Positive structural case for EM won’t collapse under a few Fed hikes
Lead — Emerging markets (EM) continue to showcase resilience against a backdrop of anticipated Federal Reserve interest rate hikes, which are projected to be three in total by the end of the year. According to Bank of America Global Research, EM equities have significantly outperformed the S&P 500, with returns more than double, signaling strong investor confidence. Per the full note from BofA, this positive sentiment is fueled by long-term capital flows into EM and attractive interest rate differentials, despite a stronger US dollar potentially weighing on these markets. Future trajectories for EM will also hinge on geopolitical stability, particularly in regions like Brazil where political clarity could aid market recovery.
What the desk is arguing
The desk emphasizes that emerging markets are likely to maintain their rally even if the Fed proceeds with multiple interest rate hikes this year. As noted by BofA's David Hauner, compelling long-term flows and a favorable structural environment continue to underpin EM resilience, reflecting a broader systemic shift rather than a mere reaction to US monetary policy.
For instance, the BofA commentary highlights that EM equities have outperformed US markets markedly, with year-to-date returns exceeding the S&P 500's moves. Such data underscores the structural support for EM, particularly through robust demand and shifting investor appetites towards diversification from the US dollar.
Where it sits in our coverage
While we do not have a specific target designated in our internal coverage, emerging market currencies have a fluid dynamic influenced by the proposed Fed hikes and geopolitical factors. According to jpmorgan, their March 2026 target for key pairs is set at 1.10, while bofa is positioned at a more conservative target of 1.04 for the same tenor. The divergence in these targets reflects contrasting views on the resilience of EM currencies against future rate hikes.
How other firms see it
Firms like jpmorgan appear to align with BofA’s bullish sentiment on EM, with both emphasizing strong fundamentals as a cushion against rising US rates, while firms like bofa present a more cautious outlook, forecasting potential headwinds from these rate changes. The mixed perspectives suggest that traders should monitor adjustments in currency pairs such as USD/BRL and USD/TRY, which directly correlate with evolving perceptions on EM stability and US monetary policy.
What the calendar says
Currently, there are no high-impact events scheduled that would directly influence the EM landscape in the next 30 days. Traders might look instead to the broader economic indicators that emerge in the wake of the Fed's rate decisions for any paintbrush strokes on emerging market confidence.
01Emerging markets show strong performance amid three expected Fed rate hikes this year.
02BofA reports EM equities have outperformed the S&P 500 significantly, reflecting strong underlying demand.
03Brazil's political dynamics could either hinder or support EM strength depending on clarity regarding future policies.
04Interest rate differentials and sustained capital flows are critical factors in maintaining EM resilience.
Market implications
Traders should monitor EM currency pairs closely, especially USD/BRL, which are likely to react to both U.S. rate changes and local political developments. A break above 1.12 on key EM currencies may indicate a stronger bullish sentiment within this space.
Risks to this view
Key risks include unexpected hawkish stances from the Fed that could lead to stronger dollar appreciation, alongside geopolitical instability related to elections in emerging economies, which could dampen investor sentiment in these markets.
Hello and welcome to Global Research Unlocked where we discuss what's rising from both industries to rising risks and opportunities in global markets. I'm T.J. Thornton, Head of Product Marketing at BFA Global Research and we're recording this episode on Wednesday, July 1st, 2026.
In fact, the way EM has held up well during this period of the Iran war, the old price volatility, I think to some extent underscores that point. So yes, we stay structurally bullish, we think that weakness on the back of Fed hikes starting would probably be a buying opportunity into better 2027, where we expect that global inflation should be coming lower. As oil prices come down, the base effects from 2026 would be favorable, meaning you can globally get lower rates again, go back to a weaker dollar view and all of that would be meaning that, again, you want to be long in emerging markets.
Emerging markets as a whole have continued to perform well, more than doubling the returns of the S&P so far this year. That said, the dollar has been rallying over the last few months and the market looks for Fed hikes before the year is through. A stronger dollar and tighter central bank policy are often viewed as negatives for emerging markets.
So today, we're talking to David Hauner, Global Emerging Markets Fixed Income and FX Strategist about his latest use on EM. We'll also hear from David Becker, Head of LATAM Equity Strategy on Brazil, which faces a critical election this October and where markets have sold off from high scene earlier this year. David, thanks for joining.
