What is driving emerging market stocks?

Investing.com -- Emerging market stocks have rallied in recent months, supported by trade de-escalation and a weaker U.S. dollar. 

The initial U.S.-China agreement is seen as a key driver behind a broader rebound in global equity markets by UBS Global Research analysts. 

The shift in trade tone has been particularly favorable for emerging markets, with Latin America among the leading beneficiaries.

A softer U.S. dollar has played a crucial role. Historically, a decline of more than 5% in the dollar has correlated with EM equities outperforming U.S. stocks by an average of 11%. 

That trend has re-emerged this year, with the weaker dollar boosting EM currencies and valuations, helping many markets recover from earlier lows.

Despite the recovery, UBS notes that much of the optimism has already been priced in. 

Current valuations are near historical averages. For further gains, continued earnings growth and stable trade dynamics will be essential. A resurgence in trade tensions or weak earnings could weigh on macro fundamentals and stall the rally.

Investors are also increasingly looking to diversify away from the U.S. UBS sees a gradual shift toward broader international equity exposure as investors seek to reduce concentration risk. 

Still, this process is expected to unfold over time. Recent gains in EM stocks have come quickly, leading to a more balanced short-term outlook. 

Meanwhile, the U.S. remains a key engine of corporate profits, particularly in technology and artificial intelligence, making it difficult for global portfolios to reduce exposure entirely.

UBS maintains a neutral stance on EM overall but sees select opportunities for active investors focused on fundamentals. 

Taiwan and India stand out for their long-term growth potential, driven by structural trends and improving earnings. In mainland China, UBS favors the tech sector following a solid earnings season. 

Analysts expect strong profitability to continue through 2025 and 2026, with markets still underestimating the potential for sustained earnings growth in the low- to mid-double digits.

In Latin America, Brazil has led gains, buoyed by favorable global sentiment and currency support. UBS notes that while this trend may persist, domestic variables are becoming more relevant. 

Brazil’s fiscal outlook, monetary policy, and the 2026 presidential elections are likely to shape investor sentiment. 

UBS expects the central bank to begin easing rates in the fourth quarter of 2025, provided fiscal conditions remain stable. Political developments will be a key determinant for market performance in 2026.