LONDON – The escalating conflict in the Middle East has rattled global markets, triggering a flight from risk assets that has significantly impacted emerging economies. However, despite substantial losses this week, a growing number of investors believe that strong economic fundamentals and a shifting geopolitical landscape could allow a year-long rally in emerging markets to resume. The initial shock of the U.S. And Israeli strikes on Iran sent emerging market currencies and stocks toward their largest weekly declines in three years, with bonds too experiencing a sharp downturn.
The immediate fallout saw JPMorgan reducing its overweight stance on emerging market foreign exchange and local currency bonds to a neutral position, citing increased uncertainty. Similarly, Citi halved its exposure to emerging market foreign exchange. Despite this pullback, veteran investors suggest that, barring further significant escalations or a sustained surge in energy prices, emerging economies are positioned to rebound, with early indicators suggesting resilience. As of March 5, 2026, the situation remains fluid, but a sense of cautious optimism is emerging among some key players.
A Pause, Not an End to the Rally?
Until recently, emerging markets had consistently outperformed expectations. Since the beginning of President Donald Trump’s second term in January 2025, investment flows into these asset classes have surged. Countries like Saudi Arabia, Mexico, Turkey, and Poland issued a record amount of debt in January, while equities soared and investors sought higher yields in local currency debt across frontier markets. However, analysts had cautioned that this influx of “hot money” – from hedge funds and other non-specialist investors – could quickly reverse course if market conditions deteriorated.
The U.S.-Israeli military campaign in Iran proved to be the catalyst for this reversal, prompting investors to seek safer havens. The dollar strengthened, gold prices rose, and investors flocked to cash as a protective measure. “We’ve seen a big shock to markets…there is more to go, should oil prices rise further,” said James Lord, global head of FX and EM strategy at Morgan Stanley. Data indicated that MSCI’s emerging market equities index lost over $1 trillion in market capitalization between last Thursday and Wednesday’s close.
The most dramatic decline was observed in South Korea, where the KOSPI equity index experienced its largest-ever crash, shedding nearly 20 percent over Tuesday and Wednesday. This index, heavily influenced by the artificial intelligence and semiconductor sectors, had previously been the top performer in emerging equities. Jonas Goltermann, deputy chief markets economist with Capital Economics, described the sell-off as “clearly panic selling in some sense,” attributing it to the “market machine” overriding underlying economic fundamentals. However, the KOSPI partially recovered on Thursday, gaining nearly 10 percent, and remains up more than 30 percent for the year.
Underlying Strength and Financial Reforms
Despite the recent turbulence, investors point to the strengthening financial positions and increased credibility of central banks in many emerging and frontier markets as factors that could mitigate the impact of a prolonged crisis. Many central banks, according to Morgan Stanley’s Lord, have adopted “a very cautious and credible approach to the easing cycles,” successfully managing inflation and bolstering their currencies against the dollar.
Significant reforms in countries like Egypt and Nigeria, which historically presented challenges for investors seeking to repatriate capital, have also improved investor confidence. The recent outflows, some argue, demonstrate that these countries are now reliable destinations for investment. Yvette Babb, portfolio manager with William Blair, noted that “Frontiers that received a large amount of inflows are now demonstrating their ability to absorb the demand for foreign exchange and also demonstrating the FX flexibility, which we think is helpful to manage exogenous shocks of this nature.” Babb added, “We think the fundamentals within EM are clearly strong to withstand an exogenous shock, as long as the story does not derail the global growth narrative.”
The Threat of Rising Oil Prices and Shifting Investment Flows
A key concern remains the potential for sustained high oil prices. A prolonged period above $100 per barrel could fuel global inflation, dampen economic growth, and prevent emerging market central banks from continuing to lower interest rates. However, Elias A. Elias, a portfolio manager with Templeton Global Investments, suggested that Latin American commodity exporters could benefit from higher oil prices, while the generally lower valuations of emerging market equities could further enhance their appeal. “We’re very constructive on the EM equities as an asset class,” he said, noting that emerging stocks currently trade at a roughly 28 percent discount to developed markets, with higher earnings growth expectations.
a shift in global investment flows, dubbed “South-South” investment, is providing a buffer for some emerging economies. This involves increasing capital flows from pools of wealth in Asia and the Gulf region, particularly to countries like Egypt. These investors are less likely to abandon emerging markets during periods of volatility. Dhiraj Bajaj, Head of Asia Credit at Lombard Odier, explained, “Today, funds and excess capital in Asia (are) being produced, and they’re investing in other markets. The dynamic is changing.”
Looking Ahead
The situation remains highly sensitive to developments in the Middle East, particularly regarding oil prices and the potential for further escalation. Investors are closely monitoring geopolitical risks and assessing the resilience of emerging economies in the face of these challenges. The next key indicator will be the release of economic data from major emerging markets in the coming weeks, which will provide a clearer picture of the impact of the current crisis.
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