23 Jun 2020
4 min read
Head of Emerging Markets and Asia-Pacific Equities
While the attention of the COVID-19 pandemic moves away from China, businesses are slowly resuming, but will China and EM continue to be global growth hotspots, and is investment in China still too big an opportunity to ignore? We take an in-depth look at the pace of recovery in Emerging Markets (EM) and explore whether the economic recovery is a roadmap for the West.
Some observers may draw parallels between COVID-19 and SARS, but the current pandemic is much more significant because of its severity and geographical spread, due mainly to the fact that world is now much more interconnected. Additionally, China is now a much more significant part of the world economy than it was before.
As we write, it is difficult to predict the shape of a COVID-19 recovery since a lot depends on how both the outbreak evolves and how the search for preventions and cures progresses. As such, this is likely to be a story that continues into next year.
But at a time when new cases, treatments and policies drive a global news cycle, the challenge for forward-looking investors is to focus on what matters. With that in mind, here are eight takeaways on our current view and the future outlook for EM equities:
Over the years, 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, thus making EM less exposed to a global downturn than they were during both the Global Financial Crisis and the SARS outbreak. However, the crisis this time is more global and the economic hit is larger. Countering this is the unprecedented amount of fiscal and monetary policy support globally.
Changes between 2008 and 2019 in MSCI Industry groups
The MSCI EM benchmark weighting have changed between 2008 and 2019, and consumer sectors are much larger
On the whole, EM company balance sheets have been improving since the Asian financial crisis in 1997/1998 and are more defensive, especially when compared to the US and Europe. That said, we may see a temporary increase in leverage in the coming months as EM companies work through the crisis period.
Net debt/equity, 1996-2019
Emerging Markets companies have much lower debt levels than other global regions
Governments across EM have stepped up with wide-ranging policy support.
On the monetary side, central banks in eleven EM countries cut rates in April (China, India, South Africa, Russia, Mexico, Poland, Turkey, Philippines, Peru, Colombia, and Pakistan). This has been possible because most countries in the EM space have maintained a prudent policy mix so far with respect to their real rates, and had room to cut rates.
On the fiscal front, governments are stepping up their efforts too. Russia for instance stated that the government plans to allocate ~3% of its GDP to fight the pandemic.
Even prior to COVID-19, the move to reduce global 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 likely continue to be both an important production base and final market for companies. South-East Asia and India are potential beneficiaries of the ‘plus one’ strategy, and we’ll likely see more reshoring to North America, Korea or Japan.
COVID-19-induced changes in behavior have accelerated the shift from offline to online services, benefiting business segments like after-school tutoring, financial services, and healthcare diagnosis.
Companies are also stepping up investment in R&D and innovation, and there is growing demand for automated solutions. Additionally, the COVID-19 outbreak is spurring consolidation within many industries both in China and EM more widely.
At the time of writing, Chinese equities¹ have outperformed US² and European³ equity markets YTD. We see three 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 and, finally, US equities started the year being much more expensive than China.
Additionally, China is showing signs of being one of the first economies to move toward a recovery, with a widespread relaxation of pandemic controls coming in early May and data on intra-city traffic and coal consumption showing incremental improvements over recent weeks.
Finally, the COVID-19 crisis has been a very good test of the standalone China thesis. 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.
The COVID-19 crisis has been a very good test of the standalone China thesis.
For all the disruption to everyday life from COVID-19, we don’t see a meaningful impact on the long-term drivers that underpin EM.
Demographic trends within EM aren’t going to change because of the pandemic; the population of working age people in EM is still expected to grow 0.81%, on average, per year between 2020 and 2050, while it will decline 0.3% per year in developed markets.
This demographic change is significant because it means that the world’s new working population and consumer bases will come from EM and support domestic demand growth. And as incomes rise in EM, consumers are shifting their wallet share towards discretionary consumption and better quality goods and services.
EM went into this crisis with inexpensive valuations and are now trading around 1.5 price/book –meaningfully lower than their historic average of around 1.8 – and EM currencies are close to historic lows on a real effective exchange rate basis.
Looking over the past twenty years, EM equities have tended to recover quickly after key outflow periods such as the SARS outbreak in 2002, and the Global Financial Crisis of 2008/2009.
Current valuations could make for nice entry points from a long-term perspective.
So while it is difficult to predict the possibility and shape of a second COVID-19 wave, we are focused on companies that can withstand at least 12 months of very difficult conditions in terms of balance sheet and cash flows.
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 potential long-term winners at appropriate price points.
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