As the conflict in Ukraine enters its third month, questions continue to arise about the relationship between war and markets. Guido Giammattei looks at the impact of the current conflict on EMs and how this translates into investment opportunities for the asset class.
What does history tell us about investing during times of conflict?
If we look at past events, conflicts have caused little in the way of deviations of market outcomes from their structural trends and initial reactions have tended to be transient and reverse once – or even before – conflicts are over. Likewise in the past, the strength of the US dollar or the spike in oil prices are two of the effects from a conflict that could reverse once that risk normalises.
Back in the here and now, what are your views on the impact of the Ukraine situation?
We’re currently monitoring food inflation very closely, as the conflict has caused two direct effects in this area. Firstly, Ukraine and Russia are the largest producers and exporters of wheat, barley and other key agricultural commodities. Secondly, Belarus is the largest producer of fertilisers, the prices of which have increased hugely, as a result of sanctions cutting supplies and extraordinarily high gas prices that are a key input of production[1]. Some farmers are not able to afford fertilisers at their current costs, and this reduces yields and aggravates the situation for food supply and prices.
The FAO Food Price Index is now higher than in 2011, during the time of the Arab Spring. We have already seen economic – and to some extent social – instability from food prices in smaller, more fragile emerging economies like Sri Lanka, Pakistan, Peru and Egypt. The step from social to political can be short. If supply is not restored, we could see food inflation and famine becoming larger issues in EMs, as food expenditure represents on average 35% of consumers expenditures vs 10% in the developed world[2].
What areas should investors look at or avoid in the current environment?
The key phrase for us at the moment is “pricing power”. It’s entirely imaginable that after a decade of no inflation, the next decade will be characterised by higher inflation than the prior decade. In such an environment, especially at the turn, it’s important to be positioned in businesses with strong pricing power.
How does that translate into stock opportunities?
As inflation stay elevated and rates rise, we favour businesses with low leverage, a cost structure that has low exposure to commodities, strong market share, relatively asset light and that have unique products that are not easily replaceable. On balance we look to invest in companies that have strong pricing power.
And how about sectors?
A sector that generally tends to have pricing power is consumer staples. Also, the tech sector has been very weak, EPS estimates weakness is discounted and valuations have become much better, so that could be a good area to revisit later this year.
Several analysts are forecasting the end of globalization. Do you believe that EMs are due to lose some of their weight in investors’ portfolios?
We had the Trump trade war in 2019, Covid in 2020/21 and now the Russian invasion of Ukraine. After three years like these, it is very easy to become overly negative on globalization. However evidence, at least for the moment, suggests the opposite and global trade is nearing six trillion dollars, which is a new historical high[3]. Russia is a country that chose a path of isolation and is quite unique among emerging economies. Looking at the next decade, we don’t believe that globalisation will end, however we could envision an environment where the structure of global trade changes.
How could this play out in practical terms?
Firstly, we could see a move towards the formation of trade blocks, which are either regional or product/technology based. Countries will trade more, but not exclusively, within these blocs. Secondly, trends such as industrial automation, cloud infrastructure, and artificial intelligence/smart manufacturing are likely to reshape manufacturing-based supply chains, as companies won’t need to rely on countries with low labour costs for production. The latter has the potential to change some of the current winners and losers but is not something, in our view, that will mark the end of globalisation.
In sum, we remain positive on the long-term outlook for emerging markets and believe there continues to be a compelling case for EM assets to perform.
[1] UBS 2022
[2] HSBC 2022
[3] https://unctad.org/news/global-trade-hits-record-high-285-trillion-2021-likely-be-subdued-2022