Citi suggests the key question for the second half of the year is whether the current robust rally in emerging markets can broaden out beyond a narrow set of winners.
The MSCI Emerging Markets Index has gained approximately 20% year-to-date, marking one of its best starts to a year on record. However, Citi Research, in its "Emerging Markets Equity Strategy H2 2026 Outlook" report dated July 19, notes this advance 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 the cross-sectional dispersion of returns among major EM markets has risen to its highest level in the past 25 years.
Citi believes that rising AI volatility exposes this concentration risk. Meanwhile, China, with its light positioning and improving macro environment, is positioned for potential "rally diffusion." The bank sets a year-end 2026 target of 29,600 for the Hang Seng Index and 5,600 for the CSI 300.
Concentration at 25-Year High; "Diffusion" Becomes Key Theme
The bank's analysts state that a genuine "broadening rally" requires two conditions to be met simultaneously.
First, evidence of a cyclical recovery—improving macro data and earnings estimate upgrades spreading to a wider range of sectors and regions.
Second, a pause in the momentum of the tech/AI leadership—creating room for relative performance catch-up by other sectors.
Currently, both conditions are only "partially met."
On the macro front, the bank's economic data change index has trended upward overall since May, and the economic surprise index (CESI) has remained positive, though the magnitude of improvement is notably weaker than in developed markets. The Iran conflict introduced stagflationary shocks, dampening growth expectations and boosting inflation expectations, particularly hurting energy importers like ASEAN nations. The bank's commodity strategists maintain their base case forecast for Brent crude at $75/barrel for Q3, declining to $65/barrel by early next year. If oil prices fall as expected, it would benefit the equity markets of South Korea, Taiwan, and India.
The issue is more pronounced on the earnings front. MSCI EM's 2026 expected EPS growth has been revised up by 28 percentage points since late February, but roughly 85% of that upgrade comes from the IT sector. The current overall EM EPS growth expectation is +63%, with the IT sector contributing about two-thirds. In Citi's tracked EM Earnings Revision Index (ERI), only 42% of sectors show net upgrades, with clear positive momentum only in tech 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, Citi makes three key adjustments to its EM country allocations.
South Korea: Overweight → Neutral (Tactical)
The bank has held an overweight position on South Korea since July 2025. However, the South Korean market has experienced intense volatility recently, with KOSPI implied volatility far exceeding that of comparable global markets.
Analysts point to three underlying pressures: 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 volatility.
The bank's quantitative data shows that long positioning in the KOSPI has retreated from extreme overweight to neutral but has not turned net short. Analysts state, "Although Korea still scores extremely well in our fundamental model, given the current trading conditions' volatility, we tactically downgrade to neutral."
Local strategists maintain a year-end KOSPI target of 10,000 points (implying roughly 47% upside from current levels). They expect the memory chip shortage to intensify further in 2027, with the memory upcycle likely to persist. Memory makers' operating profits are forecast at 58.53 trillion won and 76.36 trillion won for 2026/27, accounting for 65% of the KOSPI 200's total operating profit.
China: Neutral → Overweight
Citi has maintained a cautious stance on Chinese equities this year, primarily due to weak relative EPS momentum. The logic for this upgrade is that China is a strong candidate for "rally diffusion"—it has light positioning, a favorable macro environment from potential oil price declines and improving global growth, and still-attractive valuations.
The bank's China strategist Pierre Lau notes the Hang Seng Index currently trades at 9.4x estimated 2026 P/E and 1.1x 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, with these marginal positives expected to support the market.
Analysts set a Hang Seng Index target of 29,600 for end-2026 and 30,500 for mid-2027. CSI 300 targets are 5,600 and 5,700 points, respectively. The MSCI China target is set at $92 (end-2026) and $97 (mid-2027), implying approximately 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 Citi's "diffusion candidate" framework and has the lightest positioning among EMs. The bank sets an IPC Index target of 70,000 for end-2026 and 73,000 for mid-2027.
AI Theme: Structurally Bullish, But Near-Term Volatility Expected
Citi explicitly states it will not exit tech/AI exposure entirely due to short-term volatility.
Three reasons are cited.
First, free cash flow for Asian memory makers is projected to surge significantly in 2026-27, contrasting sharply with U.S. hyperscale cloud providers whose FCF is nearing zero. This indicates the global tech sector's profit pool is still expanding.
Second, the bank's local Korea strategists believe signals of a memory shortage will strengthen further in 2027, with trends like memory customization and AI token growth extending the upcycle.
Third, the 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 notes that for investors seeking to hedge AI exposure, Saudi Arabia, India, and Mexico, which have low correlation with the Bloomberg AI Index, could serve as effective hedging tools.
Price Targets and Overall Allocation Framework
Citi maintains its year-end MSCI EM target of 1,870 points, implying about 12% upside, and introduces a mid-2027 target of 2,050 points for the first time (about 20% upside). These targets are based on conservative EPS growth assumptions (around 40-45%, below consensus) and a slight contraction in valuation multiples.
Among local strategists, the most optimistic views are on South Korea and China, with both targets implying roughly 40% upside.
At the global allocation level, the bank currently maintains a neutral stance on EM (relative to global), citing ongoing AI volatility risks and macro complexities (geopolitics, the Fed, El Niño). A return to an overweight rating would require seeing a genuine inflection point in EPS for broader markets.
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 View: EM Valuations Are Cheapest, Fund Inflows Slow
Citi's quantitative strategists note that within the global "Worldscope" 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 U.S. 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, though 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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