buoyed by hopes that a shift is occurring in the relative strength of growth away from the U.S. and in favor of China and Europe. This has led to some dollar weakness and triggered capital flows out of U.S. assets.

The strength of the S&P 500 0ver the past decade can be attributed to two factors: first, a remarkable decade-long expansion in profit margins, of which about 60% was driven by lower interest rates and globalization—two trends that are now clearly in reverse; and second, an expansion of earnings multiples, which has brought valuations to extremely high levels on most measures.

The valuation premium of the S&P 500 over the MSCI EM Index closed the quarter at historically elevated levels, surpassed only by the 2016–2018 and 1998–1999 periods. The rising valuation premium over the past three decades may reflect the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets, except briefly in China—until Chairman Xi curtailed the tech sector to “safeguard social harmony.” However, the valuation premium may have peaked and started to trend downward, as America’s tech titans have reached very high valuations and may face lower profitability in the future as they invest heavily in developing the highly capital-intensive and competitive AI business.

The extraordinary profitability of America’s tech giants over the past decade drove profit margins and earnings to record levels. Meanwhile, many other companies in the U.S. and abroad have experienced a prolonged downturn. For example, as shown below, MSCI EM earnings in nominal dollar terms have not risen for about 15 years.

The chart below estimates the current expected returns for emerging markets and the S&P 500 based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity more recently through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted based on each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (October 2024).

As logic dictates, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that over time, market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its current growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios. The same may be true for the Philippines.

The following chart shows actual MSCI EM country returns for the past 12 months in the context of which markets had the highest seven-year expected returns at year-end 2023. The chart shows that the CAPE ratio was not predictive of performance over this one-year period, as is frequently the case. Over one- to three-year time frames, momentum, narrative, liquidity, and cyclical conditions have a much greater impact on performance than long-term valuation parameters. Nonetheless, when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling.

Looking ahead, Chile and Colombia may be well-positioned to perform over the next year, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. Chile has the added attraction of an upcoming election, which may bring in a more business-friendly administration. However, rising geopolitical tensions and sluggish global growth create an unfavorable investment environment. Only a continued weakening of the U.S. dollar could result in sustained capital outflows from U.S. assets, which would be beneficial for EM stocks.

The Big Mac Index and the Coming Currency Realignment

In a previous blog (link), we noted the remarkable strengthening of the U.S. dollar over the past 14 years, as shown in the chart below. This long dollar bull cycle has brought the U.S. currency to its highest level of valuation relative to the currencies of trading partners since President Nixon severed the dollar’s link to gold in 1971.

Another interesting measure of relative currency values is The Big Mac Index from The Economist magazine. The BMI compares the dollar price of a Big Mac sandwich in approximately 50 countries worldwide relative to its price in the United States. It serves as an alternative measure of the relative cost of living, incorporating inputs from the agricultural, manufacturing, and service sectors, including taxes and regulations.

The chart below illustrates the change in the price of a Big Mac from 2000 to 2025. In the United States, the price of a Big Mac rose by 130% during this period—significantly more than the 90% increase in the U.S. Consumer Price Index (CPI). The chart highlights striking variations in Big Mac price changes, ranging from a 300% increase in Poland to nearly no increase in Japan and Taiwan.

In accordance with the Real Effective Exchange Rate (REER), The Big Mac Index indicates a strong relative appreciation of the U.S. dollar since 2010. The rankings of the index for the past 25 years for a selection of emerging markets (EM) and developed countries are shown in the table below. The table is color-coded: developed countries in black, EM commodity producers in red, and the remaining EM countries in green. This period spans an extraordinarily turbulent economic environment, including the China “Shock,” the commodity super-cycle, the Great Financial Crisis, the COVID-19 shock, and the beginning of deglobalization. The last 15 years can be characterized as a period of “American Exceptionalism,” driven by the shale revolution and the global dominance of Silicon Valley’s tech titans.

