Iran war causes shift in sentiment towards emerging markets

The past few months have been marked by an abrupt shift in sentiment on emerging financial markets. Whilst the focus was initially on mostly positive news regarding macroeconomic trends, monetary policy and corporate earnings, the war launched by the US and Israel against Iran has been the dominant theme since the end of February.

The start of the year was characterised by a clear outperformance of emerging market equities relative to developed markets. However, emerging markets gave up some of these gains in March. In particular, the massive rise in prices for crude oil and refined products has weighed heavily on energy-importing countries in South and South-East Asia, whilst commodity producers such as Brazil held up comparatively well. In April, however, emerging market equities were performing strongly once again and effectively fully regained their performance lead over developed markets.

Financial markets have so far proven very resilient

In general, both equity and bond markets in developed and emerging economies have so far shown remarkable resilience. Given the biggest energy shock since the 1970s and a blockade of trade flows through the Strait of Hormuz that has now lasted for around six weeks, one might have expected far steeper share price declines.

That this has not happened so far is due to several factors:

• On the one hand, many emerging markets are benefiting from higher oil prices as energy exporters.

• On the other hand, there are still, at least for now, substantial reserves available to cushion the current supply bottlenecks.

• Furthermore, prior to the start of the Iran conflict, there was an oversupply in the oil markets.

• At the same time, companies operating in the semiconductor and/or artificial intelligence sectors are benefiting from massive increases in sales and profits and are regarded as (at least for now) relatively unaffected by the developments in the Gulf region. These companies are now often market heavyweights in a number of emerging market equity indices (e.g. Korea, Taiwan).

• Most emerging markets are also less dependent on the US dollar than they used to be. Expectations that US monetary policy will eventually be eased – despite, or perhaps even because of, the war in Iran – have also led many investors to already bet on a recovery in emerging markets as a result of falling US interest rates and a weaker dollar.

Real economy and stock markets on a collision course?

However, a tension is building between price movements in the financial markets and the real-economy consequences of the Iran conflict. For the time being, the latter can still be largely averted or mitigated. Yet the longer the Strait of Hormuz remains closed (and potentially the trade route through the Red Sea as well), the further the gap between market performance and the real economy will widen.

Most analysts expect irreversible negative consequences for the global economy to arise if the Strait of Hormuz remains mostly closed over the next three to seven weeks. At present, however, the market consensus still seems to believe that neither the US nor China and Russia (as Iran’s supporters) have any interest in such a development, and that a settlement of the Iran conflict of some sort will therefore be reached at the last minute. Quite a few also assume that Trump will de-escalate if the US financial markets drop too heavily. Whether these expectations will actually materialise remains to be seen, however, and there are certainly strong arguments for a more sceptical view.

Emerging Markets: Economic data already shows signs of the Iran conflict

Hard economic data is already reflecting the initial effects of the Iran war:

• Although China achieved GDP growth of 5.0% in the first quarter, there was a sharp slump in trade surpluses in March, as imports (primarily due to higher energy prices) shot up by almost 30% whilst export growth slowed significantly due to global uncertainty. China itself appears to be fairly well protected for the time being, thanks to high oil reserves and the rapid expansion of renewable energy and nuclear power. However, if China’s export markets were to experience a prolonged downturn, this will only provide limited relief.

• In contrast, India, as a major net importer of energy sources, is facing massive pressure on the real economy, as evidenced, among other things, by downward revisions to growth forecasts by international rating agencies. A weakening rupee and capital outflows signal that the markets are beginning to price in India’s heavy dependence on oil imports. Despite strong corporate profits, the Indian stock market is one of the weaker major markets globally, down by around 8% since the start of the year. Korea's stock index offers a sharp contrast, having risen by a phenomenal 50% since the start of the year, despite Korea also being heavily dependent on oil from the Gulf region. Huge share price gains among South Korean chip manufacturers, which dominate the stock index, have nevertheless caused it to literally explode.

• A different macroeconomic picture is emerging in Brazil, however, which is benefiting from the commodities rally. Here, forecasts for trade surpluses have been revised significantly upwards. Brazil’s stock market has also performed very well, gaining over 20% in since the beginning of the year. Here, the presidential elections due in October are also already looming large as a domestic political theme.

• Meanwhile, a new wave of inflation is on the horizon in Central and Eastern Europe, which could jeopardise the industrial recovery that has only just begun. Here too, a swift end to the war in Iran could still avert genuine crisis scenarios, but time is running out quickly.