How worried should investors be about the tension in Ukraine and Russia?
Scott Kubie, CFA, CLS Chief Strategist
The overthrow of the pro-Russian government in Ukraine and the subsequent intervention by Russia in select parts of Ukraine has been unsettling. I believe the events should worry investors a little, but not too much for the following reasons:
- Exposure to Ukrainian stocks is rare for most portfolios since Ukraine is classified as a frontier market. Furthermore, there is no Ukraine allocation in the iShares MSCI Frontier 100 ETF.
- The biggest near-term risk is Russia, in response to potential sanctions, penalizing foreign investors. Russia is just under 5% of the MSCI Emerging Markets Investable Market Index and is a large portion of any allocation to Eastern Europe. Russian P/E multiples are very low, so the political risk in Russia is at least partially represented in the price.
- It is also possible Russia may respond to potential sanctions by penalizing foreign companies doing business in Russia. For instance, Russia is PepsiCo’s second largest market and they also have assets in Ukraine.
The greater worry is Russia continues to be belligerent towards its neighbors. While I believe there is some modest risk that this could continue, there are some key lines in the sand. Belarus is already supportive of Russia. Our NATO allies Latvia and Estonia border Russia whilst other NATO allies Poland and Lithuania are separated only by Belarus. I believe it is highly unlikely Russia will run the risk of a negative interaction with NATO. More likely is Russia will seek to protect its key interests and maneuver Ukraine into the Russian orbit.
There are always geopolitical risks affecting international markets. Smart investing isn’t to worry about them excessively, but to make sure valuations reflect a reasonable premium for the ups and downs of the world in which we live.
Matt Santini, CLS Portfolio Manager
I would add that markets tend to act irrationally on the initial trade when governments implode. We saw this in Greece and Egypt. Often times buying opportunities are presented, but that is not always the case.
When the literal dust settles investors need to be reminded that reaching for returns in loosely regulated and often corrupted markets comes with outsized risks. That, to me, is where the worry presents itself. In order to allocate to Russia, you must be willing to absorb roughly 50% more risk than the broad market. That is not your typical value investing. On a risk adjusted basis, realizing the expected returns from the Russian market will continue to be daunting with or without exogenous forces.
Paula Wieck, CLS Manager of Investment Research
The most important reason –the region is dirt cheap! The region was already attractive, but the recent crisis has bought Russian equities to extreme oversold readings. The Moscow exchange, MICEX, trades at less than half the level of the overall emerging markets index and a third of the level of most developed markets. In addition, Russia is rich in natural resources, and has a highly-educated and very technically able workforce for an emerging market economy. Government debt is less than 10% of GDP, and consumer debt, while on the rise, is still low overall.