11 March 2020
As the coronavirus continues to rock global markets, GAM Investments’ Tim Love considers the future for emerging market equity investors and finds some glimpses of light amid the darkness of this unfolding human tragedy
A pandemic “Black Swan” risk event has been highlighted as our biggest fear for the last eight years. In the aftermath of the SARS outbreak, the risk of another pandemic has always struck me as potentially the most debilitating factor in relation to global GDP due to its ability to disrupt the transmission mechanisms of supply chains, as well as the risk off impacts for both capital investment programmes and consumer spending patterns.
The recent fall of close to 20% for the MSCI Emerging Equity Index since late January has stemmed from this risk of a pandemic and raises the issue of whether this fall has been sufficient. And, if so, should we as equity investors be increasing high quality positions at these lower levels?
As ever, the answer depends on your appetite for risk. Higher risk / return investors would say yes, albeit phasing this increase in risk over the next two months. A more prudent risk investor, such as ourselves, would also say yes but caution this should be considered over a longer term horizon such as one to three years.
For both of these investor types, it is important to consider two key criteria:
- Timeframe: should factor in catalysts for change including risk/return and appetite for broader risks.
- Starting point considering the position of emerging market (EM) equity fundamental and valuation supports.
Timeframes: To buy or not to buy
Any hope of analysing the situation involves a working assumption of the dynamic rate of change (the “delta”) of the catalyst driving this sell off; in this case, the rate of infections and the fatality levels.
Over the shorter term, such as one to three months, this is a more tricky call. Gently adding risk, such as via quality technology plays, would be an option over the next month. This would involve accepting the risk that it may be too early and a further drawdown of capital (10%+) could occur, especially if a scenario such as a US major quarantine event took place. Such an event could well trigger a short-term US recession and would also raise the likelihood that President Trump faced a serious challenge during the third quarter US election. Nonetheless, a market low is widely expected within three months (as discussed below), the outlook could be bright for an investor amid a V- or U-shaped economic scenario. In this light, we believe liquid, quality risk assets should be bought into this weakness. Depending on your favourite scientific forecaster, and based on the present rate of increase, the real impact of the virus could be at its zenith in Europe / US within 90 days. The China parallel is a lead indicator here, but its effective containment needs to be taken into the context of a ‘command’ economy and may not be as likely in a democracy. Nonetheless, a mixture of policies of containment and delay (and the arrival of spring / summer in the Northern hemisphere), are all likely to help.
However, should a further variable open up, such as discounting political change or a US recession, then further downside and a longer waiting period before taking more risk would be wiser. Portfolio construction issues and husbanding a risk budget for a better time would be the order of day – ie wait to spend your dry powder for a little longer. In this situation, more clarity would be needed before seeking to exploit these solid fundamentals and fair to low EM valuations.
One way of assessing risk / return is to assume
Firstly, the arc of Wuhan infections and subsequent decline is paralleled by other countries operating containment / quarantine strategies. The assumption is that the containment is equally effective (although possibly less so in non-command economies). On this basis, Italy seems to have started off a little more quickly than Germany / France / Spain, but it is reasonable to think that timelines will be similar. The below chart has been calculated with a one week lag and Italy upsized to match the German / French / Spanish populations. If this assumption is roughly correct then the peak infection point could be within the next 90 days – and the inflection point in the market could be the point at which the rate of increase slows – ie within the next couple of months.
Chart: New daily COVID-19 infections in Italy versus Germany / France / Spain (1 week lag)
If the above scenario is wrong, then we would look for further support other than fundamentals / valuations and policy response (both monetary and fiscal). Such support would be provided by the possibility / increased probability of a vaccine being available within 15 / 18 months. In our view, this is a reasonable probability. Hence, prolonged market weakness throughout summer 2020 could soon give way to discounting and a “potential relief rally at the end of 2020” in anticipation of such an outcome.
An interim summer sell off is always possible, with further 10+% downside possible should the following potential list of negatives unfurl:
- Panic, a self-reinforcing economic negative, as it primarily forces short-term economic collapse amid moves to protect elderly and more vulnerable parts of the population.
