Experts Tout Emerging Markets as AI Diversification Play
PIMCO's Pramol Dhawan is highlighting why emerging markets are outperforming, and other experts agree they are an attractive diversification trade. The argument is that as the AI theme proliferates globally, EMs offer differentiated returns beyond the mega-cap tech stocks that have dominated the narrative so far.
The MSCI Emerging Markets Index is on track to deliver returns of nearly 30% in 2025, marking its best performance since 2017 and significantly outpacing the S&P 500. This surge is largely attributed to the global AI boom, with more than half of the year-to-date return for EM equities coming from AI and related technology themes. Key drivers of this outperformance are concentrated in North Asia, specifically Taiwan, South Korea, and China. Companies like Taiwan Semiconductor Manufacturing (TSMC), Samsung Electronics, SK Hynix, Alibaba, and Tencent are leading the charge. These firms are integral to the AI supply chain. TSMC, for instance, builds custom chips for OpenAI, while SK Hynix holds a dominant market position in the high-bandwidth memory (HBM) essential for powering Nvidia's AI processors. Chinese tech giants Alibaba and Tencent are also developing their own proprietary large language models. Despite the strong performance, valuations remain a key part of the attraction. On average, emerging market equities trade at a 40% discount to their U.S. counterparts. Looking ahead, analysts project 2026 earnings per share growth for the EM universe at 17.3%, compared to 13.0% for the S&P 500. However, investors face concentration risk similar to that seen in U.S. markets. The top five stocks in the MSCI EM index—TSMC, Tencent, Alibaba, Samsung, and SK Hynix—now account for nearly 27% of the entire index. TSMC's weighting alone has doubled in just two years, now representing almost 12% of the index. Macroeconomic tailwinds are also providing support. A weakening U.S. dollar, falling interest rates, and improving fundamentals have bolstered the case for EMs. 2025 saw the highest-ever ratio of credit rating upgrades to downgrades for emerging market economies, signaling increased financial stability. The asset class remains significantly under-owned in global portfolios. While emerging markets represent approximately half of the world's economic output, they comprise only about 3% of portfolio allocations, suggesting a large potential for future capital rotation.
