27 March 2020
The current market sell off is presenting opportunities in a number of areas of emerging markets. However GAM Investments’ Tim Love issues a note of caution and says much could depend on finding a vaccine for coronavirus.
We believe wild swings should soon give way to rational thinking post any zenith in the US / EU virus infections / quarantines / emergency declarations. In our view down markets will soon be viewed as opportunities missed versus acceptable short term “risk–off”.
In short, this sell off could be used to continue to rotate to higher quality more cheaply in line with both top-down (currency, implied volatility and credit issues) as well as attractive stock valuations relative to its own history on bottom-up fundamentals. We believe this combination of disciplines reduces the risk of being wrong, should macro factors swamp bottom-up alpha factors short-term.
In the short term we favour:
- High quality opportunities in online education, cyber security, NAND and DRAM plays.
Secular longer-term opportunities, which we believe are offering excellent long-term entry points:
- Brazilian banks, Russian steels
We believe the better risk / return opportunities may lie in:
- Liquid higher ESG scores.
- Investment grade or oversold top positive carry trade currencies – BRL / Mexican peso (MXN) / Russian ruble (RUB).
- Positive free cash flow or positive working capital plays.
- Value / commoditised technology or steel tilt (DRAM, platinum and potentially oil).
- Higher-yielding stocks with high credit scores.
Key drivers for a first interim sustainable move are beginning to be in place – though US infections continuing to climb may push this back for a week or so. Mid-cycle consolidations normally occur at 12-18 months – this could be quicker given the virus dynamics ie infection rate falling sharply within 30-60 days.
1) Virus – at high alert in key developed economies markets – tick/good.
The risk is that US infections will continue to climb sharply near term, bringing near-term volatility.
2) Policy support – all key central banks have announced significant measures aimed at short-term liquidity (more than rates) – tick/good.
A short-term cash crunch is the key risk being averted. However there will be defaults, leading to near-term volatility.
3) Valuations – fully discounting growth air pocket – tick/good.
Earnings air pockets are likely to cause volatility, but on normalisation we believe 2021 could shape up to be strong. That is assuming a growth rate of 16% which may well sound high – but is a CAGR of forward two years. That “look over the valley” approach in effect neutralises growth for 2020, but discounts a normalisation in 2021. We still maintain that emerging market (EM) equities is one of the most attractive laggard relative asset classes, as it has not yet rallied past its 2007 highs. Furthermore, it is not over owned, over loved or overvalued. It is the most attractive relative investment grade equity asset class in our opinion on GARP / value or “search for yield”.
4) Positioning – fully shaken out – tick/good.
Capitulation moves as double circuit breakers imply panic plus high yield volume outflows. Even gold’s fall over the last few days is due to liquidity fears and selling gains. Note that EM equities are a fast way into playing new economy plays as their command economies or oligopolistic positioning has hastened the easier, earlier adoption of new technology versus developed market (DM) counterparts. This is especially so in China. The composition of the EM index has materially changed in favour of new world economy stock positions. This has a double plus, as dollar strength (a side effect of risk off), has less negative knock on to EM equity indexes. Today, materials and oil make up less than 9% of EM indexes versus 48% five years ago.
5) Risk downsides have been less or equally severe in the overall EM equity market than DM indices YTD.
This is a change to historical norms. As EM equities benefit from being an investment grade laggard, with materially less debt / GDP than DM markets, the resultant downside has not been a beta multiple of DM markets. However, equally interesting is the potential upside being materially more on any rebound – as was illustrated in 2017 versus DM markets. As such, an appealing risk return is developing in EM equity assets going forward 12 months.
Interesting further thoughts:
- The nature of the MSCI EM Index has become more “China heavy” in the short term as China has benefited from government support and from non-China country falls being disproportionately more dramatic – ie Brazil / Russia. Until these reverse, or China devalues to retain competitiveness, the MSCI EM China weight has crept up to 37.8% neutral.
- Materials (at 3.24%) and energy (5.63%) are now a combined single digit weight of 8.87%. hence becoming a lot less dollar and positive carry trade sensitive.
- Information technology (17.17%), financials (22.89%) and services (12.72%) in combination make up circa 52.8% of the index; domestic-orientated fintech and DRAMs being the largest component.
- The oil wars are adding volatility to the market. If oil is to remain low, even post a virus vaccine, then Russia should rebound less than Brazil and other non-oil exposed markets.
Last, a note of caution
However, more caution is required in the short term before fundamentals reassert themselves. The probability of a self-reinforcing negative feedback loop is increasing in the short term. This could not only lead to a recession being fully discounted in the S&P 500 (SPX) (say 2400 minimum on any dividend discount (DDM) or Federal Reserve model), but possibly more.
