Emerging Markets have been dominating headlines lately, and for all the wrong reasons, as far as investors are concerned. Over the past six months alone, Turkey, Thailand, Brazil, Venezuela and most recently Ukraine have been places of civil unrest or worse. Add to that the economic slowdown in China, and it's no wonder that Emerging Markets equities have underperformed. Actually, that would be a gross understatement. Since the beginning of 2013 through April 11, 2014, the Emerging Markets ETF (NYSEARCA:EEM) has underperformed the S&P 500 ETF (NYSEARCA:SPY) by nearly 40%, losing 5.58% vs. SPY's 34.01%, according to Morningstar. The chart below compares performance of the two ETFs together with some of the troubled single Emerging Markets country ETFs over the same period: Russia (NYSEARCA:RSX), Brazil (NYSEARCA:EWZ), Thailand (NYSEARCA:THD), and Turkey (NYSEARCA:TUR).
It's Not China
Numerous pundits are calling the slowdown in the No. 2 world economy the culprit of the changing macro climate. It's a compelling argument. Not only it's a huge economy, but the recent economic numbers might point to a changing long-term trend with potential ripple effects throughout the world. Surely, that trumps all the temporary local headline risks I listed at the beginning of the article, and many others, for that matter.
Perhaps, except one. The situation in and around Ukraine may look local and have certainly been labeled temporary by some, but make no mistake about it: this one is different. It's true that the economy of Ukraine is hardly significant in size. Even the most blatant invasion and annexation of Ukraine's Crimea region by Russia can be mistaken by a casual bystander as another event of short-lived headline risk in the mold of the 2008 Russian war against another former Soviet republic, Georgia. Perhaps that war was a logical precursor to the current one, while the UN, NATO and the West were unwilling or unable to do enough to deter or punish the aggressors who used shameless provocations and propaganda to instigate the conflict and try to shape public opinion. The so-called 6-point plan that Sarkozy brokered to bring peace in 2008 is not honored by Russia to this day, but Putin has achieved his objectives, the fighting stopped, and the world has happily moved on.
However, the political and economic implications of the current situation for Russia, its neighbors, Europe and the world are developing rapidly and are threatening to become the most profound macro shift since the end of the Cold War. Indeed, the current situation is very unstable, so what to expect next? Below I have formalized five possible scenarios that I can foresee, with assigned probabilities, which are really guesstimates based on my understanding of the situation. This approach can help arrive at the "expected value" of material economic impact.
1. Russia pulls out of Crimea. Diplomatic ties with Ukraine are restored, things quiet down following some more unrest, and the West slowly and carefully removes the sanctions. Putin takes a huge popularity hit at home, and Russia turns its attention back to its fragile economy. It's the best scenario for the world at large and perhaps for the Russian economy. My assigned probability of that event happening in the current year is 1%, and that's because I'm rounding up. Another words, don't count on it.
2. Ukraine agrees to Russia's demands. That is, Ukraine agrees to some variation of the new Constitution, federalization of the country, adopting Russian as a second national language, and officially letting Crimea go, perhaps for some financial compensation. It's hard to imagine any Ukrainian government conceding as much, and the West will not likely let that happen either. Most importantly, no one really believes that this "solution" has any chance of being the end of it, and that Russia will suddenly "play nice." While this could provide some respite, it would only be an intermediate state of affairs. I would give it as much chance as the first scenario, 1%.
3. The current "status quo" remains. Ukraine elects a new government in May, and then works on a number of political reforms. Things start to quiet down in Eastern Ukraine, and Crimea is stable under Russian rule. "De-escalation" leads to multi-way negotiations where some semblance of a deal can be reached. I think this is what most investors and observers are hoping for. However, the real economic impact of this scenario is far from rosy.
Even if such "de-escalation" can be achieved, the US and the EU have made it clear that the sanctions for Crimean annexation will remain and are likely to increase in order to continue putting pressure on Russia. The European view on the necessity of diversification of their natural gas supplies away from Russia has already fundamentally shifted. So did the American view on exporting natural gas to Europe, and neither is likely to be turning back now. The outflow of foreign capital from Russia has already begun, and as Russia starts feeling political isolation, the outflows will only increase. So will the outflows of Russian capital abroad, in part for fear of asset freezes and in part due to Putin's increasing pressure on Russian oligarchs. The assigned probability of this scenario unfolding in 2014 is 10%; the events are just moving too fast for the status quo to hold that long.
