The domino effect: Russia, Ukraine and the rest of the emerging markets

Janus Henderson Investors Portfolio Managers Hervé Biancotto, Daniel J. Graña, CFA, Matthew Culley discuss how the Russian invasion of Ukraine has ripple effects in emerging market countries.

Key points

  • Russia was or will be removed from debt and equity indices, which removes some of the technical headwinds from emerging markets (EMs) and could limit broader contagion over time.
  • Although many Russian companies have escaped sanctions, their visibility is low. Similarly, the capacity of raw materials makes supply chains difficult for investors to unravel.
  • The ripple effect of rising prices due to the disruption in the supply of raw materials and resources from Russia and Ukraine could have far-reaching effects on emerging markets. This is both a driver and a barrier to innovation in these markets.

Intervention in the capital market

The Russian invasion of Ukraine had important consequences for Russia in the form of explicit sanctions, but also in the restriction of access to capital markets. An example is the withdrawal of Russian securities from debt and equity indices. JP Morgan surprised the market by announcing that it would remove securities from its indices before any type of default occurs, which is normally the trigger for delisting.

Russia’s weight in the Emerging Markets Corporate Bond Index (CEMBI) and the Emerging Markets Bond Index (EMBI) was already small before the tensions, with a percentage of between 3% and 4%1, and was reduced to between 1% and 2% when the tensions began, and will now be completely excluded at the end of March.

This will make the weighting of other countries within the indices slightly higher, while removing some of the price volatility stemming from Russian bonds. Similarly, MSCI and FTSE Russell removed Russian stocks from all of their indices. MSCI also said it is reclassifying the MSCI Russia emerging market indices to the independent markets category, a non-investable label.

While Russia is ESG ineligible, in our view this removal from the indices could limit broader contagion to the rest of emerging markets over time. Russia’s prominence in international financial markets declined after sanctions were introduced in 2014 following the annexation of Crimea. At the start of the global financial crisis, Russia was the fourth emerging market country in the MSCI EM Index, at 10%, but its weight has fallen due to the impact of the 2008 recession coupled with economic sanctions that fueled the depreciation. of the currency Consequently, its weight in the indices and in investors’ portfolios was low. The hurdle for their inclusion again is high and we believe it will take years and regime change in Russia for their inclusion to be considered again.

Sanctions on companies

However, while some Russian companies were directly sanctioned, many were not, and some corporations have spoken out publicly against the conflict. However, visibility into where sanctions may fall is poor, as the fragmented and global nature of companies means that sometimes a parent company is sanctioned and not a subsidiary, or vice versa. This visibility can take time to unravel by government authorities and often seems capricious. The state nature of many emerging market companies compounds this risk.

Since many of Russia’s largest companies are producers of energy or raw materials, it is difficult to envisage an orderly substitution of these sources of production. Coupled with existing sanctions on Russia’s energy supplies to other nations, the sharp inflation in commodity prices may have implications beyond the companies directly affected by the sanctions. As with the lack of visibility around sanctions, the fungibility of commodities also complicates a transparent picture of intertwined global supply chains. Therefore, companies are likely to be wary of trading in goods and materials that do not have a label indicating their provenance.

the domino effect

Although Russia has moved away from international markets, its role in the supply of metals, minerals, agricultural raw materials and energy cannot be so clearly diverted.. For many emerging market economies, inflation causes a domino effect that affects the real income of consumers, to the margins of companies in industrial production and to the health of economies with a weaker terms of trade (the value of imports exceeds that of exports) and even to decarbonization efforts. An example of an affected supply chain is natural gas and minerals used to make artificial fertilizers, whose shortages or price increases could impede the quality of crops to feed the population. Both Russia and Ukraine have banned some fertilizer exports, apparently to protect domestic needs. Russia is among the top two world exporters of all three types of fertilizers (nitrogen, potassium and sulfur). Fertilizers account for about 2% of Russian export earnings (including Belarus), but 29% of total world trade (Table 1). Strong food price inflation is also evident where Russia is a key exporter, such as wheat, corn, barley and sunflower seed oil (along with Ukraine, which equates to originating the half of world production).

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Chart 1: Russian production and importance of its export earnings (% share, 2020-21e) and world trade (%)

This raises the import bill of emerging market economies, which are particularly vulnerable, as reliance on imports of wheat and fertilizer, for example, is higher in emerging market economies, with few exceptions from the developed markets. Food and energy rank higher in the EM countries’ consumer price index (CPI) basket, and this tilts even more in that direction for the poorer classes. In high-income economies, food typically accounts for less than 15% of price indices, while in emerging economies it can exceed 30% of household spending.

This higher inflation will erode the purchasing power of consumers in emerging markets and companies will have limited ability to pass on these large price increases. This has already been reflected in the weak results of consumer staples companies. In our opinion, it could be a significant blow to the profits of these companies. In addition, it creates food security problems in the poorest emerging markets and those that are net importers of basic products.

Substitute countries or raw materials?

Net commodity exporters can benefit from skyrocketing prices and use their rich supplies of commodities to meet the world’s needs in times of disruption. For example, Russia produces 43% of the world’s palladium, which is used mainly in automobile catalysts, while the second largest supplier of this metal is South Africa (Box 2). Russia is also the world’s third-largest producer of nickel, which is used in lithium-ion batteries that power electric vehicles. Indonesia is the first producer of this metal. Major producing countries can offset supply shortages, while shortages could encourage substitution. For example, the replacement of palladium – which was in short supply even before the conflict – with platinum in cars, with which some car manufacturers have already begun to experiment.

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Graph 2: Russia is the world’s leading producer of palladium

World palladium mining production from 2010 to 2020, by country (in metric tons)

As costs trickle down supply chains and with squeezed consumers unable to absorb price rises, innovation is fueled by necessity. Morgan Stanley analysts estimate that a doubling in the price of nickel increases the cost of manufacturing an electric vehicle by more than $2,0007. Along with the scarcity and cost of lithium, countries such as China, the US and India are experimenting with alternative battery technologies that do not use lithium, although we believe lithium-ion batteries will remain dominant. In short, the scarcity of supply encourages companies in emerging markets to innovate in order to prosper and take advantage of accessible resources.

Lockdowns for a low-carbon future

One area of ​​innovation that the uptick in commodity prices has complicated is the path to carbon neutrality, in which China, Korea and India, among others, have set net-zero targets. Given high prices for oil and natural gas – where Russia is once again a dominant exporter – countries are being pushed to explore alternative ways to meet their energy needs. Some emerging countries in Europe have shelved coal phase-out plans, as this source has significant existing infrastructure that can be leveraged to meet short-term needs. Many emerging economies are naturally endowed with this resource and can benefit from increased exports, such as Indonesia. While the carbon-neutral destination that emerging markets aspire to may not change, it could change the course, as attention shifts from distant goals to energy security for near-term economic growth. .

China’s National Development and Reform Commission, for example, plans to increase coal mining to reduce reliance on imports and avoid supply disruption. According to Credit Suisse, China’s plans could see Russia lose three-quarters of its export market. It is clear that supply chains and routes to decarbonization are being reshaped by the domino effect of the conflict and, in the case of China, it is another example of its progress towards economic self-sufficiency. These are the forces of deglobalization at work, as economies rely more on themselves to meet their needs. The end of the chain of dominoes is clear, but there are less predictable ways to stack them up. Rural workers in Indonesian coal mining towns, for example, may see renewed interest from a microbank lending to them. If we take a top-down view of events and influence on businesses on the ground, we can find the clear and less obvious potential winners and losers from the falling dominoes of the Russia-Ukraine conflict.

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