Anthony R. Craddock, Senior Vice President of International Equity Research, highlights the changing Emerging Markets landscape amid geopolitical and economic volatility related to Russia and China.

March 31, 2022

For all its potential, emerging markets (EM) as an asset class has been more a source of risk than reward over the past year. Russia and China are the two EM countries creating the most uncertainty for stock investors, as their actions have added significantly to geopolitical and economic tensions worldwide. Russia’s swift relegation to global pariah has brought—among many other consequences—exclusion from the standard stock market indices. Meanwhile, China remains the EM index heavyweight, even after its recent dramatic share declines that were spurred in part by the government’s heavy-handed regulation of the corporate sector.

In navigating this shifting landscape, an active investment manager can’t simply choose countries and companies based on attractive valuations and growth prospects, or trust the metrics used and the efficient allocation of global capital to produce a successful result. Instead, it seems prudent to place primary importance on politics and governance, removing certain firms (and possibly entire markets) from consideration and tailoring a unique policy for China as the dominant constituent.

Evaluating “Countries First” takes on a new meaning

Russia’s wholesale invasion of Ukraine surprised many Western analysts—those expecting a limited eastern incursion—in its brute force, and has surprised again with its incompetence. For President Vladimir Putin, war has delivered coordinated sanctions from a rejuvenated U.S.-European alliance as well as more Russian casualties in one month than were suffered during a decade in Afghanistan. For the rest of the world: a humanitarian crisis as millions of refugees flee for Poland and parts West; rising energy prices feeding already high inflation and threatening recession; and the revived specter of a nuclear standoff between the old Cold War superpowers, largely absent for a generation. As a destination of interest to equity investors, Russia was already greatly diminished, having seen its weight in the MSCI Emerging Markets Index drop from a high of 11% in mid-2008 to just over 3% pre-invasion. The Russian stock market and ruble collapsed in late February, leading the MSCI Russia Index to lose more than half its value in U.S. dollar terms over the month. The country was then removed from the overall EM Index in March as sanctions made share trading virtually impossible.

With Russia becoming increasingly cut off from the rest of the world, one looming question is how far China will go in providing an economic lifeline or even military support to the country it had earlier declared a “no limits” strategic partner. China-watchers already had plenty to worry about prior to this. Following the Hong Kong protests of 2019-2020, Beijing imposed a national security law that effectively ended the “one country, two systems” principle a quarter-century ahead of schedule. Although he did not provide a timetable, President Xi Jinping vowed last year that China will achieve “reunification” with Taiwan. China’s military has been probing airspace over the island and testing the waters of the South China Sea; one hopes that Russia’s experience underlines the difficulties that motivated and well-supplied homeland defenders can cause for a large, but largely untested, aggressor. On the economic front, China’s maintenance of its (ultimately untenable) zero-COVID policy, requiring lockdowns of cities as important to the global supply chain as Shenzhen and Shanghai, kept upward pressure on consumer prices and put a brake on trade and commerce.

The shifting sands of the EM Index

China’s importance in the EM Index has grown dramatically over the last 15 years. In fact, back in late 2006, Russia was the larger index component. Stretches of outperformance and, more to the point, a stream of new and newly-included equity listings brought China’s weighting to 30% by the end of 2017. Then, in 2018, MSCI began tapping into the huge pool of mainland A-shares, including them in indices alongside the country’s Hong Kong and U.S. listings. China’s weight peaked at 43% late in 2020, helped by strong returns out of the pandemic by its internet and e-commerce giants, as steady growers that fit into the “stay at home” investment thesis were much in favor globally. Intensifying government regulation—across technology as well as many other sectors of the economy—helped bring about the recent period’s sharp market decline, taking country weight back down to 30% by the end of Q1 2022.

With its combination of size and volatility, China has a huge influence on overall EM Index moves, making “China policy” arguably the most critical and difficult decision to make. At its high point in 2020, managers could factor in further A-share inclusion and extrapolate a near-future weight above 60% for the China juggernaut. It was then fair to ask if the EM Index would continue to behave as a diversified group at all, or become more akin to a single-country vehicle.

Currently the worry is in the opposite direction: how much further downside risk does the country embody, starting at nearly one-third of the total Index? Chinese leadership appears willing to put economics and financial interests to one side when it feels the need to reinforce the primacy of the Party over business and society. The lack of legal protection for private property (including foreign firms’ intellectual property) has been an ongoing source of tension with other nations, not least America. The U.S. government has delisted or restricted investment in shares deemed linked to “Chinese military companies” and regulators have been increasing their scrutiny of Chinese listings in New York. There has been very recent (early April) progress on sharing of company audit data that could break the stalemate on listings. And plans announced in March to ease the regulatory crackdown, support the real estate sector, and relax COVID restrictions sparked a historic one-day rally. In the EM context, China is too big to ignore, but outright bullishness should be underpinned by more such indications of “market-friendly” improvements.

Now that Russia is out, the weight of MSCI’s Emerging Europe region stands at less than 2%, in “safe to ignore” territory even for managers with a dedicated EM mandate. It is therefore possible to squint at the big picture view and see two super-regions, each with a distinct investment theme. For the first, combine Latin America with Middle East & Africa and Southeast Asia (mainly Indonesia and Thailand) to get the “old school” EM mix of commodity exposure and sensitivity to U.S. dollar strength. For the other, the rest of Emerging Asia (think China, Korea, Taiwan, and India) offers an emphasis on technology and innovation that has held greater relevance in recent years.

Questions and choices ahead

Given that energy-led inflation is on the rise with pressures likely to persist, investors might ask if we are about to witness a replay of the mid-2000’s “peak oil” and commodity super-cycle. Will the old school become new again, as resource producers become the next EM darlings and index drivers? Or will growth and tech regain and retain the bulletproof armor worn over much of recent history? The savvy EM manager will probably highlight to clients the benefits of owning a piece of both high-potential outcomes, and this is also the case to make for passive index or ETF investments.

For an active manager, whichever of the super-regions proves ascendant, by now it should be clear that individual country choices matter a great deal. Seeking out cheap and profitable companies wherever they are found—“holding your nose” to ignore reckless or unsavory or unaccountable leadership—is an approach that puts a false veneer of sophistication over a fundamental naivete.