A powerful mix of Federal Reserve rate cuts, a softer dollar, and a global boom in artificial intelligence has pushed emerging-market assets to their strongest year in nearly a decade. But the very flows that fueled this rally are now flashing warning signals. Major money managers are cautioning that some of the most popular EM trades of 2025—especially high-yielding currencies and AI-linked equities—may be entering a dangerous phase of overcrowding, heightening the risk of abrupt drawdowns that could reverberate through global markets.

When Momentum Turns Fragile

Latin American currencies, long favored in carry trades, have been top performers this year. The Brazilian real alone delivered roughly 30% in carry returns—yet strategists at Wells Fargo argue that valuations have drifted far from macro fundamentals. Fiscal concerns in Brazil and elevated options hedging costs underscore the shift: three-month risk reversals on the real have climbed to a four-year high, a sign that more traders are buying downside protection.

Similar warning signs are emerging in neighboring currencies. The Chilean, Mexican, and Colombian pesos all screen as “rich” versus long-term averages. The trade-weighted Colombian peso now sits at its strongest level in seven years, placing it one standard deviation above its 10-year norm, while the Mexican peso stands even further above trend. Such stretched pricing increases vulnerability to rate-differential shocks or broader risk-off sentiment.

Bond Inflows Hit Extremes

The search for yield has also pushed investors aggressively into local-currency EM bonds. According to HSBC’s latest survey, 61% of global EM asset holders are overweight the asset class—an extraordinary swing from the net-underweight position seen just months earlier. A Bloomberg index tracking these bonds is now on pace for its best year in six years.

Yet asset managers warn that this herd behavior can create its own fragilities. RBC BlueBay highlighted the risk that year-end profit-taking could spark elevated FX volatility, especially if liquidity thins. Overcrowding increases the likelihood that even modest outflows could trigger rapid price adjustments.

Fidelity International is particularly cautious on frontier markets such as Egypt, Ivory Coast, and Ghana. These markets have benefitted from the global rotation out of U.S. assets, but their shallow liquidity means that a sudden exit could overwhelm the buyer base—an acute risk if global volatility spikes.

AI Mania Adds to Market Stress

The past month has offered a preview of how fast crowded trades can unwind. Asian tech shares—supercharged by the AI boom—experienced their sharpest sell-off since April. South Korea’s KOSPI, the world’s best-performing major index in 2025 with a nearly 70% surge, plunged more than 6% in a single session before stabilizing. Analysts say positioning in Korea’s AI-memory sector has become dangerously tight, leaving it highly sensitive to even minor sentiment shifts.

Lazard Asset Management notes that lower-quality companies have been outperforming higher-quality peers, a dynamic that historically precedes sharp mean reversions when market positioning becomes overly concentrated.

Looking Ahead

As 2025 draws to a close, investors face a landscape where stretched valuations and crowded trades leave little margin for error. Any shift in the global rate outlook, geopolitical tensions, or AI-tech sentiment could catalyze fast-moving reversals across EM currencies, bonds, and equities. The coming months will test whether these markets can absorb profit-taking without triggering broader liquidity stress—an outcome that will shape global risk appetite heading into 2026.