COVID-19 & Emerging Markets: Q&A

Webinar: How short-term conditions have created long-term value

26 May 2020

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Projit Chatterjee, Senior Investment Specialist, Emerging Markets and Asia Pacific Equities, answers key questions following a recent webinar presentation.

Q&A

A lot depends on how the outbreak evolves and the search for preventions and cures. This is likely a story that goes on into 2021.

EM went into this crisis with little excess capacity and hence when the recovery does come, capacity utilization should ramp up to normal quickly.

EM also went into this crisis with inexpensive valuations and are now trading around 1.5 PB – meaningfully lower than their historic average of around 1.8 - and EM currencies are close to historic lows on a REER basis.

The composition of EM has shifted towards domestic sectors like consumption, e-commerce, and financial services, and away from more global sectors like energy and materials the economic, thus making EM less exposed to a global downturn.

However, the crisis this time is more global and the economic hit is larger. Countering is this is the unprecedented amount of fiscal and monetary policy support globally.

On the whole, EM company balance sheets have been improving since the Asian financial crisis in 1997/1998 and - barring a few exceptions - EM country macro parameters too are much better.

There are a few reasons for this.

Firstly, China made a decisive, successful response in controlling the outbreak and this gave investors confidence.

Secondly, China moved quickly and showed strong capacity to stimulate and support the economy.

Finally, US equities started the year being much more expensive than China.

Possibly, given we were only about half way down to GFC levels and have already had a strong bounce back.

It is important to note that in each crisis the market response is usually not a continuous one way downward trend but characterized by upmarkets or 'mini-bull' runs in between.

Having said that, it is difficult to predict market direction. We remain cautious given the hit to economies and earnings, and our base case is for markets to remain volatile.

But current valuations make for nice entry points from a long-term perspective.

The depth and length of this crisis is certainly something that is always on our minds.

On the positive side, the crisis is accelerating structural trends to which we have been exposed, such as the shift from offline to online across business segments, spending on R&D and automation, and growth of the healthcare sector.

We have had minimal exposure to the areas more challenged by this crisis, such as travel and tourism-related sectors.

We continue to have our 'ears to the ground', and continue to conduct our research and channel checks through calls with company management teams, industry experts and other stakeholders.

Even if certain consumption sectors get impacted negatively in the short term, the premiumization trend could in fact get stronger as consumers opt for better quality and brands and hence make the premium players and industry leaders stronger. We are already seeing this in some categories.

Even prior to Covid-19, the move to reduce dependence on the China supply chain had started, driven by rising costs in China and rising automation reducing labor cost differentials, the trade conflict and tariffs, and a general desire to diversify China risk. Covid-19 provides an additional impetus to diversify from the China supply chain.

Many companies are however looking at a China plus one strategy, hence China will continue to be both an important production base and final market for companies.

South-East Asia and India are potential beneficiaries, and we'll likely see more reshoring to North America, Korea or Japan.

Energy has gone from 25% to 7% of the MSCI EM index in the past 12 years.

Asia tends to be an importer and consumer of energy, so it is a beneficiary of lower energy prices, and is certainly giving countries like India more  breathing space.

That said, this boost to Asian economies may be offset by an economic hit and demand drop due to the crisis, which is the one key reason for lower energy prices in the first place.

I think the case to have an additional separate allocation to China, especially the domestic China A share market, remains at least as strong.

China's equity market remains under-represented in global equity indices. Also, the correlation between domestic China and other equity markets remains low, and this was again proven during this crisis.

It is difficult to predict the possibility and shape of a second wave but of course we take that as a quite possible scenario.

We are focused on companies that can withstand at least 12 months of very difficult conditions in terms of balance sheet and cash flows. Amongst these, we are focused on companies that we believe can outperform their peers.

In terms of changes to our portfolio, we have reduced our exposure to banks across a number of countries. We like this sector structurally, but banks in many countries face near-term headwinds as they bear the brunt of the economic slowdown.

We have added to our positions in the internet and e-commerce sectors, especially outside Asia. Consumer and IT remain our key exposures both on absolute terms as well as relative to the index.

We tend to be fully invested but continue to look for opportunities to rotate into long-term winners at appropriate price points.

Key take-outs

  • We are likely to see the deepest global recession since the great depression of the 1930's, however it is too early to predict the shape and length of the recovery given a lot depends on how the outbreak evolves and the search for preventions and cures.
  • Covid-19 has impacted EM, but China offers hope because it has managed to get the outbreak under control with decisive, early actions to control the pandemic and support the economy;
  • Activity indicators in China, such as traffic flows and coal consumption, are approaching 'normal' levels, which suggest the economy is recovering;
  • It remains hard to predict what the precise economic trajectory for Emerging Markets (EM) will be, but EM went into this crisis with little excess capacity and hence when the recovery does come, capacity utilization should ramp up to normal quickly;
  • Compared to the 2008/2009 Global Financial Crisis, EM are now more domestically driven by sectors such as consumer, financial services and technology, which means they are relatively less exposed to a global downturn;
  • The Covid-19 outbreak is accelerating a series of trends such as industry consolidation, shift from offline-to-online, and greater investment in R&D and innovation, which the strategy is exposed to;
  • Valuations for EM equities and FX remain inexpensive compared to historical levels, which may indicate an attractive entry point for investors;
  • Emerging Markets continue to offer a sizeable active opportunity because there is great potential for skilled managers to select quality companies and outperform market benchmarks.
  • The team is focusing on companies that can withstand at least 12 months of very difficult balance sheet and cash flow conditions. We have reduced exposure to banks – while we like the sector structurally, banks in many countries face near-term headwinds as they bear the brunt of the economic slowdown. We have added to positions in internet and ecommerce, especially outside Asia and maintained a preference for consumer and Education Services. We tend to be fully invested but continue to look for opportunities to rotate into long-term winners at appropriate price points.

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