Emerging markets ‘are poised to keep outperforming'

Zawya

18 hours ago

The outlook for emerging markets has stabilised in response to clearer US trade arrangements and persistent US dollar weakness, which are expected to resume, says the latest CIO Office Viewpoint from Lombard Odier.
While US tariffs may weigh more on economies in the next few months, it sees solid earnings growth and a gradual rebound beginning in the last quarter of 2025, write Dr. Luca Bindelli, Head of Investment Strategy and Patrick Kellenberger, Emerging Market Equities Strategist, and Patrick Kellenberger, Emerging Market Equities Strategist.
The US dollar's loss of momentum this year has provided a relief for many key emerging markets. Interest rate differentials, fiscal dynamics, and trust in institutional quality assets are all shifting in response to recent US policies. Lower valuations for EM equities compared with developed markets makes them attractive while in fixed income, higher-than-average yields favour EM hard currency bonds.
In spite of the anticipated tariff-triggered economic slowdown in the third quarter of 2025, trade policy uncertainties are fading. Most emerging markets have also refrained from retaliating against the US measures, limiting the fallout from tariffs on their consumers and industries from price shocks.
The impact of President Trump's country-specific tariffs, announced on August 1, may be lower if product or sector exemptions are factored in. For now, the US's average effective tariff has now risen from 2.4% in early 2024 to an estimated 16.5% today.
In relative terms, US trade tariffs have not been applied more harshly to emerging markets. This leaves them no worse off, and sometimes with better trading conditions than economies including Europe, Canada, or Japan. In addition, the US and China have extended a 90-day truce for the second time. Both countries appear keen to avoid new provocations. The US has loosened export controls on cutting-edge AI chips, and China has not, so far, limited access to its refined rare earths, a market that it dominates.
More broadly, US tariff rates on other EMs are now mostly known, and lower than first threatened. For Taiwan and South Korea, two key markets for the global economy, US tariffs are set at 20% and 15%, respectively. There may also be exemptions for strategically important semiconductors in return for investments by Taiwanese and South Korean chipmakers into the US.
US dollar weakness ahead
While the dollar has stabilised in recent weeks, the report sees further weakness ahead and has shifted its view on the currency from neutral to negative.
'With US inflation ticking slightly higher and companies neither hiring nor firing, market consensus is moving closer to our expectation for three interest rate cuts from the Federal Reserve before the year-end. For global investors, lower US rates will erode the dollar's yield advantage. Moreover, historically the US dollar also tended to weaken further in phases of increasing or elevated 'term premium', or the additional compensation for owning longer maturity bonds. Indeed, while we expect US long-term rates to moderate over time, we still expect the term premium to remain high in light of US fiscal deficit widening. As a result, we anticipate reduced demand for the US currency, while other major central banks and emerging markets are either seeing rates stabilise or fall only modestly, albeit from double-digit levels in Latin America (Brazil),' it says.
Relative yield developments will therefore be detrimental to the USD. Also undermining the need for dollars are falling hedging costs associated with lower US policy rates and less extreme short investor positioning. Another Chinese tariff reprieve can also support EM currency sentiment in the near term, and we have adopted a more positive view on EM currencies.
Investors may also be reassured by political conditions in many markets. In some Eastern Europe, Middle Eastern, and Latin American economies, there is a shift towards more business-friendly policy. In South Korea, the peaceful transfer of power to the centre-left opposition party in June led to strong market outperformance. Latin America will hold a series of important national elections, where voter fatigue with incumbents may propel more market friendly candidates to power.
Alternative flow
Starting in April with the US tariff policy announcements, international investors began looking for alternatives to the US market. Still, EM assets remain under-owned in the developed world. In 2017, a recent high, EM assets accounted for 7% of European and North American investors' portfolios, and that figure stands at 5.1% today.
How are emerging equity markets expected to perform? First, and in relation to the US dollar outlook described above, a depreciating dollar (and appreciating EM currencies) has generally coincided with EM equity inflows and positive equity performance. Relative to developed market stocks, they offer a valuation discount that is currently around 35% in forward 12-month price-to-earnings terms.
This should support inflows as investors are returning to emerging markets in a search for diversification and growth opportunities. Indeed, while we anticipate a slowdown in EM earnings in the third quarter, these should reaccelerate towards the end of the year and continue to provide a source of support to the regional equity outlook, also on a relative basis. We see a good chance that the 24 constituents of the MSCI emerging market index continue to outperform developed markets in 2026.
We increased our exposure to EM equities in May, once US trade policy started to moderate from initial levels and expect all major EMs to post solid returns over the next year.
China may deliver more attractive earnings, thanks to recent policy initiatives and a more liberal stance on the private sector. Taiwan's market looks expensive, but EPS (earnings per share) growth is being driven by AI developments. In Brazil, we see earnings challenged by lower commodity prices, but dividend yields look attractive. We also like South Korean stocks, where corporate governance reforms could lift valuations and robust earnings growth is supported by computer memory/AI demand. In India, and despite the near-term setback from tariffs imposed by the Trump administration in retaliation for Russian oil imports, we expect the situation to stabilise eventually, possibly with progress in Russia/Ukraine peace talks. We see the stock market re-accelerating after a cyclical slowdown reflecting improving domestic demand, and with low inflation, there is scope for interest rate cuts.
In fixed income, we have increased our exposure to emerging market hard currency bonds and reduced our positions in global government bonds. Despite year-to-date spreads narrowing, EM hard currency yields remain higher than their historical averages and provide more attractive yields compared to other fixed income segments. In particular, EM bonds offer similar yields to those available in the comparatively riskier credit segments. Moreover, we expect EM spreads to remain relatively more stable as the EM economic outlook becomes more resilient.
Finally, and with looser Fed monetary policy expected soon, short-dated US Treasury yields should decline more quickly than longer-dated maturities, generating a so-called steepening yield curve. This development would typically allow EM debt to continue to outperform US Treasuries. - TradeArabia News Service
Copyright 2025 Al Hilal Publishing and Marketing Group Provided by SyndiGate Media Inc. (Syndigate.info).