As the world has fretted about Russia’s designs on Ukraine, investors in both countries have been understandably jumpy. When Russian troops seized control of the Crimea in early March, stock markets fell sharply in Moscow and Kiev. They recovered some ground on hopes that diplomacy might bear fruit, but have fallen again as that was exposed as wishful thinking. Ukraine is in a particularly parlous position financially, with its bonds still pricing in potential defaults and $30bn of sovereign debt becoming due in the next two years.
Russia is in a more robust position because of its $160bn worth of annual oil and gas exports. Most analysts predict that the West will be powerless to impose energy sanctions because of Europe’s dependence on Russian fuel. “Arguably, the problems are already in the [stock market] price,” says George Littlejohn MCSI, a senior adviser to the CISI, who has been working in Russia recently. “At mid-March, Russia is priced for Armageddon and if that doesn’t happen, investors will be in the money. The earnings multiple in Russia is way below even normal emerging markets standards anyway.”
Market under-performance have not happened without good reason
There is, of course, a broader warning here for emerging markets, which have suffered a grim few months of late. Fears over China’s financial system and its de-leveraging, and the scaling down of quantitative easing in the US, have caused huge outflows of capital from riskier economies.
Speaking about the expected medium-term impact of the Ukraine events, Rain Newton-Smith, Head of Emerging Markets at Oxford Economics, the global forecasting specialist, says: “It’s re-emphasised to investors that political risk really exists in emerging markets, which has been shown repeatedly over the past year. It’s added to what we’ve seen in other countries. Investors had reached a point where they had unrealistic expectations, not just about growth prospects, but about some of the major risks. People have realised there is quite a lot more political risk, but also economic risk too.”
As evidence of this new-found realism, Jade Fu at Heartwood Investment Management estimates that in mid-March, the MSCI Emerging Markets Index was trading at just 1.5 times price-to-book value and poor sentiment had already resulted in outflows of more than $30bn from emerging market equities in the year to date.
Others argue that this could well represent a buying opportunity, particularly for those willing to make a longer-term bet on emerging markets (EM), over a five-year period.
Jan Dehn, Head of Research at Ashmore Group, the emerging markets investment manager, says: “Despite huge outflows from EM and material increases in borrowing costs for EM countries over the last year EM will grow 5%-plus this year compared with 4.5%-plus in 2013. No country has defaulted, no country has run out of reserves, no country’s banking system has gone bust, and no country has seen systemic corporate defaults. There was and is no crisis in EM. What we saw was an unwinding of very unfavourable technicals. This caused big moves in the prices of assets. Price volatility and risk are not the same thing at all.”
That said, even those most invested in emerging markets acknowledge that the recent run of bad news from countries ranging from Brazil and Argentina to South Africa, India and Turkey, shows the need to examine carefully the risks on a country-by-country basis, rather than relying on the group as a whole being propped up by cheap US money and relentless Chinese growth.
“EM is the most inefficient market on the planet,” says Dehn. “Asset prices are a terrible guide to riskiness. There is no substitute for proper sovereign analysis of each country. Investors should monitor the ability and willingness to service debt in each country, then compare this to the markets’ pricing of risk. If the two part ways, you have a trading opportunity.”
Newton-Smith agrees that investors are becoming savvier about differentiating between countries. “We are beginning to see some markets that we think have been unfairly hit, like Indonesia and Mexico, recovering a bit. And people are starting to see that the more structural problems, such as those in India and Brazil, are different to, for instance, Turkey, in terms of financing their current account.”
Fu agrees that there are “pockets of value appearing in some areas”, but warns that “the past three years of market under-performance have not happened without good reason”. She adds that “the biggest challenge facing emerging markets is growth”. Her comments are backed by the fact that China’s underlying growth continues to decline, while Mexico recorded economic growth of just 1.1% last year and Russia 1.3%.
Investors are savvier about differentiating between countries
Where opinion divides is over to what extent the cooling of investor sentiment is permanent. Dehn – who says the last time emerging markets bonds traded at a 7.1% yield, US treasury yields were 4.5% – valiantly claims that “the biggest risk by far is in the heavily indebted developed countries, not in EM”. He points out that it is developed countries that are “printing money and forcing pension funds and insurance companies to finance their deficits via regulatory-led financial repression”. Oxford Economics agrees that it still expects emerging market growth to outstrip advanced economies because of demographic trends and productivity gains.
Newton-Smith concludes: “In terms of investors and companies, they have both started to realise that doing business in these countries is much harder than they appreciated.
“That realisation, alongside slower growth and political risk – as shown by Ukraine – is leading to a fundamental reappraisal.”
Crises in Argentina and Turkey
Argentina’s attempts to shore up its increasingly worthless currency, the peso, came to a sudden end in January as the country’s stores of foreign reserves dwindled. The crisis there switched quickly to fears about other emerging market currencies, such as South Africa, Turkey and Russia.
Despite the ever-present fear of contagion, it is not certain that this year’s events carry the same level of threat as the run-up to the 1997 Asian financial crisis, when a collapse in the Thai baht led to a slump in currencies and stock markets across southeast Asia.
Arguably, Argentina and Turkey have to be lumped together because they have both suffered from seeing their currencies spiral against the dollar – by 21% for the peso in the first three months of the year, and 5% for the Turkish lira.
But Argentina is unusual in that it has not had a significant increase in external debt funded by portfolio inflows, because it hasn’t had the same degree of access to external financial markets as other emerging economies. Rain Newton-Smith at Oxford Economic says that “Argentina is, in part, more about internal mismanagement” than investors pulling out vast funds.
Turkey, by contrast, has a large current account deficit of around 10% of GDP and a hefty proportion of external debt (around 40% of GDP). This means that any correction in the exchange rate can turn into a negative spiral – as happened with many countries that were caught the Asian financial crisis: Turkey will be less able to serve the debts it owes in foreign currencies as the lira depreciates, thus making investors want to pull out more funds.
“The one comparison you can make with the Asian financial crisis is that most countries now, particularly in Asia, are in a much better position but the countries that look more vulnerable are countries like Turkey or South Africa,” says Newton-Smith.