Thanks for having me. Thanks for having me. So David, you've been bullish on EM since early 2025, but you did sound more cautious when the Iran war started.
How do you feel now? We're still cautious tactically, meaning until we have more clarity on the Fed hikes, which our team is now predicting for the last quarter of the year, but we are still constructive on emerging markets from a longer term perspective. The reason why we turned more cautious when the Iran war started was because we felt that at this point, investors were very heavily invested in emerging markets.
There was a huge amount of enthusiasm still in February and moreover, we felt that there would be probably a longer lasting global inflationary impact, which would lead central banks to tighten, which of course is negative for global growth. We also felt that there could be a risk that the impact on inflation is more pronounced in the U.S. because the economy there is doing better and that could eventually lead to dollar strength. So we still think that this theme is gradually playing out.
We as a house are calling for Fed hikes. We think that investors have not really fully come around to this view just yet. We still meet a lot of investors who doubt that the Fed will be hiking.
Markets of course at this stage are only pricing a little bit of hikes, certainly not that we predict and we therefore feel that over the course of the summer, with U.S. data based on our U.S. economics view still staying strong, we'll probably face some dollar strength, some headwinds for emerging markets. So tactical caution is still the way to go until we have clarity on the Fed, which we probably won't get before the autumn. Are Fed hikes necessarily bearish for EM?
You mentioned our U.S. economics team is actually more hawkish than the market. They're looking for three hikes by year-end. But haven't there also been hiking cycles when EM has performed well?
Yes, this is true. There have been such examples. The latest would be the hikes in 2017, where emerging markets still did very well.
But the conditions under which this can happen require that global growth is really strong. So 2017 was a rare case where global growth was really powering ahead across regions, Europe, Asia, U.S. In that case, it's fine for the Fed to hike for emerging markets because the strong growth in the U.S. and elsewhere pushes asset prices high anyway.
And it also means the dollar doesn't necessarily have to rally because there's still capital flowing into emerging markets and other developed countries. But at the moment, it just looks more like a case where the U.S. exceptionalism is a little bit back, where you have strong growth in the U.S. Of course, the AI theme, very strong labor market lately.
But Asia and Europe are still suffering from the effects of the Iran war, the supply chain disruptions, domestic demand in China has been very weak. The only thing that is really growing nicely in China is exports. Many emerging markets in Asia that are commodity crude oil importers are in a situation where they also have to hike themselves, which is not great for their domestic growth stories.
So that's why we feel that this time, Fed hikes and the three Fed hikes that we're predicting as a house are probably going to be a headwind for emerging markets. We need to be clear that three hikes would just take us back to the level of rates that we had in early 2025. So it's not a dramatic change in the bigger picture.
And it doesn't mean that we're changing our structurally constructive view on the end, but it's a headwind that we have to contend with. OK, in U.S. midterms, there was a primary in Colorado yesterday that got a lot of attention. So that's something the market's probably going to focus on again more seriously.
Are they an important theme for EM and how could they have an impact? So anything that happens in the U.S., if it has an impact on the dollar and or U.S. equities, it will have an impact on emerging markets. So the midterms may affect EM if they, for example, have an impact on the U.S. equity market, if there's some sort of impact on the popular tech trade.
In that case, let's say there was going to be some pullback in tech stocks. It would probably mean a weaker dollar. And so that actually, in some sense, is actually good news for EM.
But again, it also depends on how quickly such a move happens. If there's a very sharp move in equities, then normally during that period, there's risk off, which is not great for EM. But after such a move, it may actually mean the dollar is weaker because it could mean that the Fed actually doesn't hike as much as we are currently seeing.
So this is the mechanism through which the midterms could potentially affect emerging markets to the extent that they have some sort of impact on Fed policy. There's, of course, some discussion around whether the Fed would be moving rates around just at the time of an important election. This is one of the debates we have with investors, for example.
OK, David, how does China play into your view? The local markets have performed pretty well, even if the Internet companies and some of the ETFs that people often look at have not. Yes, we have in China, we have a very asymmetric situation for asset prices because you have some sectors, particularly tech, which is doing extremely well.
We also have exports, which are doing very well. But then again, domestic demand is very weak. So the whole domestic demand related equity space has been weak.
