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.