We have frequently written about the dominance of US large cap equity returns. Since the mid-2000s there have been many factors supporting this dominance: fiscal policy, regulatory environment, capital investment, market transparency, etc. In recent years, within the global opportunity set, we have skewed much of our risk toward US large cap equities and the S&P 500. This was done not because we were ignoring other opportunities within the global opportunity set, but because the supporting factors and our outlook suggested that US large cap was the most attractive asset class. 2025 was another strong year for US large cap equities. When the S&P500 has strong performance, many interesting things happen because of its size and visibility: hedge fund managers with strong risk-adjusted returns may see outflows even when their return per unit of risk was in line with expectations and higher than that of the S&P 500; other asset classes may be abandoned even when they provided diversification with attractive return and risk characteristics; and lastly, investors may become myopic about comparing portfolio performance to a single asset class or index – in this case, the S&P 500.
While the S&P500 may have been the only game in town for the last 20 years, we caution focusing solely on US large cap with no consideration for other assets within the global opportunity set. Figure 1 shows a breakdown of the Value-Weighted Global Portfolio which we will refer to as the global opportunity set. As you can see, US equities are the largest asset class. Their dominance becomes even more significant if we exclude fixed income and only consider equity and the remaining risk assets. While other elements of the global opportunity set may have underperformed the S&P500 in recent years and may be a significantly smaller percentage of the global portfolio, that does not mean that a portfolio can never benefit from diversifying into these assets.
Figure 1
Source: Bloomberg, Goldman Sachs, AAFMAA Wealth Management & Trust LLC
As we discussed, when the S&P 500 has returns that are significantly above their long-term average, like the 17.9% return in 2025, investors often appear to discount other assets within the global opportunity set. Figure 2 shows the 2025 returns to all assets in the global opportunity set. It may be surprising to some to see that the S&P 500 return was in the middle of the pack. Notice also the strong performance of Emerging Market equities (34.3%), second only to gold which returned 63.9%. There was significant opportunity to add value by diversifying outside of the S&P 500 in 2025. It’s important to remember that US large cap equities are only about 26% of the Value-Weighted Global Portfolio. If we restrict our analysis to global equities, then the S&P500 is still only about 53% of MSCI All Country World Index Investible Market Index (this index includes 99% of global equities). The important point to remember is that even though US large cap equities are the largest component of the global equity market, they are not so large that the remainder of the opportunity set can be ignored. It is possible to match the performance of the S&P 500 and in turn still underperform the global equity market.
Figure 2
Source: Bloomberg, AAFMAA Wealth Management & Trust LLC
We know that 2025 reversed a long-term trend of US outperformance of international equities. What have we seen so far in 2026? Figure 2 also shows the returns of major asset classes in January 2026. Interestingly, January 2026 looks much like the whole of 2025 with Gold (+12.4%) as the strongest performer, followed by Emerging Market equities (+8.9%) and the S&P500 (1.4%) in the middle of the pack. If we delve a little deeper, there are some other interesting changes in markets.
Within the S&P500, January saw a significant sector rotation with Information Technology (-0.1%) being one of the worst performing sectors and Energy (14.2%) having the strongest performance. Additionally, both small (5.6%) and mid cap (4.0%) outperformed large cap and, finally, value stocks (2.5%) outperformed growth (-1.0%).
The outperformance of international and emerging markets relative to US large cap has taken place over the last 13 months, so we think it’s important to look at these asset classes as well as others within the global opportunity set and assess their long-term outlook. In this case, we are going to focus on the relative performance of US large-cap equities and international equities, especially emerging market equities, and discuss why the trend that began in 2025 may be set to continue. As we’ve pointed out in the past, investing into an asset class that is highly correlated but has lower returns and higher risk is not diversification that we want to add to our portfolio. It’s important that our outlook suggests that these other asset classes will add true diversification and improve the return/risk characteristics of our portfolio.
Because our primary interest is ensuring that our clients’ portfolios’ return and risk allow them to achieve their long-term goals, we will take a similar long-term view of the relative attractiveness of US large cap (S&P 500) and emerging market (MSCI Emerging Market) equities. We will start with a look at valuation. Figure 3 shows the cyclically adjusted price/earnings (CAPE) ratio for both the S&P 500 and MSCI Emerging Markets. The CAPE is calculated as price divided by the average real earnings over the prior 10 years. Using 10 years of earnings removes the cyclicality and volatility associated with using a single year of earnings, which is standard in price/earnings ratio calculations. For these reasons, the CAPE has strong predictive power for forward equity returns in the 7 to 10-year range. The relationship is intuitive, higher CAPE (price relative to real earnings) is associated with lower equity returns in the subsequent 7 - 10 years.
