Investors' Perspectives on the Azerbaijani and Armenian Economies Amid Conflict

Investors are betting that the Azerbaijani economy will cope with the conflict in Nagorno-Karabakh better than the Armenian economy. This is how analysts of large investment houses write about it. In her arguments for Forbes, Evgenia Sluchak, founder and director of EPFC Asset Management, does not quite agree with such conclusions. The situation seems more contradictory than it seems at first glance.

In recent analyses, a trend has emerged where investors seem to favor Azerbaijan's economic resilience over Armenia's amidst the ongoing Nagorno-Karabakh conflict. This preference is seemingly backed by the performance of government bonds from both countries, with Azerbaijani bonds faring better than their Armenian counterparts since the conflict's escalation. Such observations have led many to conclude that the oil and gas-rich Azerbaijani economy is better positioned to weather the storm of this geopolitical strife. However, a closer inspection reveals a more nuanced reality that challenges this simplistic view.

The conflict over Nagorno-Karabakh has been a longstanding flashpoint in Armenian-Azerbaijani relations, with recent escalations transforming these tensions into a full-scale war. This has inevitably impacted the financial markets, notably affecting the countries' sovereign bonds. Initial reactions saw a sharp decline in the value of Armenia's Eurobonds, whereas Azerbaijani securities displayed a remarkable recovery. This disparity was quickly interpreted as a vote of confidence in Azerbaijan's economic fortitude. Yet, this interpretation fails to account for several critical factors that complicate such a straightforward assessment.

Beyond Face Value: A Deeper Look at Bond Performance

To fully understand the market dynamics at play, one must consider factors beyond mere bond prices. Key among these is the concept of credit spreads, which measure the risk premium investors demand over a risk-free rate to compensate for the risk of default. Equally important is the structure of bond ownership, particularly the role of bond exchange-traded funds (ETFs). The rise of passive investment strategies through ETFs means that many investment flows into bonds are dictated by their inclusion in major indices, rather than active choices based on the issuer's fundamentals.

Azerbaijan's four-year government bonds, for instance, are included in several key emerging market bond indices, unlike Armenia's comparable securities. This inclusion translates to a broader exposure and, consequently, a more significant impact from the general movements within these indices. Thus, the performance of Azerbaijani bonds is as much a reflection of broader market trends as it is of investor confidence in the country's economy.

The ETF Effect and Emerging Market Dynamics

The distinction between bonds included in ETFs and those not included is crucial. Securities within ETFs benefit from the passive investment flows aiming to replicate the performance of the underlying indices. This mechanism can amplify movements in bond prices, making them more sensitive to overall market trends. Conversely, bonds not included in such indices, like Armenia's, do not receive these passive inflows and are less subject to these systemic movements.

Recent weeks have seen significant net inflows into emerging market bond ETFs, totaling over $1.6 billion. This influx has led to a tightening of credit spreads across the board, indicating a more favorable view of emerging market debt. However, the nuanced performance of Armenian and Azerbaijani bonds amidst this trend suggests that investor sentiment is not solely guided by confidence in Azerbaijan's economic prospects but also by the structural dynamics of the bond market.

War's True Cost: A Perspective Beyond Bonds

The ongoing conflict's effects extend far beyond bond market dynamics. War inflicts profound human and economic costs on all involved parties, a reality that the financial markets recognize. Rating agencies have begun adjusting their outlooks accordingly, with both Azerbaijan and Armenia seeing downgrades or negative outlooks on their sovereign and quasi-sovereign debt.

Investors, therefore, are not merely choosing between Azerbaijan and Armenia based on perceived economic strength. Instead, they navigate a complex landscape shaped by market mechanisms, index inclusion, and the grim realities of war. The apparent preference for Azerbaijani bonds is less an endorsement of the country's economic resilience and more a reflection of broader market dynamics and the structural intricacies of global finance.

Ultimately, while Azerbaijan's oil and gas resources may provide some economic cushion, the true cost of the conflict, in terms of human suffering and economic disruption, cannot be understated. The market's response, while informative, only scratches the surface of the profound challenges faced by both nations. Investors are not just betting on economies; they are grappling with the unpredictable outcomes of a tragic and complex geopolitical conflict.