After the stampede to unload their Russia investments following the invasion of Ukraine, it is a moot point whether institutional investors should take this a step further by reconsidering their exposure to other emerging markets.
Underperformance relative to some developed markets is being compounded by the big losses reported by Chinese builders last year, particularly Evergrande, and the unclear outlook of technology companies. All of these are being exacerbated by the war in Ukraine, creating a perfect storm which is hitting emerging markets hard.
Evergrande’s default late last year is a big case in point. A lack of disclosure by China’s second largest property developer by revenue and rumours it had missed an interest payment made investors nervous and so they speedily fled the scene. This investor flight was justified when Evergrande made the staggering announcement in March that it would not be ling audited annual results.
Heading for the exit
Indeed, investor confidence in China appears to have been damaged with investors racing to get their cash out of the country. In March, foreign investors withdrew a mammoth $11.2bn (£8.5bn) from Chinese bonds and $6.3bn (£4.8bn) from equities, according to the Institute of International Finance.
This makes China responsible for a vast majority of the $9.8bn (£7.5bn) in emerging market net outflows during the month – and, it should be noted, the first outflow figure for a year. “Downside risks for emerging markets are significant,” says Jose Perez-Gorozpe, head of emerging markets credit research at S&P Global. “Additional inflationary pressures and persistently high energy prices could result from an extended conflict between Russia and Ukraine, especially if sanctions on Russia hit its hydrocarbon exports.” He adds that governments are fighting battles on several fronts.
“Emerging market sovereigns are struggling to deal with the costs of the pandemic, managing inflation and meeting protracted social demands, a balance between fiscal consolidation and social strife. At the same time, financing conditions could weaken rapidly following the hasty US monetary tightening or continued escalation of the military conflict.”
The right stuff
All of this highlights the risks associated with investing in parts of the world where systems of governance fail the Theresa May test of strong and stable. Conversely, of course, the case for emerging markets has long been that the rewards can be higher if investors pick the right sector.
“Much of the past 10 years of growth has been designed around an active and prosperous property market, but over-leverage and associated factors has led to stretched balance sheets,” says Gordon Ross, chief investment officer at LGPS Central. “Evergrande has been the headline property company to get into difficulties, but there have been others.”
Therefore, carefully choosing the right sector in China, while understanding the political context, is crucial for investors, Ross adds. “Investing in sectors that the administration wants to succeed in and currently have support, are deemed slightly less risky,” he says. “Investments must be approached on an eyes-open basis as to the potential for rule changes that may be unforeseen and value destructive. In addition, this brings in the whole ESG focus and how to treat investments going forward.”
One of emerging markets big success stories have been Chinese technology companies. They were once the future, offering seemingly endless opportunities. But now they are struggling, which is taking the shine off a sector that was once central to the emerging market investment case.
“In technology, China has been increasingly shut out of the Western ecosystem in recent years,” says Richard Bullock, senior research analyst and strategist at Newton Investment Management.
First there were sanctions imposed on Huawei in 2019, which was followed by ever-increasing export restrictions on China’s access to high-end Western semiconductors. “A growing list of Chinese companies are being added to the US Commerce Department’s Entity List,” Bullock adds.
This could have wider implications, if it brings Russia and China closer together. “With the strict application of Western sanctions and export restrictions on technology sales to Russia in the wake of its Ukraine invasion, a closer Sino-Russian technology partnership in the coming years will become a matter of necessity for both countries, given their mutual appreciation that technological progress is a matter of geopolitical survival under great power competition,” Bullock says.
Those looking for an effective investment alternative, could find Chinese government bonds attractive, Ross says “given the likely trend for lower domestic Chinese rates – to avoid an economic slowdown – although the differential to other major markets has reduced in the latest quarter.”
China’s close association with Russia makes holding its assets risky. “China’s ties to Russia have created a new geopolitical concern that requires more compensation for holding Chinese assets, we think,” says Wei Li, global chief investment strategist at the BlackRock Investment Institute. Li, therefore, prefers developed market equities, at the expense of emerging markets.
