Geopolitical Shocks Reveal Market Assumptions and EM Resilience

The market's reaction to geopolitical shocks often reveals more about its underlying assumptions than the shock itself. In a recent conversation on Goldman Sachs Exchanges, Kamakshya Trivedi, Chief Foreign Exchange and Emerging Markets Strategist, dissected the recent market turmoil stemming from the Iran conflict. What emerged was not just an analysis of oil prices and currency movements, but a deeper look at how traditional hedges fail, how inflation shocks precede growth shocks, and why emerging markets, despite immediate headwinds, are structurally better positioned than many realize. This conversation is crucial for investors and strategists seeking to understand the non-obvious implications of global events and identify durable investment theses beyond the immediate headlines. It highlights how conventional wisdom about risk mitigation can falter when confronted with complex, multi-faceted shocks, offering a strategic advantage to those who can look beyond the immediate price action to the underlying systemic shifts.

The Inflation Shock That Wasn't a Growth Shock (Yet)

The immediate aftermath of the Iran conflict saw markets price in a significant inflation shock, primarily driven by a spike in energy prices. This manifested as a shift in interest rate expectations, with anticipated rate cuts being pared back and even hikes being priced in for some economies. What was particularly striking, however, was the broad failure of traditional portfolio hedges. Long duration assets, gold, and even the Swiss franc--assets typically relied upon to cushion against geopolitical turmoil--failed to perform as expected.

Kamakshya Trivedi pointed out that this wasn't a simple, unified market response. Instead, it was an inflation shock, not yet a growth shock.

"So the market is pricing in a higher inflation shock in response to the spike in energy prices that you've seen as a result of the conflict. You see that in the way rates curves have moved up. Generally, places that were pricing cuts, central banks that were priced to cut rates, you've seen those cuts come out."

This distinction is critical. When markets anticipate a growth shock, cyclical assets and currencies tend to suffer, while defensive assets and safe havens rally. Here, the primary driver was inflation, which has a different set of consequences. The failure of hedges can be attributed to several factors. Trivedi noted that positioning played a significant role; many investors had already crowded into concentrated positions like gold, making them vulnerable to sharp reversals. Furthermore, the nature of the shock--an energy price spike--directly impacted interest rate expectations, undermining the rationale for holding long-duration bonds as a hedge.

The implication here is that the market's initial reaction was focused on the immediate inflationary impact, not the potential downstream economic slowdown. The "shoe that's left to drop," as Trivedi put it, is the growth shock. If the conflict sustains, the focus will inevitably shift to how reduced energy supply and higher prices impact global demand. This sequencing--inflation shock first, growth shock later--offers a window for proactive strategists. By understanding this dynamic, one can anticipate the market's eventual pivot and position accordingly, potentially benefiting from assets that are oversold due to the initial inflation scare but poised to recover as growth concerns mount.

The Dollar's Double Play: Risk-Off and Terms of Trade

Amidst the global uncertainty, the US dollar strengthened. This is a familiar pattern in global risk-off events, but Trivedi highlighted a crucial secondary driver: the terms of trade. The US, being a significant energy exporter, benefits from higher energy prices. This means its export prices rise relative to its import prices, a favorable shift in its terms of trade.

"The US dollar is on the right side of that. As long as that pressure on the energy prices remains to the upside, I think the dollar will remain well supported."

This dual support--as a safe-haven asset and as a beneficiary of favorable terms of trade--explains the dollar's resilience. While many emerging markets, particularly in Asia and Central Eastern Europe, are energy importers and face a direct hit to their import bills, the US dollar acts as a ballast. For investors, this reinforces the dollar's role in a diversified portfolio during such shocks. However, it also signals a potential divergence: while the dollar may remain strong in the short term due to the energy shock, its longer-term trajectory is influenced by other factors, including the relative performance of the US economy.

The orderly reaction across global FX markets, initially driven by risk unwinding and later by terms of trade differentiation, suggests a market attempting to rationalize complex inputs. The key takeaway is that while the dollar's safe-haven status is reliable, its strength in this specific scenario is amplified by fundamental economic factors related to energy prices. This provides a more nuanced understanding than a simple "risk-off = strong dollar" narrative.

Emerging Markets: Beyond the Immediate Headwinds

Emerging market (EM) assets, particularly equities, had experienced a strong run leading up to the conflict. The shock inevitably interrupted this momentum, with some of the best performers, like South Korea, seeing significant pullbacks. Trivedi attributed this to two main factors, mirroring the global market dynamics: the unwind of accumulated positioning and the terms of trade shock for energy-importing EMs.

However, Trivedi argued that this interruption does not fundamentally change the long-term narrative for emerging markets, provided the conflict is short-lived. The underlying structural drivers remain supportive.

"We expect very strong earnings growth through the emerging market universe. Korea is the poster child of that earnings growth. Why is it having that very strong earnings growth? It's the AI theme. It's the fact that Korea, Taiwan, some of these North Asian markets supply the all-important chips, semiconductors into this kind of AI supply chain."

The structural case for EMs rests on three pillars: a potentially weaker dollar in the longer term as the US macro picture becomes less exceptional, resilient macro factors within EMs (good growth, moderating inflation, healthier fiscal positions), and persistent underweight allocations by global asset managers. Despite recent strong performance, EMs remain underweight in many global portfolios.

The implication for investors is that the current turmoil, while painful in the short term, might present a buying opportunity in fundamentally sound EM assets. The AI theme, for instance, is a powerful secular trend that is unlikely to be derailed by a short-term geopolitical event. Balancing exposure to digital/AI themes with commodity exporters that benefit from higher energy prices (like South Africa and Brazil) offers a diversified approach. This perspective challenges the conventional view that EMs are simply vulnerable to global shocks, highlighting their increased resilience and the enduring appeal of their structural growth drivers.

Key Action Items

• Immediate Action (Next 1-2 Weeks):

  • Review Portfolio Hedges: Assess the effectiveness of current hedges (e.g., gold, long-duration bonds, specific currencies) against recent performance. Re-evaluate their utility in an inflation-shock-first environment.
  • Monitor Energy Price Dynamics: Closely track energy price movements and geopolitical developments to gauge the potential duration of the inflation shock versus the emergence of a growth shock.
  • Rebalance Currency Exposure: Consider the dual drivers of dollar strength (risk-off and terms of trade) and adjust currency allocations to reflect this nuanced view.

• Short-Term Investment (Next 1-3 Months):

  • Identify Beneficiaries of Terms of Trade: Explore commodity-exporting emerging markets (e.g., Brazil, South Africa) that may have been oversold due to general risk aversion but are structurally positioned to benefit from higher energy prices.
  • Capitalize on AI Theme: Recognize that secular trends like AI are resilient. Consider increasing or initiating positions in key semiconductor and AI-exposed markets (e.g., South Korea, Taiwan) if they have been disproportionately impacted by the recent shock.

• Medium-Term Investment (6-18 Months):

  • Position for a Weaker Dollar: As the US macro outlook normalizes, anticipate a structural weakening of the dollar. This creates a favorable environment for emerging market assets broadly.
  • Increase EM Allocation: Given persistent underweight allocations and structural tailwinds, gradually increase exposure to emerging market equities and bonds, focusing on countries with resilient macro factors and strong policy frameworks.
  • Diversify EM Exposure: Balance high-growth digital/AI themes with macro-driven commodity exporters to create a more robust emerging market portfolio less susceptible to single-factor shocks. This requires patience, as the payoff from these diversified positions may not be immediate.