And the currency is very interesting because it is very cheap on most models and including our own. We actually think that the Chinese currency could easily be 10 to 15 percent stronger. But then it's not.
And why is it not? Because a lot of these export surpluses that should come back to China are actually staying abroad. Why do they do that?
Because Chinese exporters find that holding them in other currencies gives them more interest rates because the Chinese interest rates are very low. So that is a problem that, of course, would get bigger if the Fed hikes three times, as we are saying, because it means that it becomes actually more attractive for exporters to keep their cash on outside of the Chinese renminbi. So what we've been saying is that there's some risk that the very popular trade in the market to be currently long.
The Chinese currency could come under some pressure because of these Fed hikes that we are predicting. So what we are saying is that there can be some weakness in the Chinese renminbi over the course of the next several months against the dollar because the market is positioned very long the currency. And we think that can come under pressure due to our view on the Fed.
OK, and David, it sounds like your caution on EM is a bit more short term, like the market just needs to deal with the Fed hikes that are coming. But, you know, we're also not talking about years of Fed hikes ahead of us. The team's looking for three and then no changes next year.
Is that right? And do you still want to buy GIPS and EM for, you know, what could be a multi-year performer? Yes, absolutely.
So we have gone structurally bullish EM in early 2025. The idea back then was that we're at the beginning of a period where investors want to diversify out of very heavy positioning in U.S. assets, particularly also in U.S. fixed income into other currencies that give carry like in emerging markets, and that we would be seeing a structurally weaker dollar over the next couple of years. And that investors were quite under-invested in emerging markets at that stage.
So all of these things are still correct, we believe. So our caution now is purely tactical. We were more cautious when the Iran war started.
We still want to be a bit cautious until the Fed hikes are clearer, until we know where the peak of the hiking cycle is really going to be. But we don't expect this to be a huge cycle. I mean, just compared to where we went in 2022, when we had an even bigger inflation problem, back then the Fed hiked literally by about five percentage points.
So in this case, we're just talking about 75 basis points. So clearly, this is a comparatively tiny adjustment. We still think that carry trades in currencies, bond markets will remain attractive in the years to come.
We still think that this is the diversification story out there. We still hear from many of our clients that their own clients, the end investors, the asset allocators, feel that they have too little exposure to emerging markets, want to add to the asset class. And we still think that emerging market fundamentals are better than they have been several years ago.
In fact, the way EM has held up well during this period of the Iran war, the oil price volatility, I think to some extent underscores that point. So, yes, we stay structurally bullish. We think that weakness on the back of Fed hikes starting would probably be a buying opportunity into better 2027, where we expect that global inflation should be coming lower as oil prices come down.
The base effects from 2026 would be favorable, meaning you can globally get lower rates again. We go back to a weaker dollar view and all of that would be meaning that, again, you want to be long in emerging markets. OK, and just on the flows case, and we've talked about this a little bit before, but right earlier in the year, EM was a pretty popular trade.
There were a lot of inflows. I guess, for one, what's happened since, you know, have people kind of changed their views on EM? Have we seen outflows?
And then, you know, looking back, say, 10 years, you know, could you talk about how little flows we've seen into EM versus other markets and, you know, why that's part of your kind of more bullish longer term view? Yes, so at the beginning of the year, investors were extremely constructive on EM. In fact, we wrote a piece early in the year which was called Emerging Market Bears are extinct.
And literally every single person we spoke to in January wanted to add into EM assets in 2026. Then, of course, we got this shock from the Iran war. And now we're talking about some Fed hikes.
Still, the good news is that this year, despite these headwinds, there has actually been inflow into emerging market assets, both in fixed income as well as in equities. The flow was very strong in January and February. In March, there was a pause because of the volatility.
In April, there was actually inflow again, which we interpret as a sign that investors still want to buy the dip. And, you know, the dip that was presented essentially by the volatility due to the Iran war was then seen as a buying opportunity. Now we still hear from many of our asset management clients that they are seeing their own clients, the asset allocators, wanting to add more.
I think that is going to remain a constructive factor. I think that it means basically that pullbacks will continue to be used as an opportunity to add more EM exposure across the board, both in equities as well as in fixed income. Now, as you mentioned, emerging markets during this decade of dollar strength that basically prevailed from 2015 when the China story took a big setback until 2025.
