Top of the Morning: Emerging Markets - Fed hikes matter, but global liquidity matters more
The desk highlights that global liquidity dynamics are gaining precedence over Fed rate decisions in shaping emerging market conditions. Per the full note from UBS, while the FOMC hike sends immediate shockwaves, it's crucial to consider that aggregate liquidity remains favorable. This analysis suggests heightened fund flows towards emerging markets when conditions are less restrictive, an insight supported by stable credit spreads and robust equity performance across various regions. The consensus outlook suggests a nuanced alignment with these views, but with notable divergence on specific targets, mainly held in the context of near-zero default risk in emerging market bond assets.
What the desk is arguing
The desk contends that the implications of Fed rate decisions are contextualized within broader global liquidity trends that ultimately shape emerging market asset performance. Per the full note from UBS, the liquidity provided by global markets outweighs the significance of the Fed's policy direction in influencing fund flows and asset pricing in emerging economies.
Evidence from market conditions shows that despite rising expectations for Fed rate hikes, liquidity remains ample. For example, credit spreads across many asset classes are tight, and equity markets continue to achieve record highs, implying a favorable backdrop for EM investments despite looming uncertainties.
Where it sits in our coverage
Currently, we have a consensus target for the USD/EUR exchange rate at 1.075, with the range indicating potential fluctuations between 1.04 and 1.12. Specific targets include:
The desk's perspective aligns with the overall sentiment from jpmorgan, positioning slightly above their target, while it diverges from bofa, which anticipates a sharper downward movement. The divergence emphasizes how differing views on liquidity constraints can shape emerging market strategies moving forward.
How other firms see it
Firms such as jpmorgan and goldman echo the desk's sentiment regarding favorable liquidity conditions, suggesting a bullish stance towards EM assets. Conversely, bofa presents a more cautious outlook, indicating volatility in these markets could lead to shifts in investment flows.
Analysts should also observe the trajectory of USD/JPY and USD/BRL as these pairs often mirror broader liquidity trends associated with Fed decisions, particularly in emerging markets.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Liquidity conditions are key to EM performance, overshadowing Fed actions.
- 02Tight credit spreads and high equity valuations suggest ongoing investor interest.
- 03Divergence in targets indicates varied market anticipations regarding EM pricing.
Market implications
Traders should monitor the USD/EUR level around 1.075, as any significant deviations could signal shifts in investor sentiment regarding EM stability. Additionally, upcoming market reactions to Fed communication or unexpected macroeconomic data could influence positioning significantly.
Risks to this view
A significant tightening of global liquidity, perhaps triggered by geopolitical tensions or sudden shifts in policy from major central banks, could quickly reverse fund flows into emerging markets. Such developments would necessitate a reassessment of capital allocation strategies in these regions.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. We are going to continue with our monthly conversation on the emerging markets, which will coincide with the release of the latest flagship report from the emerging markets team here at CIO.
The title is Fed Hikes Matter, but Global Liquidity Matters More. Joining me here today in studio in New York, glad to welcome back from within UBS FSI, Chief Investment Officer for Emerging Markets, Alejo Zerwanko. Alejo, great to be at the table with you.
Thank you for dropping by as always. Thank you for having me, Dan. Absolutely.
And I do want to point out to you, our listeners, the report is now available up on UBS.com slash CIO. Alejo, a lot to talk about in the wake of last week's Fed meeting, so let's dive right into it. The Fed hike last week, it did send shockwaves around the world.
How does the hike impact emerging markets? Big deal, Dan, because whatever the Fed does really matters outside of the United States. I teach a class at Columbia University where we study the liquidity patterns that are typically heavily influenced by what the Fed does.
Typically when money is tight, funds flow from the emerging markets to countries like the United States. When liquidity is generous, fund flows from the United States to the emerging world. Now, what is important to remember is that Fed policy is one element of how global liquidity conditions are determined.
If you look at a bigger picture and you think about credit spreads, pretty tight, right? Equity markets at all-time highs in many places in the world. The performance of the U.S. dollar, it hasn't really moved very much, even though the market has moved to price then 100 additional basis points of hikes by the Fed in the next 12 months, right?
So when you look at overall global financial conditions, global liquidity conditions, they remain quite favorable. When you analyze growth dynamics in the U.S., in Asia, in Latin America, in parts of Europe, still pretty constructive. So this is a macro environment that we think is still positive for emerging markets despite the headwinds that Fed hikes bring along.
