Middle East conflict: the view from our EMD desk

Emerging markets (EM) entered the Middle East conflict in a relatively strong position. Growth dynamics have been resilient, with 2026 forecasts above 4% for the 5th consecutive year – higher than pre-COVID-19 levels. In the external sector, current accounts were still positive, with resilient trade surpluses, strong remittances, tourism flows, and record levels of bond issuance. These surpluses, coupled with rising gold prices, have resulted in record foreign exchange reserves across EM countries – even excluding the large reserve holders. These reserves provide a buffer to sovereign balance sheets. Total reserves for EM countries are around three times the level of external debt repayments due over the next 12 months. This positive backdrop was reflected in EM credit ratings with upgrades outpacing downgrades for 27 consecutive months into February 2026, combined with no sovereign defaults for the last two consecutive years. 

As we look ahead, although markets are still relatively complacent on the outlook for the conflict, a sustained ceasefire that culminates in a peace agreement that is acceptable to all sides faces considerable uncertainties.

For the asset class, one of the direct impacts from the conflict will be via inflation, driven by higher commodity prices across energy, fertilisers, and chemicals. All else equal, a sustained increase in commodity prices will affect the external balances of EM countries and hence, exchange rate weakness. This will compound the impact of higher commodity prices. 

Additionally, exchange rates are vulnerable to a weaker risk appetite at a time when positioning in local markets had increased after 11 consecutive months of inflows (c.$25 billion) into the asset class since the middle of last year. Therefore, if the conflict persists for a sustained period and, depending on EM central banks’ reaction function, we believe this will translate into higher interest rates weighing on growth outlooks. Higher commodity prices could also result in wider-than-expected budget deficits in many countries, or a potential drawdown of sovereign assets.

Our positioning in this complex environment

The L&G Active Emerging Markets Debt team went into the conflict escalation underweight the Middle East region since we believed elevated conflict risks was not being reflected in regional valuations amid record bond issuance. At the portfolio level, our overall beta was also relatively modest (and declining) on the back of valuations. Our core exposure was and is almost exclusively in credits where we saw value on a sustained basis. We are positioned across countries where we see domestic reform efforts, those with supportive natural resource endowments, and those with funding programs from multilateral lending agencies –such as the International Monetary Fund (IMF) – providing a policy anchor for investors.

This meant at the onset of the conflict, our team assessed tactical opportunities to partially cover underweights in lower-rated names or add to credits we favour due to their fundamental stories as valuations became more attractive, in our view. However, we are cautious in our approach and hence only very gradually scale into buys or sells. Our approach reflects significant uncertainties around how the conflict evolves, and technicals in a market trading headlines with little conviction in the outcome. Since the conflict, we have also implemented hedges using credit default swaps (CDS) and currencies.

How investors can seek to manage risks 

In short, our focus is to ensure portfolios are diversified across regions and countries. We believe it is prudent to use hedges, in the form of CDS and currency exposure backed by rigorous bottom-up analysis and an understanding of technicals and positioning. Depending on the starting point of exposures, uncertainties suggest positioning changes should be gradual in nature.

At a broader level, many EM countries have very strong buffers, highlighted in their sustained investment grade ratings. However, closer monitoring is required in lower-rated credits in the immediate vicinity of the conflict and those in Asia, who are more exposed to the potential negative fallout of the crisis. We view this not only because of the impact of inflation due to higher commodity prices but also because they operate with smaller fiscal and external buffers while supply disruptions can lead to social stresses. Meanwhile, in uncertain times, we believe well anchored stories will be that much more sought after, as noted in our positioning.

The second-order effects that markets may be missing

On aggregate, while government balance sheets in emerging markets were in robust positioning going into the conflict, we are cautious of sustained inflationary pressure and its impact on social stability. We believe it’s important to monitor this as high price pressures have led to severe social strains in many EM countries over the last couple of years, as highlighted in the protests we have seen across EM regions and rating buckets. A significant portion of this is due to food and fuel prices constituting a much larger part of the consumption basket in emerging markets.

This also leads to the consideration that while the number of EM countries with independent central banks, inflation targeting monetary regimes, and more flexible exchange rates has increased, the effort to mitigate social pressures may lead governments to seek measures that impact their balance sheets.

Therefore, should the conflict sustain, this may mean larger-than-expected budget deficits which, coupled with the growth impact of the conflict, means debt sustainability measures could deteriorate. However, we do not currently expect the deterioration to be so sharp that it becomes a systemic crisis. This is due to our expectation that should strains start to emerge across a large number of countries, as we saw during COVID-19, multilateral agencies like the IMF and World Bank will increase their support with fast disbursement of lending facilities.

 

Assumptions, opinions, and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.