The terrible scenes in Ukraine, with reports of killings and threats of an all-out civil war, add to disturbing news from a number of emerging markets. How, in general terms, should investors behave?

A word that is likely to be conjoined with “emerging” this year is “instability”. Rising risks in emerging markets triggered a pullout of hot money flows last year, resulting in a wide gap between regional equity market performances. Most emerging market indices were in the red by the end of 2013; by contrast, the S&P 500 Index of US stocks, for instance, shot up by around a third.

The geopolitical news is unlikely to change this trend soon. The eruption of violence in Ukraine this week (reports of deaths are rising by the hour as these words are written), strife in Venezuela and continued conflict in Thailand are rattling investors. There remain rumblings that China’s “shadow banking” system is vulnerable. However, associated sell-offs to emerging market prices can create opportunities; investors must also be more discriminating, wealth managers say.

The MSCI BRIC Index of equity returns in Brazil, Russia, India and China is down by 6 per cent so far this year; the MSCI EM Eastern Europe Index is down by 6.3 per cent. The MSCI Russia Index is down almost 9.6 per cent this year; by contrast, the MSCI World Index of developed countries’ equities is flat for the year so far and up by 3.7 per cent over the past four weeks.

“Political risks could also add to the high levels of volatility witnessed so far this year. A number of emerging economies will experience election cycles in 2014. In some cases this is likely to be accompanied by politicians seeking to enhance their level of voter acceptance, and in some of the more fragile economies this may not be helpful. In these uncertain environments, investors should focus on securities with a lower risk of government intervention, where sustainability of their earnings is not in the hands of politicians or civil servants,” Nick Price, portfolio manager of Fidelity Emerging Markets Fund, said in a note.

“Taking at least a two-to-three year view, I believe that bouts of volatility will continue to create interesting investment opportunities to buy into high-quality businesses on attractive valuations,” he said.

Price said he likes the theme of consumer spending in emerging markets, and gives a specific Chinese example to illustrate his thinking.

“In China, for example, private education business New Oriental Education is benefiting from the country’s appetite for quality education and the government’s drive to encourage domestic consumer-driven growth. The company has become increasingly attractive as it has switched its focus to driving earnings growth through improved profitability at its existing schools and learning centres rather than maintaining a rapid expansion programme which was very capital intensive. This helps to improve the return profile of the business as a whole and hopefully shareholder returns as well,” he said.  

Pau Morilla-Giner, chief investment officer at London & Capital, the wealth management house, said more volatility is likely.

“Unfortunately as emerging markets continue to slow down, we will see more instability. This is evident whenever emerging markets are lagging – Brazil, Turkey and Ukraine are all good examples. There is of course political backgrounds to consider, but inevitably economic conditions exacerbate the situation. Emerging market investors will need to monitor any instability, as the markets are subject to very sensitive flows,” he said.

“Emerging market instability will be a key theme of 2014. There is a [interest] rate normalisation occurring and that will almost certainly translate into negative flows through some of the emerging market regions. Let us not forget, however, that uncertainty brings opportunities. It might be that emerging market stocks are the only place on earth where there is some value in listed assets. When it comes to public equities you might see opportunities arising from political situations,” he continued.

“Some emerging market stocks are being unfairly punished however; some countries have none of the issues faced by others such as net-debt position, low reserves or political stability e.g. Malaysia. Emerging markets are not all created equally,” he added.

Ukraine
The latest eruption of unrest in Ukraine is arguably the biggest shock yet this year. According to Alisa Lockwood, head of Europe/CIS Analysis at IHS Country Risk, a firm that tracks such developments to guide businesses, the “scenario of a wider violent civil conflict and even territorial dissolution of Ukraine has now become more likely, from a scenario that was previously marginal”.

“The escalation of violence in Ukraine has been triggered by frustrations with the slow progress on constitutional negotiations in Parliament. It illustrates the fundamental problem of the opposition leadership’s lack of control over more radical segments of the anti-government movement. A peaceful resolution would have to involve swift action on restoring the 2004 Constitution and the firm promise of early presidential elections,” she said.

According to preliminary eyewitness accounts, the storming of government buildings in Kiev this week was the result of a more “co-ordinated and aggressive effort”, she said, arguing that such groups and their sympathisers have consistently called for President Yanukovych’s resignation. She believes he must heed those calls if there is to be a peaceful outcome.

“Further direct negotiations between Yanukovych and leaders of opposition factions are no longer possible in the immediate future, as Yanukovych has called on them to renounce the violent wing of the movement and they are unlikely to be in a position to do so. Consequently, a peaceful resolution would have to involve swift action on restoring the 2004 Constitution – most likely as a result of certain Party of Regions factions siding with the opposition in Parliament – and the firm promise of early presidential elections,” she said.

From what had been a marginal risk, there is now a 30 to 35 per cent chance of wider civil conflict in the Ukraine, with possible territorial dissolution in the country, IHS concludes.