Weekly Investment Call Highlights: Reflections on the COVID-19 Crisis from Three Seasoned EM Investors

How the current crisis is having an impact on EM, both from a health and economic standpoint

We live in an integrated world, and the number of COVID-19 cases in many EM countries is growing quickly. The most proactive countries (China, Korea and Taiwan) have quickly marshalled public health resources. Many other EM countries do not have the resources to address a challenge of this scale, and several have struggled to respond. The economic situation is just as worrisome as the healthcare situation. On average, EM countries are likely to suffer more economically than developed markets (DM). EM countries are unable to provide the same degree of QE-backed fiscal stimulus, are less able to distribute stimulus (especially in countries with large informal economies), are hit harder by the oil price collapse and face additional funding pressure given high debt levels, a strong dollar and capital flight.

Issues that are top-of-mind for EM investors

Investors are growing concerned about the long-term EM growth model given supply chain pressures and other factors. More broadly, all investors are trying to figure out the depth and duration of this crisis, and how to properly value companies in this environment. We expect EM earnings to be down by around 15% this year (the bullish case); with a more prolonged downturn we might see a 30% decline in earnings (the bear case). One piece of positive news is that China, Korea and Taiwan make up about 65% of the emerging market index. Overall, current market conditions warrant caution, but historically these types of conditions also create opportunity.

The effect of fiscal and monetary response by EM countries

As in DM, the scale of the response in EM is historically large. Many countries have cut interest rates, introduced liquidity measures and adopted large fiscal stimulus programs. EM countries came into this crisis with some fiscal and monetary flexibility, and they are using it well. Sovereign debt and deficits are broadly manageable. The secular trend of disinflation has driven EM inflation lower alongside DM. This buys space for additional monetary stimulus. Ample currency reserves have enabled FX intervention to slow currency depreciation. Concerns about the EM response include its limited scale, compared with DM, as well as the fact that EM will have used up much of its fiscal and monetary cushion by the time the crisis ends.

How this crisis compares to the late-90s

Setting aside the pure speed of financial flows, price corrections and job losses, the situation now is better than it was in the late-90s. Widespread external debt and balance of payments crises are less likely now, particularly in larger countries. While overall debt levels are higher now than they were in the late-90s, much of that debt that is corporate rather than sovereign and a greater proportion is local currency denominated. In addition, in 2020 EM occupies a more central role in global supply chains than it did in the late-90s. This means that the rest of the world cannot simply abandon EM production overnight.

How this crisis compares to the GFC in 2008-2009

Again, setting aside the pure speed of financial flows, price corrections and job losses, the situation now is worse than it was in 08/09. Today, EM debt levels are higher and EM growth is weaker going into the crisis, i.e., there is no ready source of high growth going forward. Prior crises, though they came as a shock, were at least reasonably well understood – there was a playbook on how to deal with them. This is different, and the wide uncertainty of potential outcomes have forced major price adjustments over a short period. Of concern is also the fact that EM has lagged in the recent rally. From the March lows, EM equities are up about 20%, while DM equities have risen 25%. This is atypical, as EM often leads on the upside. Lastly, going into 2008 we were at the tail end of the EM super cycle, with many investors heavily positioned in the space. This is not the case now – EM positioning is comparatively light.

How EM Debt (EMD) has fared

Outflows in EM bonds have been the biggest since 2004; US$30 bn has been pulled out of EM bonds this year. The EM local currency
(LC) universe returned -15.2% in Q1, which is its worst quarter on record. Similarly, the EM US Dollar (USD) universe returned -13.4% this quarter. The sell-off by any standard has been extreme and quick. Given the outflows, liquidity has simply disappeared in EM USD markets as there have been absolutely no buyers in many bonds and issuers.

