Where does Russia's war leave emerging markets?

It seems a very long time since Russia, along with fellow emerging economic powers Brazil, India and China, was hailed as the next dominant investment market.

The so-called ‘BRIC’ economies – each country providing their initial to the acronym – were first grouped together by economist Jim O’Neill in 2001, when he predicted they would become the world’s dominant economies by 2050. The inference being that investors with an eye on the future should get on board.

That prognosis seems like ancient history today. Following the invasion of its neighbour Ukraine, Russia is facing financial sanctions from the international community aimed at disabling its economy. Evidence so far suggests they may be having just that effect. The rouble, the Russian currency, has fallen 40 per cent versus the dollar since the start of the year and the Russian stock market has remained almost completely closed since 28 February to fend off a crash – Russian equities listed in London have fallen around 90 per cent. The next blow may be a default on its sovereign debt.

With the stock market in suspended animation, Russia is literally ‘uninvestable’ for now. Even without that technical barrier, however, there are reasons to think it will be a long time before foreign investors summon the courage to venture back to the country.

Investors in Russia will have been left bewildered by events of the past few weeks. If they are ordinary, retail investors – those investing their own money – it’s likely their exposure to the country will have been through funds and emerging market funds, in particular. Most emerging market funds will have held only a small allocation to Russia. The MSCI Emerging Markets benchmark – the index that many funds compare themselves against – had a 3.3 per cent allocation to Russia at the end of January.

The Russian components inside these funds will have taken very heavy losses, however, and fund managers are likely to have acted to reduce their exposure to Russian companies as much as is possible.

Offshore, some funds with big Russian exposures have taken the step to suspend dealing, meaning investors cannot get their money out for now. This action is sometimes taken when funds suffer outflows that greatly outweigh inflows. In those circumstances, the fund faces having to sell assets at low prices to meet redemptions, meaning that extra costs fall on those who remain in the fund. Thankfully, the number of funds that have been suspended in this way is small.

Russia’s status as even an emerging market now looks threatened after it was removed from the main emerging markets benchmarks, meaning that it will no longer attract money from funds investing passively according to the index.

The events in recent months underline the inherent risks associated with investing in parts of the world where systems of governance are less stable and political risks loom larger than in developed markets.

No two emerging markets are alike

Many investors may now see sense in turning away from emerging markets completely. That may be a mistake in the long run, however. Investors potentially need some exposure to the high-growth areas of the world and, even if that’s not via direct investments into emerging economies, they can still benefit from companies in developed markets that derive some or all of their earnings from the emerging world.

A lesson, perhaps, is that no two emerging markets are alike and that each faces its own challenges from an investment point of view. The BRIC nations, as well as other emerging economies, will each feel the ongoing crisis in different ways – and not all will suffer, or suffer equally for that matter. One of the fall-outs of the war is a spike in energy and food commodity prices. That has potential to hurt India, for example, which is a big importer of wheat and products such as sunflower oil from the region.

As a large exporter of commodities, Brazil and other Latin American countries could well benefit. China meanwhile, as a still fast developing country, may feel the pain of higher oil prices but some of this can be shielded by the state-owned nature of many of its largest companies.

Placing too much faith in one emerging market may leave you vulnerable to one-off events and geopolitical risks. By investing via emerging markets funds with exposure spread across a number of emerging markets, you give yourself a chance of reducing the overall impact of big falls in any one of them.