Why a downward spiral for emerging markets may only just be getting started

• Emerging market stocks have fallen 10% since October amid fears of Trump's tariffs plans.
• Yet, UBS analysts say the market still hasn't priced in the full extent of tariff risks.
• The bank says a blow to China's economy from steep tariffs poses further downsides to EM stocks.

Emerging markets haven't fared well in recent months and their downturn is likely to worsen, UBS said.

The MSCI emerging markets index has fallen over 10% since hitting a two-year high on October 2 amid fears of president-elect Donald Trump's proposals for widespread tariffs, while most EM currencies have fallen sharply.

But despite the sell-off, the full extent of tariff risks aren't priced into the market, UBS strategist Manik Narain wrote this week.

Narain says there remains strong market sentiment across EM, with the UBS Emerging Markets Risk Appetite Index standing roughly halfway between neutral and euphoric — marking an atypically strong reading given the state of global growth, and with global manufacturing declining in recent years.

Earnings estimates, meanwhile, imply 13% earnings growth for EM stocks through 2026, far greater than the 3% growth realized during Trump's trade war with China in 2018 and 2019, he says.

Other indicators, like compressed credit spreads and low costs for hedging against EM currency depreciation, show the market is pricing in tariff risks at an unrealistically low level, he says.

"Some investors believe that valuations already price in such risks after recent underperformance. We disagree," Narain said in a Wednesday note.

Narain argued investors are ignoring a large possibility that the fallout of China's economy will have spillover effects on increasingly vulnerable EM economies, posing further downside for their stocks and currencies than are currently priced into the market.

"Rather than in China itself, we see larger market moves playing out in the rest of the emerging world," he wrote.

Narain explained that China is already seeing its strongest disinflationary impulse in at least three decades, with export prices down and export volumes up both outsize amounts relative to global levels.

Much of that export surge is primarily hurting emerging markets, especially as China's deflation has helped the yuan become more competitive with other EM currencies, he said.

New tariffs on China would thus likely only grow the country's existing export volume, hurting EM countries' production and capex in the process, he says.

"Tariffs may be inflationary for the US, but the opposite will be true for those economies," he wrote.

Tariffs could also help accelerate a slowdown in China's imports, too, as the country faces weaker profitability and fiscal headwinds.

Such an effect would continue to pose a drag on manufacturing competitors and also start hitting EM commodity exporters, too, he says, with little relief from the country's drastic stimulus measures.

"Fiscal stimulus won't compensate, in our view. That is tilting towards consumption — positive for the consumer and internet companies that dominate Chinese stocks — but with little spillover to broader emerging markets," he wrote.

Emerging markets are increasingly vulnerable to a potential trade war given their slowing growth in recent years, with investment as a share of GDP currently stuck at 2008 levels. Plus, tariff-sensitive sectors like autos, steel and infrastructure compose a higher share of EM stocks, and those outside of China are historically expensive despite flat returns.

Narain sees countries like Mexico, Vietnam, Taiwan, Korea, and Thailand as likely targets for further tariffs given their relative trade imbalances with the US, he says.