EM Equity Strategy Compass: Has the Dust Settled?

In a new report from Citi Research, a team of equity strategists and analysts led by David Groman looks at the meaningful alpha investors have seen in sectors and emerging-markets (EM) countries in recent months: EM Tech, for instance, has risen ~50% since President Trump’s initial tariff pause, amid relatively benign tariff outcomes and renewed confidence in the artificial intelligence (AI) theme.

In exploring where we’re headed from here and how equity investors should allocate within EM, we consider three key questions.

1. Have we passed peak tariff risk?

Our feeling is that peak uncertainty about policy is probably behind us, but fundamental headwinds will remain, which means more earnings-per-share (EPS) downgrades are likely from here. U.S. effective tariff rates currently stand at ~18%, with lingering uncertainty around certain sectors and countries. (For instance, the U.S. has yet to impose tariffs on pharmaceuticals.) U.S. revenue exposure varies widely between regions and sectors, and the risk picture for tariffs is further complicated by U.S. production capacity and sector carve-outs.

We’ve updated our estimates and now see a ~5 percentage-point drag on MSCI EM EPS growth in 2025 from U.S. tariffs. We base this estimate on country-specific tariff rates, country-level U.S. sales exposure, and the share of those U.S. sales derived from goods-producing industries. These estimates must be approached with caution given the continued evolution of tariff policy and potential second-order tariff impacts, but our framework nevertheless helps set a scale for fundamental risks.

Among major regions, EM has seen the smallest downgrades to EPS growth since Liberation Day, which implies some downside risks. Bottom-up consensus EPS growth forecasts for the MSCI EM have come down from 14% on Liberation Day to 11%, compared with Europe (+8% to 0%) and Japan (+8% to +4%). To us, this implies EM forecasts have less tariff risk embedded than their peers, and is a key reason we remain more cautious on EM.

2. Can the AI trade keep running?

The last quarter has seen the AI theme reassert itself, with sharp outperformance from the global tech sector. EPS resilience among U.S. megacaps has helped drive this, apparently helping investors grow more comfortable with large-scale capex plans. We continue to see AI as a structurally bullish driver underpinning the U.S. market; within EM, we’ve found that Taiwan, South Korea and China (to some degree) are the clearest beneficiaries of improving sentiment around AI, with Latin America and CEEMEA relatively disadvantaged.

To further visualize the AI trade in an EM context, we turn to Citi’s proprietary Theme Machine model, breaking out high-exposure EM stocks within our AI Enablers and AI Adopters groupings. On an equal-weighted basis, we find our EM-based AI Enablers have outpaced the U.S. Mag 7 year to date, while our EM-based AI Adopters have underperformed the MSCI EM so far in 2025. This implies the handoff from companies involved in the AI build-out to those using AI hasn’t yet been fully set in motion. Despite an impressive run of performance, there’s still some reason to think EM AI Enablers remain attractive on a fundamental basis. 

3. Will the USD keep depreciating?

We see further dollar weakness as likely for now. On balance, weak U.S. labor-market data, shifts in Fed leadership and a still-overvalued USD leave our base case for the second half intact. We also see several arguments that bias us toward a weaker dollar view, including a growing incentive for foreign investors to hedge U.S. assets.

USD weakness tends to favor EM equities in a global context. We also find a longer-running connection between dollar strength and global emerging markets fund flows. Within EM, markets that tend to benefit most (in relative terms) from a weak USD include Poland, South Africa, Brazil and South Korea, with Saudi Arabia and the UAE tending to underperform in weak dollar regimes. In general, we’d note that longer-term correlations between the U.S. dollar index (DXY) and EM equity outperformance have been weakening.

USD dynamics could shift into 2026, as we still see dollar depreciation as more cyclical than structural. We see President Trump’s policies focusing more on growth in 2026, with uncertainty easing, and the de-dollarization narrative fading as U.S. assets remain attractive and relative growth moves back in favor of the U.S.

On a related note, we still think diversification away from U.S. equities could have more room to run, given accumulated “over-ownership” of U.S. equities in past years. So far, flow rotation away from the U.S. has been primarily directed toward European stocks rather than EM; a “glass half full” interpretation would be that the EM could leave the next wave of diversification, while a more pessimistic view would caution that renewed interest in mega-cap Growth names could see flows once again head back toward the U.S. market.