In focus

What Russia’s war in Ukraine means for emerging markets


Since Russia’s invasion of Ukraine on 24 February, the pace of escalation has been rapid. Not only in terms of Russian actions, and their terrible impact on Ukrainian people, but also regarding the response from Western allies.

Events continue to unfold and very sadly the direct humanitarian crisis is deepening. The imposition of sanctions has severe implications for the Russian economy, but also potentially significant implications for global growth.

Against this backdrop we have become more cautious and defensive as investors.  

Our outlook prior to the invasion

We were anticipating a difficult first half of 2022 for emerging markets (EM). Global financial conditions remained loose but were tightening, while fading fiscal support was already a drag on growth. Global growth was robust, but slowing. Given post-Covid normalisation, we were expecting a continued shift in consumption from goods to services, alongside a waning inventory cycle. Inflation was proving stickier than expected.

However, there were some reasons to be positive: EM yields and currencies were attractively priced and US Federal Reserve (Fed) expectations had become hawkish. China’s credit impulse has troughed and Chinese policy was due to be asynchronous. Meanwhile, inflation was expected to inflect and ease into the second half of the year as improving supply met easing demand growth. Overall EM valuations were modestly elevated versus their own history, but cheap versus developed markets, and particularly so versus the US.

How events have rapidly escalated

The response of NATO and the West to Russia’s invasion has been more united and robust than many expected, as has Ukrainian resistance. Sanctions have been more extensive than anticipated, with severe repercussions for Russia’s economy.

NATO has been given fresh purpose and its presence in Eastern Europe is likely to rise, and European military spend is likely to increase substantially. The setbacks for Russia’s military have been widely commented upon. Meanwhile, Ukrainian nationalism has been strongly reinforced and the conflict has made a hero of President Zelensky.

President Putin has made a major error, and this is having a disastrous human impact. Putin is committed to his course of action, however, and will not want to appear weak. Sadly, this appears to have led to an evolution in the campaign to accept a higher level of civilian casualties in pursuit of military success. Both NATO/the West and Russia have hardened their positions.

Peace talks between Russia and Ukraine over the past few days have reportedly yielded some progress. A negotiated settlement would, we hope, begin to end the human suffering. However, while Ukraine has stated that it could offer neutrality and in effect commit not to join NATO, it is at this point unwilling to cede territory, something which may be unacceptable to Putin.

What is the impact of Russia sanctions?

Sanctions are more severe than expected, particularly with Europe and the US moving to freeze the Central Bank of Russia’s foreign reserves. Russia is now the most sanctioned country in the world. This will have significant repercussions for Russia’s economy.

Russia is facing a severe recession, owing to the combination of sanctions and the subsequent withdrawal of Western companies and custom. Russia and Ukraine account for less than 2% of global GDP (shown in the chart below). However, the conflict has the potential to have an outsized impact on the global economy via its impact on commodity markets. 

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Together with Ukraine, Russia’s share of global exports across various commodities is significant. These range from energy through to metals, precious metals, cereals and fertilisers. A combination of geopolitical risk premium and the threat of interruptions to supply have triggered a substantial and broad based rally in commodity prices. A sustained spike would drive broad economic stress.

There are reports of short term interruptions to Russian exports. Reputational considerations, self-sanctioning and the risk of tighter sanctions are impeding the purchase of certain Russian commodities. Meanwhile risk considerations are driving companies to add to commodity inventories. There may also be longer term implications for Russian commodity supply due to the loss of western technology, hardware and expertise to support maintenance and project development.

Food prices are a particular concern as Ukraine is a significant grower and exporter of wheat and other agricultural commodities. The sowing season is being disrupted, there are concerns for winter wheat, where a deficit of fuel and fertiliser may lead to a material decline in yields, and parts of the country are inaccessible.

The extent to which higher prices will persist remains unclear. Sanctions are likely to remain in place for the foreseeable future, and may tighten further. However, in the absence of direct sanctions on purchase, significant price discounts for Russian commodities may incentivise certain market participants to find ways to overcome impediments to trade. Furthermore, high prices may drive demand destruction, while the supply of certain commodities may also respond. For oil, there is the prospect for an Iranian deal, a Saudi Arabian and UAE led production response from OPEC, an acceleration in US shale investment and production, as well as a release of barrels from the US Strategic Petroleum Reserve. It is important to note that piped oil and gas continues to flow to Europe, under long term contracts. By contrast, it is seaborne cargoes, which trade via the spot market, that are seeing near term disruption.

The impact on food prices might be sustained if the Ukrainian planting and growing season is broadly disrupted, also if there is significant interruption to the global supply of fertilisers.

Why Russia’s actions are likely to accelerate inflation

Global inflation is already at multi-decade highs. A sustained rally in commodity prices will only add to inflationary pressure in the near term.

