Strategic allocation to emerging markets

However, we are now entering a new regime that is marked by dispersion across equity valuations, global interest rates, unpredictable business cycles, volatile stock-bond correlations and transformative technologies such as artificial intelligence (AI). This will require a rethink of prevailing asset allocation and diversification concepts within investment portfolios. Further, high valuations in listed equity markets, particularly in the US, are also a growing concern among allocators that diversified into this asset class over the past 15 years.

In 2025 – for the first in many years – EM assets outperformed advanced economies. It is worth noting though that EM Debt especially in hard currency has been outperforming for some time as indicated below.

Importantly, while the ongoing regime shift is also being defined by episodic geopolitical shocks, recent market behavior in 2026 suggests that emerging markets can remain resilient through such stress events.

During the recent conflict in the Middle East, EM debt – particularly hard currency sovereign and corporate credit – traded in an orderly fashion and proved more resilient than many investors might have expected. This is consistent with the fact that many EM sovereign and credit issuers entered the period from a position of relative fundamental strength versus developed market peers: several countries have built sizable external buffers, and multiple issuers had already pre funded or addressed external financing needs earlier in the year, reducing near term refinancing pressure. Further, EM debt was also resilient in 2025 throughout the volatility during the week of Liberation day.

From a positioning and market-technical perspective, asset-class flows have remained constructive: year to date inflows into EM debt total USD 17.4 billion, and while March 2026 saw USD 1.7 billion of outflows, according to JP Morgan, these were concentrated largely in ETF/passive vehicles, while most well performing actively managed EMD funds recorded inflows over the month. Together, these dynamics reinforce the view that EMD can provide durable income, and diversification even when risk sentiment is challenged.

Emerging market equities have also demonstrated notable resilience through the March–April 2026 Iran-related shock. Despite elevated geopolitical uncertainty and a temporary rise in global risk aversion, EM equities avoided the kind of broad-based derating that has historically accompanied Middle East crises. EM equity market volatility remained contained and drawdowns were relatively shallow, and, importantly, EM equities retained their positive year-to-date returns. This underscores our belief that EM equities are benefiting more and more from the same factors that support EM debt, including more disciplined macro policy frameworks, manageable inflation, easing domestic financial conditions and improved policy credibility, which has helped anchor investor confidence.
But this might only be the beginning. Following years of US market dominance, emerging markets remain undervalued and overlooked, despite strong fundamentals and recent outperformance. As per IMF data, emerging markets and developing economies account for over 60% of world GDP based on purchasing power parity, and yet they are underrepresented in client portfolios.

A risk-controlled approach can help investors gain secular exposure to the enhanced return and diversification benefits available, and that merits an increased allocation to emerging markets debt and equities.

When assessing historical performance, it is important to look beyond headline returns and consider risk adjusted outcomes. The Sharpe ratio provides a widely used, objective measure of risk reward by expressing the amount of excess return earned per unit of volatility. Using data from 2003–2025, the risk adjusted return profile of hard currency emerging market debt across both sovereign and corporate segments compares favorably with that of widely followed fixed income benchmarks such as the Global Aggregate and Global Corporate indices.

Beyond risk adjusted performance, we believe valuations remain compelling in hard currency EMD. Using data as of end March 2026, index-level credit quality underscores the asset class’s positioning: EM Sovereign (BB+) and EM Corporates (BBB ) compare favorably with US High Yield (B+), supporting the case that investors are being paid to take risk in segments where fundamentals and balance sheets have improved meaningfully over the past cycle.

On the equity side, compared with earlier shocks, many EM equity markets are now less reliant on external financing, and supported by stronger local investor bases. Sector composition has also evolved, with technology, financials and consumer-oriented industries playing a larger role relative to energy-import-sensitive or externally leveraged sectors. As a result, while sentiment briefly softened in March, there was no sustained capitulation, and subsequent stabilization reinforced the view that EM equities can continue to participate in global growth even in a more fragmented geopolitical environment.

All in all, the episode highlights that emerging market assets, across both equity and fixed income, can increasingly act as shock absorbers rather than shock amplifiers in diversified portfolios.

This supports the case for investors to reassess strategic positioning and consider whether current allocations to emerging market equities and emerging market debt adequately reflect their long-term return potential and diversification benefits. This note, and the discussion that follows, addresses several of the key considerations that underpin this argument.

Over the past fifteen years, emerging market economies have grown, on average, almost 2 percentage points higher than developed economies (see Figure 3). This growth has not been achieved solely through increased spending. EM gross government debt is still close to 70% of GDP (gross domestic product), while for advanced economies it has consistently exceeded 100%.

Despite the uncertainty of potential tariffs, the growth outlook remains strong for EMs according to IMF World Economic Outlook. This economic growth without a commensurate increase in debt implies that debt/GDP should continue to improve, thus supporting the creditworthiness of their governments. This positive growth outlook is further supported by a dynamic corporate sector.

