Emerging Markets Have Changed. Should Allocations Follow?

Investors may be underexposed to a compelling asset class because of outdated assumptions. 

For years, global debt and equity investors have been voting against emerging markets (EM) through their allocation decisions. But today’s EM opportunity set looks very different from the one investors have been avoiding, backed by stronger fundamentals and diverse drivers of return potential. 

Today’s allocation trends reflect investor skepticism. EM equities account for about 5.6% of global assets under management, well below the 20-year average of 8.1%. Closing that gap would equate to US$950 billion in inflows, according to our estimates. Fixed income tells a similar story: in US dollar terms, 2022, 2023 and 2024 were the three worst years for EM debt outflows on record. 

EM Flows Show Signs of Recovery

Positioning, however, has begun to turn. EM stocks and bonds posted positive flows over the last two years from a very low base (Display). Sustained inflows could be supportive for the asset class, as our research suggests that flows and performance have tended to travel together. For instance, EM equity flows and returns have moved in lockstep for roughly seven months out of every ten since 2004.

Investors Were Paid to Look Away

To rebuild confidence, investors will need to overcome the negative sentiment that has pushed capital away from EM. Investors were scarred by past crises, from the Asian financial crisis (1997–1998) and the Russian default (1998) to the taper tantrum (2013). Many asset allocators still view the asset class through that crisis-prone lens. 

But risk was only one side of the equation; investors were also rewarded for looking elsewhere. A decade of extraordinary US equity outperformance reduced the perceived need for diversification, while EM was often viewed as a macro trade shaped by country risk, currencies and geopolitics rather than company-level opportunity. That perception gap persists. Many investors still associate EM with commodities, state-owned enterprises and economic volatility, even as today’s opportunity set is increasingly driven by technology, innovation and domestic consumption.

Can Improving Fundamentals Change Perceptions?

In the early 2000s, EM was effectively a one-trick pony tied to the commodities supercycle: China built infrastructure, EM countries supplied raw materials and a weakening dollar did the rest. Today's asset class is barely recognizable. Most large bond-index constituents aren’t in distress and several higher-quality EM countries—from Chile to parts of Asia—look more like developed markets (DM) than emerging ones. 

Debt-to-GDP levels are generally lower in EM than DM. While the comparison is imperfect because DM sovereigns have greater debt capacity, debt affordability and the direction of travel look encouraging for a growing cohort of EM issuers. Across many EM countries outside China, fiscal positions are improving, while DM fiscal positions are deteriorating, particularly in the US. Meanwhile, the EM–DM growth gap has widened in EM's favor (Display), historically a helpful backdrop for relative performance gains.

Supporting evidence abounds. Across many EM countries, external balances have improved substantially since the taper tantrum and reserve buffers are generally healthier. Credit-rating upgrades have outnumbered downgrades across the EM hard-currency sovereign index, reflecting improving fundamentals and policy credibility (Display). Corporate balance sheets tell a similar story, with EM issuers typically carrying lower leverage and more cash than similarly rated DM peers.

Monetary policy, too, has become more credible. When inflation spiked in 2022, EM central banks moved more decisively than their DM counterparts, hiking interest rates quickly and preventing inflation expectations from becoming unanchored. Prompt action eventually gave several EM central banks more room to ease. Such policy orthodoxy—once the exception in EM—is now closer to the rule, while DM policymakers are becoming more reluctant to take painful decisions. Consequently, while political risk remains ever-present in EM, it’s become a growing hazard across DM countries.

Credit Spreads Pass Stress Tests

EM’s greater resilience has been tested in real time. For instance, during the 2025 tariff shock and the 2026 Iran conflict, EM hard-currency spreads widened, local yields rose and currencies sold off. Not only did those moves quickly reverse, but also the magnitude of the sell-off was relatively mild when compared to other historical stress periods. We believe withstanding heavy outflows and global shocks without a wave of defaults points to real structural improvement.

