Cherry Reynard asks if political risk is always synonymous with emerging markets or if it is more the case that in the present climate of upheaval the economic risks of the developed markets present a greater danger for investors
In recent years there has been a reappraisal of the risk/reward characteristics of emerging markets. The traditional view of emerging markets as high-risk has evaporated as their economic position has looked increasingly strong when compared with many of the debt-ridden, crisis-prone developed markets. But this reappraisal has relied on the benign political backdrop that has characterised emerging markets over the past few years. The Georgia situation has threatened that and forced a re-examination of political risk in these countries. But to what extent has this changed the outlook for emerging markets? And are there other, more important, factors at work?
Bear in a bear market
Up until August, when Russia invaded Georgia, the Russian stockmarket had been one of the better performers of the emerging markets. The MSCI Russia index was down 'just' 20.31% year-to-date at the end of July. This put it well ahead of China and India, which were down 25.28% and 31.54%. Fast forward less than two months and the Russian market is the worst performer of any emerging market except China, down 41.62% to mid-September, and culminating in the suspension of trading on two Russian exchanges, RTS and Micex, on 16-18 September. Although this is partly attributable to the slide in the oil price, other oil producers, like Brazil, have held up much better.
Estimates from international banks suggest that around $20bn in foreign capital has been pulled out of Russian markets since the problems began. The value of the rouble has slumped and there have been rumours of the government stepping in to shore up both the currency and the financial markets.
Russia has also suffered from the fallout of the Mechel case, where Prime Minister Putin's comments about the coal group's price rises to consumers raised fears of a Yukos-style intervention and possible appropriation of assets. State intervention remains a threat in the region, though for the time being the government has largely restricted its heavy-handedness to foreign companies attempting to compete with domestic companies, like many of the oil majors.
The crisis has amply demonstrated that political risk is not a thing of the past and can still impact returns in emerging markets. The situation in Russia remains largely theoretical but it has clearly had an impact on Russian stockmarkets and foreign direct investment in the short term. So does it matter in the long term, and does it affect the wider emerging markets picture?
Rob Burnett, head of European equities at Neptune, suggests that the Georgia crisis is unlikely to have a significant effect on the growth of Russia, despite Georgia's strategic position on the energy route into Western Europe. He points out that Russia has been involved in a number of territorial disputes without any significant economic fallout.
Georgia is more an oil issue than one of wider economic development, and other key themes remain valid. Burnett says that over half of the Neptune Russia & Greater Russia fund is invested in the materials and consumer staples sectors.
Although the oil price has been a significant driver of long-term economic growth in Russia and oil companies make up a hefty chunk of all Russian indices, there are other drivers at work in the economy: most notably the development of a consumer society and infrastructure building.
For much of the wider world economy, Russia's actions in Georgia are important because of their potential impact on the oil price. But commentators are sanguine on the extent to which Russia's actions in Georgia will influence the oil price. Nicholas Brooks, head of research and investment strategy at ETF Securities, says that the world had grown used to not relying on Russian oil supplies, which had already been declining. He adds: "There was the view that it had peaked anyway and the disruption in Georgia has not had a significant effect." His view has been validated by the subsequent movement in the oil price, which has slipped substantially in spite of the Georgia situation.
Out of Africa
So has political risk tended to make an impact elsewhere? Africa has lived with political upheaval for years and, for much of the time, this has made it an investing no-go zone. Jamie Allsop, manager of the New Star Heart of Africa fund, says political risk is a fact of life in the region and diversification is the best way to mitigate it. He adds: "The record of African elections has been chequered. There is a will to have elections and democratise in most cases, but it is coming from a low base."
Allsop believes that political interference is becoming less of an issue in many African states. He points to a recent proposed windfall tax in Zambia that was to be onerous on copper companies. This was overturned. Allsop says: "There is a recognition that while tax take is important and companies shouldn't get a free ride, windfall taxes are not the way to do it."
There are still some examples of bad practice, of course. The Nigerian authorities recently tried to shore up the country's stockmarket by placing limits on how much a share could drop in a day. This was in response to falls in the oil price. It had the effect of creating a big initial rally and then a sustained sell-off. Allsop says: "These are immature markets and interference will happen."
That said, there are a number of things that cause him to avoid particular countries. Zimbabwe remains a no-go zone in spite of the recent power-sharing agreement between Mugabe and Tsvangirai. War is another deciding factor. He also won't take a risk where there is a high chance of appropriation of assets. This has been a long-running problem with African governments, but is becoming less of an issue as the governments realise the benefits of foreign capital investment.
Aidan Kearney, joint head of UK multi-manager at Credit Suisse, believes that these types of 'frontier' market warrant an active management approach. He says: "You wouldn't want beta exposure for this type of market. You want someone who knows the market and can avoid the huge companies that can comprise a big chunk of the index."
