Emerging Markets: Looking Forward, Cautiously and Selectively
Success in EM investing requires recognizing how companies and countries are evolving during the COVID-19 pandemic. We assess market liquidity, corporates’ flexibility to change and valuations to identify opportunities.
We expect the unprecedented breadth and scale of the global policy responses to enable economies and financial markets to recover in time. Indeed, the gradual reopening of economies in China, Taiwan and other geographies is encouraging. Yet, we know the COVID-19 pandemic will have a lasting impact on the structure of the global economy and especially on emerging markets (EM). A new normal is emerging and we are diligently evaluating how EM countries and companies are responding to the crisis to understand where new opportunities lie.
Adequate Global Liquidity a Necessity
Adequate global liquidity is necessary for global markets to function smoothly. Globally, governments and central banks along with international financial institutions, such as the International Monetary Fund, have acted swiftly in the face of the pandemic crisis. Governments are using both monetary and fiscal policies to cushion the adverse impact on their economies. The US Federal Reserve continues to play an important role in providing US dollar liquidity to the world, and open spigots have helped improve liquidity, not necessarily to pre-pandemic levels but certainly to levels better than the crisis lows. Adequate liquidity (plus slowing rates of infection) in turn has helped reduce market volatility.
Policy Flexibility Separates the Strong From the Weak
We tend to speak broadly about EM, but it is important to recognize that individual countries within EM are vastly different – the pandemic will hit some countries harder than others. Differences across countries include the size and age of populations, the quality of health care, the structure and credibility of government institutions and fundamental drivers such as the strength and quality of economies. It should be remembered that the oil price crisis will hurt oil producers and exporters but will help importers. Besides, some EM economies are more exposed to global trade than others and some others were in better fundamental economic position even before the crisis, giving them more policy flexibility.
Importantly, the policy response of each EM country will have an impact on that country’s ability to recover from the current crisis and deliver sustainable economic growth in the future. Rate cuts and extraordinary monetary policy measures as well as increased government spending may help boost economic growth this year and the next, but they come at the cost of higher debt and deficit levels and possibly higher inflation. These costs may impede a country’s ability to deliver sustainable longer-term growth.
In this context, we favor macro conditions in countries such as Russia, Poland, South Korea, Taiwan and China. Each of these countries has adequate policy room to cut rates and increase fiscal spending to cushion the economic impact on its economy. Countries such as China and South Korea, which were among the first to be hit by the COVID-19 outbreak, may be the first countries to recover. Russia is getting hit by both the virus outbreak and the oil price crisis, essentially a demand shock compounded by a supply shock. But the country has a proven resilience to crisis, and going into this set of crises, Russia was in good fiscal shape with increased monetary policy credibility. On the other hand, countries such as South Africa, Turkey and Brazil are less attractive to us.
Recognize New or Reinforced Investment Themes
There is a possibility that trends such as deglobalization, including bringing production or supply chains to home countries, and increased trade tensions may get reinforced. Themes such as automation and disruption may become more dominant. Sectors such as IT – semiconductors, digital media, gaming and mobile – as well as consumer discretionary – education services and ecommerce – which were trending before the virus outbreak, should continue to perform in a recovery as the crisis should reinforce the demand for advances in technology, internet, mobile gaming, online education services as well as online shopping and food delivery.
Some Key Risks
As always, opportunities must be weighed against risks. The pandemic may also strengthen the demand for onshoring. The increase in trade tensions over the past few years had already prompted some companies to bring production back home. The virus outbreak may strengthen this trend as many countries and companies reevaluate the supply chains of various critical products. Geopolitical risks may also rise as countries look to place blame and seek retribution for the damage caused to their economies.
We all know a strong US dollar creates a headwind for EM even in the best of economic times. However, US dollar strength caused by a global crisis, as a result of a flight to quality or a ‘risk-off’ stance, has the potential to create unprecedented turmoil in EM economies. In this context, as part of our process, we will be looking at relative value and building that into our thinking about opportunities/risks for the underlying stocks we are considering.
A crisis could often also create opportunities for investors as indiscriminate market declines push good countries and companies to much lower valuations. Lower valuations on quality countries and companies should prompt investors to put sidelined cash back to work at depressed levels, creating a market environment where prices become more differentiated and investors are better compensated for risk. Quality countries and companies with credible and transparent polices and business models will be best positioned to deliver sustainable growth and fare best in the long term.
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