During this period, there were significant outflows from emerging market assets. And moreover, of course, global financial markets kept growing. I mean, even financial markets in EM kept growing, just that foreign investors participated less in that.
And it was more about locals buying their own assets. So that means that over this period of time, global asset allocators, we think, have become even more underweight emerging market assets than they ever have been. So that is something that hasn't really changed completely over the course of this relatively short period of bullishness that started in the spring of last year and lasted until the Iran war this year.
So in other words, we don't really think that the flows of less than one year can literally offset outflows and structural underweight in EM that existed for a whole decade. OK, and what could change your mind on the structurally bullish EM view? And I'd add, you know, is AI a consideration there?
Sometimes we hear about certain EM markets that might be vulnerable to AI, for example. Yeah, so I mean, on the AI, there's a very active debate, I mean, our own view is that AI is constructive for EM as long as it lifts global productivity across the board. So in other words, as long as the technology that, of course, is very much produced in China and the US gets actually disseminated around the world and as long as this is the case, it should be essentially constructive for global growth and not just for the US.
And if, of course, there is a situation where it is really a very, very US centric positive productivity shock, then the concern would be that this means the dollar could be getting structurally stronger and that would be a big problem for emerging markets. Now, what would change our structurally bullish view aside from the AI discussion I just mentioned? I think otherwise, if you had a science that you're actually going to need, let's say, a really big Fed hiking cycle, which, again, is not our own forecast, but again, the last time we had a big hiking cycle, it was almost 500 basis points.
If we experience something like that, then surely there would be a major break in the emerging market story. And I think that the third potential risk I would be watching is the trade relationships between China and Europe, because there's increasing tensions there, which are reflected in more and more calls from Europe on higher tariffs on China. And so China, at the same time, is not growing very well domestically.
It's growing very strongly in the export space. So if we end up in some sort of trade tensions between Europe and China in a similar way as we have trade tensions between the U.S. and other regions, that could be a quite negative hit to growth in the rest of the world. And it would just, again, cement to a greater extent the performance of the U.S. and would be quite negative for emerging market assets.
OK, David, last question for you before we go to David Becker and talk about some of the unique aspects of Brazil. EM currencies, which do you think are most attractive on a one year basis? Yeah, so on a one year basis, we still like the Chinese renminbi.
I mean, as I mentioned, we're a little concerned about it into the beginning of trade hikes, but it is still a very cheap currency. We like the renminbi for that reason. It's best to put this trade against other currencies than the dollar, for example, against European currencies.
We also continue to like very much carry trades that provide, you know, high interest rates, high interest rates than in the U.S. So, for example, that would be in Turkey. It would be in in fact, it would be in Brazil, which we would discuss more with David.
And we also continue to like the Argentine peso. We like the Colombian peso and we like some frontier market currencies, which also give very high carry and underpinned by pretty strong balance of payments fundamentals, like, for example, in Nigeria. So basically, the theme is essentially belong, carry trades in markets which pay you substantially higher interest rates than the dollar, but have decent balance of payment fundamentals, high interest rates, responsible central banks.
And on top of that, belong from a longer term perspective, the Chinese renminbi, which is very cheap, but we are less enthusiastic about lower yielding currencies in emerging Asia, which doesn't don't really pay you a high carry. And at the same time, and maybe also suffering over the course of the next year from headwinds on the growth side. So that's the setup we have in mind.
Long carry in Latam and in senior markets versus short term, the lower yielding currencies in Asia, with the exception of China, which we like because it's very cheap. So let's shift to David Becker, because I did want to get more specific on one market within EM and that's Brazil. This is a market that started the year really strong, benefiting to some degree from the Iran war and how it boosted commodity prices.
But it's now about 10 percent or more below highs. It's underperformed MSCI EM over the last few months. And there are important elections coming this October.
So, David, what's your view on Brazil equities? Thanks, TJ. So actually, as you said, we started the year with a very positive narrative and market participants were enthusiastic about Brazil, but the positive shock from oil disappeared for Brazil.
As you know, Brazil is a big oil exporter and was benefiting from this positive oil shock. So oil actually declined more than people expected. And the other thing is that is this discussion about what's going to happen with the dollar.
