When I visited Russia and Ukraine late last year I did not include Crimea in my itinerary. A region that contributes less than 3% to the country’s already small economy was never going to grip the imagination of foreign investors. How quickly things have changed. Sevastopol (home of the Russian Black Sea Fleet) and Simferopol (capital of Crimea) are now making regular appearances in the daily news.
The Crimea referendum this past Sunday was covered by media outlets around the world as an overwhelming majority voted in favour of joining Russia. The results were widely expected by investors with Russian assets (equities, bonds and currency) indicated by an aggressive selloff ahead of the referendum. Investors, including ourselves, are now pondering the next move.
A large number of investors see this situation as having binary outcomes: the Russian annexation of Crimea and parts of southeastern Ukraine will be combined with another sharp drop in the value of Russian assets, or diplomacy wins over Russia and Russian assets make a spectacular comeback given dirt-cheap valuations. But the outcome might not be a simple binary result, especially if military de-escalation is replaced by a prolonged diplomatic process that only moves forward at a painstakingly slow pace. Investors will be faced with a difficult decision given these uncertainties.
Regarding our holdings, direct exposure in the Signature Emerging Markets Fund is limited to Sberbank (the largest retail and commercial bank in Russia) and a few indirect exposures through Atrium (an Eastern European retail real estate company) and Richter Gedeon (Hungary-based pharmaceutical company). Barring a deep recession or severe financial sanction, the 32% selloff in Sberbank in less than a month seems like a classic overreaction. We were also not surprised at the 18% gain since the intraday low last Friday. From a macro perspective, however, we remain skeptical about any near-term solution and therefore continue with our long-standing underweight of Russia (the fund’s direct exposure is 3% vs. 5% in the MSCI Emerging Markets Index). The political complexity is coming at a time when the Russian economy is already struggling and the possibility of a mild recession later this year continues to grow as the political standoff drags on.
These Crimea-Russia developments are critical for the region but the negative spillover into the rest of the emerging market universe and Western Europe has, so far, remained relatively contained. Given the fluidity of the situation, 24 hours is truly a long time in these negotiations and given all the complexities the outcome has become a game of probabilities with little certainties. Past geographical tensions has taught us that, if mishandled, a situation can easily move from contained to contagious. We are keeping a close eye on how Russia proceeds on integrating Crimea, Russia’s dealings with the “new” Ukraine and how the West will react. For the time being, we maintain our cautious macro view with stock picking dictating Russian-specific exposures.
Although Russia remains on our (political) radar, Turkey and China are topping our financial and growth watch list for emerging markets. But that’s a discussion for another day.