The table highlights several trends over this period, best observed through the color-coded categories:

Developed Countries: These economies have maintained a relatively narrow range of currency values relative to each other. Although the U.S. dollar is currently at a high level, it has typically remained in the top third of the table. The Scandinavian countries, Britain, and Switzerland have stayed within a stable range near the top. Even Canada and Australia—both major commodity producers—have remained within a relatively tight range, as have Hong Kong and Singapore, two service-driven economies at the core of global trade. A notable exception in the developed world is Japan, which has experienced an extraordinary devaluation of the yen due to chronic deflation, quantitative easing, and external economic shocks. However, recent yen strength and pressure from the Trump administration may indicate that this trend is beginning to reverse.
Emerging Markets (Excluding Commodity-Dependent Countries): These countries can be divided into two groups:
- Mercantilist Economies: Taiwan, South Korea, China, Thailand, Malaysia, and Vietnam have prioritized export competitiveness, leading to remarkable stability in the index, positioning them consistently in the bottom third. These nations have been among the biggest beneficiaries of hyper-globalization but now stand to lose from deglobalization. The cases of South Korea and Taiwan are particularly striking—despite their increasing wealth, their currencies have become more competitive in terms of the BMI. Given their strategic alliances with the U.S., strong pressure from the Trump administration regarding tariffs and currency realignment is expected. All these countries find themselves caught between the U.S. and China, facing the dual challenge of Chinese export competition and the threat of U.S. tariffs.
- Domestic Market-Oriented Economies: Countries such as Turkey, Poland, India, and the Philippines show little commitment to currency stability, experiencing broad exchange rate fluctuations that undermine their export competitiveness.
Commodity-Dependent Emerging Markets: These nations experience high levels of currency and economic instability. Over the past 25 years, free capital flows have exacerbated commodity-driven currency cycles, leading to extreme volatility due to “hot money” inflows and capital flight. This instability has contributed to acute deindustrialization in many of these economies. Argentina’s recent experience is particularly revealing—since 2020, the cost of a Big Mac in Argentina has surged by 143%, making it the second most expensive in the world. In contrast, in 2010, Argentina had the second cheapest Big Mac, surpassed only by China. Similarly, Brazil had one of the world’s most expensive Big Macs in both 2010 and 2015, exceeding even traditionally costly countries such as Sweden and Denmark. Among commodity-linked currencies, Indonesia stands out as an exception, behaving more like an “Asian Tiger” currency with relatively low volatility.

In the current landscape of trade wars, shifting economic alliances, and increasing geopolitical tensions, currency realignment is becoming an essential tool for policymakers. The trends highlighted by The Big Mac Index and the Real Effective Exchange Rate (REER) reflect deeper structural shifts in the global economy—from the rise of American exceptionalism to the challenges faced by both developed and emerging markets. As the forces of deglobalization take hold, nations will likely respond with a mix of tariffs, industrial policies, and monetary interventions to maintain competitiveness. The coming years will test the resilience of global currencies, determining which economies can adapt to this new era of economic realignment and which may struggle to keep pace.

America First and Currency Wars

A month into the second coming of Donald Trump, the world is grappling with the meaning of his obsession with trade tariffs. Though it is highly unclear what the details of trade policy will be, it appears the primary objective may be to force global firms to reshore manufacturing to the United States. Policymakers, such as Treasury Secretary Scott Bessent, are talking about a “great economic restructuring,” leading analysts to speculate on possible international agreements to secure investments and bring down the value of the dollar, as was successfully achieved during the Reagan Administration in the 1980s.

The strength of the U.S. dollar is a problem for a government determined to bring back the mercantilist policies of the late 19th century in America. As the chart below shows, the Real Effective Exchange Rate (REER) for the USD is at an extraordinarily high level, well beyond previous peaks in 1960, 1970, 1984, and 2002.

Periods of dollar weakness are associated with strong international growth relative to U.S. growth and a spell of “American malaise,” while periods of dollar strength are linked to stronger U.S. growth and phases of “American exceptionalism.” The dollar has been appreciating since early 2011 in a remarkable occurrence of American exceptionalism, driven by a relatively strong recovery from the Great Financial Crisis, the shale oil and gas revolution, and the phenomenal success of America’s tech titans. Over the past decade, the dollar has also been buttressed by enormous capital flows into U.S. assets, which originate both from institutional investors seeking high returns and from capital flight from emerging markets.

It is unclear how dollar weakness could be engineered by the Trump Administration, as “America First” strategies would tend to favor U.S. growth at the expense of foreign partners and could lead to large investment inflows. Moreover, the chaos created by Trump’s disruptive nature may increase geopolitical risk and further encourage capital flight into U.S. assets.

We can speculate on which countries may be targeted by Trump for retributive attacks. The chart below shows the REERs of America’s main trading partners and emerging markets in terms of the current REER relative to the median of the past 32 years. Japan stands out as an outlier and as an easy target for forced currency appreciation. Europe, Mexico, and the Asian tigers (Korea, Taiwan, and Malaysia) also could be singled out. The circumstances of most emerging markets (Chile, Brazil, Nigeria, etc.) are very different, as currency weakness is not engineered to sustain export competitiveness but rather caused by low growth and capital flight.

