While the human toll of Russia’s aggression against Ukraine is horrific, it is a stark reminder to investors of the inherent volatility of emerging markets. In 2021, Russia was a top contributor to MSCI Emerging Market Index returns (despite its modest 3.6% weight) as Russian equities returned 19% on the back of higher oil prices as economies emerged from pandemic shutdowns.

A few short weeks later, Russia’s brutal invasion of Ukraine has been met with sanctions from the U.S., U.K., and EU and the shutdown of the Moscow Exchange. Deemed uninvestable, Russia has been removed from all MSCI and FTSE Russell emerging markets indices. Global investors held Russian assets worth approximately $170 billion and foreign holdings of Russian stocks totaled $86 billion at the end of 2021. Those assets were effectively frozen overnight and some steep write-downs may be on the horizon.

On the sidelines of Russian exposure

Our portfolios did not have direct exposure to Russia. Over the years, on occasion we have had a small weight – usually just one company, if any. We have been cautious on Russia for several reasons. From a style perspective, we focus on identifying companies that can deliver consistent and sustainable earnings growth. Part of this involves assessing the political and regulatory context in which they operate. Most Russian companies are not a fit. In Russia, the market is dominated by volatile energy and materials sectors; combined, they accounted for nearly 70% of the MSCI Russia index. Another 20% came from financial companies, and we believe caution is warranted when it comes to Russian banks.

More importantly, leading academics, political economists, and regional industry heads have repeatedly corroborated our view that under Russia’s authoritarian regime, companies are not truly independent, despite appearances. The lack of rule of law is a looming factor. For example, in 2003, motivated by political reasons, the government seized oil giant Yukos and arrested its head, Mikhail Khodorkovsky. A legal battle for shareholder compensation ensued and continues to this day. And it’s not as if Russia’s invasion of Ukraine is unprecedented – Russia has invaded countries before, and sanctions post the 2014 annexation of Crimea were hardly a deterrent.

Figure 1: MSCI Russia Index | Sector Breakdown

MSCI Russia Index Sector Breakdown

Source: FactSet, as of December 31, 2021.

A stark reminder of the inherent volatility in emerging markets

The Russia-Ukraine crisis illustrates the inherent risks of emerging markets (EM) investing. Emerging markets offer a plethora of durable businesses with decades-long runways for growth and some world class companies. Volatility is the price of admission for participating in that growth yet is easily forgotten when markets are strong. And when things go south, the decline can be sharp.

Russia’s expulsion from EM indices is not without precedent. The MSCI Emerging Markets Index has removed countries before. Venezuela was a constituent until 2006. Argentina was added in May 2019, only to be removed at the end of 2021 (and reclassified as a standalone index) due to “severe and prolonged” capital controls implemented shortly after its admittance. Pakistan was also removed in late 2021 and reclassified as a frontier market.

Quality isn’t just about the company, but also the regulatory and political environment

China is another recent example of how quickly the tides can turn in emerging markets. Many investors who enjoyed the robust, linear returns China offered over the last several years were caught off guard in the second half of 2021 when President Xi Jinping’s regulatory crackdown reverberated across the region.

Beginning in the spring of 2021, the Chinese government advised more than a dozen IT companies that they may be required to “delink” their financial products businesses from their social media, gaming, and other operations. In July, private education companies were transformed into non-profit businesses overnight, sending some of those stocks tumbling. In addition, restrictions were placed on gaming companies to address their “negative influence on young people,” reducing near term visibility. Over the course of six months, China became the worst performing major market in the MSCI Emerging Market index, sliding 22% for the year.

We believe the motivations behind China’s regulatory crackdown were well telegraphed over many years. Although China’s GDP per capita has significantly improved over several decades and millions of people have been lifted out of poverty, income disparity has been persistent. Chinese leaders insisted numerous times that inequality above 0.40, as measured by the Gini coefficient1, was considered potentially destabilizing. The government’s social agenda and regulation to combat anti-competitive practices should not have come as a surprise.

