After underperforming developed markets for over a decade, emerging markets are showing signs of resilience amidst global geopolitical tensions and lofty equity valuations. Several factors suggest emerging markets, particularly China, could provide both diversification benefits and more attractive return potential going forward compared to their traditional role as a high beta play.

First, China's post-Covid consumer is in a remarkably strong position. Strict lockdowns led to suppressed demand, resulting in substantial savings and pent-up spending power. Chinese households are far less levered than their Western counterparts. As China steadily reopens and consumer confidence rebounds, this "dry powder" could fuel a powerful rebound in domestic consumption and economic activity.

Second, China's rapid emergence as a global leader in innovation is becoming too obvious to ignore. Far from being mere copycats, Chinese companies are now at the cutting edge in areas like electric vehicles, batteries, digital payments, e-commerce and more. Interviews with younger Chinese consumers reveal tremendous pride in the quality and capabilities of homegrown technology. This "rise of Chinese cool" looks set to drive demand for local brands. While geopolitical tensions grab headlines, China's sheer economic weight means most countries have a strong incentive to maintain close trade ties.

Third, after a decade of underperformance, valuations in emerging markets are heavily discounted both in absolute terms and relative to developed markets. It's not unusual to find high quality, fast-growing emerging market companies trading at single digit PEs with high single digit dividend yields - a far cry from the nosebleed valuations still prevalent in the U.S. If domestic-oriented emerging market companies and sectors can decouple even partially from global sentiment, the risk/reward looks very favourable.

Fourth, the long-term structural story of emerging markets' under-penetrated consumer sector remains intact. As was vividly illustrated in the so-called "elephant chart", the middle class in developing countries experienced dramatic gains in income and living standards over the past 30 years as the Western middle class stagnated. While Covid temporarily halted this progress, that rising middle class aspiration and growth potential is still there to be unlocked again if and when they start to spend that “dry powder".

To be clear, selectivity remains crucial. Passive, broad-brush emerging market allocations are unlikely to automatically provide as much diversification. Investors will need to identify the specific countries, sectors and companies with resilient domestic demand, attractive valuations and innovative capabilities. But the ingredients are there for emerging markets to potentially offer both higher returns and diversification in a world where both are scarcer than ever. After flying under the radar for years, emerging markets may be the stars aligning for the much vaunted emerging consumer growth strategy of yesteryear to finally play out.