Figure 3
Source: Bloomberg, AAFMAA Wealth Management & Trust LLC
The current level of the S&P 500 CAPE is 36.9. The last time the CAPE was at this level, when we have 10 years of subsequent returns, was August 2000 and the annualized return for the S&P 500 over the following 10 years was -1.37%. We reached a similar level in December 2021 and, after selling off 18.12% in 2022, the market recovered over the following three years. Again, the predictive power of the CAPE is in the subsequent 7–10-year periods, so it’s too early to draw any conclusions about the more recent spikes in the CAPE.
If we think about equity returns broken down into their components, then total equity return is equal to earnings growth, plus dividend yield, plus valuation change (we could also add buybacks plus currency translation, but for the sake of this example we’ll just focus on the three components). When we look at the current levels of the CAPEs versus their long-term means, we can get a sense of what the potential impact from valuation change could be. Looking first at the S&P 500 with a current CAPE level of 36.9 and a long-term mean of 22, if we assume that the CAPE will revert to its long-term mean over the next 10 years and the change is discounted equally over each year, then the potential annual drag from valuation change would be -5.7% per annum.
If we do the same exercise with MSCI Emerging Markets, which has a starting CAPE of 24.6 and a long-term mean of 19, then the annual drag from valuation change would be -2.5%. However, we don’t expect total returns for either market to be negative over the next 10 years as we expect earnings growth and dividend yields to be larger than annual valuation offsets (that will likely be smaller than those in this example). This exercise is simply to show that starting valuations are much more attractive for emerging market equities and the potential for valuation compression drag is much lower relative to the S&P 500.
Dividend yields are fairly stable, and our expectations are that the MSCI Emerging Markets dividend yields will be about 1% higher than the S&P500, which is consistent with the spread over the last several years. This gap could widen against the US as some emerging markets are encouraging higher payout ratios. Now, to get an idea of what the trend in earnings might be, Figure 4 shows the Bloomberg real GDP estimates for the US, world and major emerging markets. First, we see that global growth is expected to be in excess of 3.0% over 2026 and 2027; this should by itself be positive for emerging markets. Second, we see that many of the major emerging markets, especially India and Asia excluding Japan have expected GDP growth well in excess of the US. The GDP estimates are consistent with the Bloomberg expected earnings growth over the next two years. S&P 500 earnings growth over the next two years is forecasted at 15% and 12.49%, respectively, while MSCI Emerging Markets come in at 19.43% and 28.20%.
Figure 4
Source: Bloomberg, AAFMAA Wealth Management & Trust LLC
Longer-term, our point is that the attractiveness of emerging markets is based on more than relative valuation. Emerging markets are benefiting from many supportive factors that are underpinning expected growth and earnings. Many of these factors suggest emerging market equities should benefit in the near term. Improving fiscal discipline, corporate governance and regulatory support helped drive strong emerging market equity returns in 2025. International Monetary Fund estimates show that in 2025, developed markets had debt/GDP ratios of more than 110% whereas emerging market ratios stood below 72%. Many of the countries within the MSCI Emerging Markets Index are countries that could be considered developed -- for example, South Korea. In addition, we see the following factors providing near-term support for emerging markets in 2026:
Expected US Dollar weakness and waning confidence in American Exceptionalism were two factors supporting our allocation to international equities in 2025, and we expect these factors to continue to be supportive in 2026 and beyond. The US Dollar Index fell more than 9% in 2025, which supported strong Emerging Market equity performance. Emerging Market equities are significantly negatively correlated (US Dollar down, emerging market equities up) with the US Dollar. We see the US Dollar as overvalued and expect this weaker trend to continue, especially versus Asian currencies.
While gold’s 63.9% increase in 2025 was headline news, many other metals had similarly large gains. Copper, silver, lithium and other metals had strong gains. In some cases, returns were driven by AI infrastructure demand. Strong metals prices will be supportive of the non-Asia emerging markets like Brazil, South Africa and Chile.
Emerging Markets should continue to benefit from interest rates that were broadly lower in 2025. Generally, less monetary easing is expected in 2026 with the exception of Brazil, which is expected to cut rates as much as 3% this year.
We expect the benefits of AI to be more broad-based, which should support US companies outside of mega-cap technology as well as emerging markets. AI-driven capital expenditure adoption has been strongest in Northern Asia, then China, with lower adoption rates in non-Asian emerging markets.
While US large-cap equities have dominated returns over the last 20+ years, that trend may not continue forever. We caution investors not to become fixated on the S&P 500 as the only asset class and only measure of performance. The long-term trend in outperformance has resulted in global investors being overweight US large-cap equities, which makes it especially important to consider the entire global opportunity set when constructing a strategic portfolio going forward. We added to international equity exposure in 2025 on narrowing growth differentials, a weaker US dollar, and concerns about US Exceptionalism. For these reasons and others, we have a similar constructive outlook on emerging market equities, especially Asia Pacific. Relative valuation, growth and rate expectations, as well as more broad-based AI benefits should underpin emerging market equities in the near future.
Yours in trust,
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