When the EM-to-DM Ratio Hits Extremes: A Historical Lens on the 2025 Outperformance Signal

The current setup in global equity markets is flashing a signal that has only appeared twice in the past four decades. The ratio of emerging markets to developed markets has reached an extreme low, a condition that historically marks the early innings of a major leadership rotation. In 1988 and 2002, this same divergence preceded multi-year outperformance cycles for emerging markets, lasting six and eight years respectively. The pattern is clear: when the gap becomes this wide, it often sets the stage for a fundamental shift in market leadership.

In both historical instances, the narrative was one of a value trap. In the late 1980s, emerging markets were reeling from a lost decade and a debt crisis, with high inflation driving investors toward the perceived stability of U.S. and developed markets. The early 2000s saw a similar dynamic, with the Asian financial crisis fresh in memory and U.S. stocks emerging from the tech bubble burst. In both cases, weak economic fundamentals and badly damaged investor sentiment pushed emerging markets to historically low levels relative to their developed counterparts.

The aftermath of those lows tells a powerful story. After the 1988 trough, emerging markets began a six-year stretch of outperformance, driven by accelerating globalization and increased capital flows. The 2002 low was followed by an even longer eight-year cycle, fueled by industrialization and rising commodity demand. These were not short-term rebounds but sustained regime shifts where leadership rotated decisively away from the dominant U.S. megacaps of the era.

The current setup bears a striking resemblance. The performance gap between emerging markets and the S&P 500 has been consistent for 15 years, a period that is historically long. Today, the valuation disconnect is stark: the S&P 500 trades at a premium P/E of 28, while the emerging markets ETF trades at just 17.5 times earnings. This extreme divergence in relative valuations, investor positioning, and long-term expectations is the same signal that preceded those past rotations. It suggests the market may be in the early stages of a similar, multi-year shift, where international stocks finally step out of the shadow of domestic megacaps.

The Mechanics: Why the Rotation is Now Plausible

The historical signal for emerging markets is actionable today because the structural drivers have shifted from mere valuation to a more durable foundation of quality earnings and favorable capital flows. The core of the case is a massive, historically extreme valuation gap. Emerging markets trade at a roughly 40% discount to US equities, a level that has typically marked inflection points for EM outperformance. This isn't just a cheap stock story; it's a setup for mean reversion, but only if the underlying business quality can catch up.

That catch-up is happening. The earnings growth projections for EM companies are now comparable to the US (20%+ year-over-year), and realized earnings-per-share growth has already surpassed the US over the past year. This breadth is critical. Unlike past rallies driven by a few sectors, positive earnings revisions are now broad-based across all eleven GICS sectors. This suggests a genuine, diversified economic recovery within EM, not a speculative tech bubble. For investors, this moves the thesis from a simple "value trap" bet to one backed by improving corporate fundamentals.

The macroeconomic backdrop provides the final, powerful tailwind. A weaker-or-at-least-not-stronger dollar is a direct catalyst, as the USD has fallen roughly 10% from its 2022 highs. This, combined with a global shift in monetary policy, creates a perfect storm for capital flows. While the Fed and ECB remain cautious, 19 out of 21 EM central banks are expected to cut rates in H2 2025. This divergence, paired with high EM real yields relative to both history and DM, makes EM assets a compelling destination for yield-seeking capital. The result is a shift in EM macro from a "marginal satellite risk bucket" to a "core source of macro alpha" for sophisticated investors.

The bottom line is that the rotation is plausible because the three pillars-extreme valuation, broadening earnings, and favorable macro flows-are now aligned. This combination has historically preceded multi-year EM outperformance phases, as seen after the Global Financial Crisis. Today's setup suggests the market is not just cheap for a reason, but is beginning to offer a reason to be cheap.