A recession would equate to a normal cyclical bear market pulldown (circa 25-30%). However, a secular or structural bear market could be one further oversell leg lower, say 45% ie circa 2150 for the SPX. Such a trigger to move from one camp to the other would include a strategic imbalance such as a black swan, for example overly zealous coronavirus containment measures, a liquidity event leading to a bankruptcy exacerbating a sell off, or a deleveraging-driven credit event (exacerbated by large ETF holdings and the higher oil company weighting in BBB credit universes).
The most likely weak links in any risk off chain would be liquidity reversal. The remarkably small market capitalisations of select EU financial institutions are coming into focus. Deutsche Bank and Societe General market capitalisations are circa EUR 10 billion each. Furthermore, sovereign wealth funds are pulling back funding to select hedge funds who are therefore in a material deleveraging mode. With volatility high, unwinding any hedged fund book so dramatically will surely be painful. Additionally, the size of debt rollover and re-financings in several levels of global debt markets, (not least mortgage-backed securities), coupled with sovereign bond stresses with Italian bond yield spreads over bunds materially widening, as are Italian CDS levels to 292 levels (18 March), higher than credit crunch highs, are a long way to the EU banking crisis’ 2011/12 highs of 500.
A further twist is that A1 and algorithm-based trading is the majority trader in the market nowadays and the fact the ETF funds are so heavy a weight versus active funds is further likelihood that a liquidity event will be more unpredictable this time round.
These could all be examples of events leading to unintended consequence acting as possible negatives, which then become realised negatives.
So, with 24 hour media events cajoling all politicians to act in a seemingly homogenous manner (despite local differences in coronavirus points of infection, local healthcare risk / resources and local weather expectations), it seems the economic impact will likely be harsher, at least in short term.
Unless the size of any global combined fiscal and monetary policy response is commensurately larger, then the morbid focus on short-term US / EU fatality rates will dominate headlines and add to risk aversion. Therefore, short-term “fear” may well get the better of “greed” ex sizeable “shock and awe” policy response.
As such, given the risk of a short-term economic crevasse, it might be wise to consider taking down a little sail, but keeping to the same course. Within the next month, a better risk return should emerge. And one where liquidity, credit knock-on risk and oil price collapses are more clearly absorbed into market fundamentals / valuations.
We are not quite at that point of clarity. As such, a little more prudence is required before exploiting this entrance point into quality long-term assets. Nonetheless, we do expect that a year from now we should be materially higher. The question for us at present is risk budget and entry point.
The real has historically been perceived as a carry trade currency and, therefore, home to the most volatile / short-term investment monies. Despite the positive carry trade opportunity all but disappearing at year end, the market still treated both Brazilian equities and currency as risky assets, to be sold and shorted heavily in a scenario of risk-aversion expansion. This seemed odd to us as – by the end of 2019 the Brazilian real (BRL) carry trade was near to non-existent. By the end of 2019 the Selic (Brazilian federal funds) rate had contracted from 14.25% (in 2016) to 4.50% (it is currently at 4.25%). With inflation running near 4%, real rates were near zero, supporting our view that Brazil was not home to substantial carry-trade investments anymore.
So, why did Brazil collapse in the current risk-off spike? It is hard to explain:
- As we mentioned the perception that Brazil and its currency are risky assets to be sold fast if risk-off periods prevailed.
- An exaggerated noise about the impact of delays on reforms due to disagreements between Congress and the president / economics team. In our view the most critical reforms have been approved – namely the structural reform on select social security reforms. This was the reform that would have eventually bankrupted the government had it not been approved. The remaining reforms will be useful, but are not anywhere as critical.
Brazil was further heavily hit due to the systemic risk associated to the unprecedented oil price moves. Oil prices were caught in an unusual critical storm from both the demand and supply sides of the equation. In our analysis, Brazil is unfairly hit on this basis, as it is still a net oil importer and is misunderstood on this issue. It is a neutral on external oil prices, but the perception, especially in currency markets, is that it is a beneficiary.
Together, the reform passage slowdown, oil and positive carry association (albeit wrongly so), plus further modest Selic rate cut YTD, led to a “risk-off” environment, that was enough for a remaining liquid currency in the so-called “oil sensitive / positive carry” space to fall further. We believe this may be an opportunity to exploit – not to run away from.
We believe it may be time to start drip feeding assets into EM equities in the next few months as the time to a vaccine narrows. We also believe it may be time to exploit any “crevasse” risk brought on by market dislocations; the caveat being closed exchanges in the short term. Nonetheless, unlike the global financial crisis (GFC) of 2007/8, the central bank response has been large, quick and a commensurate offset. Nonetheless, structural risks do exist (especially in the short term as investors adjust their books to the new normal), but so too does a high probability of a vaccine within 18 months. In our view, that would gap up risk assets very, very materially.
Source: GAM unless otherwise stated.
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. Reference to a security is not a recommendation to buy or sell that security.