Emerging Market Turmoil: Iran Conflict Rattles Investor Confidence
Hedge funds that recently increased their exposure to emerging market (EM) stocks are now reassessing their positions following the attacks on Iran. The escalating tensions have triggered a slide in shares and currencies across several developing countries, reversing earlier gains seen this year.
A Sudden Shift in Sentiment
MSCI’s broad EM equities index experienced a nearly 2 percent drop on Monday, with markets like Turkey and India facing significant pressure. JPMorgan’s EM currency index similarly declined, falling 0.7 percent. This marks a notable turnaround, as EM equities had been up 14 percent year-to-date as of Friday, benefiting from a weakening dollar and lower oil prices.
The attacks on Iran threaten to disrupt these positive trends. The dollar has strengthened as investors seek safe haven assets, and Brent crude oil prices jumped approximately 6 percent. Gas prices in both Asia and Europe have also surged, adding to the economic uncertainty.
Leverage and Risk in Emerging Markets
“I think the EM trade is a big risk now,” one executive at a large macro hedge fund told the Financial Times. The executive warned of significant leverage within the system, suggesting that funds betting on gains in EM equities and fixed income face substantial challenges. This could have widespread implications for the entire hedge fund community.
Several key markets experienced declines on Monday. India’s Nifty 50 index fell 1.2 percent, Hong Kong’s Hang Seng declined 2.1 percent, Taiwan’s Taiex lost 0.9 percent, and Turkey’s Bist 100 gauge slid 2.7 percent.
Goldman Sachs’ prime brokerage report indicated that hedge fund allocations to EM stocks were near five-year highs leading up to the recent events, suggesting a potentially crowded trade.
Oil Imports and Currency Defense
Investors who diversified away from Wall Street stocks due to concerns about AI disruption are now re-evaluating their strategies. 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 imports in emerging Asian economies. Fidelity had been bullish on the asset class and held an overweight position.
Yet, some analysts believe a prolonged conflict is necessary to trigger a lasting sell-off. They point to continued inflows into chipmakers like TSMC, Samsung, and SK Hynix as a supporting factor for EM indices.
“If this becomes a prolonged conflict, the crowded emerging market trade is at risk. Everyone is piled into emerging markets,” a portfolio manager at a large macro fund cautioned. “Most macro returns have come from being long emerging markets.”
EM currencies typically correlated with global risk assets also experienced declines. The Hungarian forint, South African rand, and Brazilian real each fell between 1 and 2 percent against the dollar. However, this impact was less severe than the market reaction to Donald Trump’s tariffs last year.
Central Bank Intervention
Turkey’s central bank took steps to relieve pressure on its currency, and Indonesia’s central bank signaled its readiness to defend the rupiah. Carlos de Sousa, a portfolio manager at Vontobel, noted that while higher oil prices could be inflationary for Turkey, the country possesses reserves to support its currency.
De Sousa also emphasized the fundamental drivers supporting EM fixed income, including reduced reliance on imports and foreign capital flows. Current account deficits are lower than in the past, and positioning is not considered overly exuberant.
In the past year, hedge funds increased their investments in local debt markets in Egypt and Turkey, attracted by double-digit interest rates. As tensions surrounding Iran escalated, some investors exited these trades, resulting in a $2 billion decrease in foreign holdings of Egyptian debt, according to Citigroup.
However, others purchased protection to maintain their positions, anticipating a limited duration of the conflict. One investor noted that hedges were placed in Turkey, Egypt, and other crowded positions through credit default swaps and forward currency bets.
Currently, We find no signs of “serious outflows” from EM trades overall. “Things haven’t reached that panic event. It’s not that kind of liquidity event where those lines are cut and there’s a flight to safe havens. That is the really painful event for emerging markets historically, and we’re just not there yet.”
Frequently Asked Questions
Q: What is driving the recent decline in emerging market assets?
A: The attacks on Iran and the resulting geopolitical uncertainty are causing investors to seek safe haven assets, leading to a strengthening dollar and increased oil prices, which negatively impact emerging markets.
Q: Which emerging markets are most vulnerable?
A: Oil-importing countries, particularly in Asia, are most vulnerable due to the rising cost of energy. Turkey and Egypt, which have recently attracted hedge fund investment, are also facing increased scrutiny.
Q: Is this a buying opportunity?
A: It depends on the duration and escalation of the conflict. If the conflict remains contained, the current dip could present a buying opportunity. However, a prolonged conflict could lead to further declines.
Pro Tip: Diversification is key. Don’t put all your eggs in one basket, especially during times of geopolitical uncertainty.
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