Beyond Covid: Quality in emerging markets
The first quarter of 2020 saw not only the biggest shock to demand in living memory, but an oil price war, to boot. I’m sure very few investors need reminding that mid-March saw markets dip to their most dramatic lows since the 2008 Global Financial Crisis in response to the global coronavirus pandemic.
Investors’ heads may still be spinning as we head into the second half of a year that has reminded everyone that the unexpected is always possible. However, as we move into the summer and beyond, we believe that there is reason for confidence among emerging-markets (EMs) investors who know where to look. In the early days of the Covid-19 crisis, there was a clear (and expected) flight to quality in developed markets (DMs). However, there wasn’t a corresponding flight in EMs. EM companies with strong quality characteristics haven’t done as well as their DM counterparts. In our view, there are several reasons for the pronounced difference in style performance between the two, including passive funds’ indiscriminate selling and strong relative performance from the Chinese market. China has led global equity markets thus far in 2020 because investors have believed that the nation is better equipped to weather the Covid-19 storm since it has already passed its peak of cases and has effectively controlled recent outbreaks. Smaller and less liquid markets have been hit harder, particularly in Southeast Asia and Latin America.
Investors view most EM countries as unable to contain coronavirus effectively and lack the ability to stimulate their economies as significantly as we have seen in DMs. This has led to a significant selloff and, as a result, EMs are now relatively and fundamentally cheap. For example, for the 2020 year to date as of June 21, the MSCI Brazil and MSCI Indonesia indexes were down about 37% and 23%, respectively. By contrast, the MSCI China A Onshore Index was posted a gain of 5% for the same period. EM currencies excluding China are now trading near all-time lows, further exacerbating the return dispersion between geographies.
However, large-scale monetary and fiscal policy support has aided the overall market recovery since mid-March lows. The U.S. Federal Reserve (Fed) dollar swap lines for EMs, for example, have helped to address demand and liquidity issues. As we move away from the initial market selloff and begin to focus more on the depth of the recession and potential scenarios for recovery, we believe that stronger or higher-quality companies will fare best.
As we move away from the initial market selloff and begin to focus more on the depth of the recession and potential scenarios for recovery, we believe that stronger or higher-quality companies will fare best.
Looking ahead, we think that robust fundamentals, namely strong balance sheets and good liquidity positions, will be crucial considerations in EMs. Companies with the financial strength to survive this period of severely restricted activity most likely will emerge in a stronger competitive position. We believe that the better-funded and capitalized companies will be well positioned to win market share from overstretched competitors, or engage in M&A activity to acquire competitors cheaply, entrenching their positions.
While we are beyond the initial market selloff and believe recovery is on the horizon, the bottom line is that there are new macro stresses on EMS resulting from of the Covid-19 crisis. The pandemic has accelerated fundamental changes in the financial-services industry, and this needs to be balanced against the significant value on offer in many parts of EMs and the still-strong, long-term fundamentals of companies in some hard-hit areas.
In our view, the best way to do this is to manage factor risk actively and recognize that recovery in the areas that have been affected most deeply will likely be protracted. We are confident this can be achieved by taking a long-term view, doing extensive research and committing to quality.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
This article originally appeared in FA Mag on July 2, 2020.