- A major quarantine announcement of a major US state / city.
- Further risk off leading to any of the following
- Positive carry trades unwinding (for example South African rand / Brazilian real / Indian rupee / Russian ruble / Mexican peso).
- Liquidity reversal exacerbated by passive structures now being over 50% of all EM flows.
- Fundamentals deteriorating as top line growth slows / halts and operating margins fall.
- Credit quality deteriorates and forced capital raisings dilute equity holders.
- In structurally challenged markets, either capital controls or material currency weakness appears (for example Turkish lira / South African rand / Argentine peso).
In this second scenario, we would expect to see some more recession-orientated downside (as implied by the yield curve and credit markets), followed by a floor and a V-shaped recovery for risk assets within a six month to one year time frame as the market tends to discount six to nine months in advance.
EM equity fundamentals and valuations are still supportive
In a wider context, EM equities remain an investment laggard, eight out of 10 top EM equity markets are still investment grade and we believe these assets still appeal to value, GARP and yield investors. Assuming no major containment quarantines take place, we believe valuations are not expensive and the consensus growth expectation is circa 14% (+/-minus 5%).
With this in mind, even if we encounter a recession in developed markets and EM growth slows to 3-4% levels, EPS growth could reasonably be expected to fall to 9% at worst. That would still imply a forward PER of 12.8 for 2021, which is still attractive in our view. Furthermore, with stronger balance sheets and deleveraging measures in many markets, the resilience of the EM consumer and corporates is stronger than in prior cycle lows. It is useful to remember that the legacy 48% of the MSCI Index weight to materials and energy (five years ago) has fallen to a mere 11.8% in the present index composition.
Positive policy response
An additional positive should come from positive policy moves. We expect to see policymakers follow the regular playbook of helping to cushion demand shocks and ensure ample liquidity is available to the banking system as credit stress rises. In this regard, recent actions taken by the US Federal Reserve (Fed) and China are providing important leadership. We expect to see a broad global monetary and fiscal policy response take hold in the coming weeks. Indeed, we now look for the European Central Bank (ECB) to lower policy rates 10 bps shortly and step up the pace of its quantitative easing purchases from EUR 20 billion / month to EUR 40 billion / month. The Fed is now expected to lower rates 100 bps to the lower bound at its upcoming March meeting and the Bank of England has announced a surprise 50 bps cut. However, given the unique nature of the shocks facing the global economy, and the limited firepower available for rate cuts, we believe a more creative and broad-based policy response will be required to avoid recession.
If the situation was not complicated enough already, there are a host of other fundamental issues to consider including the oil price dispute, the immigration standoff between Turkey and the European Union as well as debt in Lebanon and Argentine restructuring.
Opportunity to buy attractively valued quality stocks
An old adage springs to mind here – out of adversity comes opportunity. Without seeking to minimise the human tragedy of current events we believe it could be opportune to gently start picking up mispriced assets in the near term, as outlined in the first scenario, focusing on our philosophy of buying quality cheap. We believe it is also pertinent to start positioning for change – asset prices in EM equities are not likely to remain at these levels if any of the current virus / oil shock headwinds start to abate. However, we reiterate our second scenario where timelines may be pushed out longer term. We intend to focus on global growth opportunities, especially those with secular stories such as dynamic Random-access memory (DRAM) semiconductors and NAND memory plays, as well as other long-term themes such as urbanisation (the increasing appetite for protein among the growing EM middle class), the aging global population and developments in healthtech. EM equities have outperformed developed markets in recent weeks and, given higher expected earnings growth and attractive valuations we favour EM equities over developed market stocks. An added positive for EMs could also be further US dollar weakness over the medium term, given the Fed is likely to cut rates by more than the ECB, meaning the long-held US yield advantage could shrink. It is also worth pointing out some changes driven by the virus are very supportive of ESG themes – air travel is declining in favour of video conferencing and businesses are implementing wider use of flexible working patterns. We are currently in the middle of stormy times, but it is important to remember that every cloud has a silver lining.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. March 2020