A little local trouble
Elsewhere, there have been isolated examples of political risk having a significant impact on the economic outlook and markets. Since the 2006 coup in Thailand, neither the military leadership nor the current elected government has restored faith in the economy or the stockmarket, in spite of the country's perceived economic strength after the Asian crisis. Pakistan has seen similar equity market turmoil on the back of political problems.
Nitin Jain, fund manager at Kotak Mahindra, believes that political risk between emerging markets varies wildly. He says that any increase in political risk should benefit countries like India, which have political stability and a robust legal system. This is in contrast to countries like China where the legal system is still relatively weak.
But as yet, contagion between emerging markets has been limited. Where there have been falls this year, they have tended to have other causes. Initially and most importantly, the recent slide in emerging markets equities can be attributed to some wild exuberance in the middle of last year.
Andrew Wilson, head of investments at wealth manager Towry Law, says: "We took the view that while emerging markets were cheaper and faster-growing, we wanted a larger exposure, but then in 2007, they became more expensive than developed markets and earnings growth was no faster. Therefore there was no reason to be overweight. In China, some stocks were trading on up to 50x earnings.
"This year they've sold off badly and are now back down to valuations similar to developed markets'. They are growing a little bit faster in most cases so they now justify an overweight position. Valuation and growth measures have generally guided investors pretty well over the past few years."
In India, inflation remains a much greater problem. Andrew Beal, investment manager of TR Pacific investment trust, says: "India has a tricky inflation problem. It has had to raise interest rates substantially to deal with it." Jain says that the Indian economy is very sensitive to oil and the markets are around 25% correlated to the oil price. The declining oil price has therefore helped deliver stronger comparative returns for the Indian markets over the past couple of months, though this has not yet been seen in headline inflation numbers. He adds: "There has been a trend of money moving out of commodity producing nations to commodity consuming nations."
Inflation has also been an issue for China. Food and fuel make up a substantial part of spending for the average household and so the effect of rising prices has been disproportionate. However, there are signs that this is becoming less of an issue.
The Chinese government felt confident enough to cut interest rates to 7.2% from 7.47% this month following six increases last year. Economic growth slowed to 10.1% in the three months to June, down from 10.6% for the previous quarter. Inflation slipped back to 4.9% in August, its lowest figure in 14 months.
Despite these improving signs, Marcus Brookes, manager of the Cazenove Multi-Manager Diversity fund, is sticking with the underweight position in emerging markets that he has had all year. He says: "There has been a huge expansion in Asia. Monetary policy was loose and there has been an investment spree, though admittedly some of that was needed, such as for infrastructure. But now with slowing economic growth and the rise of inflation, emerging markets are unlikely to do well."
Brookes says that he didn't believe in the decoupling story and too many emerging markets are linked to the dollar, which is now appreciating and will threaten their ability to export to OECD countries.
He says: "China has had to buy commodities at desperately high prices. There is a view that Brazil will be able to export iron ore to China forever. "Brookes says that Russian geopolitical risk is a real issue and the situation in Georgia has affected his view of emerging markets.
However, emerging markets have their supporters as well. Rob Burdett, joint head of multi-manager at Thames River Capital, says: "We are still overweight emerging markets. At the moment, they are suffering and the Bric markets have fared worse than the US since the start of the year. The oil price is having a mixed effect. It should be good for importers and bad for exporters. China is likely to remain the engine of growth in emerging markets."
Burdett believes you have to make volatility your friend in this type of market. He had reduced his weighting in Russia prior to the fall in the oil price. He says that the Georgia issue was important to analyse, but is now in the past.
Kearney says: "I still believe in the growth story, though they have suffered this year. Lower energy prices will be good and food prices have also started to fall. Interest rates will be lower as a result. The last 20 years have been about the developed markets. The next 20 years will be about emerging markets."
The growth on offer is still favourable. Jain says: "GDP growth for most developed markets will probably come out between flat and 1% this year. You can still get 6-10% growth in emerging markets and penetration of goods and services is still at very low levels. For example, there is huge scope for financial services. There is hardly any mortgage penetration in India. Emerging market companies are still very confident. They have very strong balance sheets and they are acquiring global assets."
While emerging equity markets have been hit in the short term, emerging market bond prices have not yet moved in response, suggesting that the Russian crisis has not brought about a wider fear of default. In fact, Jim Leaviss, head of retail fixed income at M&G and manager of the M&G Emerging Markets Bond fund, believes that emerging market bond prices still look very expensive and are not yet fully pricing in the new economic climate.
Political risk is just one of a package of risks that need to be considered when investing across all markets. However, with a few notable exceptions, the Russia situation is unlikely to prompt any full-scale repricing of risk for emerging markets. Its potential impact on the oil price was the only thing likely to cause contagion to other emerging markets, and this has proved limited.
Emerging market governments are stronger, more stable and operate more independently now than at almost any time in their history. And with the current turmoil in the Western financial system, who is to say emerging markets are riskier any more?
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