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.