Emerging market risk premia have risen in recent weeks, given the uncertainty over economic growth and inflation. In some respects, the market shift is a reminder that emerging economies remain subject to political risks that had been dormant for some time, and which traditionally are factored into asset prices.
Ironically, the apparent riskiness of emerging market indices has fallen with the removal of Russian assets as constituents. That’s because Russian bonds and equities were disproportionately discounted by the markets before the war, based partially on well-known governance risks and on Russia’s propensity to aggression.
This highlights an important aspect of environmental, social and governance (ESG) investing in emerging markets. Although all of these factors play their part, governance is becoming increasingly important for those seeking to invest in these countries. Meaningful engagement with governments is often frustrating and fruitless for all but the very largest investors. This leaves them facing withdrawal from markets where governance is particularly poor.
It will force investors to think more deeply about governance in countries in which they invest.
Aside from trimming our positions in Russian assets, as liquidity permits, we responded to the crisis by focusing on the rise in commodity prices and inflation and taking relevant positions across assets. In sovereign debt, we have refocused our interest on a handful of countries, particularly in Latin America and Africa, which, in part, should gain from the commodities boom. At the same time, we have reduced positions in vulnerable countries like Turkey, Taiwan, Thailand and India.
Within emerging corporate bonds, we have responded by reducing our sensitivity to rising interest rates. We increased our position in short-dated banks and commodities credit, which should benefit at this point of the cycle, but reduced our allocation to bonds issued by consumer-facing companies, which are vulnerable to food and energy price hikes.
As for emerging equities, we own a number of stocks that give our clients exposure to commodities, including a Middle East-based fertiliser feedstock producer and a Latin American base metals miner, and have a general overweight in Brazil. We also hold positions in companies focused on solar and wind renewable energy.
In all, the Russian invasion of Ukraine leaves investors with both short- and long-term issues. Over the coming year or two, its influence on inflation and growth through squeezing commodity prices will be felt globally. Longer-term issues are muddier, depending on the degree to which developed governments take on the role of global policemen – and the response of emerging countries. The dollar’s hegemony could be permanently dented. Either way, it will force investors to think more deeply about governance in countries in which they invest.