Positive performance has been posted despite rising COVID-19 cases, especially in India, Indonesia, Brazil and Mexico. As with developed markets (DM), investors are still looking through the COVID-19 disruption (even “second wave” risks) and focusing on the massive whatever-it-takes stimulus programs, which are providing a floor to markets. Market sentiment is also being assisted by:
The economic recovery, which appears to be taking hold as countries exit lockdowns to various degrees; June quarter company profits have been released and were not as dire as expected (or feared), and in some cases – mainly related to technology – were considerably above consensus; The continued weakness in the US dollar (down -10 per cent from its March peak), as well as the unprecedented monetary stimulus by the Fed, and commitment for “lower for longer” policy rates (this has also assisted asset allocation away from US dollar securities and into EM debt and equity capital markets); and China’s post-COVID economic recovery continues to fuel commodity price rises.
In the wake of the global COVID-19 economic slump, and associated negative impact of global supply chains, tourism and export demand – we have seen profound central bank easing. Indeed, the breadth of central bank easing across global capital markets is totally unprecedented with a net 149 policy rate cuts over the past seven months alone, since COVID-19 became a pandemic.
However, with central bank policy rates now so low, the frequency of plain vanilla cuts is obviously slowing as lower bound limits are reached. This has brought on more unconventional stimulus programs.
As such, widespread policy rate cuts have been matched by equally aggressive bouts of money printing and new fiscal policies (including direct loans to companies, and substantially increased unemployment benefits). The aggressive policy response to COVID-19, especially QE, continues to be led by the US, Europe, Japan and many other developed markets.
Away from rate cuts, EM policy initiatives in terms of GDP continue to be comparatively restrained. EM central banks are very mindful of potential currency vulnerabilities if they attempt aggressive QE – without “reserve” currencies. Additionally, many EM governments have a general commitment to conservative fiscal policy (some dictated by legislation), typically a result of past experiences during episodes of economic/fiscal crises. In sum, this has led to a much milder monetary and fiscal response from EM to the economic shock of COVID-19 relative to DM.
Where to for EM?
With limited unemployment benefits and an inability to control social distancing for sustained periods, EM’s working population will go back to work almost by necessity – otherwise there is a risk of widespread unrest/rioting. Further, given EMs’ much younger populations (median age 28) the death rate would seem to be materially lower in any case at this stage, given approximately 97 per cent of COVID-19 deaths occur in people over 55 years and 75 per cent above 70 years (Source: US Centres for Disease Control and Prevention).
Accordingly, despite rising cases and tragic deaths, lockdowns have materially eased across most EM countries. Even the worst-hit COVID-19 countries of Brazil, Mexico and India continue to exit lockdowns. Whilst we do not rule out the possibility of national lockdowns recurring (under second wave risks) – our base case for EM is no significant lockdowns, rather at most surgical/localised lockdowns to try and limit the economic fallout.
The world will inevitably deal with COVID-19, and economies will recover from current depressed levels. We continue to see opportunities and remain overweight India, Malaysia, Thailand, Mexico, South Korea, Taiwan and Indonesia, and underweight our assessed more riskier EMs such as Turkey, South Africa, Argentina, Russia, the Middle East and China.
We think the former are collectively better placed to undertake policy responses to the growth shock from COVID-19 and subsequent economic slowdown, plus have added benefits of an array of good-quality companies to invest in and stand to benefit from a growing share of foreign direct investment (as it pivots away from China).
Our long-term base case view on China is one of slowing growth as the country seeks to deleverage and further devaluation in the RMB. We believe the dispute with the US is likely to be only partly resolved at best and COVID-19 will have a lasting impact on China’s ability to attract FDI, debt and equity portfolio investment. We may see many of China’s EM Index mega caps (currently listed in the US) being forced to relist elsewhere.
In EM if there is an exogenous shock in financial markets – the ability to raise capital (debt or equity) can become near impossible for many companies. Accordingly, highly leveraged companies in EMs are at times extremely susceptible to selling their most prized assets at precisely the wrong time – at the bottom of an asset price cycle – the nadir! This risks permanent capital loss. Indeed, recent EM geopolitical events suggest that capital adequacy is becoming even more paramount.
As investors in EM, we want to be positioned on the other side of this phenomenon. Owning the companies that are well placed to make opportunistic, yet sensible acquisitions from distressed sellers, from which they can create greater shareholder value over the years ahead. Or alternatively, pay more cash back to shareholders.
Patrick Russel, Northcape Capital, portfolio manager for the Warakirri Global Emerging Markets Fund