Quo Vadis, Brazil? Opportunities and Challenges in The New World Order

The vast majority of Brazil’s population has no recollection of the “miracle economy” years (1968–1973), when the country was a rising industrial power and the star of the developing world. After over 40 years of suppressed ambition, economic stagnation and mediocrity have become the accepted norm in Brazil. With the important exception of agroindustry, where Brazil has maintained world-class status, the country has become an unproductive service economy with poor prospects for growth.

The post-World War II evolution of Brazil’s economy can be divided into two periods. The first, from 1950 to 1980, saw Brazil—aligned with foreign and domestic capital—dominate the mass production technology paradigm. This led to rapid industrialization and the emergence of an urban middle class. During this period, the economy diversified away from commodity exports. The second period, from 1980 to the present, has been characterized by rapid deindustrialization and a return to a level of dependence on commodity exports last seen in the early 1950s.

By 1980, Brazil had largely exhausted the growth potential of mass production technologies unless capital could be reinvested to either support a growing domestic market or access export markets, neither of which occurred. Around the same time, revolutionary advances in transportation (container ships) and ICT (Information and Communication Technology) triggered the migration of Western capital to Asia, where companies sought to exploit cheap labor for outsourcing activities. Since 1980, the Asian Tigers, including China, have followed Brazil’s earlier path and fully dominated the mass production technology paradigm.

Weakened by political, economic, and financial instability, Brazil was unable to respond to the Asian threat in the 1980s. The debt crisis of the early 1980s severely discredited the industrial planning mechanisms used by the Military Regime (1964–1985), but no consensus emerged for a replacement.

As the world embraced the Washington Consensus, promoting the liberalization of capital, goods, and labor flows, Brazil rejected trade liberalization but embraced the deregulation of capital accounts. This made the economy more vulnerable to speculative “hot money” financial flows and capital flight, creating a “rentier” elite with little commitment to reinvesting profits in domestic productive assets.

The great commodity boom (2002–2012), driven by China’s aggressive infrastructure expansion, led to a surge in liquidity for Brazil’s commodity-dependent economy, along with credit expansion, currency appreciation, and increased fiscal largesse. Meanwhile, in 2005, Petrobras announced the discovery of the massive pre-salt offshore oil fields, transforming Brazil from a large oil importer into the world’s seventh-largest oil producer (as of 2024). However, the “commodity curse” hit Brazil hard after 2012, leaving both its manufacturing sector and institutions severely weakened.

Over the past forty years, Brazil has undergone a remarkable transition from a dynamic industrial economy to a low-growth, unproductive service economy. From 1950 to 1980, Brazil’s GDP grew at an impressive 7.1% per year, one of the highest rates in the world. Since then, GDP growth has slowed to a meager 2.1% per year. This transformation is evident when analyzing the contribution of factors of production—labor, capital, and total factor productivity (TFP)—to overall annual growth. The following chart, based on Conference Board data in ten-year rolling periods, highlights the collapse of TFP as the economy has deindustrialized and become dominated by low-value-added services and commodities. Simultaneously, the contributions of both capital and labor have declined sharply.

Brazil’s Opportunity in the New World Order

Because Brazil did not benefit significantly from globalization, it has little to lose from its unwinding. A more protectionist global environment, coupled with a renewed emphasis on industrial planning policies, could be advantageous for Brazil. Such a world would favor large-population countries with significant domestic markets.

Additionally, the emerging technological paradigm of AI and robotics is on the verge of eliminating the labor cost advantages that drove the outsourcing of manufacturing and IT services to Asia. A well-designed approach to industrial planning, combined with the strategic adoption of new technologies, could potentially revive Brazil’s manufacturing sector and drive a surge in productivity growth.

If Brazil could simultaneously expand its domestic market, its chances of success would greatly improve. Today, with a population of 220 million, Brazil’s market opportunity is no larger than that of the Netherlands. However, this market could easily double in size if wealth distribution were made more equitable, as seen during the Plano Cruzado of the 1980s and the commodity boom of the 2000s.

Brazil’s Considerable Headwinds

Unfortunately, the Brazilian opportunity faces considerable headwinds.

