IEFA vs. SCHE: The Strategic Choice Between Developed Stability and Emerging Growth

The strategic choice between stability and growth crystallized in 2025. The year delivered a stark performance split, with emerging markets decisively outperforming their developed counterparts. This gap is not a minor fluctuation but a structural inflection, reversing a five-year trend of underperformance and demanding a deliberate allocation decision.

The data is unequivocal. The iShares MSCI EAFE ETF (SCHE), a proxy for developed market equities, delivered an annualized return of 26.55% for the year. That strong investor appetite is clear. Yet it pales in comparison to the broader emerging markets story. In sterling terms, the MSCI Emerging Markets index returned 24.25%, while the MSCI World index gained just 12.75%. The performance gap is the first such outperformance for EM equities since 2020, marking a clear reversal from a prolonged lag.

This divergence sets the stage for a fundamental trade-off. Developed markets offered solid, if unspectacular, returns, providing a haven of stability. Emerging markets, by contrast, delivered a powerful growth re-rating. The question now is whether this was a one-year wonder or the start of a new regime. The evidence points to the latter. As fund managers note, a confluence of factors-declining US interest rates, a weaker dollar, and a window for looser monetary policy in EM countries-has created a favorable macro backdrop. This has sparked a significant investor shift, broadening interest beyond traditional AI-driven names into structural stories like India's demographics and digitalization. The 2025 performance is the first tangible sign of this shift, but the real strategic choice lies in betting on its continuation.

Structural Drivers: Stability vs. Growth

The performance divergence between developed and emerging markets is not random. It is being driven by distinct macroeconomic engines and fundamental shifts. For developed markets, the story is one of contained risk and a gradual return to trend growth. For emerging markets, it is a powerful growth re-rating fueled by a widening economic gap, accelerating corporate profits, and a shift toward more resilient sectors.

Developed market stability is anchored in resilient domestic demand and a manageable policy path. The U.S. economy, the largest developed market, shows signs of labor market weakness but appears to be avoiding a recession, supported by resilient consumer demand. The base case sees U.S. growth accelerating to 2% in 2026, underpinned by fading tariff impacts and easier financial conditions. This provides a solid, if unspectacular, foundation for developed equities. The global backdrop is also improving, with global growth expected to return to trend levels by 2026. This gradual normalization supports the developed market narrative of stability and predictability.

The emerging market engine, by contrast, is built on a powerful growth gap and a favorable policy tailwind. The EM-DM growth gap is set to remain robust at 2.5% in 2025, a key structural advantage. This is translating directly into corporate earnings, with MSCI EM earnings growth expected to accelerate to 17% this year. The catalyst for this acceleration is a shift in monetary policy. As U.S. interest rates decline and the U.S. dollar weakens, emerging market central banks gain the room to cut rates without triggering currency collapse. This policy easing, combined with subdued oil prices, is a major driver for the region, allowing for a significant investor shift toward opportunities in consumption and digitalization.

Financial Impact and Sectoral Resilience

The structural drivers now translate into concrete financial metrics and reveal which parts of each market are best positioned. For developed markets, the financial story is one of quality and yield. The base case of U.S. growth accelerating to 2% in 2026 supports stable earnings, while the resilience of consumer demand provides a buffer against volatility. This environment favors companies with predictable cash flows and less exposure to commodity shocks, a key advantage for developed market equities. The financial impact is a more stable, if less explosive, earnings trajectory compared to the growth re-rating seen in emerging markets.

For emerging markets, the financial impact is more dynamic, centered on profit margin stabilization and a broadening growth engine. The EM-DM growth gap is set to remain robust at 2.5%, and MSCI EM earnings growth is expected to accelerate to 17%. A key catalyst for further equity upside is the prospect of profit margin stabilization, especially in China. This dynamic is less relevant in developed markets, where margins are already more stable. The resilience of the emerging market theme, therefore, comes not from a single powerhouse but from diversification. China's structural challenges are offset by growth in India and Latin America, which are less exposed to trade tariffs. This diversification is a critical buffer, as seen in the de-escalation of U.S.-China tensions, which improves the outlook for a broad range of EM assets.

Sectorally, the divergence is clear. In developed markets, the focus is on quality and stability. In emerging markets, the rally is broadening beyond "hard tech" into more durable "soft tech" and structural growth stories. The performance gap between MSCI China's software-heavy index and onshore A shares illustrates this shift, with the former rallying 17% YTD. This move toward sectors with global reach and less capital intensity-like software and IT services-diversifies the growth engine beyond narrow export-driven economies. The bottom line is that the financial impact of the emerging market re-rating is being captured by a wider set of companies and regions, making the theme more resilient and less vulnerable to a single country's stumble.

Strategic Allocation and Forward Catalysts

The performance divergence of 2025 sets a clear strategic choice, but the path forward hinges on a few critical catalysts. For investors leaning into developed market stability via SCHE, the primary risk is a resurgence in U.S. dollar strength. A stronger dollar could reverse the recent flow dynamics that have fueled EM outperformance, pressuring emerging assets and potentially dampening the broader growth re-rating. The evidence shows this is a persistent fear, with global investors noting that EM assets are often seen as overly dependent on the dollar's direction. The key for SCHE, therefore, is to monitor the durability of the soft dollar trend and the resilience of domestic demand in its core markets.

For those betting on emerging market growth, the forward catalysts are more multifaceted. The most immediate is the continued effectiveness of stimulus in key economies like China, where stabilizing data suggest measures are finally taking effect. More broadly, the theme depends on the durability of the EM-DM growth gap beyond 2026. The base case expects global growth to return to trend levels by 2026, which supports the EM narrative, but any significant slowdown would challenge the earnings acceleration story. The pace of AI adoption in EM's "soft tech" sectors is another watchpoint. The rally in software and IT services, exemplified by MSCI China's 17% YTD gain, shows a move toward more durable growth engines. If this adoption accelerates, it could fuel further profit margin stabilization and broaden the growth base beyond traditional commodity exporters.

The bottom line is that the current divergence is supported by a confluence of macroeconomic tailwinds-solid global growth, easing U.S. policy, and a soft dollar. These factors are not expected to reverse abruptly. However, the strategic allocation must be dynamic. Investors should watch for the durability of the growth gap and the resilience of the soft tech rally, while remaining vigilant for any shift in the dollar's trajectory. The 2025 performance was a powerful inflection, but the sustainability of that move will be determined by these forward catalysts.