Emerging Markets – From Vulnerability to Resilience

Emerging market investors started this year with unease and risk aversion, having cut exposures to the asset class in the aftermath of the overlapping shocks of the pandemic, ongoing geopolitical strife and the aggressive tightening of monetary policy by advanced economies during 2022-24. Trump tariffs added to the prevailing uncertainty and investor caution in 2025, threatening to erase the benefits of globalization and integration that had lifted the fortunes of many emerging market economies.

Yet, in comparison with 2020-24 when the benchmark Emerging Market MSCI index yielded cumulative returns net of withholding taxes of only 13% and underperformed the MSCI World index’s cumulative net returns of 62%, the year 2025 has produced a spectacular performance. Emerging market net returns rose close to 34% vis-à-vis 21% on the global index. Barring a few outliers like the Vietnamese dong, the Indonesian rupiah, the Indian rupee, the Turkish lira and the Argentine peso, emerging market currencies have enjoyed the strongest annual run in 2025 since 2010. Equities have also enjoyed a near record performance since 2010, with the Emerging Market MSCI equities index giving net cumulative returns of close to 77%. Local debt has also posted gains as measured by currency-hedged debt indices, and dollar-denominated high-yield debt has given even better returns.

In a year of extreme policy oscillations and fracturing unleashed mainly by the global hegemon, emerging market economies have demonstrated inner strength in terms of macroeconomic performance. It is this positive development that is reflected in financial markets serenading them. Their resilience has empowered them to opportunistically exploit every favourable shift in external conditions to their advantage, whether in issuing debt or attracting portfolio investors. Some of the larger ones – Brazil; Russia; India; China; South Africa – face the most punitive tariffs and sanctions. And although multilateral commentators see their outlook as challenging, they appear poised to hold their own, more or less, with the eventual pass-through of US tariffs not appearing to convey the same shock and awe as their announcements did. 

So far, they have weathered the breaking of the storm and seem prepared to deal with its landfall.

The IMF is hinting at a possible structural change in their historical vulnerability to ‘risk-on’ episodes when global shocks cause investors to flee them, leaving behind output losses and inflation surges. Is this time different?

Given that the experience is still formative, several hypotheses seeking to explain this remarkable phenomenon can be grouped under two heads. One is typically offered by those of little faith, the ‘Cinderella’ sceptics: good luck. The fact that advanced economies largely averted recession while lowering inflation and the surprising resilience of global trade to drags may have created a congenial environment for growth in the emerging market economies. Moreover, financial conditions have been accommodative, with monetary policy normalisation in advanced economies and the dollar’s retreat from its unrelenting upward march right up to January 2025. The dollar plays a crucial role in emerging market trade as the main invoicing currency for imports, and in their financial systems due to the large share of debt denominated in it. A weaker dollar also helps simultaneously to improve the current account balance of developing economies and reduce their external liabilities.

As the Bank for International Settlements has noted, emerging market economies have capitalised on the global risk-on sentiment, benefiting not only from the US dollar’s weakness but also from subdued corporate bond yields and markets paying less attention to lingering trade tensions.  The appreciation of some emerging market currencies suggests that asset managers have been raising currency hedge ratios on their US dollar asset holdings while increasing their long positions in emerging market currencies. Portfolio flows have been positive on net. Sovereign bond issuances have picked up pace, echoing the improved risk sentiment as global investors have sought higher yields. Dollar-denominated emerging market bonds saw a notable compression in spreads. Equity markets rallied. More generally, the financing of emerging markets has been shifting towards portfolio flows and away from bank related funding. Portfolio flows tend to be more sensitive to large swings in risk appetite driven by the dollar. All this could have taken the edge off external pressures.

A more palpable and hence plausible explanation, however, could be good policies: emerging market economies have steadily strengthened their policy frameworks. The most visible aspect is monetary policy, which has enabled them to overcome the inflation surge of 2022-23, bring down inflation to target and even below, and anchor inflation expectations. Emerging market central banks are displaying a greater capacity than before in setting their own interest rates rather than simply reacting to the US monetary policy stance. Foreign exchange interventions coupled with greater flexibility have kept exchange rates reasonably stable by historical standards and have limited pass-throughs into domestic inflation. External positions have generally skirted clear of unviable imbalances. Macroprudential policies have been circumspect and pre-emptive in discouraging financial excesses.  Although fiscal policy headroom remains severely constrained, domestic borrowing costs have been contained. This is a function of having less need to borrow on international markets, while also, in many cases, developing domestic capital markets where bonds are sold in the local currency, rather than relying on overseas investors buying dollar-denominated bonds. All in all, doing the right things is what characterizes the performance of emerging markets.

There is now cautious optimism among investors that these positive developments can continue. Emerging market assets represent an appealing alternative to those wishing to diversify away from US and advanced economy exposure, being worried about fiscal vulnerabilities that inexorably mutate towards a point of no return. Alongside generally healthier debt positions, the asset side of many emerging market balance sheets is geared towards commodities, manufactures and services that provide a hedge against inflation risk.  In addition, the centre of gravity of the global economy is shifting eastwards towards Asia where much of the world’s wealth is being created. Furthermore, these dynamic traders are shifting artificial intelligence supply chains and pulling in more and more emerging and developing economies from other continents into these networks.

Undoubtedly, these significant gains notwithstanding, emerging markets will be tested. Yet they appear to be charting a course of their own and the paradigm of their vulnerability to risk-on shocks appears to giving way to a resilience that has endured. As Pliny the Younger, lawyer, author and magistrate of ancient Rome during 61-113 AD said of his uncle and mentor Pliny the Elder, a commander of the armies of the Roman empire who set sail to investigate the eruption of Mount Vesuvius in 79 AD:  audentes Fortuna iuvat - fortune favours the bold.