When there are worries about overvaluation in developed markets (DMs), the last place most investors would look is emerging markets. Dan Scott, chief investment officer and head of multi asset at Vontobel, is looking there anyway.
“It sounds completely counterintuitive,” he said. “I'm worried about overvaluation, and I go to emerging market equities. Historically, I'd slap myself in the face for saying something like this. It makes no sense.”
In his view, however, this is justified because developed markets have become more risky and their pricing compared to emerging markets (EMs) has not yet caught up.
An example is the comparison between US and Chinese AI. While Scott is nervous about US tech valuations (but cannot afford to walk away from the trade entirely), Chinese equities offer what he sees as a lower-risk way to stay exposed to the artificial intelligence theme.
“Chinese equities trade at a fraction of the valuations [of their US counterparts]. Even if you do have a consolidation in the AI trade, I think the downside in Chinese AI-related stocks is much less than it is in US AI-related companies,” he said.
Beyond China, he also likes emerging market stocks that have exposure to commodities, which Scott views as an indirect AI play given the power and industrial metals intensity of data centre build-out. He also is positive on broader EM stocks due to the tailwind from a weaker dollar.
The same logic applies in fixed income too, where Scott said that emerging market sovereigns have outgrown the risk premium they still pay. Compared to developed markets, they have lower debt burdens, stronger demographics and better growth prospects, and yet they still offer a yield pickup to developed sovereign debt.
“There's a repricing that there's no longer a need for EM to pay such a big additional yield to developed, just because it's actually more creditworthy than it used to be. These spreads are historically narrow, but they might get even narrower,” he said.
“I actually feel fairly safe in something like Mexican government debt or some far east Asian government debt, whereas I don't feel so safe in French government debt.”
France is just an example of more structural deterioration of developed sovereign credit burdened by fiscal deficits, political constraints on reform and the end of the US tax cut era.
“A tax rate that after [Donald Trump’s] One Big Beautiful Bill can't go any lower is such that it will diminish the ability that US corporates have always had to compensate you for the dollar decline.”
According to Scott, most portfolios have not priced in the dollar decline enough, which is already evident though the lens of Vontobel’s Swiss franc clients.
“Any Swiss franc investor would have been better off just holding Swiss franc cash than being invested in Warren Buffett, because the dollar decline has just completely destroyed any return you've been able to get.”
Traditionally, this is the problem that developed-market investors had when investing in places like India, as they have to account for a yearly depreciation of the currency.
A weakening dollar now is pushing up commodity prices in local currency terms, supporting capital flows into emerging markets and eroding the currency-adjusted return on dollar-denominated assets.
For Scott, this dynamic is not fully reflected in either developed or emerging market pricing.
“EM is safer now than it was 10 years ago, and we need a reappraisal in our minds in terms of risk budgeting for that. [Conversely,] developed is more risky,” he said.