Emerging markets have performed well in recent months and their slowdown will most likely worsen, UBS said.
The MSCI emerging markets index has fallen more than 10% since hitting a two-year high on Oct. 2, on fears over President-elect Donald Trump’s proposals for widespread tariffs, while top emerging market currencies They fell sharply.
But despite these big sell-offs, the market is not taking into account the magnitude of the price dangers, UBS strategist Manik Narain wrote this week.
Narain says there remains strong market sentiment across EM, with the UBS Emerging Markets Risk Appetite Index standing roughly halfway between neutral and euphoric — marking an atypically strong reading given the state of global growth, and with global manufacturing declining in recent years.
Earnings estimates, meanwhile, imply 13% earnings growth for EM stocks through 2026, far greater than the 3% growth realized during Trump’s trade war with China in 2018 and 2019, he says.
Other indicators, such as credit spread compression and low hedge prices rather than depreciation in emerging currencies, show that the market is pricing price perils at an unrealistic level, he says.
“Some investors say valuations are already pricing in those dangers after the recent poor performance. We disagree,” Narain said in a note Wednesday.
Narain argued investors are ignoring a large possibility that the fallout of China’s economy will have spillover effects on increasingly vulnerable EM economies, posing further downside for their stocks and currencies than are currently priced into the market.
“More than in China itself, we see greater market movements in the rest of the world,” he writes.
Narain explained that China is already seeing its strongest disinflationary impulse in at least three decades, with export prices down and export volumes up both outsize amounts relative to global levels.
Much of this increase in exports basically hurts emerging markets, especially since China’s deflation has helped the yuan become more competitive against other emerging market currencies, he said.
New tariffs on China would thus likely only grow the country’s existing export volume, hurting EM countries’ production and capex in the process, he says.
“Tariffs would likely be inflationary for the United States, but the opposite will be true for those economies,” he wrote.
Tariffs could also help accelerate a slowdown in China’s imports, too, as the country faces weaker profitability and fiscal headwinds.
Such an effect would continue to weigh on manufacturing competition and would also begin to affect commodity exporters in emerging countries, he says, with little relief from the country’s drastic stimulus measures.
“In our view, fiscal stimulus will not compensate. “This is tilted towards ingestion, which is positive for the customer and the corporations that dominate Chinese stocks, but with little spillover to broader emerging markets,” he wrote.
Emerging markets are vulnerable to a potential industrial war given the slowdown in their expansion in recent years, with investment as a percentage of GDP lately stagnant at 2008 levels. In addition, tariff-sensitive sectors, such as automotive, metal, and infrastructure, account for a larger share. The percentage of emerging market and non-Chinese stocks are traditionally expensive despite strong returns.
Narain sees countries like Mexico, Vietnam, Taiwan, Korea and Thailand as the most likely targets for new price lists, given their relative industrial imbalances with the United States, he says.