Emerging Market Risks Rise as Iran Conflict Escalates

Escalating tensions following attacks on Iran are prompting a reassessment of investment strategies in emerging markets (EMs). Hedge funds, which had significantly increased their positions in EM stocks, are now facing potential setbacks as the conflict introduces new risks to the asset class.

EM Equity and Currency Declines

MSCI’s broad EM equities index experienced a nearly 2% decline on Monday, with markets in Turkey and India particularly affected. JPMorgan’s EM currency index also slid, falling 0.7%. This marks a reversal of the positive trend seen earlier in the year, where EM equities had risen 14% as of Friday’s close, benefiting from a weakening dollar and lower oil prices.

Dollar Strength and Crude Oil Surge

The attacks on Iran have triggered a flight to safe-haven assets, strengthening the dollar and pushing up the price of Brent crude oil by approximately 6%. Asian and European gas prices have also surged, adding to the economic uncertainty.

Hedge Fund Exposure and Leverage

According to an executive at a large macro hedge fund, the EM trade is now considered a significant risk due to the high levels of leverage within the system. The previously “easy one-way trade” of betting on gains in EM equities and fixed income is expected to face substantial challenges, with potential implications for the broader hedge fund community. Goldman Sachs’ prime brokerage report indicated that hedge fund allocations to EM stocks were near five-year highs.

Regional Market Performance

Several key emerging markets experienced declines on Monday: India’s Nifty 50 fell 1.2%, Hong Kong’s Hang Seng declined 2.1%, Taiwan’s Taiex lost 0.9% and Turkey’s Bist 100 gauge slid 2.7%.

Investor Concerns and Diversification Plans

Investors who had diversified away from Wall Street stocks due to concerns about AI disruption are now questioning their plans. Salman Ahmed, global head of macro at Fidelity International, stated that his firm is actively reviewing its EM exposure due to the high degree of oil import dependence in emerging Asian economies. Fidelity had previously been bullish on the asset class and held an overweight position.

Prolonged Conflict Risks

Portfolio managers emphasize that a prolonged conflict in Iran would be necessary to trigger a lasting sell-off in EM indices. The recent inflows into chipmakers like TSMC, Samsung, and SK Hynix have provided some support to these markets. However, a sustained conflict could jeopardize the crowded EM trade, as many investors have significant long positions.

Currency Impacts and Central Bank Responses

EM currencies typically correlated with global risk assets experienced declines on Monday. The Hungarian forint, South African rand, and Brazilian real all fell between 1 and 2% against the dollar. Turkey’s lira remained relatively stable following interventions by the central bank, even as Indonesia’s central bank signaled its readiness to defend the rupiah.

Fundamental Drivers and Debt Markets

Despite the current volatility, some analysts remain optimistic about the long-term fundamentals of EM fixed income. Carlos de Sousa, a portfolio manager at Vontobel, noted that current account deficits are lower than in the past and that positioning is not excessively exuberant. Hedge funds have recently returned to the local debt markets of Egypt and Turkey, attracted by double-digit interest rates, although some investors had begun to hedge their positions in anticipation of increased conflict.

Liquidity and Outflow Concerns

As of now, there are no signs of “serious outflows” from EM trades, and the situation has not yet reached a “panic event” characterized by a flight to safe havens, which historically has been detrimental to emerging markets.