The Deepseek Effect

Sean Neethling

Rethinking the stories driving global equity markets

Financial markets are prone to look for news that has the potential to trigger shifts in investor behaviour. Unexpectedly good news tends to increase risk-taking as growth forecasts are revised upwards while unexpectedly not-so-good news tends to decrease risk-taking and usually precedes market sell-offs. The emergence of Deepseek, a Chinese tech startup, that appears to offer a high-quality AI product at significantly lower cost has triggered a relatively pronounced shift in sentiment as investors rethink some of the stories that have been woven into markets. While our investment process at Morningstar does not explicitly consider catalysts for unlocking value, it is important to assess how the impact of Deepseek has impacted market sentiment.

Story #1 | US Exceptionalism

This is a relatively new theme in 2025 but is just the latest version of the Magnificent 7 narrative that positioned US Equity markets as the only game in town despite expensive valuations and record high concentration levels. The latest iteration focused on US market exceptionalism is founded on leading companies including Nvidia, Broadcom and Microsoft having a close to oligopolistic control on AI technologies, with development spending providing growth runways that would take non-US peers years to replicate. Successive 20% plus returns over the last 2 years has normalised US Equities delivering abnormal returns in an environment where risk taking should be significantly more considered than general market sentiment suggests.

The belief that the incumbent US market leaders have developed entrenched barriers to entry that crowd out the emergence of global competitors is being questioned. More specifically, the capital expenditure that was considered necessary to develop a viable product has been challenged by the emergence of Deepseek. This is actually a positive development for the market. It follows historical trends ranging from the introduction of the PC, internet and more recently cloud computing where innovation and competition drives down costs to improve both the quality and accessibility of emerging technologies.

US tech companies remain clear market leaders with established business models and wide economic moats. While they are unlikely to be displaced by new entrants in the short term, the increased competition from rivals like Deepseek improves market structure by potentially leading to better global supply integration and reducing costs. Most importantly, the emergence of new entrants allows investors to better understand industry fundamentals and the price they should be paying for expected growth.

Story #2 | Un-investable Emerging Markets

The story around US exceptionalism can be contrasted with the especially negative sentiment towards supposedly high-risk emerging markets. China, in particular, is (was) perceived as largely too risky to allocate capital to despite historically depressed prices on their own subset of high-quality tech companies. Even within dedicated EM Funds, the average fund manager was approximately 10% underweight China coming into the year.

EM equities delivered an underwhelming 8% last year, but flying largely under the radar was China with a strong, albeit somewhat lumpy, total return of 20% in US dollars. The chart below shows the acceleration of the outperformance by Chinese tech stocks, as indicated by the Hang Seng Tech index, versus general EM as well as broad US Equity and US Tech.

Exhibit 1 | Total cumulative returns of China vs US Equities over the last 12 months (USD)

Source: Morningstar Direct. Data as at 26 February 2025.

It would be incomplete to attribute the approximately 30% year-to-date gain in the Hang Seng Tech index to the Deepseek effect. The most important takeaway from the shift in sentiment is not necessarily based on the emergence of Deepseek itself, but more around the fundamentals of the Chinese equity market. While wide moat Chinese companies like Tencent and Alibaba are not pure tech businesses, they trade at significant discounts to broader US tech peers.

EM is not a one trick pony and by combining differentiated positions investors can feed into the tailwind stemming from Deepseek sentiment without compromising on fundamentals. Broader Emerging markets continue to generate healthy returns in 2025. Brazil and Mexico are very different markets that have both started the year strongly after experiencing significant drawdowns last year. Korea has been mixed but allows a more differentiated entry point in the AI and more specifically semi-conductor supply chain. Both Samsung and SK Hynix are approved to supply high-bandwidth memory (HBM) chips for use in AI processors to Nvidia.

Story #3 | Diversification is the only free lunch

2025 has already started off with investors not putting all their eggs in the US basket. While that is an important development, diversification can actually be exceedingly costly without careful consideration of the forward-looking reward for risk at both the underlying equity and portfolio level. Emerging markets introduce an additional complexity where equities markets are exposed to currency volatility that is exceedingly difficult to price. The correlation of both the level and variance of returns between different assets is one of the most important things to understand in especially turbulent markets.

While US Equities are expensive in aggregate, completely avoiding exposure potentially exposes investors to higher investment risk given the relative size of the market. Investors with a wider opportunity set can look outside the more popular tech names towards small caps as well as more defensive sectors including consumer staples, healthcare and selected financials for better value. Emerging markets are generally undervalued as a group but more considered allocations would allow portfolios to benefit from a lower correlation of returns on both the upside and downside. We currently favour direct exposure to China, Korea and Latin America to complement both the broader emerging and development market allocations in portfolios

Conclusion

Rotating into seemingly less popular countries or regions that may appear un-investable and into less crowded sectors of more popular markets are likely to serve investors well in the current environment. While the Deepseek effect has been net positive for China and mostly negative for the US, Morningstar Global Funds continue to hold overweight positions to a broader mix of EM and DM positions whose fundamentals are not pegged to narrow range of events or catalysts for unlocking value. Volatility can be incredibly difficult to stomach but is potentially the price that investors would need to pay to reach longer term investment goals. Most importantly, choosing a strategy consistent with your willingness and ability to accept an appropriate level of risk, as well as staying invested through volatile markets is key to meeting your investment goals.