Emerging Markets Brace for Volatility as Geopolitical Tensions Escalate

Emerging-market currencies have faced significant pressure as concerns over the conflict in the Middle East have driven investors towards the safe-haven US dollar. Meanwhile, strong US economic data has fueled expectations that the Federal Reserve may moderate the pace of interest rate cuts, further complicating the outlook for developing economies.

Navigating the Turbulent Landscape of Emerging Markets

Geopolitical Tensions Weigh on Emerging Currencies

The ongoing tensions in the Middle East have sparked concerns about potential disruptions to energy supplies, which has led to a surge in demand for the US dollar as a safe-haven asset. This has put significant pressure on emerging-market currencies, with the MSCI benchmark for developing-nation currencies slipping for the third consecutive day, losing around 0.4%. Currencies such as the Malaysian ringgit and the Chilean peso have experienced declines of approximately 1%.The escalating conflict has also had a ripple effect on the broader emerging-market landscape. The key gauge for developing-nation equities fell 1.5%, with stocks traded in Hong Kong pulling back from a recent rally. Investors are closely monitoring the situation, as any further escalation in the Middle East could have far-reaching consequences for energy shipments and global trade.

US Economic Data Fuels Expectations of Moderated Fed Action

The release of strong US economic data has added to the uncertainty facing emerging markets. Data showed that US service providers expanded in September at the fastest pace since February 2023, while applications for US unemployment benefits rose slightly last week. These figures have bolstered expectations that the Federal Reserve may be less inclined to aggressively cut interest rates, which could have significant implications for emerging economies."We have been surprised by the muted reaction to the conflict in the Middle East, which suggests that the main driver of returns remains the expectation of central bank easing," said Anders Faergemann, a fixed income portfolio manager at PineBridge Investments. "US yields are rising since it 'remains uncertain whether the economic slowdown warrants another 50 basis point rate cut.'"Investors are now eagerly awaiting the release of the monthly US labor data on Friday, which could provide further insights into the Fed's policy path and its potential impact on emerging markets.

Emerging Markets Seek Resilience Amid Uncertainty

Despite the challenges posed by the current environment, some analysts remain cautiously optimistic about the long-term prospects for emerging markets. "Fewer cuts by the Fed may delay the easing by EM central banks, yet EM currencies still have a good cushion in terms of higher interest rates and have clearly benefited from the removal of the downside risk in China's economy," Faergemann said.The Turkish lira, for instance, has strengthened marginally after inflation in the country accelerated faster than expected, which may delay the country's first rate cut since early 2023. This highlights the diverse nature of emerging markets and the need for investors to closely monitor individual country dynamics.Moreover, the recent stimulus measures introduced by the Chinese government have transformed the outlook for the country's equities. HSBC strategist Alastair Pinder has upgraded Chinese stocks to overweight, stating that it's "not too late to enter the rally." Similarly, Morgan Stanley's Laura Wang believes that China's equities can gain a further 10% to 15% as the government may announce additional fiscal measures to expand the stimulus already announced."The rally has further to run," said Fredrik Bjelland, portfolio manager of the $1.5 billion Skagen Kon-Tiki emerging-market fund. "Chinese valuations are attractive. Moreover, flows have been negative for a number of years, leaving global investors' positioning light compared with history."The influx of funds into US exchange-traded funds that invest in Chinese stocks, such as BlackRock Inc.'s iShares China Large-Cap ETF, which received $577 million of fresh deposits on Wednesday, further underscores the renewed investor interest in the region.As emerging markets navigate this turbulent landscape, investors will need to carefully assess the evolving geopolitical and economic dynamics to identify opportunities and mitigate risks. The ability to adapt to the changing landscape will be crucial for those seeking to capitalize on the potential of these dynamic and diverse markets.