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Emerging markets: what are the effects of the war in Ukraine?

It goes without saying that the conflict between Russia and Ukraine has an impact on emerging markets.

Currencies and bonds

The impact on currencies and bonds has been quite positive. Currencies are benefiting from commodities and attractive interest rates. The war in Ukraine has led to a sharp rise in commodity prices and the currencies of several commodity exporters can fully take advantage from it. Examples can be found mainly in Latin America with, among others, Brazil (+19%), Chile (+12%) and Colombia (+11%), but also in South Africa (+13%). 
Since the beginning of the war, the Indonesian rupiah has also gained nearly 3% as investors shift capital from Russia to other commodity exporting countries where local interest rates are high. In Asia, Indonesia is one of the few countries that meets both conditions. Russia's and Ukraine's neighbours, such as Romania, Hungary and the Czech Republic, initially saw their currencies depreciate somewhat, but they have since recovered significantly. Since the beginning of the year, the Czech koruna has appreciated by 1 percent, while the Polish zloty and Hungarian forint have lost 3 percent and 1 percent respectively. 
Emerging market currencies are also benefiting from high interest rates and are also proving to be a good diversifier for equities in the same regions. For example, last year the Chinese renminbi continued to perform well, despite the turbulence that Chinese equities faced as a result of stricter regulations (in the technology sector).
Emerging market bonds continue to benefit from being one of the few thriving opportunities in a low-yielding bond desert. Central banks in most emerging countries have already begun to raise interest rates significantly in the past year to combat inflation. As a result, interest rates in these countries have reached very attractive levels, even for short maturities. 
Thus, in contrast to Western Europe, there are still examples of countries within emerging markets with strong economic fundamentals that offer attractive yields for government bonds. For example, the interest rate on two-year government bonds is around 4% in the Czech Republic, around 5% in Poland and even around 6% in Hungary. These three countries all have investment grade credit ratings. In more exotic destinations, we can find short-term bond rates of 7.5% in Chile and even 13% in Brazil. In South Africa, the long-term interest rate is 10%. 

Russia’s exclusion from the MSCI EM Index

On March 9, MSCI Inc, the well-known stock index provider, excluded Russia from its MSCI Emerging Markets Index. The company considers the country's stock market ineligible for investment after Russia's invasion of Ukraine. 
This means that other emerging countries are likely to see their weighting increase. If we assume that Russia's weighting is distributed proportionally among the other markets, the new estimates for the markets of interest to us are as follows: 

Russia’s exclusion from the index should benefit other emerging markets, although it is difficult to estimate to what extent. The question is when foreign investors will actually be able to sell their Russian assets and at what price. It will therefore take some time before they can redirect their investments from Russia to other markets. 

We have not changed the strategy of emerging funds following the Ukrainian crisis, and the number of transactions has remained very limited.

The reaction of central banks in emerging countries

In “normal times”, emerging market central banks follow, more or less, the US central bank, the Fed. But that was not the case last year. Many central banks in growing regions had already raised interest rates to fight inflation. 

In Brazil, for example, the base interest rate rose from 2 per cent (March 2021) to 9.25 per cent (end of 2021). In the meantime, it has already reached 10.75%. As a result, some capital has moved into fixed income securities. Analysts believe that the peak in interest rates is almost in sight. And if interest rates start to fall in Brazil, it will certainly give a boost to local equity markets. Lower interest rates could also be expected for other emerging countries this year.  

What to think about the measures supporting the economy and markets by the Chinese authorities?

China remains plagued by the coronavirus, despite the government’s Zero Covid policy. This policy is being met with increasing resistance as it becomes clear that the rest of the world is apparently able to live with the latest variant of the virus. The fact that Chinese vaccines are somewhat less effective may explain the government’s decision to stick with the Zero Covid policy for now. 

At the end of March, the city of Shanghai – the country’s economic center – imposed the most severe containment since the pandemic began. Given the city’s importance (ports, financial district, many foreign multinationals’ headquarters), the containment will have a global impact. It has already caused the price of oil to fall.

The news from Shanghai was particularly unfortunate given that, just prior to this, the National Team (which includes, among others, state-controlled pension funds that can help steer market movements) had announced that it would take significant steps to support the economy and capital markets. Measures against certain technology sectors would also be eased or at least made more transparent. These measures came not too soon. Indeed, we had been wondering for some time why Beijing has been so slow to make its voice heard. After all, the government is aiming for stability and transparency, and ultimately, that is what investors are looking for as well. Stock markets reacted euphorically to the news, especially promising technology stocks. 

While the government did not provide many details and it is unclear how this announcement will play out in practice, the signal itself is already significant. At the very least, it provides a temporary base for Chinese equities, which have suffered greatly in recent months. We therefore remain convinced that a careful selection of quality technology stocks is certainly relevant in a diversified fund portfolio. Let’s not forget that, fundamentally, China’s situation seems favorable (growth of the middle class, urbanization, technological developments). The potential of the Chinese market therefore remains intact in our view over the long term. But in the shorter term, there may still be some interference on the line given the Covid-19 and the confinements, and depending on the evolution of the Ukrainian conflict (impact of sanctions on China, China’s positioning against Russia). The interest rate policy of the US Central Bank is also a determining factor for the Chinese stock markets.

What other factors should we keep in mind in 2022?

While the Ukrainian crisis is getting all the attention today, there are other important developments in emerging markets that deserve our attention.

Elections, especially in emerging markets, are often a tipping point, whether positive or negative. Take India, for example, where Modi’s election victory in 2014 had ushered in a boom period in the stock markets. We had witnessed a similar phenomenon in Brazil when Bolsonaro was elected in 2018: the “nightmare of the left” had been pushed back and all hopes had been placed in the new president. The stock markets had reacted enthusiastically, at least initially.

This year, too, the polling stations are opening in many countries: 

– March: presidential elections in South Korea and Hungary 

– April: general elections in Serbia 

– May: presidential elections in Colombia and the Philippines 

– October: General elections in Brazil 

As investors in emerging markets, we should mark these dates in our diaries. They can provide a good dose of extra excitement.

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