8. Emerging markets have the wind in their sails

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8. Emerging markets have the wind in their sails

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8. Emerging markets have the wind in their sails

What we said
We expressed a constructive view on emerging markets, expecting them to benefit from a stable‑to‑weaker US dollar, fiscal discipline and solid underlying growth.

How it has played out

Strong equity performance despite headwinds
The thesis has played out strongly, even against the backdrop of the Iran conflict and its impact on commodity markets. The MSCI EM Index is up around 27% in local‑currency terms year‑to‑date, outperforming developed markets by roughly 16 percentage points.12

This outperformance also reflects EM currency appreciation versus the US dollar, as investors have sought diversification away from increasingly concentrated developed‑market indices.

Despite this strong run, the valuation gap between emerging and developed markets – particularly the US – remains wide, which should continue to attract capital flows.

A key feature of the rally is its concentration in AI‑related names. Taiwan and South Korea have overtaken China as the largest markets in the MSCI EM Index, following gains of about 55% and 103% respectively since the start of the year.

Solid fundamentals
Macro fundamentals remain a powerful support. The IMF’s Spring 2026 World Economic Outlook projects EM GDP growth in 2026–27 at roughly double that of advanced economies, despite the negative impact of the Persian Gulf crisis on countries most exposed to the Strait of Hormuz, including parts of Southeast Asia and India. Stronger growth underpins healthier public‑finance profiles than in many industrialised economies. In markets, this has supported the resilience of EM bond spreads versus US Treasuries and contributed to higher total returns for EM bonds, helped by favourable carry.

Commodities and geopolitical risks
High commodity prices are usually a tailwind for EM, and at first glance H1 2026 appears to confirm this. However, the current cycle is more nuanced. Prices across energy and industrial metals have risen largely because of supply disruption from the closure of the Strait of Hormuz.

This potential scarcity is a double‑edged sword:

  • On the positive side, demand has shifted towards alternative suppliers, particularly in South America, supporting export revenues.
  • On the negative side, higher input costs – especially for fertilisers – risk driving a sharp rise in inflation in lower‑income economies, where food prices carry a larger weight in consumption baskets

Outlook for H2 2026
H2 2026 could mark the beginning of a structural re‑rating of emerging markets. Stronger growth fundamentals, improving governance in several key countries and the diversification benefits EMs offer relative to increasingly concentrated developed‑market indices should continue to attract capital. Furthermore valuations remain supportive, as well as EM currency appreciation underpins the case for further inflows.

The main risk to this constructive outlook is commodity‑driven inflation. The current energy and metals price shock is driven more by supply disruption from the closure of the Strait of Hormuz than by demand. While this supports export revenues for some EM commodity producers, higher input costs – especially for fertilisers – could trigger a sharp rise in inflation in lower‑income economies, where food carries a larger weight in consumption baskets. A prolonged Middle East conflict and more persistent supply disruptions would increase this risk.

Overall, we remain positive on EM for H2 2026, but see a more differentiated environment ahead, where country‑ and sector‑level selection – particularly around AI‑linked markets such as Taiwan and Korea, and more vulnerable lower‑income economies – becomes increasingly important.

Action for investors:

  • Maintain a constructive stance on EM equities, with a focus on markets where fundamentals are strongest. As in Theme 1, Taiwan and India as a value diversifier remain core exposures.
  • Keep exposure to commodity‑related equities, which can benefit from elevated prices and supply re‑routing, while monitoring inflation risks in more vulnerable EMs.
  • Manage concentration risk actively: the EM index is increasingly dominated by a handful of AI‑linked markets and stocks. An active approach is preferable to purely passive exposure.

12 Source: LSEG Data & Analytics. Data as at 31 May 2026.

8. Emerging markets have the wind in their sails

It is fair to say that the attitudes of investors to emerging markets have waxed and waned over long periods. Enthusiasm over their long-run growth prospects has so often been quashed by the re-emergence of crisis. Cheap valuations have been revealed as a value trap. And structural reforms often fail to materialise. 2026, we think, will be a year in which a more favourable appraisal materialises.

Strong valuations
Emerging market equities are currently priced at a discount relative to developed markets (Figure 11). While such a discount is normally the case, it is wider than on average and we expect that it will attract capital inflows, especially in an environment of low global interest rates.

A weak US dollar
In an environment of moderating inflation and trough interest rates, we expect the US dollar to be generally stable to lower in the year ahead. Historically, emerging market equities have fared well against a lower/stable dollar trend, as it reduces dollar-denominated debts and makes local assets relatively more attractive.

Fiscal discipline
Emerging market economies are often incorrectly assumed to face higher debt burdens than advanced economies. In fact, many of these economies have become fiscally disciplined over the last few decades, learning lessons from previous debt crises such as the Tequila Crisis of 1994. Now, countries such as Mexico, Brazil and India face gross government debt levels as a percentage of their GDP lower than those of advanced economies such as the US, UK, France and Japan.

Emerging market domestic demand resilient
In emerging markets, domestic demand resilience and strong consumer spending remain important pillars of growth. This is most notably the case in India, whereas in China consumer demand is still restrained as a result of a debt overhang, a weak housing market and poor consumer confidence. Even so, China still remains key to overall emerging market developments. It has outsourced production to smaller economies (for example Vietnam) and has helped build infrastructure around the world under its Belt and Road Plan – even though that is now more constrained in its ambitions.

“ Favourable global demand or supply constraints for key commodities (minerals, metals, energy) could improve export revenues and fiscal balances. ”

Commodities
In addition to domestic demand forces, several emerging markets are commodity exporters. Favourable global demand or supply constraints for key commodities (minerals, metals, energy) could improve export revenues and fiscal balances.

A salient example is China’s rare earths dominance. The world’s second largest economy accounts for almost half of global reserves, two-thirds of global production and over 90% of global refining (Figure 12). China has been strategically building these capabilities over decades. A famous quote from former leader Deng Xiaoping in 1992 highlights this point: “The Middle East has oil and China has rare earths”.

Rare earths are versatile, entering supply chains for products ranging from loudspeakers and X-ray machines to missile guidance systems. They are also used in the production of high-tech hardware that AI relies on and will benefit from the AI race. Additionally, the transition to clean energy may raise demand for critical minerals (lithium, cobalt, etc.), benefitting emerging economies that host these resources.

Strong demographics
Emerging economies that have typically received less attention – notably those in the Gulf region – should continue to do well even as the world pivots away from the use of oil and gas. In particular, they should benefit from their commitment to substantial infrastructure projects and favourable demographics of younger and growing populations (notably female participation in the Saudi workforce).

There have been outflows of funds from emerging market fixed income markets since 2002 (and broadly flat equity flows over the same period). We think the above points set the scene for fund flows into emerging markets to increase and for emerging market performance to recover relative to developed markets.

Risks to recognise
As with any theme, there are risks that one should be aware of. Geopolitical tensions have been elevated in recent years and this remains the case today. If these tensions were to spike, a flight to safety could pause the weaker dollar trend that benefits emerging markets. This trend could also be arrested by a more hawkish Fed which fails to deliver on market rate cut expectations if US labour market or inflation data is stronger than expected. In addition, the overhanging threat of US tariffs is a prominent risk for the commodity exporting emerging market economies, threatening to disrupt trade flows and lower economic growth.

Action for investors:

  • For 2026, we see a swing back in emerging markets favour supported by a generally benign global environment (low, but stable growth and inflation) and a stable to weaker dollar. Valuations are at a discount to developed markets
  • EM local currency debt favoured in addition to emerging market commodities.
  • ‘Picks and shovel’ materials companies offer potential growth and opportunities.

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