Executive Summary: As of year-end 2025, Emerging Markets have begun to challenge U.S. “exceptionalism,” driven by shifting growth dynamics and a turbulent U.S. political landscape. While the S&P 500 remains at historically high valuation premiums, a CAPE-based analysis suggests superior expected returns in “cheap” EM markets like Brazil and Turkey, particularly as EM earnings are projected to finally break out of a 14-year plateau in 2026.
Emerging Market (EM) stocks in 2025 outperformed the S&P 500 for only the second time in the past decade, and the third time since the end of the China/commodity boom in 2012. Latin America, with the exception of Argentina, led the way, while Southeast Asia and Turkey continued to sputter. China once again trailed the MSCI EM Index, providing further reason for investors to turn their attention toward the MSCI EM ex-China Index.
Over the past decade, EM stocks have underperformed the S&P 500 in a persistent and dramatic manner. Of the larger markets significant to EM investors, only India and Taiwan delivered attractive returns.
EM stocks continue to trail the U.S. market by a large margin over the ten-year horizon. During this period, EM stocks returned 4.8% annually in USD terms, compared to 13% for the S&P 500.Not ably, the MSCI EM ex-China Index outperformed the standard MSCI EM Index by a significant 1.5% annually. Taiwan, driven by TSMC and other tech stocks, dominated the decade, with traditional Latin American commodity producers—Peru, Argentina, Colombia, and Brazil—not far behind. In contrast, China and Southeast Asia trailed significantly, mired in industrial overcapacity and deflation.
The Shift in U.S. Exceptionalism
The recent strength in international and emerging markets can be explained by hopes that growth is shifting away from the U.S. relative to the rest of the world. This has led to dollar weakness and triggered capital flows out of U.S. assets, raising tentative concerns that the long period of “U.S. exceptionalism” may be faltering. The remarkably turbulent first year of the second Trump Administration may be contributing to fears that the U.S. is no longer the reliable partner or safe haven for capital it was once reputed to be.
The strength of the S&P 500 over the past decade can be attributed largely to two factors: first, a remarkable expansion in profit margins (roughly 60% of which 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 a moderate level, close to the 25-year average and well below the peaks of 2000–2001 and 2015–2016. This rising premium over the last three decades may reflect the U.S. market’s transition from capital-intensive cyclical businesses to capital-light companies with persistent, rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets—except briefly in China, until President Xi curtailed the tech sector to “safeguard social harmony.” However, the valuation premium may have peaked. America’s tech titans have reached very high valuations and may face lower future profitability due to heavy investment in the capital-intensive and highly competitive AI sector.
Earnings and CAPE Analysis
The extraordinary profitability of U.S. tech titans over the past decade drove margins and earnings to record levels. Meanwhile, many other companies abroad have experienced a prolonged earnings depression. As shown below, MSCI EM earnings in nominal dollar terms are currently lower than they were in 2011–2012, while S&P earnings have nearly tripled. If earnings estimates for 2026 are correct, EM earnings will finally surpass the levels previously reached in 2010–2013.
The table below estimates current expected returns for emerging markets and the S&P 500 based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio—the average of inflation-adjusted earnings over the past ten years—helps smooth out cyclicality. This tool is especially useful for volatile assets like EM stocks and has gained popularity through the work of Professor Robert Shiller. We use dollarized data to account for currency trends, and seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average. Earnings are adjusted for each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s October 2025 World Economic Outlook.
As logic dictates, countries with “cheap” CAPE ratios (below their historical average) tend to have higher expected returns. This model relies on two assumptions: first, that current CAPE levels relative to historical averages are unjustified; and second, that market forces will eventually correct the discrepancy. Historical data strongly supports the second assumption over seven-to-ten-year periods, though rarely in the short term. The model may give a false signal if a country’s historical average is out of sync with its current growth prospects; for example, one could argue that current prospects in Chile or the Philippines do not justify their historically high CAPE ratios.
Market Outlook
The following chart shows MSCI EM country returns for the past 12 months, organized by their CAPE scores as of December 2024. With the exceptions of the Philippines and Turkey, the cheapest markets (left of the chart)have performed well, while more expensive markets (right of the chart) have underperformed. When “cheap” markets show short-term outperformance, the combination of value and momentum is compelling.
Looking ahead, Turkey and the Philippines appear very cheap and may benefit from an economic recovery phase. Colombia, Brazil, and Peru remain cheap with significant price momentum, with Brazil also benefiting from early-cycle dynamics. Chile is no longer cheap but may benefit from high copper prices and a new pro-business government. Conversely, expensive markets—Korea, Taiwan, the U.S., Argentina, and China—may benefit from continued momentum but will require positive earnings surprises to achieve superior performance.