Emerging markets equities have taken a significant hit since Russian troops marched on Ukraine. On the face of it, the reasons for the weakness are self-evident – Russia and Ukraine are both emerging markets and their difficulties looks set to drag the index lower. However, it could be argued that sliding share prices have more to do with global risk sentiment than the reality in emerging markets.
Over the past month, the average global emerging market fund is down 7.9%. The only areas that have been notably weaker are European equities and certain specialist cyclical sectors, such as financials. In spite of relatively low valuations, emerging markets have still been hit by global risk-off sentiment.
Nevertheless, there is real nuance to emerging market performance, in particular between commodity producers and commodity dependents. It’s been a very strong period for Latin America, as the price of commodities has soared. Commodity-dependent India, on the other hand, has been particularly weak. China, which now dominates the emerging market indices, has also been weak.
Brics are a thing of the past
This has been far more important than the direct weighting to Russia or Ukraine. Russia’s importance in global stock markets has been declining significantly over the past decade, as MSCI makes clear: “Russia’s weight in the MSCI Emerging Markets Index dropped sharply during February 2022. At the start of the year, it accounted for just under 4% of the index. While this year’s decline is sharp, its weight has been steadily on the wane since 2008, when it made up 10% of the index.
“At the onset of the global financial crisis, Russia was the fourth-largest EM country, behind China, South Korea and Brazil. Since then, its weight has fallen due to the fallout of the 2008 recession, and a decade of economic sanctions that resulted in currency depreciation. Today, Chinese, Taiwanese and Indian firms have taken share, pushing Russia (and Brazil) toward the rear of the pack.” MSCI also announced that from 9 March, the Russian market will be removed from its emerging markets indexes, given the difficult of trading shares in the region.
The majority of active managers had limited holdings in Russia and where they had exposure, they have reduced it. According to Morningstar, Fidelity Emerging Markets, for example, came into the crisis with a 7.6% Russia position, which is has trimmed back to 2%. JPM Emerging Markets started with a 1.1% position and now has zero. Invesco Developing Markets’ Russia stake shrank to about 4% as of late February, from 9% at the end of 2021
Samuel Meakin, associate director of equity fund strategies, Morningstar, says: “Mainstream global emerging markets equity managers tend to have limited exposure to Russian equities. Because of this, there hasn’t been a need to suspend dealing, and managers have reported relatively normal trading conditions in terms of investor inflows and outflows.” While those who have Russian holdings are now struggling to price those holdings, this doesn’t account for relative weakness of emerging market funds.
When everyone one else is selling…
The question for investors is whether the current weakness represents a buying opportunity. Emerging market equities were already cheap and have, in general, got cheaper. Selectively, this would seem to suggest that there may be opportunities within emerging markets.
Tracy Chen, portfolio manager on the Global Fixed Income team at Brandywine, believes the disruption to commodities prices is likely to persist: “Russia’s economy is relatively small, so the impact is mostly felt from its position as a commodity exporter to Europe. If you look at the short to medium term, it could extend the trend to stagflation or slow-flation – higher inflation and slower growth. Just as we’re recovering from Covid, the supply chain could be disrupted again. Ukraine is the bread basket of Europe, so the prices for oil, gas, metals and wheat have been rising very fast and there will be a shortage in the near-term.”
She believes this will prompt a shift from commodity consuming countries to commodity producing countries: “[Commodity producers] have more pricing power. We are more constructive on commodity producers as a result.”
In the longer-term, she also sees a drastic change in the world order, from a unipolar to multi-polar world. This is watershed from the post-cold war world order: “The multi-polar world will be characterised by greater instability, more frequent flare-ups, potentially the peak of globalisation and more regionalisation.”
The impact for individual emerging markets is likely to be idiosyncratic. Countries are likely to prioritise energy security, which could see them strive to become more self-reliant – perhaps through the adoption of sustainable energy options. They will almost certainly look to reduce their dependence on faithless partners such as Russia. Whether they will also seek to reduce their dependence on other emerging markets such as Brazil is open to question. However, their choice will affect outcomes for emerging markets.
Either way, it seems likely that the concept of straightforward stockpicking in emerging markets is going to become more difficult. Macroeconomic considerations should play a more important role in asset selection from here as the world becomes a more complex place. However, it remains the case that emerging market equities look cheap on historic comparisons and risk-off sentiment may have been overplayed.