Apr 3, 2020
The virus has spread further and faster than expected, which has resulted in governments severely curtailing economic activity to attempt to contain the outbreak. This ‘switching off’ of economic activity across the world has been a significant driver of stock market weakness. However, the major bright spot here – certainly in an emerging market context – is the recovery of China from the virus.
The Chinese economy has recovered to roughly 80%-85%% of normal capacity. However, future progress may not be smooth. There is a risk of stop-start cycle where economic activity picks up after a suppression of the virus, and then an increase in infection rates follow given the economy is up and running. We are yet to see what trigger point would cause the Chinese government to halt activity, but broadly speaking, China has held up well. Potentially, we could see targeted stimulus, encouraging consumers to buy particular items. Companies such as infant milk formula producer China Feihe, auto manufacturer Geely and sportswear
Looking at other EM equity markets, it is clear that Brazil, with its significant exposure to commodities – namely steel, iron ore, paper and oil – has been severely impacted by the slump in prices. Earnings for these companies will be under severe pressure this quarter and beyond, only partially offset by the approximate 20% fall in the Brazilian real in the year to date.
Performance of the more domestically oriented sectors, dominated by banking, will depend on the spread and longevity of the pandemic in Brazil. Near term, however, this will take time to impact credit quality in the bank sector and impact profits. Politically, the response to the virus has been slow, and it is difficult to have clarity surrounding the outlook for corporate earnings. In our view, there is a strong possibility that interest rates will be increased to help support the currency.
The virus has not escaped the second-most populous nation, either. India has announced a nationwide lockdown to halt the spread of the virus, however the country entered the pandemic already in a precarious economic position and GDP growth forecasts for the country have been cut, which has led to significant outflows from equity markets. On a more positive note, Hong Kong and Taiwan have shown signs of recovery, in part due to the stabilisation of the outbreak in China.
In the past three months, emerging market equities have fallen 30%, making this the fastest market decline in history, and close to 1929 and 1987 in terms of the speed of the fall. Looking at other bear markets – in particular the Asian financial crisis of 1997/98, the end of the dot-com bubble and 11 September attacks in 2000/01 and the global financial crisis of 2008/09 – the peak-to-trough declines tend to be around 50%, but over a 12-month period.
The only exception to this rule is 1987, where the market fell 50% over only three months, and then recovered strongly. Therefore, while we believe we have seen the worst of the falls already, we expect several months of very volatile stock markets before they settle down and bottom out. One positive is that from the bottom, emerging equities bounced between 40% to 115% over the next year after all four bear markets, so the patience of staying invested is eventually rewarded.
Although the recovery is so far proceeding slowly, it appears that China and South Korea are through the worst, while infections continue to rise in the US and Europe. For this reason, it is quite possible that some emerging markets offer more defensive exposure currently than developed markets. The US could enter recession, while we believe the dollar’s strength is likely to be near its limit. EM interest rates will likely be maintained to support currencies, and while the coronavirus has caused a significant negative shock to EM growth that will likely impact the next few months, the effects are not likely to stay over the next few years, in our view.
In our 4Factor Emerging Market Equity Strategy, we have thoroughly assessed the balance sheets of our holding. Many of our companies have net cash positions, while we have maintained a focus on assessing liquidity positions. We believe there are resilient opportunities in technology, which is broadly defined as e-commerce, internet gaming, semiconductors, hardware manufacturers and the like, given strong structural dynamics supporting growth of these companies. More electric cars mean more semiconductors. People will continue to upgrade their phones, while telecoms will continue to invest in 5G. In fact, the coronavirus and its associated impacts, including social distancing and homeworking, might actually accelerate certain secular shifts over the medium term to anything online, such as banking, shopping, advertising, alongside cloud and data providers.
Highly defensive consumer staples companies such as food, life assurance, electricity and telecoms also offer opportunities, as do some cyclical stocks, which could benefit from a rebound given many are trading at very low valuations. Some of the impending earnings weakness is not yet reflected by consensus estimates, however in 4Factor, we are considering this when assessing companies. The structural earnings potential in emerging markets remains intact, in our view, and we are confident that our consistent and repeatable process to assess new and existing opportunities will help position us to navigate these choppy waters.