Citibank: Emerging markets rally is strong but overly concentrated, upgrades China to overweight and tactically downgrades Korea.

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This year’s emerging markets rally has been a feast for the few—while Citi believes that the core question for the second half is: can this rally expand?

The MSCI Emerging Markets Index is up about 20% year-to-date, marking one of the strongest starts in history. However, according to Chase the Wind Trading Desk, Citi Research stated directly in its "Emerging Markets Equity Strategy 2H 2026 Outlook" released on July 19 that this round of gains is "extremely concentrated," with South Korea and Taiwan contributing almost all of the index’s gains. Such a degree of concentration is historically very rare. According to the bank's data, cross-sectional dispersion of returns among major EM (Emerging Markets) countries has risen to the highest level in the past 25 years.

Citi believes heightened AI-driven volatility exposes concentrated risks, yet China's light positioning and improving macro environment are favorable for “rally expansion.” The bank sets end-2026 targets at 29,600 for the Hang Seng Index and 5,600 for the CSI 300.

Rally Concentration Hits 25-Year High—“Expansion” Is the Key Second Half Theme

The bank's analysts point out that a true "broad-based rally" requires two conditions to be met simultaneously:

First, evidence of cyclical recovery—improving macro data and earnings upgrades spreading to more sectors and regions.

Second, a phase of pause in Tech/AI-led outperformance—leaving room for other sectors to catch up in relative performance.

At present, both conditions are "partially met."

On the macro side, the bank’s economic data change index has been rising overall since May, with the Economic Surprise Index (CESI) also continuing positive. However, the degree of improvement is markedly weaker than in developed markets. The Iran conflict caused stagflation shocks, lowered growth expectations and pushed up inflation expectations, which hit energy importers such as ASEAN countries particularly hard. The bank’s commodity strategists maintain a Brent crude Q3 average of $75/bbl, dropping to $65/bbl by early next year. If oil prices drop as expected, it will benefit the stock markets of Korea, Taiwan, and India.

On the earnings side, the problem is more pronounced. The 2026 expected EPS growth for MSCI EM has been revised up by 28 percentage points since late February, but about 85% came from the IT sector. Currently, EM’s overall expected EPS growth is +63%, of which IT contributes about two-thirds. In Citi’s EM Earnings Revision Index (ERI), only 42% of sectors have seen net upward revisions, with clear improvement only in Technology and Financials. In comparison, earnings upgrades in Japan and Europe have already shown a broader expansion.

Tactical Downgrade for Korea, Upgrade China to Overweight

Based on the judgments above, Citi announced three key EM allocation adjustments:

Korea: Overweight → Neutral (Tactical)

The bank has been overweight Korea since July 2025. But recently, Korea’s market has seen violent volatility, with KOSPI implied volatility far exceeding global peers.

Analysts point out threefold pressures behind the volatility: concerns about the sustainability of AI capex, local resistance to data center construction, and rising threat from open-source models to frontier AI labs. In addition, massive retail inflows and use of leveraged products further amplify volatility.

Quantitative data indicates that KOSPI long positioning has moved from extremely overweight back to neutral, though not yet net short. The analysts state, “While Korea still scores extremely well in our fundamental model, given current volatile trading conditions, we tactically downgrade to neutral.”

Korean local strategists maintain a KOSPI year-end target of 10,000 (about 47% upside from current levels) and anticipate memory shortages to worsen in 2027, with the memory upcycle continuing and memory manufacturers’ operating profits expected to reach 58.53 trillion won and 76.36 trillion won in 2026/27, accounting for 65% of KOSPI 200’s total profit.

China: Neutral → Overweight

Citi has maintained a cautious view on China equities this year, mainly due to relatively weak EPS momentum. But the logic behind upgrading is: China is a strong candidate for “rally expansion”—it has light positioning, benefits from falling oil prices and improving global growth, and valuations remain attractive.

China strategist Pierre Lau notes that the Hang Seng Index is trading at 9.4x 2026E PE and 1.1x PB, both below historical averages (10.3x PE, 1.2x PB). Citi’s economists expect a PBOC rate cut and faster fiscal policy deployment, marginal positives that should support the market.

Analysts set year-end 2026 targets at 29,600 for Hang Seng Index and 30,500 for mid-2027; 5,600 and 5,700 for CSI 300; MSCI China at $92 (end-2026) and $97 (mid-2027), around 31% potential upside from current levels.

Mexico: Underweight → Neutral

Mexico has underperformed all year, weighed down by USMCA renegotiation uncertainty and tightening policy expectations. But like China, Mexico scores well on Citi’s “expansion candidate” framework and has the lightest EM positioning. The bank sets a 2026 year-end target for the Mexican IPC at 70,000 and mid-2027 at 73,000.

AI Theme: Structurally Bullish, But Short-Term Volatility Is Unavoidable

Citi makes it clear it will not exit tech/AI exposure entirely due to short-term volatility.

There are three main reasons:

First, Asian memory manufacturers’ free cash flow is expected to surge in 2026–27, in stark contrast to U.S. hyperscale cloud companies whose FCF may drop near zero, indicating the profit pool for global tech continues to expand.

Second, Citi’s Korea strategists believe signals of memory shortages will be further reinforced in 2027; the customization trend in memory and AI token growth will drive the upcycle onward.

Third, EM tech sector fundamentals remain solid: IT sector EPS growth far exceeds global peers, earnings upgrades continue, and relative valuations are attractive.

Meanwhile, for investors seeking to hedge AI exposure, Saudi Arabia, India, and Mexico show low correlation with the Bloomberg AI Index and can be effective hedging instruments.

Target Prices and Overall Allocation Framework

Citi maintains its year-end target for the MSCI EM Index at 1,870, about 12% upside from now, and introduces a mid-2027 target of 2,050 (about 20% upside). These targets are based on conservative EPS growth assumptions (about 40–45%, lower than market consensus) and a slightly lower valuation multiple.

Among local strategists, the bank is most optimistic on Korea and China, with their target prices implying around 40% upside.

Globally, Citi remains neutral on EM (relative to the world) due to ongoing AI volatility risk and macro complexity (geopolitics, Fed stance, El Niño). For a return to overweight, a broad-based EPS inflection is still needed.

The bank’s global Bear Market Checklist (BMC) is now at its highest level since the financial crisis, but has not yet triggered a “manic exuberance” signal. Historically, toward the end of bull markets, cap-weighted indexes tend to keep outperforming equal-weighted—implying that tech-led leadership may persist until euphoria ends.

Quantitative View: EM Valuations Cheapest Globally as Inflows Slow

Citi’s quant strategists note that in the global "world radar" model, EM valuations are the cheapest in the world and rank highest overall.

But fund flows are not so optimistic: Global and U.S. funds continue to attract more inflows than EM funds, which (excluding China) have nearly stalled inflows. China funds have seen redemptions year-to-date, though have started to see modest inflows in recent weeks.

Korea saw continued net foreign outflows in Q2, totaling about $97 billion. Crowding in tech is rising further; the IT sector is Asia’s most crowded, with a crowding score of 60%.

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The above content is from Chase the Wind Trading Desk.

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