Low-Value-Added Economy: Brazil is increasingly a low-value-added service economy highly dependent on commodities, a trend that will be difficult to reverse. A key indicator of development, the value-added content of exports (measured by MIT’s Economic Complexity Index, or ECI), highlights this decline. In 1995, Brazil ranked 24th in the world—alongside South Korea, a leader in emerging markets. By 2022, Brazil had fallen to 49th, lagging behind many emerging markets. Even in service sectors where Brazil has natural advantages, such as foreign tourism, it ranks only 40th globally—far behind Turkey, Mexico, Thailand, and the Dominican Republic.
Declining Productivity and Investment: Falling productivity, low investment levels, and the end of Brazil’s demographic dividend have reduced potential GDP growth to below 2%. As shown in the chart above, productivity, labor quantity and investments are all heading in the wrong direction.
Increasing Dependence on China: Brazil’s growing reliance on China—both as a buyer of its commodities and as the primary source of its manufactured imports—coupled with its geostrategic alignment with China through BRICS, is likely to create tensions with the Trump Administration, increasing risks for investors.
Regulatory and Political Challenges: Brazil’s complex legal, regulatory, and tax systems stifle entrepreneurship, while dysfunctional politics make meaningful reform unlikely. There is no clear consensus on the need for intelligent industrial planning, and recent policy experiments have been poorly designed and wasteful.
Chronic Deficits and Rising Debt: Persistent fiscal deficits have pushed Brazil’s gross government debt to 90% of GDP, with a trajectory toward 100% in the near future. Extremely high real interest rates set by the Central Bank exacerbate the debt burden and contribute to wealth concentration. Some form of financial repression will likely be necessary to manage debt levels, prompting investors to shift capital into dollar-denominated assets.
Capital Flight and Brain Drain: Brazil’s highly sophisticated and cosmopolitan elite is increasingly detached from domestic issues, preferring to invest and reside in Europe and America. Brazilians are reliving Argentina’s 1980s experience, liquidating domestic assets and minimizing their exposure to local policies. Furthermore, cryptocurrency technologies are making capital flight easier than ever.

Given Brazil’s challenges, the return to a growth path that can provide better lives for its population will not be easy. Consensus and shared sacrifices are necessary to effect change, something very difficult to achieve in a highly heterogeneous and fragmented society.

China’s Infrastructure Dead-End

China’s economy grew by 5% in 2024, which was exactly the target announced by the government at the beginning of the year. The 2025 target will be announced at the annual Two Sessions conference in March and, no doubt, confirmed at the start of 2026. Though these growth numbers are dutifully parroted by the IMF and the World Bank, they cannot be compared to the GDP data provided by most countries. While GDP is normally calculated post facto based on measures of output, in China it is presented ex ante as political guidance for economic agents, most importantly banks and local governments. In China, this is made possible by the overwhelming power of the central government and the Communist Party. Since the end of China’s Economic Miracle (1986–2010), this system has become increasingly divorced from market reality because resource allocation has been made more challenging by declining productivity growth and worsening returns on capital investments.

China’s post-miracle growth since 2010 has been accompanied by an enormous increase in debt levels. As shown in the chart below, China’s debt-to-GDP ratio has nearly doubled since 2010, mostly to fund infrastructure projects with rapidly declining returns. The current ratio reported by the Bank for International Settlements (BIS) is probably significantly understated because China’s GDP has been arguably overstated over the past decade by some 20–30%.

Large infrastructure investments made in China decades ago led to enormous increases in productivity, which enabled China’s “economic miracle.” On one of my first visits to China in 2000, I drove on a newly built 100-mile highway linking Shanghai to Hangzhou. It was an eerie experience: the road was entirely deserted. Today, this is one of the busiest highways in the world. That same visit, a train ride the 650 miles from Shanghai to Beijing took 16 hours. Today, 240,000 people every day make the same trip by bullet train in about four hours. That same year, Shanghai had three bridges crossing the Huangpu River, which divides the city. Today, there are 24 structures crossing the Huangpu, providing Shanghai with world-class infrastructure on par with Paris, London, or New York- cities that built most of their infrastructure by the 1930s. :

This kind of highly productive investment in infrastructure took place all over China from the mid-1990s until around 2010, accompanied by the greatest process of urbanization the world has ever seen. These kinds of investments are one-time effort that cannot be replicated. Over the past decade, quality infrastructure projects have become scarce, but that doesn’t stop politicians from churning out more highways and bullet trains with dubious utility.

Below, we review a few examples that characterize the nature of infrastructure spending in China today, many of which are trophy projects driven by politicians and the enormous construction/engineering lobby.

High-Speed Rail Expansion

China State Railway (CSR) has ambitious plans to expand its high-speed rail network from 30,000 miles today to 37,500 in 2030 and 45,000 in 2035, mostly into sparsely populated regions. To put this into context, the rest of the world has 9,200 miles of high-speed rail (almost entirely in Europe and Japan), and current plans are for an additional 800 miles by the end of the decade. CSR has spent $500 billion over the past five years and accumulated one trillion dollars in debt. Returns on investment have plummeted, amid reports of empty trains and stations.

