Emerging market "fear index" falls to 25%, marking the biggest drop in six years; South Korean stock market deleveraging signals a cooling trend.

Emerging market stock volatility is declining at its fastest pace in more than six years, driven by a cooling speculative frenzy in South Korean tech stocks and tightening regulations, bringing a temporary end to the sharp fluctuations previously triggered by the AI boom.

According to Bloomberg, the Chicago Board Options Exchange (CBOE) metric for implied volatility in emerging market stocks has fallen nearly 11 percentage points this month to 25%, marking its biggest monthly drop since April 2020. The metric had previously climbed to a peak of 46% in July, when sharp fluctuations in Asian semiconductor stocks fueled hedging demand for AI-driven sell-offs.

The rapid decline in volatility was primarily driven by a concentrated clearing of leveraged positions in the South Korean market, rather than a substantial shift in the fundamental outlook for technology companies. As retail investors gradually closed out their positions and inflows into leveraged ETFs slowed, market sentiment became more rational. Meanwhile, the premium of emerging market volatility relative to the US VIX has narrowed significantly from nearly 30 percentage points in July to less than 10 percentage points.

Leverage clearing drives a sharp drop in volatility

The recent surge in emerging market "fear index" stems from an AI rally earlier this year driven by leveraged funds. The MSCI Emerging Markets Index rose 28% before peaking on June 22, with approximately 75% of the gains concentrated in three companies: South Korea's SK Hynix, Samsung Electronics, and Taiwan's TSMC. Many retail investors borrowed funds to bet on AI stocks, facing the dual pressures of margin calls and forced liquidation when the market reversed.

Varun Laijawalla, co-portfolio manager of emerging market equities at asset management firm Ninety One, said the current decline in volatility appears to be a result of "position unwinding" rather than a shift in the fundamental outlook for tech companies, and the pace of this move is "consistent with leverage clearing."

Tighter regulations further accelerated this process. Since July 31, the cash margin requirements for single-stock leveraged ETFs have increased, directly leading to a decline in both trading volume and asset size of funds linked to Samsung Electronics and SK Hynix.

HSBC upgrades South Korean stocks, optimistic about their earnings prospects.

Slower inflows into single-stock leveraged ETFs prompted HSBC Holdings to upgrade its rating on South Korean stocks to overweight last week. HSBC analysts noted that excess leverage has been flushed out of the market, and South Korea's earnings growth prospects remain strong.

Investors generally remain confident in the long-term prospects of AI, but their asset allocation strategies are quietly shifting. A growing number of fund managers are turning to second-tier companies that previously missed out on the AI boom but are poised to benefit from the capital expenditure plans of massive US cloud computing companies.

Laijawalla stated that within emerging markets, funds are flowing into sectors such as healthcare, financials, domestic consumption, and Latin America, "none of which have substantial exposure to the AI capital expenditure cycle." Other investors are turning their attention to growth sectors like Chinese biotechnology, or betting that a weaker dollar will boost commodity demand, thus shifting their focus to resource producers.

Risks remain, but the three major tech stocks still dominate the index.

Although market sentiment has stabilized, potential risks should not be ignored.

The iShares MSCI Emerging Markets ETF, which serves as the underlying asset for the CBOE volatility benchmark, still lists SK Hynix, Samsung Electronics, and TSMC as its largest holdings, accounting for approximately 30% of the portfolio.

Geopolitically, the Iran war remains unresolved; in terms of monetary policy, if the Federal Reserve maintains a hawkish stance, it may push up the dollar again, thereby putting downward pressure on emerging market assets.

Currently, emerging market volatility is declining much faster than in the US market, and its premium relative to the VIX has narrowed significantly from its July high. However, given that the three major tech stocks still hold a pivotal position in the index, it remains to be seen whether market sentiment can remain stable should the AI narrative change again.

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