I agree with most investors that COVID will be transitory, and my position has not changed.4 We’ve likely seen the depth of the impact (March 2020), but we still aren’t sure about the duration. This is the one area where investors need to pay careful attention. The ”end” would come about either through a successful vaccine or treatment regime, which would likely provide fuel strong 2021 growth. To be blunt, we could see the ”mother of all” V-shaped recoveries if pent-up demand and economic stimulus both get traction at the same time. Personally, I think the current rosy 2021 EPS growth estimates (e.g., more than +35%)5 reflect an inertia among analysts, who are waiting for more company guidance in the September/October timeframe. However, a successful health regime could begin a powerful synchronous global economic recovery, the likes of which we last saw in the post-GFC timeframe. Earnings in this environment could mirror what was delivered in 2010, i.e., increasing 23% year over year.6
A final reason for optimism here would be the impact of the US dollar. The USD rallied sharply due to fear, the flight to quality, and, in general, tighter liquidity conditions. So, it makes sense that the recent weakness is just an unwind, as market conditions improve and fear subsides. But so far, the dollar weakness is about Euro strength, and EM currencies aren’t that well bid given their very low real rates and experiments with QE. A reversal, or normalization, of EM policy would be very supportive of EM FX in an environment of global synchronous recovery.
What about de-globalization? There will be some regulatory response, perhaps in areas deemed critical (pharma, PPE, some tech components), but we have ”crossed the Rubicon” in terms of globalization. The dynamics of major supply-chain onshoring will be costly, and there will be many other bills to pay for the COVID pandemic response. This is low on my list of worries.
As we head into the fourth quarter of 2020, State Street’s EM Small Cap strategy continues to carry an overweight to China, South Korea, and Taiwan – large Asian markets that offer the most breadth, liquidity, and sector diversification in the EMSC universe. These are also the countries that have met the challenges of the pandemic, both from a health and economic point of view. They will be best positioned for the medium term. This overweight is funded by underweights to Latin America and EMEA. From a sector perspective, the portfolio has long exposure to Health Care and Information Technology sectors, and underweights to Financials and Industrials.
We continue to keep an eye on cash generation and leverage in our portfolios. Some companies in the Latin American transport sector have high debt and no customers. They have rallied alongside all risky assets, but these are names that remain on the precipice.
A final reminder for investors is that idiosyncratic risk and trading costs are likely to remain high until we see the backside of COVID-19. The secondary and tertiary impacts on the macro and micro fundamentals are going to create both real and paper tigers. Even though the market has come back, it is hard to call this environment “normal.” It is important to partner with a strong manager to help guide you through this period.
Risks to Recovery
In closing, having already seen one “swan” this year, I would be remiss in not listing three risks that could potentially alter the scenarios I have outlined:
- COVID remains a headwind, pushing out recovery to 2022 or later Vaccine trials disappoint
- The fiscal/monetary policy response loses traction. Gold goes to $3500, US rates go negative, deflation sets in
- COVID health challenges are addressed in developed markets, but they linger in poorer ones