EM equities have exhibited an equivalent performance pattern: periods of extreme fear have historically preceded unusually strong EM returns, precisely because so much bad news is already in the price.

Part of EM’s improved durability stems from a long-term shift in funding structure. Over the past three decades, many EM sovereigns have increased their ability to borrow in local currency, reducing—though not eliminating—their vulnerability to external currency shocks. This has helped ease the "original sin" that made earlier crises so damaging. 

In 2025, EM local-currency debt delivered its strongest year of returns since 2009, supported by a growing domestic investor base. While gross sovereign issuance was high last year, and has been almost as high so far this year, it’s been easily absorbed by investors. As we see it, lower net issuance year on year for hard-currency sovereigns and corporates, together with continuing inflows, create a favorable technical backdrop. 

Sovereign spreads versus DM are undeniably tight by historical standards, which, in our view, reflects a genuinely lower structural risk premium and a changed index composition. Within high yield, elevated spreads on individual names show how bifurcated—and how large—this asset class has become. Tight on average is not the same as tight everywhere.

EM Equities: Beyond the AI Trade

In equities, one of the key catalysts for recent outperformance has been the stronger earnings growth outlook relative to DM, supported by increasingly positive earnings revisions that have helped keep valuations attractive (Display).

Much renewed interest in EM has followed the AI supply chain. As a result, EM equity leadership has become highly concentrated, with the 10 largest companies accounting for roughly 40% of the MSCI Emerging Markets Index. While that increases concentration risk, particularly for passive investors, EM assets no longer rely on a single growth driver. Their diversification potential spans an array of growth opportunities including industrial upgrading across Asia and governance reform in South Korea, as well as financial institutions benefiting from deeper credit penetration and improving capital returns. We're also seeing pockets of resilient domestic consumption across a number of emerging markets.

Many investors assume they already have sufficient exposure to the world's fastest-growing innovation themes through US technology holdings. However, key beneficiaries of AI adoption and infrastructure spending are increasingly found across EM, spanning semiconductor manufacturing, memory technology, industrial automation and digital platforms. In many ways, the dominant companies in EM today bear little resemblance to the businesses that defined the asset class two decades ago.

Meanwhile, EM earnings growth forecasts continue to outpace DM from a much lower valuation base. In our view, avoiding EM exposure because a portfolio already holds US technology is doubling down on risk. Instead, investors should aim to identify quality EM stocks at attractive valuations that benefit from strong operating trends. We believe plenty of EM companies across sectors meet these criteria and help diversify DM exposures too.

Risks Remain: Geopolitics, Inflation and the Dollar

None of this makes EM rock solid. We’re mindful of three risks in particular: renewed geopolitical tension accompanied by sustained high oil prices (though some EM exporters would benefit); an inflation shock that forces the US Federal Reserve and other central banks back into hiking rates; and a materially stronger US dollar. 

The dollar remains the single most important external variable for EM assets, especially local-currency debt—a weaker dollar is a tailwind, a stronger one a headwind. Our base case is that the dollar will stay broadly range-bound. Risk hasn’t vanished, but we believe the composition of risk has changed, while prices and positioning have been slow to catch up.

Time to Revisit EM Allocations 

Low historical allocations to EM assets may support future return potential. For example, if EM equities drift back to their 20-year share of global assets, the arithmetic implies close to a trillion dollars of inflows into an asset class where flows and performance have historically reinforced one another. Debt investors are being asked to buy improving fundamentals at spreads that already reflect those improvements, which is why security selection—and the hard-versus-local-currency decision—matter more than a single directional call, in our view.

The question for asset owners is whether today's EM exposure reflects a considered decision or an accumulated legacy of decisions taken in a different era. We believe that many investors remain positioned for the EM of the past—yet today's opportunity set looks increasingly aligned with the sources of global growth for the future. As we see it, revisiting EM allocations may be less about adding risk and more about correcting an increasingly obsolete portfolio assumption.