Emerging markets investors have been facing a host of headwinds during the first quarter, including: ongoing Covid-19 concerns, particularly across Asian manufacturing hotspots; supply side cost pressures and a rising inflation threat; downside risks to global economic growth; and the impact of a new and more mercurial regulatory environment in the world’s largest emerging market, China, which spooked investors late last year. And all this was weighing on sentiment far before geopolitics and ultimately war in Eastern Europe took center stage. 

Conflict roils markets
In late February Russia launched “special military action” and invaded Ukraine. Economic sanctions were quickly imposed, including the removal of some banks from the international banking system (SWIFT) and a ban on all Russian oil and gas imports to America. The UK and EU joined in the sanctions, while Russia restricted the export of many goods and raw materials, which elevated concerns surrounding fertilizers, nickel, aluminum, palladium (in addition to oil & gas). 

Meanwhile, MSCI and Russell both announced the removal of Russian securities from their respective emerging markets indexes. Local markets reopened in recent weeks to Russian domestic investors, and while theoretically possible, it has remained practically impossible to-date for non-residents to trade in and out of Russian equities since the conflict began. It remains to be seen when liquidity will return for these securities. For context, prior to the conflict, Russia amounted to roughly 4% of the MSCI EM Index. 

Thanks to the turmoil and headwinds, the MSCI EM Index shed roughly 7% during the first quarter as global investors are now acutely focused on the Russian invasion of Ukraine and its inevitable ripple effects. The short-term impact was clear as oil prices spiked above $100 per barrel before backing off, and the price continues to bounce around based on the news flow.

 Unsurprisingly, this was accompanied by a flight to quality into U.S. Treasuries and the U.S. dollar. The Russian ruble sank to a record low in early March before bouncing back to pre-war levels (at least for the moment) thanks to some intervention by the Russian Central Bank and a requirement for buyers of Russian energy to pay in rubles, thus creating demand for the currency. Whether these measures will have a lasting impact remains to be seen. Meanwhile, other emerging market currencies have exhibited weakness to a lesser extent, and of all the emerging markets regions, Latin America has been the most resilient so far.

And while the world’s focus has been on Eastern Europe, it’s worth noting that China has also generated news independent from the Russian-Ukraine conflict. 

China has been a major drag on emerging markets for the past year, and during the first quarter we saw a wave of different sectors sell off in the Chinese and Hong Kong stock market as well as in the ADR¹ space here in the U.S. This reflected a host of uncertainties, including the fact that in early March, the SEC clarified a position that any US-listed company (including Chinese ADRs) would be forced de-list by 2024 if it used a foreign accounting firm that the Public Company Accounting Oversight Board (PCAOB) cannot inspect. It also reiterated that Chinese firms are not permitted to disclose “nationally sensitive” information. As a result, several major Chinese ADRs declined precipitously. However, Chinese officials intervened in an extraordinary manor on March 16 and directly addressed most of the core issues weighing on market sentiment. This included a signal of collaboration with U.S. authorities on the ADR de-listing; improving the transparency of regulatory reforms and intervening to de-risk the massive property and development market, among others. All this was embraced by large institutional investors and spurred a large rally in China and Hong Kong stocks. 

The takeaway
As always in emerging markets, there’s never a dull moment. Certainly, the situations in Eastern Europe and China are dynamic and fast-moving. All this merely suggests that most investors are likely to continue with their risk-averse behavior with regard to emerging markets, at least until there is any lasting resolution to the Russian-Ukraine war and investors can better digest the inflationary and other longer-term fallout. Currency controls, higher oil prices and rising inflation, a stronger dollar, and disrupted trade are likely to act as a break on global growth in the short- to near-term. 

If this all sounds like a grim back drop for emerging equities markets, now is a good time to step back and consider why investors allocate to these dynamic far-away places. In general, it is for the long-term growth and diversification potential provided by nearly two-dozen different countries on four continents. 

As we outlined in prior posts, we were expecting a choppy first half of 2022 across much of the emerging markets universe thanks to higher deficits, rising interest rates and inflation. Of course, not many thought the Russian-Ukraine crisis would escalate so quickly, and that has certainly complicated matters from an investing perspective, to say nothing of the humanitarian toll. 

Nevertheless, we do not believe that Russia invading Ukraine signals an end to globalization, nor does it dampen our long-term enthusiasm for emerging markets. Rather, it may simply signal a new stage and a further shift towards regionalization. Thus, in addition to hoping for quick and lasting peace to this conflict, we believe that the key global regions around the world will remain tightly linked, and trade will continue and ultimately increase. Not just trade in goods and services, but in ideas and in intellectual capital. That can be a huge benefit to all global investors, both in emerging and developed markets. Remember, we’re accustomed to periods of turmoil and remain long-term bullish on emerging markets. 

¹American depositary receipts (ADRs) are shares of foreign company stocks that trade on American stock exchanges.