The collapse of the Russian rouble has provided another reminder for investors in emerging markets that contagion persists as a risk.
From Asia to Latin America, stocks, bonds and currencies fell sharply as markets woke up to Russia’s invasion of Ukraine last Thursday. Some of those markets extended their losses on Monday after sanctions against Russia’s central bank at the weekend sent the rouble plunging as much as 29 per cent.
“We’re entering a new phase where we get broader EM risk-off given the Russian shock over the weekend,” said Kevin Daly, a debt portfolio manager at Aberdeen Standard Investments. “The sub-Saharan Africa complex is down 1 to 3 [percentage] points,” he added, referring to sovereign bond prices in the region, which dropped in a flight to quality across global markets.
So-called risk-off events, when investors rein in exposure to riskier markets are, it turns out, still bad for EMs as a group.
Since the 1990s, when debt crises swept from Asia to Russia to Latin America in rolling waves of contagion, many governments have built buffers to external shocks, such as budget and current account surpluses and large reserves of foreign exchange. But the pandemic has drained those resources, leaving many economies exposed.
The immediate impact of the invasion on Russian assets last Thursday was “catastrophic”, said Timothy Ash of BlueBay Asset Management. “I’m staggered that people didn’t think [the invasion] would happen,” he said. The country’s currency, stocks and bonds all fell steeply, dragging other EM assets down almost in tandem.
Russia’s markets staged a partial recovery before the weekend but Monday’s collapse of the rouble has renewed jitters in EM. The fallout from widespread sanctions on Russia will have unpredictable effect on banks and financial flows.
And even before the sanctions, investors were worried about the impact of higher prices for oil and other commodities on inflation and growth. This spells trouble, especially at a time when emerging market output growth — and the shrinking differential between growth rates in emerging and developed economies — is causing concern for investors.
“You have to model this as a classic oil shock, where EMs will inevitably suffer,” said Bhanu Baweja, chief strategist at UBS Investment Bank.
It is not only that there are more oil consumers than producers in the benchmark MSCI emerging markets equities index, he notes. As energy and food prices rise — both likely, should the war drag on — developing countries will be hardest hit by inflation, as food and fuel make up a bigger share of household consumption than in advanced economies.
Central banks in emerging markets have already shown that they are willing to raise interest rates to avoid any repeat of the runaway inflation that has plagued them in the past, even if this means putting an additional brake on growth. That would add to the threat of stagflation, with slow growth accompanied by rising prices driven by bottlenecks and currency weakness.
Ukraine “will play into the global stagflation story”, said Ash. Baweja at UBS said Brazil, where consumer demand is falling short of expectations, provides a test for other emerging markets of whether stagflation will take root.
Adding to the mix is uncertainty over US monetary policy. As analysts at BCA Research noted on Friday, a tightening of financial conditions triggered by the conflict might cause the Federal Reserve to slow the pace of interest rate rises. But if rising energy prices keep inflation higher, they added, the opposite may happen.
This has profound implications for EM investors. Rising US interest rates suck money out of EM assets and tend to lead to dollar strength, which raises financing costs for developing countries and saps investment.
In the short term, many analysts regard a sovereign default by Ukraine as all but inevitable. “I don’t think debt service is a priority in the middle of a war,” said Ash. On Friday, S&P Global Ratings downgraded its ratings on Russian bonds from investment grade to speculative, and moved Ukraine’s deeper into speculative territory. Action by JPMorgan on the position of either country’s bonds in its benchmark indices was likely soon, according to a person familiar with internal discussions.
MSCI, the provider of benchmark equity indices, announced a freeze on any changes to the weightings of Russian equities in its indices and said it was considering further actions including deleting certain companies. The longer-term, broader fallout of the Ukraine invasion remains, of course, as uncertain as the war.