Across major EMs, companies are rapidly moving up the value chain. Chinese firms are accelerating breakthroughs in AI and advanced manufacturing, positioning themselves at the forefront of next generation technologies. Hong Kong continues to attract a healthy pipeline of regional IPOs, underscoring deep investor appetite. India’s corporates are posting robust earnings across digital services, renewables and manufacturing as reforms translate into scale. And Korea’s semiconductor leaders have delivered standout equity performance, highlighting EMs’ ability to compete globally in the most complex, capital intensive industries.

Figure 3: EM-DM growth differential

The positive growth outlook is also due to a more balanced monetary policy framework. Over the past 50 years, many countries in Latin America and other emerging markets have experienced high inflation coupled with economic and financial crises. Central banks in these countries developed hands-on experience dealing with inflationary regimes as well as financial instability. Certain countries adopted the inflation-targeting approach from developed markets that recognizes the key role of central bank monetary policies in determining the inflation rate.

Controlling inflation has been one of the drivers of rapid economic growth and stability in output and employment in several emerging market economies. To stem inflation, many EM central banks started raising policy rates from as early as 2021, while DM central banks were still grappling with how best to respond. Such actions have played a large part in elevating the credibility of emerging markets.

Finally, prices for commodities such as oil and gas, industrial and precious metals including gold and agricultural products continue to trade in a higher range than pre-pandemic due to supply constraints caused by years of underinvestment as well as demand from decarbonization and climate change. Many emerging markets countries are commodity exporters and are poised to benefit from the commodity upcycle.

Over the last decade, EM sovereign hard-currency debt has approximately doubled in size from around USD 700 billion in the early 2010s to USD 1.4 trillion today according to data from JPMorgan. EM corporate hard-currency debt has grown at an even higher rate and is now at USD 2.5 trillion. Just over half of this debt is rated investment grade (IG).

Over the same time period, EM local currency debt for sovereigns and corporates has grown to become the dominant segment of EM debt as shown below. The JPMorgan GBI-EM Index (local currency debt) has become more representative of the investment universe, with China and India being added in 2020 and 2024 respectively.

Figure 4: EM fixed income market

Over the last decade, EM equities have broadened into a larger, more institutionalized opportunity set anchored by global benchmarks. The MSCI Emerging Markets Index, one of the most widely used reference points, now represents over USD 11 trillion of index market capitalization and includes roughly 1,200 large- and mid-cap constituents across 24 EM countries, covering around 85% of each market’s free-float-adjusted investable universe.

Over the same period, the composition of EM equities has evolved meaningfully across both countries and sectors. China’s weight in the MSCI EM Index declined from close to 40% in 2020 to ~26.5% by January 2026, while Taiwan’s weight has risen to ~21% and South Korea’s to 16%, making index leadership more contested. At the sector level, EM is increasingly shaped by “new economy” exposures: technology has grown to over a quarter of the MSCI EM Index and has more than doubled in size since 2010, reflecting a shift away from commodity- and cyclical-heavy leadership toward global and domestic digital champions.

Figure 5: EM Equity Market

Emerging markets enter this cycle with stronger policy credibility and cleaner macro balances than in the past. After moving early and aggressively to contain inflation, EM central banks now offer some of the highest real rates globally while maintaining space to ease policy if growth slows. This combination of high carry and policy flexibility has lifted forward-looking return expectations across EM assets.

Growth dynamics also remain supportive. EM GDP growth has been stable around 4% in recent years, even as China moderated and the U.S. experienced cyclical deceleration. At the same time, EM sovereign fundamentals have improved: countries have avoided major new defaults, and several former distressed credits are emerging from restructuring. Rating actions have turned decisively positive since 2023 as fiscal positions stabilize and external balances strengthen.

Figure 6: EM sovereign debt – credit ratings upgrades versus downgrades

The next phase of the global cycle is also likely to be more favorable for EM because of the currency channel. The dollar’s multi year appreciation has pushed several indicators into stretched territory just as the U.S. fiscal position deteriorates and real rate differentials are expected to narrow. A period of broad US dollar consolidation or weakness would create a powerful tailwind for EM total returns, historically one of the most important drivers of both local debt and equity performance. Diversifying away from dollar centric portfolios therefore not only reduces exposure to long term U.S. fiscal risks, but also positions investors to benefit from the revaluation of EM currencies.

For fixed income investors, EM also offers a way to diversify away from increasingly unsustainable debt trajectories in advanced economies. Several large EMs now run more disciplined fiscal frameworks, enjoy healthier primary balances and rely less on domestic financial repression. In contrast, many DM sovereigns face rising refinancing needs and structurally negative fiscal dynamics, making EM sovereign and quasi sovereign debt an appealing risk diversifier.