4. Russian army invades. This is, obviously, the worst-case scenario. Aside from the human tragedy and the inevitably horrible loss of life, the political aftermath of any movement of Russian troops across Ukrainian border is hard to underestimate. The unthinkable possibility of NATO and Russian troops getting into a military conflict will be the highest since the Cuban Crisis, though still unlikely. NATO will most likely move hastily to dramatically strengthen its presence in Eastern Europe, the Baltics and the Black Sea, which will break the rest of any meaningful treaties between Russia and the West. Russia will likely be kicked out of many international organizations, and a wide range of cooperation suspended, further isolating it.
"Iran-style" wholesale economic sanctions will likely be approved, targeting key Russian export industries - energy, mining, banking, and defense. President Obama already visited Saudi Arabia recently and was widely speculated to have gotten a commitment of the Saudis to ramp up oil production if necessary to bring the price down, which will hurt Russian exports. Europe will turn away from Russian gas. Visa (NYSE:V) and MasterCard (NYSE:MA) already voluntarily pulled out of the Russian market, and more Western financial institutions may stop doing business in and with Russia. Imports of consumer goods into Russia might be curbed as well.
Of course, all these sanctions will be designed and likely succeed to deal a crippling blow to the Russian economy and the ruble, but that will come at a steep price to the rest of the world as well, which is why those sanctions are so unpopular in Europe in the first place. The higher prices of natural resources, the enormous lost sales of goods and services, the political and economic costs of putting pressure on Russian arms buyers, as well as the increase in defense spending - all of that will have a huge toll on the still recovering US and European economies, threatening to tip them over back into recession. I assign a 30% probability to this scenario, which is still not dangerously high, but perhaps higher than most people perceive.
5. The "Crimean scenario" in East Ukraine. Russian unmarked Special Forces infiltrate the eastern regions of Ukraine, creating "instability" and arming and supporting the local pro-Russian population. If not stopped in time, declarations of local independent states and referendums to join Russia would soon echo the recent events in Crimea. Russia, of course, would then have to oblige to annex any and all such regions. As I was working on this article, I had to bump up this event's probability twice, to 58%, as some events supporting it are already unfolding. It's only this low because it may still end up in Scenario 4. But the world's response to this scenario will not be much different, I believe. Trying to make the annexation of parts of a neighboring sovereign country look legitimate through outrageous Soviet-style propaganda seems to only fool Russia's own population, deprived of independent media.
What Is An Investor to Do
If I'm right, investors face a difficult dilemma. For starters, 99% of my scenarios are outright bearish long-term for Russian economy, which had already been weakening significantly prior to recent events. Shorting Russia can be achieved through any of the dedicated ETFs such as iShares MSCI Russia Capped (NYSEARCA:ERUS), SPDR S&P Russia (NYSEARCA:RBL), Market Vectors Russia (RSX), VelocityShares Russia Select DR (NASDAQ:RUDR), or Market Vectors Russia Small-Cap (NYSEARCA:RSXJ). Alternatively, a very aggressive option is to go long Daily Russia Bear 3x Shares (NYSEARCA:RUSS). Another way to play it is shorting Eastern Europe stock ETFs, which allocate 50%-plus to Russia and the rest to the neighbors whose economies will be affected in the short term as well: iShares MSCI Emerging Markets Eastern Europe (NYSEARCA:ESR) or SPDR S&P Emerging Europe (NYSEARCA:GUR). Going long USD-RUB is also a consideration, although there's no dedicated ETF for the ruble.
However, that's just the beginning. As the unfolding events are pushing the world to the brink of the beginning of the new Cold War, I believe we're in for a big global risk-off trade. I think the coming months will bring higher equity volatility, higher oil and gas volatility, lower EM currencies, lower long-term Treasury yields, and lower valuations of Western European and North American exporters. We're also likely to see higher gold, higher dollar, higher national debts in the developed world, and higher defense spending. Consider iShares U.S. Aerospace & Defense (NYSEARCA:ITA) or PowerShares Aerospace & Defense (NYSEARCA:PPA) ETFs to capitalize on the last point.
We're on the verge of a tremendous macro shift in the world's politics and economics. I believe that the current events in Ukraine cannot be ignored by investors worldwide who would be wise to prepare for the eventual outcome of new, permanent and significant geopolitical and economic risks.
Disclosures: I'm long RUSS. I wrote this article myself.