Investors seeking growth and diversification saw emerging economies as an obvious destination over the years. However, recent events have made it clear that some emerging economies are more exposed to geopolitical risks than others, making them far less attractive than they seem on paper.
China and Russia are at the center of this recent shift. Both economies required foreign capital to unlock the value of their abundant natural resources and ambitious economic targets. For a while, they were successful. Russia pulled in $5-$15 billion in net foreign direct investment every quarter since the early 2000s. Meanwhile, China attracted capital from growth investors, including notable names like Warren Buffett and Ray Dalio.
Russia’s invasion of Ukraine and China’s ongoing tensions with Taiwan have shifted the tide for these investments. Over 1,000 international firms have abandoned Russia since the invasion, according to a list created by Jeffrey Sonnenfeld at Yale University. These include investment giants like Goldman Sachs, Credit Suisse, Julius Bear, Moody’s and Trafigura, while Buffett and Masayoshi Son have slashed their stakes in Chinese companies in recent months.
Geopolitical risks are likely to impact M&A activity, according to the latest CEO Outlook survey by EY. “Cross-border deals are more difficult now than they were a decade ago,” says Andrea Guerzoni, global vice chair of strategy and transactions at EY. “The higher barriers to cross-border investing, especially in sensitive or strategic sectors, means that we are more likely to see deals between countries that have a strong economic and political alignment. For deals between companies in countries where this relationship is not as strong we will see far fewer deals.”
Perth Tolle, founder of Life + Liberty Indexes, attributes the capital outflows on “autocracy risk.”
“Growing up in both China and the U.S., I saw the difference that freedom made in my life and on markets,” says Tolle, who now lives in the States. “As a financial advisor at Fidelity, I had clients who, like me, did not want to invest in their home countries, due to autocracy risk. For example, I had a Russian client who said that investing in Russia would be ‘funding terrorism.’ I felt the same way about investing in China.”
Tolle believes investors underappreciated the level of exposure they have to geopolitics when they invest in broad emerging market funds, which is why her firm created the Freedom 100 Emerging Markets ETF (FRDM), which excludes emerging economies run by autocrats.
“By freedom-weighting instead of market capitalization weighting on the country level, FRDM makes it possible for investors to capture the long-term growth potential in EM with freer country exposures and without autocracy drag,” she says.
Unsurprisingly, Russian equities are not included in Tolle’s fund. But neither is China, which has seen rising conflicts with the West in recent years over territorial disputes in the South China Sea. “I worry about my investment dollars funding terrorism and aggression, and the risk of instant worldwide sanctions on China if they were to invade Taiwan,” she says.