The Risks & Constraints: Where the Thesis Could Break

The rotation into emerging markets is not a risk-free trade. The thesis faces three critical constraints that could derail the expected outperformance. First, the market sentiment is dangerously unanimous. The HSBC survey shows that bearish views on emerging markets prospects had entirely disappeared, with record net sentiment at the joint highest in the history of the survey. When every investor is bullish, the trade becomes crowded. History suggests this is a negative signal, as it often precedes a period of consolidation or reversal when consensus is too strong.

Second, the trade is highly sensitive to a shift in U.S. economic and monetary policy. The entire rally has been fueled by a weakening dollar and capital flowing out of perceived safe havens. If the United States enters a recession, it would likely trigger a capital retrenchment, hurting emerging markets. Similarly, a Fed policy pivot that strengthens the dollar could reverse the capital flows that have powered the rally. As one analyst notes, "If the Fed hikes rates, it could bolster the greenback and stymie emerging market local currency strength". The thesis is thus hostage to conditions in the world's largest economy.

Finally, valuations, while cheaper than developed markets on a relative basis, are not cheap on their own terms. The MSCI Emerging Markets Index trades at a trailing P/E of 15.30, a level that does not offer a deep margin of safety. More critically, some major markets are trading at premium multiples. India's stock market, for instance, has a trailing P/E of 23.25, reflecting strong investor demand and high growth expectations. This creates a bifurcated market where the cheapest EMs may not be the ones driving the rotation, and the most expensive ones are vulnerable to disappointment. The bottom line is that the rotation faces a perfect storm of crowded sentiment, external policy risk, and stretched valuations in key markets.

The Scenarios & Catalysts: Mapping the Path Forward

The path for EM outperformance hinges on three critical, interlocking factors. The primary catalyst is continued Federal Reserve easing, which would further weaken the dollar and support global risk assets. The key risk scenario is a U.S. recession triggering capital retrenchment. The durability question is whether EM's earnings growth can sustainably outpace DM over the next 12-24 months.

The first and most powerful tailwind is the expected continuation of Fed policy accommodation. Analysts see the Fed continuing to ease policy in December and potentially cutting rates further next year. This creates a favorable environment for EM by lowering global funding costs and boosting liquidity. Historically, this combination of Fed cuts and non-recessionary growth has been a strong driver for risk assets. The resulting softening of the U.S. dollar is the second major tailwind. With the dollar about 10% above its fair value, further depreciation is seen as likely. A weaker dollar directly supports EM currencies, reduces external debt burdens for EM borrowers, and improves the competitiveness of EM exports. These macro dynamics are already in motion, with EM assets delivering stellar double-digit returns in 2025 and sentiment at record highs.

However, this positive scenario faces a clear and present danger: a U.S. recession. The evidence shows that while recession risks in the U.S. seem contained for now, they remain the single biggest threat to the EM rally. A downturn would likely trigger a global capital retrenchment, with investors fleeing to traditional safe havens like U.S. Treasuries. This would reverse the flow of capital into EM assets and could bolster the greenback, stymying the currency tailwinds. The risk is not theoretical; it is the central counterpoint to the bullish narrative.

The ultimate test of sustainability is earnings. The rotation thesis requires that EM's strong relative performance be backed by durable, broad-based profit growth. The evidence suggests this is beginning to happen. As of late 2025, forecasted earnings for the next twelve months exceed trailing earnings across all eleven GICS sectors in EM. This breadth is critical-it points to a diversified recovery, not just a tech-sector rally. Furthermore, EM companies now show comparable or stronger earnings momentum than the US, with realized earnings-per-share growth already surpassing the U.S. over the past year. This fundamental improvement, paired with compelling valuations (a roughly 40% discount to US equities), provides a foundation for the outperformance to continue.

The bottom line is that the catalysts are aligned for EM, but the path is not without friction. The rotation is being fueled by a powerful macro cocktail of Fed easing and a soft dollar, while the earnings foundation is strengthening. Yet the entire thesis remains hostage to the U.S. economic cycle. For EM outperformance to be more than a cyclical bounce, it must weather a potential U.S. slowdown and demonstrate that its earnings growth is broad enough to outpace DM over the next two years.