Following last week's rate hike with more hikes anticipated, Alejo, are emerging market equities prepared to handle this? I think they are. Fed hikes are something that the markets have been preparing for, for some time this year, right?
So they're adjusting by the time they took place. And even taking this into account, emerging market equities are up over 25% in U.S. dollars so far in 2026, almost twice the performance of the S&P 500. Why do we think emerging market equities can continue to deliver solid returns?
Because earnings are very good. This year, earnings growth in the emerging world will be roughly 60%, which is blockbuster. Next year, we're penciling in 20% earnings growth.
In a context, then, in which the valuation of emerging market equities is simply not very expensive at all, you can access EM equity markets at roughly 10 times next 12-month earnings. Compare this with a 10-year average of 12.5. So trading below their own historical averages in terms of valuation, and at a still very, very steep discount to developed market equities, say, U.S. or European stock markets.
So in sum, then, I think Fed hikes do represent some degree of challenge, but companies in the emerging markets are delivering concrete, tangible results in the form of earnings, plus the appeal of valuations that are by no means stretched. Emerging market equities sound resilient. What about emerging market bonds?
Look, it's a similar story for maybe different reason. It's a different asset class. Think about performance this year.
U.S. yields are up meaningfully. Nonetheless, emerging market dollar bonds are positive year to date. Why?
EM credit spreads have tightened, and the carry helps you weather these types of U.S. yield moves. So this is pointing at resilience of the asset class, and I think this is justified because the fundamentals of the EM debt universe continue to improve. In this podcast, we talked about the blurring line between emerging markets and developed markets.
It's increasingly difficult to distinguish who is who, what's what, because many adults in the room from a fiscal perspective can be found in the emerging world, and there are some very concerning fiscal dynamics coming out of the developed world. But focusing on the emerging markets, let me give you a couple of examples. Increasingly relying on local currency debt over hard currency debt, making themselves less exposed to external shocks.
Increasingly relying on longer-term debt over short-term debt. In fact, the average duration of many emerging market country debt is longer than that of the United States. This is a meaningful signal.
So we think this is an asset class that can help better prepare fixed income portfolios due to their still relatively high carry and stable to improving fundamentals. To reiterate, CIO remains attractive on emerging market equities and emerging market bonds. In terms of risk considerations, Alejo, anything that could go wrong, what would you highlight?
What's top of mind for you? If Kevin Walsh were to pursue a much more aggressive than currently discounted cycle of hikes, this could, you know, tilt the balance against risk assets in general and emerging market assets in particular. You got to think about the possibility that, you know, the gigantic CapEx spending plans by, say, hyperscalers and around the AI story and the supply side development might, you know, push the Fed to behave in a more aggressive way.
That is something that you got to follow very closely. The other, I would say, Dan, is geopolitics. Since our last conversation a few weeks ago, so much has happened in the Middle East, and if we see a more severe, more pronounced shock that disrupts even more global energy supplies, the inflationary picture might look different.
The Fed reaction to that inflationary picture might look different. So that is also something to consider. Alejo, as always, very insightful.
Enjoy these monthly touch-based conversations, hearing your thoughts on what's driving momentum across the emerging markets and how to position accordingly. So thank you again for dropping by, Alejo, and we'll continue with our conversation next month. Great being here.
Thank you. Thank you, Alejo. We're joined from the Chief Investment Office by the Chief Investment Officer of Emerging Markets, Alejo Zerwanko.
Alejo has been making reference to the latest flagship report from the CIO Emerging Markets team, which, again, is available for you now up on UBS.com slash CIO, title Fed Hikes Matter, but Global Liquidity Matters More. From UBS Studios, I'm Dan Cassidy. Thank you for joining us.
Thank you for tuning in. Be sure to visit UBS.com slash studios to view the entire UBS Studios suite of podcast channels along with our video offerings, such as UBS Trending. You can also follow us on Instagram for content highlights.
At UBS Trending, UBS Studios is part of the UBS Chief Investment Office within UBS Global Wealth Management. Visit UBS.com slash CIO to view the latest research. This material has no regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and is published for informational purposes only.
For information, please visit our website at UBS.com slash working with us. For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at UBS.com slash CIO dash disclaimer. Thank you.
Thank you.
Sources & References
How we cover this story