The US dollar has been, let's say, stronger than expected at the margin. The BRL was benefiting from the weak dollar and also from the diversification away from the US. So those two things actually hurt Brazil performance on the domestic side.
Also, we got some things happening. The first one was a change in the expectations regarding interest rates. We started the year thinking that interest rates were going to see a major decline in Brazil.
Since then, what happened is that activity has been supported by measures announced by the administration. Unemployment rate has been quite low and inflation has been higher than expected. So that changed the expectations for interest rates.
Right now, we no longer expect the central bank to cut rates ahead. Of course, if the data changes, eventually there could be a risk for them to resume the easing cycle. But the size of the potential easing is much smaller than what we expected earlier in the year.
And the second point, TJ, is growth. We recently did our mid-year review in our global forecast and we revised our growth estimate for Brazil for next year from 2 percent to 1.3 percent. So there'll be more rates, right, and less growth.
And when you think about earnings growth for next year, actually, the market has at this point very high expectations for earnings growth. And we think there are huge downside risk on those earnings expectations, as most of these earnings growth was coming from lower financial costs and lower interest rates. OK, understood.
And of course, there's also the issue of the election, which is coming up in October presidential election. The current president, Lula, is running against Bolsonaro, the challenger who is at the right wing. Lula is on the left.
What do you think the scenarios are for Brazil markets in these two scenarios of either a Lula or Bolsonaro win? Thanks, TJ. So the elections or the polls right now, they are showing Lula slightly ahead of Flavio Bolsonaro, the son of Jair Bolsonaro.
And the elections are only in October. So there's still a lot of time during July. Actually, there'll be conventions, party conventions happening.
So the candidates are going to be set in stone. The deadline to register the candidates is actually 15 August. So until 15 August, the candidates could change.
But the market thinks, as you said, that there'll be this polarization between Lula and Flavio Bolsonaro. Some polls actually show that they are tight within the margin of error, even though Lula is ahead. So it's very difficult to know at this point who is going to win the elections.
In terms of what to expect from the markets, I think the biggest discussion, TJ, is the fact that the policy mix right now under Lula has a relatively tight monetary policy with very high interest rates combined with relaxed fiscal policy and also expansionary credit policies. So the big discussion for next year is independent on who wins, what's going to be the fiscal adjustment and if those three policies, credit, fiscal and monetary, are going to be more aligned. So in a scenario in which whoever wins does a fiscal adjustment, probably we could see much more declining interest rates.
And this would indeed create a bigger upside for Brazilian equity markets. The perception is that Lula could deliver some fiscal adjustment. But at this point, the market thinks that Flavio would do a bigger one and then eventually under Flavio, the potential for rate cuts would be bigger.
But at this point, TJ, I think the elections are still very uncertain and we still don't know who are going to be the finance ministers, either under Lula or under Flavio. So that makes it very complicated to have a strong view in terms of asset prices down the road. And interestingly, TJ, we recently have been visiting local clients here in Brazil and no one is willing to make a structural or to add a structural position based on the election because they think it could be too volatile.
So what they are trading right now, the locals, is pretty much the dollar and the Fed. OK, understood. So that's one we're going to have to we're going to have to watch.
And, you know, I guess as expectations go one way or the other, as you point out, it's so close, people will start trading or taking the other side. But super interesting. Thanks very much, David, for joining.
Thanks so much for having me. While emerging market stocks have treaded water over the last two months, they've held up pretty well considering the change in the market's Fed view and strength in the dollar. That's one of the reasons why David Howner remains long term bullish on EM.
Even at a time like this, we're seeing investor interest in EM as allocators look to get exposure to areas other than the U.S. and where there's better carry. There are risks in the near term, though, especially as our U.S. econ team is more hawkish than consensus on the Fed. Three hikes, which is what they expect, could be a headwind over the next quarter or so.
But we remain structurally bullish on EM unless three hikes turns into many more or in case trade tensions really start to flare up again. As for Brazil, the headwinds there are both international, specifically around the dollar and crude prices, and domestic, since expectations for both GDP growth and rate cuts have been scaled back. On top of that, you have an upcoming election, which as of now is looking quite tight and that's kept many investors on the sidelines, especially as some of the other positive narratives have faded.
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