Emerging Markets: Stirred, But Not Yet Shaken

Episode Summary

Executive Summary: In this Goldman Sachs Exchanges podcast, host Alison Nathan and strategist Kamaksha Trivedi analyze market reactions to the Iran conflict, noting an inflation shock from energy price spikes but no growth shock yet. They discuss why traditional hedges like gold and duration failed, the dollar's strength, and emerging market resilience. Trivedi highlights structural drivers for EMs, including AI demand and underweight allocations, while cautioning that prolonged conflict could trigger growth damage.

Main Topics: Market Reaction to Middle East Conflict (Priority: 5/5): Markets are pricing an inflation shock from higher energy prices, with rate curves moving up and central bank cuts being priced out. Traditional hedges like long duration, gold, and Swiss franc have not performed as expected due to positioning and policy actions. Absence of Growth Shock (Priority: 5/5): Despite equity declines, there is no clear cyclical growth tilt; assets like Australian dollar and copper haven't underperformed. A growth shock is the 'shoe left to drop' if the conflict sustains, potentially causing physical shortages. Dollar Strength and Terms of Trade (Priority: 4/5): The dollar has strengthened due to the US being on the right side of the terms of trade divide from higher energy prices. The differentiation between energy exporters and importers is becoming a key driver of currency pairs. Emerging Market Performance and Narrative (Priority: 4/5): EM assets had strong momentum before the conflict but have been interrupted. The narrative hasn't fundamentally changed if the conflict is short-lived; long-term structural drivers like AI demand and underweight allocations remain supportive. Structural Drivers for Emerging Markets (Priority: 4/5): Three structural drivers support EMs: a weaker dollar trajectory over time, resilient macro factors (good growth, lower inflation, healthier fiscal deficits), and underweight allocations (EMs are 12% of global benchmark but allocations are ~10%). AI Theme and Korea's Earnings Growth (Priority: 3/5): Korea and Taiwan benefit from AI-driven demand for semiconductors, providing strong earnings growth. This theme is expected to endure absent a global recession, supporting EM equities beyond the conflict.

Key Arguments: The market is pricing an inflation shock from energy prices, not a growth shock, as seen in rate curve movements and lack of cyclical asset underperformance. Traditional hedges (long duration, gold, Swiss franc) have failed due to positioning and policy interventions, making portfolio management painful. The dollar is supported by both a global risk-off shock and favorable US terms of trade from higher energy prices. EM assets remain resilient due to healthier macro fundamentals and underweight allocations, with AI-driven earnings growth in North Asia being a key support. If the conflict is short-lived (weeks), the EM narrative remains intact; prolonged conflict could trigger growth damage and physical shortages. Structural drivers for EMs include a weaker dollar over time, improved policy frameworks, and the trend toward diversification into global assets.

Data Points: EM equity upside expectation: 10 to 12 percent - Expected upside from current levels for emerging market equities, driven by earnings growth. EM share of global benchmark: 12% - Emerging markets are roughly 12% of the overall global benchmark. Current EM allocation in global equity funds: 10% - Asset allocators are underweight EMs, with allocations at about 10% versus the 12% benchmark. Duration of conflict priced by commodity markets: Weeks rather than months - The highest point in energy prices at the front month of the futures curve suggests a short-duration conflict. EM equity outperformance vs DM: Comfortably outperforming - Despite recent underperformance, EM equities are still outperforming DM and US equities over a broader period.

Pivotal Quotes: "It's been an inflation shock that the market has priced across assets. It hasn't really been a growth shock that's been priced. That's the shoe that's left to drop." — Kamaksha Trivedi: Summarizing the current market pricing and warning of potential future growth damage if the conflict persists. "The US is on the right side of that divide. So, a global risk-off shock and the US being on the right side of that divide, I think both of them lend itself to a stronger dollar." — Kamaksha Trivedi: Explaining why the dollar has strengthened amid the energy price shock and global risk aversion. "It's a less racy asset class, it's a more reliable asset class. I think that's what people are going to discover even as we go through this shock." — Kamaksha Trivedi: Describing the improved resilience of emerging market assets due to better policy frameworks and macro fundamentals.

Implications: Listeners should expect continued dollar strength and EM volatility if the conflict persists. A short-lived conflict supports EM recovery, driven by AI and structural underweights. Prolonged conflict risks a growth shock, making diversification and focus on energy exporters like Brazil and South Africa prudent.