A stronger emerging markets rally will need a new era of reforms

Emerging market equities are rallying in 2025, helped by a Goldilocks macro backdrop. But for this rally to stick, we need more than macro tailwinds; we need a productivity story. A modernized “Washington Consensus”—adapted for today’s fragmented, tech-driven world—just might be the place to start.

We have seen, in 2025, a rather peculiar macro Goldilocks scenario for emerging market (EM) equities. Despite real conflicts—and some theatrical ones—the global backdrop has settled into a “not too hot, not too cold” environment, which has been supportive for a variety of risk assets, especially outside the US. Global growth is hanging in there, the US is cooling but not crashing, and recession fears have eased. Central banks have either entered or are about to enter easing cycles, while the “King Dollar” trade sentiment has shifted somewhat, giving a degree of external support.

Emerging market stocks (MSCI EM Index) are up +15.3% in the first half of the year (MSCI World ex US is up 19.0% and is clearly enjoying a similar trade).¹ There is room for the dollar to move lower, but we would be more comfortable with a better micro story to go with the macro—the two together would be powerful.

Geopolitical risks have flared up but mostly been ignored, fiscal pressures across the G-7 are believed to be “tomorrow’s problem,” and the trade dramatics continue to get shrugged off. These three “inconvenient truths” are all still true, but the market appears to have seen this movie before and, at least so far, it has always had a happy ending.

As systematic investors, we are a bit agnostic to macro-driven, “push” style rallies—we take what we get, but at the end of the day, all stock investors buy real companies, so company fundamentals are what drives stock prices over the long term. All things being equal, we prefer micro trades over macro ones.

More productivity in emerging markets, please

In the 1990s, when EM equities were beginning to gain traction as a real asset class, a wave of productivity-focused reforms was underway—urbanization, trade liberalization, privatization of inefficient state enterprises, fiscal discipline, market-based exchange rates, and deregulation. This package became known as the Washington Consensus, championed by the Bretton Woods institutions (though not always practiced by the political leaders in Washington or elsewhere). At its core, it was about using free-market policies to strengthen economic fundamentals—and to a fair extent, it worked.

Today’s challenges are different, but the principle still holds: smart, productivity-enhancing policies are usually the right place to start. That said, the later evolution of the Washington Consensus—especially its emphasis on harsh fiscal tightening during crises—proved problematic. Without generous external support, that kind of conditionality often did more harm than good.

The EM productivity engine is idling

While it may be tempting to do a deep dive into the causes of productivity decline, we will for the sake of brevity, simply state that many emerging market countries have fallen into a “middle income trap,” in which countries that escape high levels of poverty through high growth then stagnate when a general level of moderate per capita income is reached. The impact on global investors is that the climate for debt and equity becomes less attractive (less competition, more complicated access for foreign investors, etc.).

The clearest way to see the impact of this is via trends in foreign direct investment (FDI) where it’s easy to spot the stagnation. FDI flows into emerging markets—excluding China, which relies more on domestic savings—have been largely flat for two decades. The reasons are both internal and external: while many emerging market countries face persistent domestic barriers at home, externally, developed markets have pulled back from trade liberalization. A refreshed Washington Consensus is needed to address that side of the equation.

This time is different

The original Washington Consensus still has a role to play, but it’s an insufficient set of policy tools for emerging markets to regain the productivity crown. Emerging markets now face a more complex landscape shaped by AI, robotics, and a shifting global trade system. Each country will need to reassess where it holds strategic advantage in this new order. Unlike the 1990s, there’s no one-size-fits-all solution. Today’s challenges will be investing in infrastructure (both physical and digital), developing skilled labor forces, and securing reliable energy access. In this regard, China, Korea, and Taiwan are ahead of the game. India has some advantages as well, but others will need to keep pace.

The bottom line

The macro backdrop may be supportive, but lasting gains in emerging markets will depend on renewed productivity and reform. A modernized policy framework—flexible, country-specific, and forward-looking—could be the catalyst this rally needs to become something more durable.

Current positioning

Shifts in risk aversion dominated headlines in the second quarter, but in the end produced more smoke than fire for investors. We have long viewed these macro shifts as risks to be mitigated rather than profited from and kept our focus on the underlying drivers of our alpha generation process (Value, Quality, Sentiment, and Catalysts factors), supported by carefully calibrated risk controls.

Our positioning has not changed significantly throughout the quarter and our preferred trades are shown below. India remains an underweight for us at the moment, but we maintain core positions in selected areas.

Global investors have been largely underweight emerging markets for some time, a positioning that has been profitable, but we think it may be time to reduce these underweight positions. Overall, profitability remains the headwind keeping us from recommending an overweight position. Improved productivity would make us more constructive.