Taiwan Semiconductor Manufacturing Co. Ltd. (NYSE: TSM), Tencent Holdings Limited (OTCMKTS: TCEHY), Samsung Electronics (OTCMKTS: SSNLF), Alibaba Group Holding Ltd. (NYSE: BABA), Vale SA (NYSE: VALE), and Infosys Limited (NYSE: INFY) are some of the biggest companies classified as emerging-market stocks. They are among the top holdings in the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM). 

With the exception of TSM, which is part of the blazing hot chip industry, the others have been languishing lately. 

But no broad asset class underperforms forever; different classifications of stocks rotate in and out of leadership. Does the relative underperformance of emerging-market stocks mean they’re poised for better gains in the coming months?  

According to a June report from analysts at Morningstar, emerging-market stocks are the cheapest they’ve been, on average, in the past 15 years. That means investors could jump in soon to add these stocks, but there are some near-term roadblocks, including the continued rally in U.S. stocks, as well as U.S. inflation and a relatively strong dollar. 

EM Stocks Have Been Couch Potatoes

A glance at the EEM ETF chart shows you that emerging market stocks have been in a holding pattern since mid-February. While it’s not the most exciting thing to watch as it happens, it’s actually a good sign when a stock or exchange-traded fund just sits around like a couch potato, not doing much. 

Emerging market stocks tend to either outperform or underperform other equity assets in long cycles. For example, seasoned investors might remember the so-called “Asian Tigers” of South Korea, Taiwan, Hong Kong and Singapore, South Korea, and Taiwan. These economies expanded rapidly for several decades, and their stocks were must-haves until growth slowed in the mid-1990s.

They were eventually replaced by China’s rise, and the quadrant of BRIC nations: Brazil, Russia, India and China, whose stocks were among the fastest-moving in the early 2000s. 

EM Stocks From Fast-Growing Industries

Since U.S. growth stocks have been so overwhelmingly dominant in recent years, you probably haven’t heard much about emerging-market stocks. Chipmakers such as TSM or EV manufacturers such as BYD Company Ltd. (OTCMKTS: BYDDF), Li Auto Inc. (NASDAQ: LI), Nio Inc. (NYSE: NIO) and XPeng Inc. (NYSE: XPEV) are exceptions, as they represent fast-growing industries.  

A reduction in U.S. inflation and a weaker dollar would give emerging-market assets a boost. Although U.S. inflation appeared to be peaking earlier in the year, it’s proven to be stubborn. The dollar has also retained strength. 

Rising U.S. interest rates can lead to greater capital outflows, currency depreciation, higher borrowing costs, and reduced competitiveness of exports for emerging nations. 

Strong Dollar Weighs On EM Stocks

Meanwhile, a strong dollar makes imports more expensive.

All of this can weigh heavily on the performance of emerging-market stocks.

However, another factor affecting EM performance as a whole is the emergence of China, which has tilted the composition of indexes. In the past, Latin America, the Middle East and the handful of Eastern European countries counted as emerging had more influence over broad index performance. Lately, with the Russian war in Ukraine, European emerging-market stocks have lagged, which hasn’t helped broad index performance. 

China’s underperformance, was, of course, due to Covid-related closures. More recently, China’s economic recovery has been disappointing, creating a drain on EM indexes. 

Ready To Reverse Higher?

So where do those indexes go from here? Are there any bright spots to suggest the weak performance is set to reverse higher?

According to a report from asset manager Blackrock, “Emerging Markets: Under the Radar,” the tilt toward Chinese stocks “is both a bane and boon given the index has missed out on the tailwind from the commodities rally.” However, the overweighting toward China means the index is well-positioned to capture gains from tech rallies. However, the recent tech rally has been driven by AI, and the China-based Internet content providers and e-commerce companies haven’t really participated.

It’s probably not necessary to hold a long EM index allocation at all times. However, emerging stocks have a role to play in portfolio diversification. For that reason, it’s worth tracking EM performance to determine whether the asset class is in rally mode, and when it can add juice to a portfolio when U.S. stocks are underperforming. 

Emerging markets generally have a lower correlation with U.S. equities, than do non-U.S. developed stocks, so it’s likely they can outpace the S&P 500 at times, but should be added judiciously.