Emerging markets have performed well in recent months and their slowdown 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 the sell-off, the market is not factoring in the extent of price risks, UBS strategist Manik Narain wrote this week.
Narain says market sentiment remains strong in emerging markets, with the UBS Emerging Markets Risk Appetite Index roughly halfway between fairness and euphoria, an atypically strong result given the state of the economy. global expansion and the decline of global production 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 believe that valuations already price in such risks after recent underperformance. We disagree,” Narain said in a Wednesday note.
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 experiencing its most powerful disinflationary drive in at least three decades, with export costs falling and export volumes rising, outsized amounts compared to global levels.
Much of that export surge is primarily hurting emerging markets, especially as China’s deflation has helped the yuan become more competitive with other EM 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.
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.
“In our view, fiscal stimulus likely won’t pay off. This is tilted toward uptake, which is positive for the consumer and web corporations that dominate Chinese stocks, but with little spillover to emerging markets overall,” he wrote. .
Emerging markets are vulnerable to a potential industrial war given their slowing expansion in recent years, with investment as a percentage of GDP lately stagnant at 2008 levels. Additionally, tariff-sensitive sectors such as automotive, metal and infrastructure, represent a greater proportion. Shares of emerging market and non-China stocks are traditionally expensive despite strong returns.
Narain sees countries like Mexico, Vietnam, Taiwan, Korea, and Thailand as likely targets for further tariffs given their relative trade imbalances with the US, he says.