On the equity side, EM remains the most direct way to gain exposure to the world’s fastest-growing corporate ecosystems. Beyond traditional sectors, many EM companies are now global leaders in digital commerce, payment systems, renewable energy and advanced manufacturing. Their business models are increasingly outward facing, innovative and capital efficient, offering growth that is hard to replicate in aging DM markets facing demographic and regulatory headwinds.

Valuations add further support. We believe both EM equities and EM local debt still trade at attractive discounts/yield premiums when compared with long term averages, even as fundamentals improve. Historically, such valuation asymmetries have been followed by strong multi year EM performance, reinforcing the case for a structural allocation even if backward looking portfolio simulations do not fully capture the shift in regime.

Finally, the transition to a more multipolar global economy is likely to increase the importance of EM exposure. Supply chain realignment, nearshoring into higher quality EMs and rising South-South investment flows will likely create new winners across Asia, Latin America and parts of Africa. These developments will not be well captured in historical datasets, but they represent meaningful forward-looking opportunities for investors.

As a consequence, when looking at the seven-year capital market expectations that our quant modelling team is developing, EM debt (EMD) in hard currency is expected to generate robust returns. According to our estimates, in our baseline scenario this asset class could generate a return of over 5.5% for EMD Sovereigns and 6.1% for EMD Corporates over the next seven years. While this is slightly lower than for the S&P 500 (6.5%), EMD is expected to achieve these returns with considerably lower risk of 9.7% for EMD Sovereigns and 9.0% for EMD Corporates, compared with 16% for the S&P 500. Within the EMD space, IG Corporates are expected to have a better risk/return profile than IG Sovereigns.

Based on current seven-year capital market assumptions, the S&P 500 (6.5% expected return at 16.0% volatility) is expected to be outpaced also by its emerging market counterpart, MSCI EM (8.75% expected return at 19.2% volatility), implying a stronger return potential for the incremental risk taken and, in turn, we believe, a more compelling risk return trade-off.

Figure 7: EMD expected returns and volatility

In institutional multi-asset portfolios, dedicated EM exposures are getting more and more meaningful but can still be considered “underweight” versus EM’s share of global opportunity set. For public pension plans, target allocations to emerging markets average around 5% (per eVestment data), materially below EM’s ~11% weight in the MSCI ACWI benchmark, suggesting many plans treat EM as a satellite allocation rather than a core / full benchmark-matching position. Fiscalpositions stabilize and external balances strengthen.

Figure 8: EM exposure still low in typical strategic asset allocations

On the fixed income side, allocations to EMD are often even smaller: Investors’ allocations to EMD are typically only around 1–3% of portfolios, despite the asset class’s growth and diversification characteristics. This often reflects a “core satellite” approach where EMD complements, rather than replaces, developed market duration and credit. Also on the fixed income side, an “under-allocation versus benchmark-implied weight” dynamic therefore exists in EMD as the Bloomberg Global Aggregate Index includes a meaningful EM component, with EM countries accounting for close to ~16% of the index.

In practice, this means that investors with only a small dedicated EMD sleeve can remain structurally underweight relative to what a broad global fixed income benchmark would imply. On top of that, the Global Aggregate is an IG benchmark by construction, which limits exposure to the broader EM credit spectrum and can leave out parts of the opportunity set that many allocators associate with EMD’s diversification and income potential.

Summary

The post GFC playbook (where investors overweight developed markets, especially U.S. equities, and rely on stable stock bond diversification) has been highly rewarded, but the regime is changing. Today’s environment is defined by wider valuation dispersion, higher and more uncertain rates, unstable equity–bond correlations and structurally different growth drivers (including AI). In that context, EM stands out as one of the few large opportunities where fundamentals are improving, and where we believe valuations remain comparatively discounted. EM already began to reassert leadership in 2025, and the conditions that typically support multi year EM cycles like policy credibility, high real yields, improving sovereign balance sheets and the prospect of a less supportive US dollar backdrop are increasingly in place.

For institutional investors, the key message is straightforward: current portfolio weights do not reflect EM’s economic footprint or the asset class’s expanding, more institutional investable universe. With many plans still holding EM equities as a small satellite and EM debt at only modest dedicated weights, investors risk remaining structurally underexposed to a return source that can improve risk adjusted outcomes. Historical evidence shows hard currency EM debt has delivered competitive Sharpe ratios versus major fixed income benchmarks, while forward looking capital market assumptions suggest EM equities and EM credit can offer compelling return potential per unit of risk relative to richly valued developed market equities.

Historical performance indications and financial market scenarios are not reliable indicators of future performance. This does not constitute a guarantee by UBS Asset Management.
Projections of market performance or economic conditions are subject to significant uncertainty and change. They are provided for illustrative purposes only and are not a guarantee or indication of actual future performance or results.