What EM trading is like in this environment

Mid-March was extremely difficult, with bid-ask spreads 5-10 times December and January levels (at their worst). We were able to get trades done but had to pay a high cost and execute with an abundance of care and patience. That peak stress only lasted 3-5 days. Now, liquidity is stressed but costs are only in the region of 2-3 times normal levels, and it is easier to execute larger trades without moving the market. Trading in the large cap segment has been functioning with only a modest to moderate increase in expected transaction costs. The Korea, Taiwan and China markets have been operating quite well. Bond bid offers for LC
doubled during March. Bid offers for EM Sovereign almost tripled to 1.9%, while those in EM corporates quadrupled to about 2.5%. In the case of US dollar debt, there were just too many sellers and too few banks/dealers with balance sheets to absorb the flow. EM LC was well-behaved, as there were enough domestic buyers, and domestic debt was perceived to be a safer asset than the falling EM equity markets.

How the crisis will impact DM/EM supply chains and globalization

There will be an accelerated rationalization of the global supply chain, which began 7-8 years ago and picked up steam during the US-China trade dispute. This rationalization will include growth in automation, diversification of production sources to insulate firms from regional shocks and on-shoring or “near-shoring” to lower-cost EM producers. It is almost a cliché to say that global co-ordination needs improvement after a major crisis, but it is clear now that some threats do not care about lines on map. There will also likely be a trend for many countries to attempt to be self-reliant on core supplies and products. That said, while globalization may take a hit in few strategic sectors, the broad trend will likely continue.

What fiscal expenditures and the rise in debt will mean for EMD total returns

Total debt issued by EM countries stands at US$23.6 trillion. Of that, China alone accounts for US$11.6 trillion and the top-5 countries (China, India, Brazil, S. Korea, Mexico) account for 74%. Too much debt is being issued in the bigger economies, and that is a trend in EM and DM. 74% of this debt has been issued in last five years (2015 onward) and 82% of this debt will mature in next ten years. The good news is that there would not be a long debt overhang, but the bad news is that this debt has to be either paid away or inflated away. Also, for the top-5 countries cited previously, debt-to-GDP will be about 87%, which is not out of context in a world where some countries exceed 100%. Lastly, as more countries need to issue debt, it opens opportunities for investors to move away from the bigger, increasingly indebted countries. More countries with higher yields will likely be coming into EM indices, which will likely be a return driver for the future.

Whether LC or HC debt is preferable; FX opportunities; US dollar’s trajectory

The dynamics for EM LC look better compared to hard currency (HC) debt. HC spreads look good at current levels but so do local FX valuations. And local curves have largely steepened – there is some term premium to be earned. We favor LC over HC but would also think about adding to both on dips as the crisis plays out. Regarding FX opportunities, the basket of currencies in JP Morgan’s GBI-EM index is near 20-year lows relative to fair value. That is cheap enough to begin to think about accumulating, but it is important to be selective. We have not yet reached a point where one should just buy all EM currencies. A weaker dollar would help EM assets show stronger relative returns as EM corporates and sovereigns rely heavily on dollar funding. A weaker dollar eases financial conditions and amplifies growth. Of course, a weaker dollar also increases returns relative to US assets simply because of the currency mark-to-market effect. The dollar should fall, but for it to fall steadily we would need to see some degree of natural recovery from the coronavirus recession. Once that happens, a weaker dollar should super-charge an EM asset recovery and a rebound in EM currency.

Whether value is emerging in EM

While valuations are tough to pin down since estimates are flying fast, the US market is probably trading at a 19x multiple. If we discount EM earnings by 30% – the bear case – we are only at a 13x multiple. Historically, EM has traded well on large-scale global stimulus, given its cyclical characteristics. We would not expect this time to be different. The sustainability of outperformance gets us back to the question of whether companies will broadly be able to improve their margins and their ROEs. The durability of a rally will depend on this. A rise in supply chain capex will be helpful in this regard.

Why EM equity performance still seems to be driven by old world factors, e.g., US dollar, commodities

EM is still a pro-growth and pro-risk asset class. Higher commodity prices are generally associated with a faster pace of global growth.
A softer US dollar suggests that risk appetite is back, global liquidity is abundant, and US dollar borrowers should get a reprieve. Finance 101 reminds us that FX and rates affect equity market valuation –and they still cling to the old order.