A New Way to Trade Emerging Markets

Emerging Markets (EM) Performance & Drivers

• Global EM equities have attracted $45 billion in inflows year-to-date (YTD), surpassing the full-year total of the previous year within just two months.
• Current strength is attributed to robust capital flows combined with strong earnings fundamentals across the broader emerging market spectrum.
• Year-to-date, broad EM indices have risen approximately 15% in less than two months.

China's Divergent Performance

• China is currently lagging behind the broader EM narrative due to a lack of underlying earnings growth; last year's gains were driven primarily by multiple expansion rather than fundamental improvement.
• Market flows are diverting away from China toward Korea, Taiwan, and Japan.
• The Chinese economy is bifurcated: exporters are performing well, while companies exposed to domestic demand face weakness.
• A weaker US dollar is not currently providing tailwinds to China; instead, the currency dynamic benefits "EM ex-China" assets.
• Tariff regulations may further limit relief for Chinese exporters, creating a disconnect between external trade performance and domestic expectations.

Latin America & Brazil Outlook

• Goldman Sachs maintains a bullish stance on Brazil, anticipating 250 basis points of interest rate cuts starting soon.
• The investment thesis relies on exposure to a favorable commodity cycle and potential upside from the upcoming Brazilian election.
• While Brazilian assets remain attractive, they are no longer as cheap as in the past, and positioning is less "underweight" compared to previous periods.
• Historically, rate-cutting cycles in this region tend to outlast market expectations and remain supportive of equities.

Currency Dynamics & The Dollar

• Emerging markets are viewed through a framework of "EM ex-China" and "China," with "EM ex-China" heavily correlated to US dollar weakness.
• Weak dollar exposure provides a direct tailwind for EM ex-China equities, particularly when invested via ADRs and US-listed ETFs.
• A weaker dollar typically coincides with commodity strength, benefiting resource-heavy EM regions like Latin America.
• Korea is highlighted as a primary beneficiary, with gains of nearly 100% last year and an additional 60% gain in the current year to date.

Investment Strategy & Structuring

• Despite the strong YTD rally, the recommendation remains long emerging markets (specifically EM ex-China) but with altered derivative structures.
• Due to the rapid 15% gain, implied volatility skew has flattened, making high upside calls expensive (highly bid).
• The preferred strategy involves utilizing call spreads and call ratios (selling one or two upper strikes against an ATM or slightly OTM call) to secure 5:1 or 6:1 payout ratios.
• This approach anticipates continued market appreciation but expects a slower velocity of growth compared to the previous two months.

Forward-Looking Catalysts

• The upcoming Brazilian election is identified as a near-term catalyst, with market trading increasingly reacting to election-related news.
• Global macro themes, specifically the market's digestion of AI versus "AI at-risk" firms, remain central to international equity sentiment.
• Future performance depends on broader risk sentiment; a significant sell-off in US equities (S&P 500) could limit EM upside even if relative outperformance occurs.