Figure 2: China GDP per capita and inequality, 1981-2019

China GDP per capita and inequality, 1981-2019

Source: Data for Gini Coefficient 1985-2002 are from Lu and Perloff. Data for Gini Coefficient 2002-2019 are from National Bureau of Statistics of China. Data for GDP per capita in international dollars are from World Bank’s World Development Indicators database. As of February 11, 2021.

Despite the events of last year, we believe China offers investors a lot of opportunity. However, it is not just the quality of Chinese companies that matters, but the unique environment in which they operate. For example, we have long avoided China-based banks as we generally view them as policy tools of the government. The interests of investors, management, and the government are simply not aligned.

Where we see real opportunity in China is in domestic consumption and companies that lie outside of regulators’ crosshairs. Operating environments can evolve, and investors must adapt. While some companies will be high-profile targets of regulation, there are also companies that may be beneficiaries. For example, measures to end anti-competitive practices, such as exclusivity agreements in e-commerce, will negatively impact the leading company but should help level the playing field for its competitors.

The bottom line is that EM investments require careful consideration. Russia is but the latest example where rule of law and governance are important issues. In Russia, the rights of shareholders have been suspect for some time and government actions can be unpredictable.

What does Russia’s invasion of Ukraine portend for China and Taiwan?

Russia’s invasion of Ukraine begs the question of whether China could take over Taiwan. While there are clear geopolitical tensions, there are also important differences that make the likelihood more remote. For one, the sanctions placed on Russia are severe and likely to have a drastic impact on its economy. The international backlash is substantial and may serve as a cautionary tale of what can befall aggression. Taiwan’s chip production has become integral to everyday life across the globe. Its semiconductor industry is important on a global scale and makes it less likely to be a target of aggression. Moreover, China has been enjoying economic prosperity, and although there have been trade tensions with the U.S., China has worked to integrate further with Europe. While we will continue to monitor the geopolitical climate, we do not believe this is an imminent threat.

Being mindful of absolute risks on a country level

At Vontobel, we aim to invest for all scenarios, seeking out companies that can successfully navigate a variety of economic backdrops and challenges. In emerging markets, country risk is more relevant than in developed markets. There are times when the macro environment is so challenging that we determine a country is in what we call an “off switch” position. We have always been wary of Russia, however, we were additionally cautious in recent months when the risk of invasion was high. Some felt that Putin was posturing to obtain concessions and some quality names in the internet space came down to levels that looked attractive. While it appeared that an invasion was a low probability event, we did not want to take significant event risk, and Russia was clearly in the “off switch” position for us.

There are other countries that have both significant fiscal and current account deficits or political strife. Turkey, South Africa, and Argentina have been in the “off switch” position for us for some time. There are periods when this may mean foregoing near-term returns in order to preserve returns for our clients over the long run. Should circumstances improve, we can revisit turning the switch back on. In the meantime, there are plenty of opportunities to find quality businesses at reasonable valuations in emerging market countries where we feel the risks are manageable.

In the face of extreme volatility, a quality growth approach can help mitigate risks especially in emerging markets, where country turmoil can be more pronounced than in developed markets. As quality growth investors, we believe close consideration of absolute risk can provide downside protection, which should lead to higher compounding of returns over the long term. Historically, our strict adherence to this philosophy has contributed to lower volatility of our portfolios versus our peers.

1 In economics, a statistical measure of inequality in a population. Measured from 0 (perfect equality) to 1 (complete inequality).

The commentary is the opinion of Vontobel Asset Management. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.

Past performance is not an indicator of future results.


Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk. Foreign & Emerging Markets: Investing in foreign securities, especially in emerging markets, subjects the portfolio to additional risks such as increased volatility, currency fluctuations, less liquidity, and political, regulatory, economic, and market risk. Market Volatility: Local, regional, or global events such as war, acts of terrorism, the spread of infectious illness or other public health issues, recessions, or other events could have a significant impact on the portfolio and its investments, including hampering the ability of the portfolio manager(s) to invest the portfolio’s assets as intended.

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