Emerging markets haven’t fared well in recent months and their downturn is likely to worsen, UBS said.
The MSCI emerging markets index has fallen over 10% since hitting a two-year high on October 2 amid fears of president-elect Donald Trump’s proposals for widespread tariffs, while most EM currencies have fallen sharply.
But despite these big sales, the market is not taking into account the magnitude of the price dangers, UBS strategist Manik Narain wrote this week.
Narain says market sentiment remains strong in emerging markets, with the UBS Emerging Markets Risk Appetite Index sitting roughly halfway between fairness and euphoria, an atypically strong result given the state of global expansion and decline of the global manufacturing industry in recent years.
Meanwhile, earnings estimates mean a 13% earnings expansion for emerging market stocks through 2026, well above the 3% expansion achieved during Trump’s industrial war with China in 2018 and 2019, he said. .
Other indicators, like compressed credit spreads and low costs for hedging against EM currency depreciation, show the market is pricing in tariff risks at an unrealistically low 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 that investors are ignoring the option that the fallout from China’s economy could spread to vulnerable emerging economies, causing their stocks and currencies to fall even further than they have done recently. incorporated into the market.
“Rather than in China itself, we see larger market moves playing out in the rest of the emerging world,” he wrote.
Narain explained that China is already experiencing its most powerful disinflationary impulse in at least three decades, with exports falling and export volumes rising, amounts disproportionate 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.
China’s new price lists would most likely only increase the volume of the country’s existing exports, hurting production and investment in emerging markets, he said.
“Tariffs would likely be inflationary for the United States, but the opposite will be true for those economies,” he wrote.
The price lists could also fuel a slowdown in Chinese imports as the country faces lower profitability and fiscal problems.
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.
“Fiscal stimulus won’t compensate, in our view. That is tilting towards consumption — positive for the consumer and internet companies that dominate Chinese stocks — but with little spillover to broader emerging markets,” he wrote.
Emerging markets are increasingly vulnerable to a potential trade war given their slowing growth in recent years, with investment as a share of GDP currently stuck at 2008 levels. Plus, tariff-sensitive sectors like autos, steel and infrastructure compose a higher share of EM stocks, and those outside of China are historically expensive despite flat 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.