This conflict may also have longer term inflationary implications. An acceleration in the pace of energy transition away from fossil fuels towards renewables is inflationary. Input costs for renewables hardware have been escalating, and the production of renewables hardware has an upfront energy cost. In addition, a potential acceleration in supply chain diversification and economic polarisation via greater regard for security of supply in relation to certain products, is also inflationary.

The net impact of increased geopolitical and supply driven commodity price rises adds to stagflation risk - that is higher inflation and slower growth. This complicates the response from central banks. Expectations for the pace of US Fed rate rises has moderated, although we still expect a total of 100 basis points (bps) in hikes this year.  

Global growth is expected to slow, though the impact will vary by market. The US is better insulated than Europe and other developed markets, given its energy self-sufficiency and lower exposure to global trade. Monetary tightening is less likely to be scaled back in the US versus other developed markets. This is expected to support the US dollar, which could see further appreciation.  

What are the implications for emerging markets?

The Fed may be more gradual with regards to policy tightening, but it is likely to be raising rates into an environment of weaker global growth. Together with a stronger US dollar, this creates a more challenging environment for EM. 

As discussed, the key impact of Russia’s invasion of Ukraine on global growth has been through commodities. For those EM that are net commodity importers, higher prices will pressure external accounts and weigh on currencies, albeit the effect will vary by economy and the specific commodities exposures. The chart below illustrates the impact of higher energy costs on EM balance of payments.

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For lower income EM, energy and food typically represent a greater share of consumer price indices (CPI). India is particularly vulnerable, with food accounting for over 50% of the CPI basket. For many EM it is around 20-40% of the CPI basket, as this next chart emphasises.

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A slowdown in global trade will also weigh on the outlook for EM. We had already anticipated some deceleration into the second half of this year, as inventory rebuild eased and we saw an ongoing post-Covid consumption shift from goods to services.  

In certain sectors, we may see pressure on margins, as companies struggle to pass on higher input costs in a weaker demand environment.

By contrast, commodity exporting EM are relatively better positioned. These countries are found broadly in Latin America and the Middle East. Within Asia, Malaysia and Indonesia also benefit.

Elsewhere, China’s credit impulse has bottomed. This typically impacts economic activity and EM earnings with a lag of 9-12 months. China is easing policy at a time when most other countries are tightening. We have recently seen renewed commitment by the government to provide stimulus to support the economy. It has also pledged to do more to support real estate developers, to ease stress in real estate, and to conclude regulatory actions in the Chinese technology sector.

The Chinese authorities are likely to be concerned about the deterioration in the external outlook while domestic economic conditions are soft. The extent to which a weak Chinese equity market has a negative wealth effect and is a drag on consumer confidence is also of concern.

There has been significant progress with regards to vaccine distribution across EM. Most EM are well ahead of the global average, and a large number have fully vaccinated a greater share of their population than either the US or EU. Furthermore, natural immunity levels are higher in a number of EM that saw high levels of Covid cases through the pandemic. These factors bode well for continued activity normalisation through this year. 

As noted above, those EM which are net commodity exporters should be beneficiaries, at least in the near term. Valuations are beginning to become interesting too, although uncertainty and earnings pressure may persist in the near term.

What do valuations look like?

Aggregate valuations do not stand out as compellingly cheap relative to history. The forward price-to-earnings multiple for example is just above the historical median. However, there is now clear value appearing in certain areas, even if near term challenges remain.

Relative valuations for EM versus the US look attractive compared to history, as illustrated below. Meanwhile, US return-on-equity looks elevated, and may be under pressure from rising input costs. However, the relative cheapness of EM may not matter in the near term.

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What are the risks to the outlook from here?

The extent to which commodities prices spike and the duration of those price spikes is key to global growth. Uncertainty and volatility may persist, at least in the near term.

We could see further escalation in Russia’s actions in Ukraine which could draw more punitive sanctions from the West.

There are other geopolitical risks which bear close monitoring, most notably US-China tensions.

The timing and impact of a potential lifting of China’s zero Covid policy is a further factor to be aware of. The Omicron variant is more infectious and China has recently seen a rise in mainland Covid-19 cases. In recent days China has responded by locking down the North-eastern city of Changchun, as well as Shenzhen, a major economic hub, and by closing some Shanghai schools.

Within EM there are various elections this year, notably Brazil’s presidential election in October. This has historically been preceded by a period of heightened market volatility.

More broadly, the potential for new variants of Covid-19, and the risk of delay to activity normalisation, more prolonged inflationary pressure, and the pace and path of policy tightening are also issues to consider.

On the other hand, a turnaround in many of these issues could cause markets to rally. Chinese authorities may also be moving to provide more stimulus for the economy and support for the Chinese equity market.