Airports, Dalian Jinzhouwan International Airport

China increased airport capacity by 45% over the past five years. The latest five-year plan (2026–30) calls for 140 new airports, to be located mainly in China’s sparsely populated Central and Western regions. Located off the coast of Dalian in Liaoning province, the Dalian Jinzhouwan International Airport is being constructed on a 21-square-kilometer artificial island, making it the world’s largest offshore airport upon completion. The project includes four runways and a terminal designed to handle up to 80 million passengers annually. Dalian is a moderate-sized provincial city with a population of 5.5 million, which already has an airport with a capacity of 20 million passengers annually.

Eco-Cities Initiatives

The Xiong’an New Area is an enormous urbanization project sponsored by Xi Jinping that showcases “Xi Jinping Thought” concepts, such as “ultimate Chinese modernization” and “high-quality productive forces.” The aim is to build a green, highly livable, and innovative “city of the future” with a “noble character and artistic temperament.” $200 billion will have been invested in Xiong’an by 2027, not including the expense of expropriating 124 square miles of prime farmland 60 miles south of Beijing. The city is a creation of bureaucratic urban planning with minimal participation of private interests. Though many government agencies are being forced to move to Xiong’an, their employees may not follow to what is characterized as a “ghost town.”

Solar

China is building a vast ‘Solar Great Wall’ that will power Beijing with green energy. Located in the Kubuqi Desert in Inner Mongolia, known as the Sea of Death, the project, expected to be finished in 2030, will be 400 kilometers (250 miles) long and 5 kilometers (3 miles) wide, and achieve a maximum generating capacity of 100 gigawatts, enough to meet the energy needs of Beijing. This project alone would represent 70% of the current capacity of the U.S. The project may be a godsend for China’s beleaguered solar panel manufacturers, which, incentivized by government subsidies, have invested $50 billion from 2011 to 2022 to bring capacity to 1,200 gigawatts, double total global demand in 2024.

4Q 2024 Expected Returns for Emerging Markets

Emerging markets underperformed the S&P 500 in 2024, extending a long losing streak. This marks the seventh consecutive year of underperformance and the thirteenth in the last fifteen years. Only Taiwan and Argentina (actually in the Frontier Market Index) managed to outperform the S&P 500 .

The U.S. market appears to be experiencing a blow-off rally, fueled by a broad consensus on an immaculate soft landing for the U.S. economy and optimism about AI-driven productivity growth. The U.S. market is also benefiting from a remarkable expansion in profit margins, driven almost exclusively by the “Magnificent Seven” technology giants, which is reflected in high expectations for earnings growth in 2025.

The strength of the S&P 500 can be attributed to two factors: first, a remarkable decade-long expansion in profit margins, of which about 60% was caused by lower interest rates and globalization, two trends that are now clearly in reverse; and second, an expansion of earnings multiples, which has brought valuations to extremely high levels on most measures.

The valuation premium of the S&P 500 over the MSCI EM Index closed the year at high levels, surpassed only by the 2016–2018 and 1998–1999 periods. The rising valuation premium over the past three decades may reflect the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets, except for a while in China until Chairman Xi squashed the tech sector to “safeguard social harmony.”

Earnings growth has been the main driver of the S&P 500’s outperformance relative to emerging markets over the past ten years, as shown below. From the inception of the MSCI EM Index in 1986 until 2014, earnings growth was similar in both markets, but a dramatic split occurred from that point on. While emerging markets have been in a prolonged earnings slump, S&P 500 earnings have surged since 2014, largely due to the spectacular margin expansion of the tech giants. Although the strong dollar has contributed, it accounts for only about 20% of the relative outperformance. Thus, the key question for investors is: How much longer can the “Mag 7” phenomenon continue?

As logic dictates, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that over time market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its current growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios. The same may be true for the Philippines.

The following chart shows country returns for 2024 in relation to which markets had the highest 7-year expected returns at year-end 2023. Of the markets with high long-term expected returns, only Peru and Turkey currently have good momentum characteristics. The chart shows that the CAPE ratio was not predictive of performance returns over this period, as is frequently the case. Over one to three-year time frames, momentum, narrative, liquidity, and cyclical conditions have a much greater impact on performance than long-term valuation parameters. Nonetheless, when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling.

Looking ahead, Peru and Turkey may be well-positioned to perform over the next year, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. However, rising geopolitical tensions and sluggish global growth create an unfavorable investment environment. As always, a strengthening dollar indicates the need to remain focused on dollar-denominated quality assets.