March 26, 2020
Addressing the Coronavirus Impact: Emerging Markets Equity Portfolio
March 26, 2020
Addressing the Coronavirus Impact: Emerging Markets Equity Portfolio
March 26, 2020
In the past couple of weeks, an increasing number of clients have asked us about the coronavirus pandemic and its potential impact on our Emerging Markets portfolios. Here are highlights of those questions and our answers.
What are your views on the current environment and how does that affect portfolio positioning?
Whatever course the coronavirus takes, it is already accelerating de-globalization, which began when countries turned inward after the global financial crisis of 2008 and cross-border flows of people, goods and money slowed. Fear of contagion is likely to deepen the conviction of populist politicians who want to erect barriers to block imports, immigrants and cultural influences at the border anyway. The trend toward localization—companies looking to produce more locally, and consumers looking to buy from local brands—was getting underway and is likely to pick up speed. Perhaps most clearly, the roster of manufacturers who are moving factories out of China, in search of lower wages and a more friendly business environment, is likely to grow after this episode.
We have not made any immediate changes to the country allocations in our Global Emerging Markets (GEM) portfolio, which we believe already takes into consideration slower global growth and protectionism as the de-globalization trend likely continues for many years to come.
Our rules of the road framework has taken into account the advantages of countries which have, among other factors, cheap currencies—many of which have become cheaper with the market selloff—and low debt levels. Our country weights reflect these views.
Our portfolio has already been positioned for resilient domestic demand in quality companies with low debt capable of delivering steady earnings. The sharp oil price decline hurts Russia and the Middle East in the short term, but for other countries the effect of lower oil prices is either neutral to beneficial. India, for example, is a major importer of oil and this price drop not only helps their current account balance but also aids consumers and industries in the recovery that is just beginning after a significant slowdown during the past couple years.
We have learned, in our more than 25 years of managing an Emerging Markets (EM) portfolio, not to overreact in periods of crisis. That said, the market correction does provide opportunities for smart reallocation. The exercise we are going through is to look beyond the current turmoil and assess what we think will be the environment 6 to 12 months from now and make sure the portfolio is best positioned to be prepared for that outcome.
While we think it is important to keep portfolio turnover broadly in line with historic practice, we have been adding to some of our high conviction names where the stocks of companies we own have seen sharp price declines.
How has the current situation affected supply chains?
While the current crisis will certainly cause some temporary disruptions in supply chains, we were already positioned in part to minimize exposure to those companies particularly vulnerable to disruption in sync with our view on de-globalization, as referred to earlier.
We also think that supply chain disruptions will sow the seeds for a lot of new investment opportunities for the next decade. Acceleration in diversifying supply chains away from China—to the benefit of such countries as India, Vietnam, Indonesia and even Mexico for example; growth in e-commerce and increased penetration of online education are some of the trends that we think will present compelling investment opportunities.
Is it a good time to allocate to the portfolio and why?
While the next several months are likely to be volatile as markets adjust to disruptions, likely recession and lower growth prospects longer term, we believe strongly that select EM countries are entering this lower world growth phase with several advantages, including: weak currencies; debt reduction over the past five years—particularly at the corporate and household levels; and in many cases fairly resilient domestic demand, aided by lower interest rates, access to credit and in some countries improving real wages and rising GDP per capita.
Even before the corona-induced sell-off, EM equities were cheap relative to the US and to their own history. We believe most asset allocators are too underweight to EM equity relative to their market cap and economic capacity. After the COVID-19 drawdown, the Emerging Markets index sits a staggering -44% below its long-term nominal return trendline1. This extreme dislocation is a 2 standard deviation low and has only happened on two previous occasions since the EM index inception: in 1987 ahead of a period in the first half of the 1990s which was marked by significant reforms in many EM countries, and in the 2001/2002 global recession, which marked the beginning of a nearly decade long EM bull run (see Figure 1). As markets gradually sort out the actual implications of the corona virus, we believe that investors will reward countries and companies where growth is stable or improving, and we feel strongly that EM Equities as an asset class will become an area of increased focus and allocation.
Emerging Markets: Long-Term Deviation From Trend
Data as of March 23, 2020.
Source: MSIM, Bloomberg, Factset, Haver.
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