Conflict in Middle East adds new concern for EM investors

The outbreak of conflict in the Middle East is adding to a long list of concerns that has investors dumping developing-nation assets for the safety of the dollar. 

The surprise weekend attack on Israel sent Middle Eastern stocks plunging and rippled across crowded currency trades. Equity gauges in Dubai and Istanbul dropped at least 2.6%, while crude oil rose more than 3%. The Mexican peso, one of the more liquid emerging-market currencies, fell as much as 1.4% before rebounding as risk sentiment improved across global markets. 

Investors were ditching emerging-markets even before the conflict broke out. Stocks have already wiped out year-to-date gains, and fewer and fewer currencies are holding up against the greenback. 

The unwinding of what some saw as the decade of emerging markets has had no shortage of drivers. Indications global interest rates will stay higher for longer and rising oil prices have put a cap on how much developing nations can ease policy to boost their economies, while disappointing Chinese data has dented expectations for improving global growth. 

And then there is the historic move in the US Treasury markets, which kicked the rout into high gear. Exchange-traded funds that buy developing-nation stocks and bonds have seen five straight weeks of outflows, with $3.12 billion being pulled last week alone — the most in a year. Credit default swaps that protect bondholders against default by a major emerging market in the next five years jumped for a fifth successive week, the longest streak since May 2022.

“The Israeli war is what seems so far as a mini-shock to the markets, which have otherwise been driven by ‘higher-for-longer’ story alone,” said Sergey Goncharov, a money manager at Vontobel Asset Management. “It is hard to assess how the situation on the ground will evolve as well as broader geopolitical consequences.” 

In a show of just how volatile markets have become, assets rebounded in afternoon trading as investors reassessed rate bets amid comments from Federal Reserve officials. The Brazilian real flipped to end the day higher, while the Mexican peso traded just 0.2% lower versus the dollar as of 4:50 p.m. in New York. Trading in US cash Treasuries was closed for a public holiday Monday, which also helped limit a more widespread selloff. 

The piling up of negative factors have discouraged traders from taking on risk, with money flocking to the safety of the dollar, gold, or global bonds. About $287 billion in shareholder wealth in emerging-market stocks has been erased so far in October, bringing the total wiped out since July 31 to $1.67 trillion, according to an analysis of data compiled by Bloomberg.

The souring mood has hit not just countries that are in deep distress, like Ethiopia, Argentina and Egypt, but also more stable trades. Latin American currencies, which had consistently topped the list of developing-world winners this year, have seen their appeal fade amid exacerbated volatility. Emerging-market carry trades are heading for a third monthly loss, the longest run since November 2021. 

ESCALATION

Now, concerns about the escalation of conflict — including the possibility the US takes a more active role and a Wall Street Journal article saying Iran was actively involved in planning the attack — should further crimp demand for riskier assets. 

“The general consensus is that the effects of this conflict are going to be localized,” said Simon Harvey, head of foreign-exchange analysis at Monex Europe Ltd. “But, there is a risk that this broadens out into a larger conflict threatening to destabilize the region as a whole, and that is why close attention is being paid to the actions of the US and Iran in the coming days.”

The shekel tumbled more than 2.5% against the dollar even after the Bank of Israel unveiled an unprecedented $45 billion program to defend the currency. US-traded exchange-traded funds tracking Israel assets plunged the most since March 2020 on high volume. 

“For now, the impact is largely being siphoned through the risk channel and this is why you’re seeing carry currencies with saturated positioning bearing the brunt,” Harvey said.

CHINA

China’s mainland markets returned from a week-long holiday on Monday and posted mixed performances. The Shanghai-Shenzhen CSI 300 Index fell 0.1%, though indexes of Chinese stocks listed in Hong Kong rallied. The yuan capped an increase after the central bank indicated continued support for the currency with a stronger fixing.

The grim newsflow from Israel had already sunk those Middle Eastern stock markets that were open on Sunday, but the losses continued across the region for a second day as concerns of a prolonged war deepened. 

In the dollar-bond market, Israel and Jordan posted some of the biggest losses in emerging markets. The extra yield investors demand to own sovereign bonds of developing nations rather than US Treasuries narrowed Monday, according to tentative data from JPMorgan Chase & Co, after widening by 21 basis points last week, the biggest increase since the period ending Aug. 18. 

Elsewhere, emerging markets are looking forward to a crucial milestone this week, especially for debt-burdened African nations. The continent plays host to the annual meetings of World Bank and International Monetary Fund, where much of the focus will be on speeding up the debt-relief process for some of the world’s poorest nations.