This year's emerging market performance has been a feast for a select few, and Citigroup believes the central question for the second half is whether this rally can broaden out.
The MSCI Emerging Markets Index has gained approximately 20% year-to-date, marking one of its best starts to a year on record. However, in its "Emerging Markets Equity Strategy H2 2026 Outlook" report dated July 19, Citigroup Research stated that this rally has been "extremely concentrated," with South Korea and Taiwan contributing almost all of the index-level gains. This level of concentration is historically rare. The bank's data shows that the cross-sectional dispersion of returns among major emerging market (EM) countries has reached its highest level in the past 25 years.
Citigroup argues that rising AI volatility has exposed concentration risks, while China's light positioning and improving macro environment provide conditions for a "broadening of the rally." It sets a year-end 2026 target for the Hang Seng Index at 29,600 points and for the CSI 300 at 5,600 points.
Concentration Hits 25-Year High, "Broadening" Becomes Key H2 Theme
The bank's analysts note that a genuine "broadening rally" requires two conditions to be met simultaneously.
First, evidence of a cyclical recovery—improving macro data and earnings upgrades spreading to a wider range of sectors and regions.
Second, a temporary pause in the leadership of the tech/AI rally—creating space for other sectors to catch up in relative performance.
Currently, both conditions are only "partially met."
On the macro front, the bank's economic data change index has generally trended upward since May, and the economic surprise index (CESI) has also remained positive, but the magnitude of improvement is significantly weaker than in developed markets. Conflict in Iran had brought stagflationary shocks, depressing growth expectations and raising inflation expectations, particularly impacting energy-importing regions like ASEAN. The bank's commodity strategists maintain a base case forecast for Brent crude at $75 per barrel for Q3, falling to $65 per barrel early next year. A decline in oil prices as expected would benefit the equity markets of South Korea, Taiwan, and India.
The issue is more pronounced on the earnings front. The 2026 expected EPS growth for the MSCI EM index has been revised up by 28 percentage points since the end of February, but about 85% of that comes from the IT sector. The overall expected EPS growth for EM is currently +63%, with the IT sector contributing about two-thirds. In Citigroup's tracked EM Earnings Revision Index (ERI), only 42% of sectors show net upward revisions, with clear positive momentum only in technology and financials. In contrast, earnings revisions in Japan and Europe have already shown a broader diffusion pattern.
Tactical Downgrade for South Korea, Upgrade for China to Overweight
Based on the above assessment, Citigroup has made three key adjustments to its EM country allocation.
South Korea: Overweight → Neutral (Tactical)
The bank has held an overweight position on South Korea since July 2025. However, the South Korean market has recently experienced high volatility, with KOSPI implied volatility far exceeding that of comparable global markets.
Analysts point to three pressures behind the volatility: doubts about the sustainability of AI capital expenditure, local resistance to data center construction, and rising threats from open-source models to frontier AI labs. Additionally, heavy retail inflows and the use of leveraged products have further amplified the swings.
The bank's quantitative data shows that KOSPI long positioning has retreated from extreme overweight to neutral but has not yet turned net short. Analysts stated, "Although South Korea remains extremely strong in our fundamental models, we tactically downgrade to neutral given the current volatility in trading conditions."
Local strategists for South Korea maintain a year-end KOSPI target of 10,000 points (implying approximately 47% upside from current levels) and expect memory shortages to intensify further in 2027, potentially extending the memory upcycle. Operating profits for memory manufacturers are forecast to reach 58.53 trillion won and 76.36 trillion won in 2026 and 2027, respectively, accounting for 65% of the total operating profit of the KOSPI 200.
China: Neutral → Overweight
Citigroup has maintained a cautious stance on Chinese equities this year, primarily due to weak relative EPS momentum. The rationale for this upgrade is that China is a strong candidate for a "broadening rally"—it has light positioning, a macro environment benefiting from potential oil price declines and improving global growth, and still attractive valuations.
The bank's China strategist Pierre Lau noted that the Hang Seng Index currently trades at 9.4 times 2026 expected P/E and 1.1 times P/B, both below historical averages (10.3x P/E, 1.2x P/B). The bank's China economists anticipate potential interest rate cuts by the People's Bank of China and an acceleration in fiscal policy deployment, which could provide marginal support for the market.
Analysts set a Hang Seng Index target of 29,600 points for year-end 2026 and 30,500 points for mid-2027. Targets for the CSI 300 are 5,600 points and 5,700 points for the same periods, respectively. The MSCI China target is set at $92 (year-end 2026) and $97 (mid-2027), implying roughly 31% upside from current levels.
Mexico: Underweight → Neutral
Mexico has underperformed this year, weighed down by uncertainty over USMCA renegotiation prospects and expectations of policy tightening. However, similar to China, Mexico scores well in Citigroup's "broadening candidate" framework and has the lightest positioning within EM. The bank sets an IPC index target of 70,000 points for year-end 2026 and 73,000 points for mid-2027.
AI Theme: Structurally Bullish, But Near-Term Volatility Expected
Citigroup explicitly stated it would not fully exit tech/AI exposure due to short-term volatility.
The reasons are threefold.
First, free cash flow for Asian memory manufacturers is projected to surge significantly in 2026-27, contrasting sharply with FCF for US hyperscale cloud providers approaching zero, indicating the global tech profit pool is still expanding.
Second, the bank's local South Korea strategists believe signals of memory shortages will strengthen further in 2027, with trends toward memory customization and AI token growth likely to extend the upcycle.
Third, fundamentals for the EM tech sector remain solid: IT sector EPS growth far outpaces global peers, earnings revisions continue upward, and valuations are attractive relative to peers.
The bank also noted that for investors seeking to hedge AI exposure, Saudi Arabia, India, and Mexico have low correlations with the Bloomberg AI Index and could serve as effective hedging tools.
Price Targets and Overall Allocation Framework
Citigroup maintains its year-end target for the MSCI Emerging Markets index at 1,870 points, implying about 12% upside from current levels, and introduces a first-time mid-2027 target of 2,050 points (approximately 20% upside). These targets are based on conservative EPS growth assumptions (around 40-45%, below consensus) and a slight contraction in valuation multiples.
Among the bank's local strategists, the most optimistic views are on South Korea and China, with both targets implying around 40% upside potential.
At the global allocation level, the bank currently maintains a neutral stance on EM (relative to global), citing ongoing risks from AI volatility and macro complexities (geopolitics, the Fed, El Niño). A return to an overweight rating would require seeing a genuine inflection point in EPS for the broader market.
The bank's global Bear Market Checklist (BMC) is currently at its highest level since the financial crisis but has not yet triggered an "exuberance" signal. Historical patterns show that in the late stages of a bull market, market-cap-weighted indices often continue to outperform equal-weighted indices—suggesting the tech-led rally could persist until market exuberance ends.
Quantitative Perspective: EM Valuations Most Attractive, Fund Flows Slowing
Citigroup's quantitative strategists noted that within the bank's global "World Radar" model, EM's relative valuation is the cheapest among all regions, giving it the highest composite ranking.
However, fund flow trends are less optimistic: inflows into global and US funds continue to outpace those into EM funds, with inflows into EM funds (ex-China) nearly stalling. China-focused funds have seen net redemptions year-to-date, but small inflows have begun in recent weeks.
South Korea continued to experience net foreign outflows in Q2, with cumulative net outflows reaching approximately $97 billion. Crowding in the tech sector has increased further, making it the most crowded sector in Asia, with the Information Technology sector's crowding score reaching 60.
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