It is not just Chinese assets that could be too hot to handle. The war in Ukraine is likely to leave a stain on Russian assets for some time.
London CIV is one asset owner having to reconsider its approach to Russia and has come to stark conclusions. “London CIV does not believe Russia will be an investable proposition for the foreseeable future,” says Jason Fletcher, London CIV’s chief investment officer. “Further investment is not consistent with our responsible investment policy and investment beliefs. We have, therefore, instructed all managers to make no further investment in Russia at this time.”
A point echoed by Ross. “Given the current situation in Russia, we do not expect to be allocating any exposure to the regime for the foreseeable future,” he says. Interestingly, the monies that had historically been invested in Russia are “now allocated to other emerging markets – in terms of hard currency and local currency exposures,” Ross adds.
When asked: does the situation in Russia require a re-think to its emerging market investments in general, Ross offers up a categorical “no.” Adding: “There continue to be bene ts from such allocations in terms of diversification, investment risk and returns.”
He then qualifies and expands on this: “Although we are seeking to reduce our limited exposure to Russian debt and equity for the obvious associated responsible investment and engagement reasons, allocations to emerging market debt and equity continues to be an active asset allocation decision made by our partner funds and executed either in-house or via externally procured managers.”
Paradoxically, all this will have a limited impact on Russia itself, argues Bullock. “The Kremlin has been preparing its ‘fortress’ economy for siege-like conditions since the first significant sanctions were imposed on it following the 2014 Crimea annexation,” he says. “Trade with the US was already at a low level and Moscow had been substituting many of the consumer-goods imports from European countries with its own home-grown goods.”
The situation does have energy-transition implications for western governments and investors, who may need to look again at their portfolios. “Governments will need to factor geo-politics into a more pragmatic energy-transition policy, and investors are likely generally to want to accommodate fossil fuels and clean energies in their portfolios,” Bullock says. Given the perfect storm, what should investors do?
“If the Russia-Ukraine conflict has taught investors anything so far, it is that the US wields enormous economic power through its control of the global financial system owing to its currency hegemony and the ability to stop non-compliant states accessing and using its financial system,” Bullock says.
This in turn could lead to a “new global currency order” with possibly the dollar, euro, yen and the pound palpable to each other, Bullock says, but “the latter three are e ectively beholden to the dominance of the dollar as a result of the US’ supremacy in the ‘democratic alliance’,” he adds.
Yet it could well become a more complicated picture, especially for investors. “The emergence of a multi-polar world economy with autocratic and democratic blocs that are competitive along technological and security lines, yet largely independent in their economic interaction – save for non-strategic value chains such as low-end manufacturing and bulk commodities – has profound implications for investors,” Bullock says.
A long-term view
For some investors, there is no need to get ahead of ourselves. Essentially, there is no great need for change in the emerging market investment outlook. What is happening should not distract from the appeal of emerging markets, Ross says. “Although, while there is much that is negative in emerging markets, they play an important role in investor portfolios and continue to be a good diversifier for allocations and returns,” he adds.
“You need to be conscious of the economic and political stability of the particular countries. Many are either oil producers or oil dependent so economic health will be strongly correlated to the price movement of oil,” Ross says. “Many have already increased monetary policy to fight inflationary pressures and there are several national elections during 2022, where regime changes could add to the caution.”
Therefore, for Ross, while taking into account the pitfalls, emerging markets continue to play an important role, despite the many converging factors seemingly undermining them. “Emerging markets continue to be a part of our partner fund’s asset allocation for emerging market equity and debt exposure for diversi cation and risk-adjusted returns,” Ross says.
At the same time, it is important to have an effective process, employing trustworthy managers when investing in emerging markets. “We procure external managers for both disciplines and have allocated monies to them,” he adds. “These managers are appointed following a robust process that analyses the philosophy, process and the team that manage the product enabling us to determine suitably skilled providers, that will manage the products we have designed to achieve our partner fund’s investment requirements.”
This proves there is more than way to see out a perfect storm.