The war situation in Iran has quickly turned emerging markets into one of the worst places for global investors. Stocks and bonds, which hit record highs just days ago, are now facing downward pressure as traders assess how rising oil prices and a stronger dollar - both shocks triggered by the conflict - will weaken prospects for some of the world's fastest-growing economies. Asia has borne the brunt of the sell-off, with South Korean stocks falling 18% this week.
The sudden shift has raised concerns about whether the value of emerging market investments has changed. Top fund managers had been building long positions in Asia, Latin America and parts of EMEA before the war, as investors bet on strong growth, slowing inflation and easing global monetary policy. Now, the risk of rising energy costs and a stronger dollar has triggered a wave of investors cutting back on their holdings.
"The resilience of emerging markets will now be tested, and after a strong start to the year, we may see the strongest shock here," said Sonal Desai, chief investment officer of fixed income at Franklin Templeton.
The decline in emerging market stocks intensified on Wednesday, with the benchmark index falling as much as 4.4% and approaching a technical correction range. By comparison, the MSCI Global & Developed Markets Equity Index fell less than 1% before U.S. markets opened.
An index of dollar-denominated emerging market bonds experienced its biggest two-day drop since April, and a gauge of currency exchange rates has fallen 1.7% since Monday and is heading for its biggest weekly drop since March 2020.
Fund flows reflected worsening market sentiment. Chipmaker-heavy markets like South Korea - a major beneficiary of this year's stock market rally - led the decline.
For many investors, the most pressing question now is how to adjust their portfolios to rising energy prices. A key strategy now emerging across trading desks is to separate winners and losers based on oil exposure, selling large importers and buying exporters instead.
Marcelo Assalin, head of emerging market debt at William Blair, said, "While we believe it is too early to directly increase exposure, as energy prices rise, we have begun to shift investments from oil price-sensitive importers to more geographically neutral oil exporters." The company is currently underweight the Middle East market.
In Asia, importing countries such as South Korea, Thailand and India are vulnerable to continued increases in oil prices, while exporting countries such as Malaysia may be more resilient. Rising crude oil prices are likely to push up consumer prices, complicating the outlook for some central banks that have only recently begun considering interest rate cuts.