Avoiding emerging markets may be the greatest risk in 2026
31 December 2025
Valuations, AI exposure, and a weaker dollar are tilting the balance back towards emerging markets, even as geopolitical and macro risks persist. This shift could be a game-changer for investors, challenging the long-held belief that emerging markets are uncomfortable and risky.
The Case for Emerging Markets
Emerging markets had a challenging start to the year, but they rebounded strongly, reinforcing the idea that the most attractive long-term opportunities often lie in the most uncomfortable assets. At the heart of this argument is valuation.
Stefan Magnusson, head of emerging markets investing at Orbis Investments, highlights a key point: investors' reluctance to return to emerging markets stems from a misplaced faith in backward-looking risk measures. He argues that traditional risk measures don't accurately reflect the potential of emerging markets.
"Over the past 15 years, emerging markets have severely lagged their developed-market peers in terms of returns and have been more volatile. For a rational investor with a reasonable level of risk aversion, this has made emerging markets an uncomfortable investment choice," Magnusson explains.
However, he believes that today's prices tell a different story. On a cyclically adjusted basis, US equities trade at nearly 38x earnings, near record levels, while emerging markets trade at around 16x, below their long-term average and at a significant discount of approximately 60%.
"When US shares have been valued at this multiple historically, they have reliably returned just low single-digits nominally over the next decade," Magnusson notes. In contrast, emerging markets offer a broader range of outcomes, with forward returns historically ranging from low single digits to over 15% per annum, skewing more positively.
These starting points are crucial because they shape long-term outcomes more reliably than near-term macroeconomic forecasts. Political instability, governance weaknesses, and currency volatility in emerging markets are real, but Magnusson emphasizes that these risks are visible and already reflected in depressed prices.
In contrast, ballooning fiscal deficits, trade policy uncertainty, and concentration risk in the US "appear to have had little to no impact on valuations."
The Investment Case Strengthens
John Citron, manager of the JPMorgan Emerging Markets Growth & Income fund, agrees that the underlying investment case in emerging markets is strengthening. He points to clear signs that the tide is turning, including firmer earnings expectations and macro trends like a weaker US dollar and improving domestic demand.
This year's rebound, supported by dollar weakness and a rotation away from the US, along with improving sentiment in China, is a testament to these trends. Technology has been central to this recovery, particularly the role of emerging markets in the global AI supply chain.
Citron describes AI as a defining theme, emphasizing that the AI revolution is still in its early stages. Taiwan and Korea, he notes, continue to play critical roles as suppliers of memory chips, advanced processors, and data-center hardware, with companies like SK Hynix and TSMC already benefiting from accelerating demand.
China's Policy Shift
China's policy shift has also been key. Efforts to stabilize the property sector and support consumers have helped sentiment, while US trade policy has prompted a wave of domestic investment as manufacturers seek to localize supply chains.
However, not everyone at JP Morgan shares the same level of optimism about China. Omar Negyal, portfolio manager of the JPMorgan Global Emerging Markets Income trust, warns that expectations may have run ahead of reality, especially in China and parts of the technology complex.
Despite this, Negyal believes that volatility isn't a reason to retreat but rather an opportunity to find the next wave of long-term winners. He highlights the importance of geopolitical factors, elections, and the path of the US dollar in shaping outcomes in 2026.
India's Disappointing Path
India, another emerging-market heavyweight, has been on a disappointing path this year due to its exclusion from the AI trade. Despite this, it remains expensive after several strong years.
Magnusson warns that high-growth stories often disappoint equity investors when starting prices are elevated. He emphasizes that there is no reliable link between overall GDP growth and equity returns, and India's premium valuation leaves little margin for error.
Chris Tennant, co-portfolio manager of Fidelity Emerging Markets, shares this caution. While he acknowledges India's strong demographic tailwinds, he notes that the market is expensive and challenging for investors focused on both quality and valuation.
"The portfolio is currently underweight in India, and we have minimal exposure to the consumer," Tennant says. However, he sees opportunity within financials, where the financial ecosystem stands to benefit from per capita GDP growth in the coming years, and there are good-quality businesses trading at more reasonable valuations.
Other Opportunities
In global emerging markets, Tennant has become increasingly constructive on electrification, where the shift in global power generation and the build-out of renewables are driving demand for copper. He notes that copper supply remains constrained following a decade of underinvestment and that this year is likely the first in which mine supply declines.
Tennant has also increased his exposure to gold, as the historic relationship between gold and real rates has broken down, with investors and central banks turning to gold as a store of value. Despite price moves this year, gold miners continue to look attractively valued and generate high free cash flow, with improved capital discipline across the sector.
In smaller emerging countries, banking sectors are often oligopolistic and generate strong returns on equity while trading near book value, resulting in "excellent value across much of the universe," particularly in central and eastern Europe. Financials and fintech companies are also attractive.
Fixed Income Opportunities
With the dollar breaking its long-term uptrend, the environment increasingly favors non-US assets, according to Abdallah Guezour, head of emerging market debt and commodities at Schroders. He notes that a recovery in portfolio flows to emerging market debt is underway, combined with abundant global liquidity, which reinforces the appeal of emerging market debt, particularly in local currency markets.
Schroders continues to favor countries like Brazil, Mexico, South Africa, India, and parts of central Europe, where valuations remain compelling and policy flexibility is high.
The Risks
Despite the relative strength of many emerging economies entering 2026, the managers acknowledge the risks. Charles Jillings, co-portfolio manager of Utilico Emerging Markets Trust, highlights two key threats:
A material slowdown in global growth, which would result in a fall in consumption, impacting export-driven economies and markets, and subsequently affecting commodity-driven countries due to reduced demand for resources.
Geopolitics, with a material increase in geopolitical tension potentially leading to a sudden increase in oil prices, causing short-term inflationary pressures and placing financial stress on energy-importing economies.
