Underweight emerging markets – SGPB Hambros’ Verleyen comments
Eric Verleyen, CIO at SGPB Hambros gives his market views following events in Ukraine.
Russian military intervention into the Ukraine has triggered a market sell-off propping up safe haven assets and pushing down Russian and Ukrainian assets. Although this confrontation is casting political and economic uncertainty, we still consider that the risk of a major upheaval is to be contained. Should the crisis be resolved in some way, the negative impact on markets is set to fade away as investors will gradually shift their focus away from the region to concentrate on traditional market drivers (i.e. growth). Yet, any military or political escalation would warrant a reassessment of the situation.
Assuming a quick resolution of the crisis, consequences on financial markets are likely to be limited
• Despite the recent price correction in the equity market, we remain positive on risky assets such as Equities from Developed Markets (DM).
• These events highlight the return of political risk at the forefront in the Emerging Market (EM ) space and is a demonstration of the EM specific risk that has probably been underestimated by investors in the past few years. As this may continue to impact EM assets including currencies negatively, we remain underweight on the asset class.
• Russian equities that have consistently traded at low Price/Earnings multiples on the back of corporate governance issues may need further time to head for a rerating. Although economic policy has been moving to the right direction in recent years – setting up of an oil-stabilization fund, inflation targeting – the intervention in Ukraine may warrant renewed cautiousness as Russian politics has become again unpredictable.
• As for developed equity markets, we are keen on keeping a positive view on risky assets. For sure, higher uncertainty in the short term will feed into higher volatility but this is part of our main scenario. Recent economic figures point to a robust underlying momentum in the US (ISM index, personal income) and the Eurozone (EZ) is advancing further with less imminent deflation risk. Therefore we take the recent correction on some markets or sectors as an interesting entry point for investors who are still underweight on equities.
• The year-to-date good performance of sovereign bonds should come to an end and therefore we suggest reducing the exposure to long-duration bonds. We would also take profits on gold after the recent rally.
Current developments point to heightened tensions in the short term but a war looks unlikely
• At the current juncture, Russian military intervention in Ukraine is unlikely to degenerate much further as Russia is mainly willing to reassert its grip on Crimea, a strategic region for its naval fleet. Although foreign sanctions should have limited deterrent impact, diplomatic negotiations are ongoing behind closed doors between Russia and its European and US counterparts. This is a sign that the military intervention could be contained at some point and might not turn into a war.
• From an economic and financial standpoint, Ukraine is a small player accounting for 0.2% of global Growth Domestic Product (GDP) and 0.1% of banking claims as reported by the BIS data. Yet from a fixed income angle, the Ukraine market accounts for about 3% of the Emerging Markets Bond Index (EMBI). Russian banks have around $28bn loan exposure to Ukraine (1.2% of Russian GDP) and have already decided to stop making new loans.
• The political standoff has heightened the financial pressure on Ukraine as the country is already going through a severe economic crisis stemming from the domestic political unrest. As foreign exchange reserves could be no more than $15billion, Ukraine is in urgent need of a bailout package to face bonds repayments in the months ahead and notably the redemption of a $1.6bn Eurobond coming due in September. The International Monetary Fund (IMF) already agreed to send a technical mission to assess Ukraine’s needs.
• Russia is already bearing the brunt of the brisk return of risk aversion. Before the recent developments, Russia’s economy was already slowing with an annualized 1.3% Quarter on Quarter in Q4. The political crisis will take its toll on the Russian economy but the economic impact will mainly depend on how much time the confrontation will last. Already the ruble has depreciated by more than 11% Year To Date against the USD, falling to unseen levels in spite of interventions on the foreign exchange market. The equity markets (MICEX) dropped by more than 10% on 3 March while the central bank hiked its benchmark rate by 150 basis points to 7% aiming at stabilising the ruble. Investors’ confidence towards the Russian economy is likely to further fall, and the ruble to be under substantial pressure. To defend its currency, Russia can make use of its considerable FX reserves and can raise interest rates further.
• Neighboring EMEA economies will continue to be affected, with Poland at the forefront since the country has meaningful trade links with both Russia and Ukraine. Market tensions will continue to reverberate onto other Eastern economies as well. Also Turkey and Central Asia countries are not immune from spill over effects through trade and financial linkages.