From the moment Russian tanks crossed the Ukrainian border, the world of investing changed. It is a war between two countries which mainly export raw materials.
Russia is the world’s largest oil exporter – at the start of the year it was producing 11.3 million barrels a day, according to the International Energy Agency. It was also the world’s largest exporter of wheat. Ukraine is another major grain producer. It exported 48 million tonnes of corn and wheat last year, according to S&P Global estimates. Both countries share the same most important market for their products: China.
With trade with Russia and Ukraine all but shut down, commodity prices have risen globally. When fuel and food prices rise, it often increases political risks in emerging markets, where these staples make up a significant portion of many households’ daily budgets.
Wheat prices experienced a similar increase in 2010, when there were droughts in Russia and Ukraine and severe weather-related problems in other grain-producing countries. The Arab Spring followed. Rising food prices were not the only cause, but they helped tip political tension into uprisings.
For a global equity manager, emerging markets can provide excellent growth momentum when conditions are favourable. However, the history of investing in emerging markets is marked by occasional crises. Behind many of them is often a political story that begins beyond the borders of the affected countries.
So, for example, there is a current risk that Russia will not pay interest on its public debt. The last time this happened was in 1998 under Boris Yeltsin (the previous one was in 1917 after the revolution). 1998 is a dark year in the memory of emerging market investors as many Asian stock markets crashed. The collapse is probably more due to Brazil and Mexico’s defaults in previous years than Russia’s default, but still, a Russian default would stir memories.
Russia remains a small part of emerging market investment. At the beginning of this year, it represented around 4% of the index, compared to 32% for China, 16% for Taiwan, 12% for India, 12% for South Korea, 5% for Brazil and 22 % for the others. . China therefore rather dominates the degree of exposure an investor can currently choose in emerging markets, especially if you are a passive investor.
Even before the war in Ukraine, China presented difficulties to international investors. Just under a year ago, I wrote to explain why my team decided to sell all of our fund’s Chinese investments. We had been monitoring how regulations had begun to change in ways that could impede the creation of shareholder value. We also noted that shareholders of big tech companies – such as Alibaba and Tencent – were not Chinese, as the shares were listed outside the mainland and local investors could only invest locally. We feared this would lead to scrutiny from Beijing.
In November 2020, the public offer of Ant Financial, the fintech arm of Alibaba, was canceled at the last moment. It was expected to have been valued at over $35 billion, so a red flag was raised.
Over the following months, a wide range of regulations and some fines were announced, affecting the value of other Chinese stocks, from food delivery to education to gaming companies.
Each announcement made sense in terms of caring for the Chinese people, but many foreign investors inferred that the growth prospects for China’s most popular listed stocks had been significantly reduced. Share prices of the targeted companies plunged.
We wouldn’t be brave enough to predict that this regulatory change is over. Demographic factors no doubt prompted Beijing to continue its actions.
When I started investing in China in 2002, there was an economic case to be made for creating manufacturing jobs in coastal areas and allowing people to leave the land for these more productive roles. Foreign investment has made this possible and has been encouraged.
Two decades later, China’s one-child policy has left China with fewer young people to fill jobs and an aging population. China does not need foreign investment; he needs money to pay social security. That likely means higher taxes, and it’s the profitable businesses that are most likely to be in demand.
So how did the Russian invasion of Ukraine affect China? He sided with Russia, but has so far avoided being drawn into the conflict. Undoubtedly, Beijing has watched the effectiveness of Western sanctions against Moscow and noted how such sanctions would affect their own economy.
Again, look at the trade data that underscores how important China is to the global economy. It exported $2.7 billion in goods in 2020, according to the world Bank, and is the world’s largest manufacturer of mobile phones, computers, office machines and apparel. The United States is by far its biggest market. Neither country wants a sudden halt in trade.
Overall, what is the risk of investing in China for investors? A good test is to ask yourself, “If you bought a stock and found that your shareholders’ rights were being abused, would you expect the local courts to uphold your rights?” You might also ask, “How likely is the stock market to close or the local currency to devalue sharply during a crisis?” »
Very cautious investors will note that Russia closed its stock market at the start of the war, effectively leaving Western equity investments worthless. Some may recall that many stocks listed on the Shanghai index were suspended for a few weeks in 2018. The market fell sharply during trade disputes with the Trump administration in the United States. Beijing currently appears to be trying to avoid a repeat of such a dispute. It’s encouraging.
Indeed, some investors could be tempted by the very low valuations of Chinese companies. According to data from Bloomberg, the Shanghai stock exchange is trading at 15 times this year’s earnings and in Hong Kong at 8 times. The US stock market is trading at 23x on the same basis. The Chinese economy is very likely to grow faster than that of the United States over the next 20 years, probably with less risk of inflation. Thus, in some eyes, current Chinese valuations offer an attractive “entry point”; and that may be true.
As a global equity manager, I have a wider range of options than managers specializing in specific regions or sectors. Although it is a big economy, I can get out of China. Other markets in the region can expose me to the higher growth rates expected in Asia while allowing me to spread my holdings across different political environments. South Korea’s Kospi index trades at 12 times earnings and Taiwan at 14 times earnings.
A few years ago, the funds I manage had 10% of assets in China. Today we have a similar amount in South Korea and Taiwan, including Samsung and Taiwan Semiconductor, which are the largest stocks in each index.
We also have broader exposure to emerging markets through holdings in developed countries. Take, for example, Singapore Telecom, which owns majority stakes in the largest mobile operators in Indonesia and Malaysia. It’s a good illustration of the companies we particularly like – resilient companies operating in ‘cockroach’ industries from what we consider safe abodes.
Investors cannot avoid risks, but there are often ways to mitigate them.
Simon Edelsten is co-manager of Mid Wynd International Investment Trust and Artemis Global Select Fund