Hedge funds that had heavily invested in emerging market stocks are now scrambling to reassess their positions, as tensions between the U.S., Israel, and Iran have triggered declines in equities and currencies across several developing economies.
On Monday, March 2, the broad MSCI Emerging Markets Equity Index fell by nearly 2%, with stocks in markets such as Turkey and India coming under pressure. JPMorgan's Emerging Markets Currency Index declined by 0.7%. Popular semiconductor stocks, including Taiwan Semiconductor Manufacturing (TSM), Samsung, and SK Hynix, also face revaluation risks.
This marks a reversal for emerging market stocks, which had risen 14% this year as of the previous Friday's close. Earlier gains were supported by a weaker U.S. dollar, which lowered dollar-denominated debt and import costs for developing nations, while low oil prices provided a boost to energy-importing countries. However, the recent U.S. strike on Iran threatens to disrupt these trends. As investors seek safer assets, the dollar has strengthened, Brent crude prices surged by approximately 6%, and natural gas prices in Asia and Europe also rose significantly.
A senior executive at a major macro hedge fund stated, "I believe the emerging market trade now carries substantial risk." The executive added, "There is significant leverage in the system. Betting on emerging market equities and fixed income has been a straightforward one-way trade, and I think it will face serious challenges. This will impact the entire hedge fund industry."
On Monday, India's Nifty 50 Index fell by 1.2%, while Turkey's Bist 100 Index dropped 2.7%. According to Goldman Sachs' latest prime broker report, covering the week ending last Thursday, hedge fund allocations to emerging market stocks as a share of total exposure were "hovering near five-year highs." The report noted that, in dollar terms, emerging markets were among the most favored trades that week, with stocks from South Korea and Taiwan being particularly popular.
In recent months, investors had diversified away from Wall Street equities amid concerns about AI-driven market disruptions. Now, the conflict involving Iran has cast doubt on those plans. Salman Ahmed, Global Head of Macro at Fidelity International, said that due to the high reliance of Asian emerging economies on oil imports, "we are actively reviewing our emerging market exposure." The asset management firm had entered the year with an optimistic view on the asset class and held an overweight position.
Others emphasized that only a prolonged conflict involving Iran would lead to a sustained sell-off in emerging market indices. These indices have also benefited from strong inflows into chipmakers, including Taiwan Semiconductor Manufacturing, Samsung, and SK Hynix.
A portfolio manager at a large macro fund noted, "If this turns into a drawn-out conflict, the crowded emerging market trade will be at risk. Everyone has piled into emerging markets. Most macro returns have come from being long emerging markets." The manager added that investors who increased their emerging market exposure in recent months "need the conflict to end quickly."
Emerging market currencies, which typically move in line with global risk assets, declined on Monday. The Hungarian forint, South African rand, and Brazilian real fell by 1% to 2% against the U.S. dollar. The Turkish lira held steady against the dollar after the central bank took steps to ease currency pressure. Indonesia's central bank also signaled its readiness to defend the rupiah.
Carlos de Sousa, a portfolio manager at Vontobel, commented that for oil-importing countries like Turkey, "if prices remain at these elevated levels or higher for several weeks or more, it will fuel inflation," but the country has reserves to support the lira. He added, "The fundamental drivers that have supported emerging market fixed income performance remain intact," noting that many of these countries have reduced their reliance on imports and foreign capital flows in recent years.
Over the past year, hedge funds had returned to local currency debt markets in countries like Egypt and Turkey, attracted by double-digit interest rates offered to support weak currencies. According to Citigroup, as tensions with Iran escalated in recent weeks, some investors exited these positions, with foreign holdings of Egyptian debt falling by $2 billion to $30 billion.
However, some investors have taken protective measures to remain in the trade, betting that the conflict will not be prolonged. One investor noted, "In the past few days, we've seen hedging on some of the more crowded positions in Turkey, Egypt, and local markets," including through credit default swaps and forward bets on currencies.
The investor added that there is no indication yet of "severe outflows" from emerging markets as a whole. "Things haven't reached that level of panic. This isn't the kind of liquidity event where credit lines are cut and capital flees to safe-haven assets. Historically, that's when emerging markets experience real pain, and we're not there yet."
