• Editor

What Russia's war in Ukraine means for emerging markets

Since Russia’s invasion of Ukraine on 24 February, the pace of escalation has been rapid. Not only in terms of Russian actions, and their terrible impact on Ukrainian people, but also regarding the response from Western allies.

Events continue to unfold and very sadly the direct humanitarian crisis is deepening. The imposition of sanctions has severe implications for the Russian economy, but also potentially significant implications for global growth.

Against this backdrop we have become more cautious and defensive as investors.

Our outlook prior to the invasion We were anticipating a difficult first half of 2022 for emerging markets (EM). Global financial conditions remained loose but were tightening, while fading fiscal support was already a drag on growth. Global growth was robust, but slowing. Given post-Covid normalisation, we were expecting a continued shift in consumption from goods to services, alongside a waning inventory cycle. Inflation was proving stickier than expected.

However, there were some reasons to be positive: EM yields and currencies were attractively priced and US Federal Reserve (Fed) expectations had become hawkish. China’s credit impulse has troughed and Chinese policy was due to be asynchronous. Meanwhile, inflation was expected to inflect and ease into the second half of the year as improving supply met easing demand growth. Overall EM valuations were modestly elevated versus their own history, but cheap versus developed markets, and particularly so versus the US.

How events have rapidly escalated

The response of NATO and the West to Russia’s invasion has been more united and robust than many expected, as has Ukrainian resistance. Sanctions have been more extensive than anticipated, with severe repercussions for Russia’s economy.

NATO has been given fresh purpose and its presence in Eastern Europe is likely to rise, and European military spend is likely to increase substantially. The setbacks for Russia’s military have been widely commented upon. Meanwhile, Ukrainian nationalism has been strongly reinforced and the conflict has made a hero of President Zelensky.

President Putin has made a major error, and this is having a disastrous human impact. Putin is committed to his course of action, however, and will not want to appear weak. Sadly, this appears to have led to an evolution in the campaign to accept a higher level of civilian casualties in pursuit of military success. Both NATO/the West and Russia have hardened their positions.

Peace talks between Russia and Ukraine over the past few days have reportedly yielded some progress. A negotiated settlement would, we hope, begin to end the human suffering. However, while Ukraine has stated that it could offer neutrality and in effect commit not to join NATO, it is at this point unwilling to cede territory, something which may be unacceptable to Putin.

What is the impact of Russia sanctions?

Sanctions are more severe than expected, particularly with Europe and the US moving to freeze the Central Bank of Russia’s foreign reserves. Russia is now the most sanctioned country in the world. This will have significant repercussions for Russia’s economy.

Russia is facing a severe recession, owing to the combination of sanctions and the subsequent withdrawal of Western companies and custom. Russia and Ukraine account for less than 2% of global GDP (shown in the chart below). However, the conflict has the potential to have an outsized impact on the global economy via its impact on commodity markets.

Russia and Ukraine account for less than 2% of world GDP

Together with Ukraine, Russia’s share of global exports across various commodities is significant. These range from energy through to metals, precious metals, cereals and fertilisers. A combination of geopolitical risk premium and the threat of interruptions to supply have triggered a substantial and broad based rally in commodity prices. A sustained spike would drive broad economic stress.

There are reports of short term interruptions to Russian exports. Reputational considerations, self-sanctioning and the risk of tighter sanctions are impeding the purchase of certain Russian commodities. Meanwhile risk considerations are driving companies to add to commodity inventories. There may also be longer term implications for Russian commodity supply due to the loss of western technology, hardware and expertise to support maintenance and project development.

Food prices are a particular concern as Ukraine is a significant grower and exporter of wheat and other agricultural commodities. The sowing season is being disrupted, there are concerns for winter wheat, where a deficit of fuel and fertiliser may lead to a material decline in yields, and parts of the country are inaccessible.

The extent to which higher prices will persist remains unclear. Sanctions are likely to remain in place for the foreseeable future, and may tighten further. However, in the absence of direct sanctions on purchase, significant price discounts for Russian commodities may incentivise certain market participants to find ways to overcome impediments to trade.

Furthermore, high prices may drive demand destruction, while the supply of certain commodities may also respond. For oil, there is the prospect for an Iranian deal, a Saudi Arabian and UAE led production response from OPEC, an acceleration in US shale investment and production, as well as a release of barrels from the US Strategic Petroleum Reserve.