Global capital is exiting emerging market equities in Asia at the fastest pace in nearly four years. Rising tensions surrounding Iran have triggered a flight to safety, compelling investors to reassess risks, which has rapidly transmitted to regional stock and currency markets.
According to data compiled by Bloomberg, global funds recorded a net sale of approximately $110 billion in developing Asian equities excluding mainland China this week, marking the largest weekly outflow since March 2022. Among these, South Korea accounted for about $1.6 billion and India for about $1.3 billion.
The capital outflows, combined with a sharp decline in risk appetite, have triggered steep declines in regional stock markets. The MSCI Asia Pacific Index fell more than 6% this week, on track for its largest weekly drop in nearly six years and its worst underperformance relative to the S&P 500 since April. South Korea's Kospi index experienced a record single-day drop, with some markets seeing multiple trading halts.
Morgan Stanley strategists have adopted a more cautious stance on Asian and emerging market equities due to risks associated with the conflict involving Iran. They downgraded India and the UAE from overweight to neutral, noting that Asia is "heavily reliant on crude oil, refined products, and LNG supplies from the Middle East" and suggesting that markets are underestimating supply chain risks.
This wave of outflows marks a reversal of a recent high-yield trade known as "Sell the US, Buy Asia." This strategy bet on a weaker US dollar, moderate inflation, and demand for regional chip stocks driven by the AI boom, rotating capital from highly-valued US equities to Asian stocks. However, the situation with Iran has undermined its core premises. Gary Tan, a portfolio manager at Allspring Global Investments, stated that investors had previously bought Asian stocks based on expectations of a weaker dollar and benign inflation, but the Iran situation challenges both assumptions. Markets are now assessing the potential for prolonged dollar strength and whether high oil prices could reignite inflationary pressures.
A key reason for the deeper retreat in Asian assets is their relatively high dependence on Middle Eastern crude oil. A significant portion of fuel imports transit through the critical Strait of Hormuz, and escalating conflict has increased the risk premium on supply chains. Rising oil prices have intensified concerns about resurgent inflation, particularly as many central banks had just begun to gain confidence that inflationary pressures were subsiding. Economies like Japan, South Korea, India, and Indonesia are among the world's largest crude importers, while the US has become a net oil exporter. This divergence reinforces the market view that Asia, as a net importing region, is more vulnerable to inflation and policy constraints under oil price shocks.
Amid the risk-off sentiment, a stronger US dollar is pressuring emerging market currencies, with particular focus on the currencies of net oil importers and their impact on domestic inflation. The South Korean won registered its largest single-day closing decline since 2009 on Tuesday, raising investor concerns about forced deleveraging and liquidation risks. Concurrently, volatility measures are rising. JPMorgan's emerging market foreign exchange volatility index climbed this week to surpass comparable G7 indices, ending a prolonged period of trading below them and highlighting a rapid shift in market risk pricing.
On the strategic front, Morgan Stanley strategists, citing risks related to the Iran conflict, have turned more defensive on Asian and emerging market equities. They downgraded India and the UAE to neutral while upgrading Saudi Arabia from underweight to neutral. Strategists including Daniel Blake and Jonathan Garner wrote in a report that they "maintain a defensive stance," reiterating Asia's heavy reliance on Middle Eastern energy supplies and the market's underestimation of supply chain risks. Citigroup emphasized the importance of timing. Analysts including Luis Costa noted in a report that they had significantly reduced risk exposure in recent days but would look to re-establish long positions in emerging markets if stabilization signals emerge. While there are "initial signs of stability" in oil prices, it is too early to conclude that a repeat of 2022's price surge is imminent.
Beyond the Middle East situation, investors will also monitor the upcoming US non-farm payrolls data for clues on the Federal Reserve's interest rate path. The ongoing repricing of the US dollar's strength and global risk appetite will likely determine whether this "exit trade" for Asian assets is a temporary fluctuation or the beginning of a more sustained portfolio rebalancing.
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