Short Term Pain, Long Term Gain in Emerging Markets
In the short-term, the Covid-19 global pandemic has given rise to material concerns about the economic health of countries across the developed and developing world. However, the virus does not eradicate the long-term case for an exposure to emerging market equities. Emerging markets continue to offer many opportunities, supported by structural growth drivers such as urbanisation and lifestyle changes. This will drive demand for different goods and services in underpenetrated markets.
Emerging markets continue to offer many opportunities
In China, activity drew to a halt in the first couple of months of 2020, which in the short-term can have a devastating impact on an economy. In March we saw a sharp rebound in activity as the Chinese economy began to return to normalcy. Of course, we must acknowledge that we live in a joined-up world, where the spread of the virus to Europe and the US will impact both supply and demand, but China provides us the evidence that there is a path to recovery.
As we move forward, the real effect on China’s economy will become evident; whilst policy makers have been relatively measured thus far. Looking ahead it is feasible that more traditional stimulus may be provided in the form of infrastructure investment.
No doubt, there will be lingering changes in demand and behaviours, and some of China’s largest companies are well positioned to capitalise on the appetite for e-commerce and home entertainment. More broadly, technological advancement will remain persistent, deriving benefits for component manufacturers across China, Taiwan and South Korea. In due course, once the disruptive forces of the virus have subsided, we anticipate the continued roll out of 5G, and greater emphasis on the internet and connectivity will become one of the permanent effects of Covid-19.
India remains a large and interesting domestic economy, but it faces some challenges. The country is behind the curve on testing for the virus outbreak, and quarantine and lock down measures have recently been announced. The scope for any large-scale fiscal stimulus is limited in an economy which was already slowing. The equity market has sold off sharply, with financials bearing the brunt of investor fears. The extent to which de-risking has taken place has been indiscriminate, with quality financials with solid balance sheets faring very poorly too. In short term, there will of course be some impact, however, we maintain the view that good quality companies remain well placed over the medium to long-term.
At this juncture the reform agendas of some of the developing world’s largest economies has become secondary to the potential effects of Covid-19. Brazil has seemingly started to falter; with high levels of government debt, and the stock market and currency have suffered heavy losses. Those losses have been compounded by the extent to which Brazilian stocks went into this crisis at relatively expensive levels. Both Brazil and Mexico - the largest economies in the Latin America region - are marred by the lack of certainty regarding government strategy for dealing with the virus, although Central Banks have sought to play a role by cutting rates and providing liquidity.
Certainly, for the resource rich Latin America and Emerging EMEA regions, the outlook for commodities is critical. No doubt the effects of a lower oil price are being felt from Colombia to Mexico and from Russia to Saudi Arabia. The oil market unravelled as discussions between Russia and Saudi Arabia broke down and the demand shock given Covid-19 began to take hold. In the short-term we could see oil decline further before stabilising in the medium term. The implications for oil producing nations are very different. Here Russia can weather a significantly lower price than Saudi, however, we would anticipate that such a material decline in the price will drive the need for pragmatism and bring stakeholders back to the negotiating table in time.
In the interim, Russia has a strong balance sheet and low-cost production, making it the most resilient to these tough conditions. In the Middle East, the situation is more serious. Across the Gulf Co-operation Council (GCC) currencies are pegged to the US Dollar so there is limited ability to rebalance these economies and their respective budgets with FX devaluation. Furthermore, most of GCC countries have fiscal break-even points at oil prices close to $70 (and much higher for Saudi on a standalone basis). Here, we expect more austerity measures that will hit GDP growth. More broadly, a lower oil price is helpful to a beleaguered South Africa, however, there is leverage in the system and question marks regarding government ability to support the economy.
Central Bank activity is unprecedented, albeit in the emerging world the ability of governments to respond to the crises will be mixed. Central bank activity leads economic activity; setting the backdrop for stock markets. If we consider the attractiveness of emerging market stocks today, at a high-level valuation the market looks attractive following the sell off - on a price-to-book basis the MSCI Emerging Markets Index is trading at levels comparable to the Global Financial Crisis.
Traditionally more expensive markets such as India have seen the premium to the wider EM Asia region collapse. China’s resilience and apparent recovery mean that valuations look more expensive relative to the wider emerging markets, although in absolute terms we are not concerned. Elsewhere, we are prompted to revisit opportunities where valuations look exceptionally cheap; in markets such as South Africa, and in industries where the sell-off has been particularly punishing.
We anticipate that conditions will remain volatile and investors should anticipate that with such big dislocations it may take some time for market participants to take stock and for the dust to settle. We have long argued that despite the headlines, emerging market equities offer an abundance of structural growth opportunities, which lends support to a positive view on the asset class.
There are pockets of long-duration growth which underpin the argument for being structurally positive, with companies operating in significantly underpenetrated categories. These are attractive characteristics for the discerning investor, as these areas of the market can offer long-term sustainable growth.
Anthony Doyle, Cross-Asset Specialist, Fidelity International
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