Emerging market equities have seen a sharp reversal of the gains posted over the past year as the conflict in the Middle East moves into its third week, according to a UBS strategy report. The report says that markets have shifted into a clear risk-off posture, putting emerging markets among the weakest performing asset classes globally since hostilities began.
UBS analysts single out energy supply shocks as the main risk to the EM story. They note that Asia in particular remains a significant net consumer of fossil fuels originating from the Middle East, leaving the region exposed if conflict disrupts flows or sends prices higher.
The report highlights a historical pattern in which emerging market returns deteriorate materially when oil trades above the $90 per barrel threshold. "In normal course, an extended period of conflict could be challenging for EM equities," the analysts wrote, pointing to that relationship between higher oil prices and weaker EM performance.
Compounding the immediate energy risk is a lack of valuation support. Heading into the conflict, UBS says EM stocks were not especially cheap. Their discount relative to U.S. equities was well below long-term averages, reflecting a market that had already priced in considerable optimism. With limited valuation buffers, UBS observes there is little margin for error as geopolitical tensions escalate.
That optimism reversal has already begun to show through investor behavior. UBS summarizes the market reaction as "a reversal of most trades that worked in the preceding three months," and notes the emergence of a "sell the oil consumers" theme as institutions rotate into perceived safe havens.
Against this darker backdrop, UBS identifies one factor that could prevent a full collapse in EM sentiment: the Artificial Intelligence investment cycle. Over the last 15 months, UBS says the AI theme was the dominant contributor to EM returns and to revisions in earnings expectations. The note argues that continued heavy investment from U.S. hyperscalers is largely insulated from the conflict, potentially providing a floor for technology-heavy emerging markets in Asia.
"Future EM outperformance could continue if the AI drivers remain immune to the conflict and any further oil shock concerns," UBS wrote, while also warning that a rapid resolution of the conflict is required for prior momentum to resume. Without swift de-escalation, the analysts caution that what may appear as a short-term excursion into volatility could instead become a prolonged recalibration of growth expectations for the asset class.
UBS frames the recovery of the EM narrative as conditional on two visible developments: a stabilization in energy costs and confirmation that the global technology capital expenditure cycle remains unbroken by the geopolitical instability in the Middle East. If both conditions are met, the report suggests, the factors that supported EM outperformance over the past year could reassert themselves.
Summary takeaways from the UBS note include the interplay between a supply-driven energy shock and fragile valuation cushions, the reversal of recent profitable trades in EM, and the central role of AI-related investment flows as the primary stabilizing influence for select markets in the region.