Emerging markets were on the cusp of something very big at the beginning of the year. People around the world were continuing to join the ranks of the middle class, helping build consumption economies. China was licking its wounds after a trade war and seemed poised for rebound after a trade deal was signed with U.S. President Donald Trump. The MSCI Emerging Markets Index had risen 18.4% in 2019. The International Monetary Fund predicted a 4.4% growth in emerging economies this year. To some minds, the fact that most of the world GDP growth has come from these economies—and the fact that they make up a fraction of the big indexes and market cap—showed a huge disconnect that smart investors could take advantage of.
Then came Covid-19. In just a few days, the pandemic made the world markets sick, forced people to stop gathering in restaurants, stop flying, stop going to movies, stop construction. Millions of migrant workers were stuck in cities far away from home in India. As global poverty estimates have risen, people who had just entered the middle class were likely suddenly wondering about having to re-enter the middle class.
According to the Institute of International Finance, $83 billion in funds flowed out of emerging markets just in March—a combination of Covid-19’s chilling of the economy and the shock in oil prices. An April 9 report said, “Since January 21, our high-frequency daily tracker shows portfolio equity outflows of $72 billion and debt outflows of $25 billion.”
Portfolio managers’ disquiet over the King Midas in reverse story admit it’s been an excruciating year so far.
Rishikesh Patel, portfolio manager of the BMO LGM Emerging Markets Equity Fund, says all the tailwinds that have spurred emerging markets’ long-term growth opportunities have now become serious liabilities—the poor infrastructure, underdeveloped health-care facilities that can get overwhelmed, a low penetration of goods and services. India, for instance, has seen a shortage of ventilators and hospital beds, according to a Brookings India report.
These markets “are going to be hit, there’s no way to sugarcoat this,” Patel says. “And if you add the oil price correction, then some of these oil exporting countries are going to get significantly impacted.”
Even in emerging market countries, however, there’s a division of haves and have-nots. Asset management firm GMO said in a recent white paper that emerging market countries were divided into two camps—those with better bearings to handle the crisis and those without.
“About 60% of the MSCI EM index comprises countries that rest in what we define as a ‘safe cluster,’” said the GMO mid-April white paper, penned by Amit Bhartia, Tiger Tong, and Uday Tharar. South Korea, China, Thailand and Taiwan get good marks for their strong health-care systems; their response to the pandemic, including massive testing and early lockdowns; and for their ability to respond economically with stronger government finances and central bank balance sheets. (South Korea has about 12 hospital beds per 1,000 people, India only 0.55, says the World Health Organization.) Turkey, Mexico, Brazil, Indonesia and Malaysia also greatly suffer by GMO’s comparison. Though Russia has the albatross of oil around its neck, it’s won high marks from these analysts for its virus response.
Bart Grenning, manager of the TIAA-CREF Emerging Markets Equity Fund (at Nuveen), says many of these countries don’t have the fiscal flexibility to offer large handouts to their populations the way developed markets do. A lot of them are burdened with high fiscal and current account deficits and rely on foreign capital to fund them. When the money tide washes out, as it does in cases like a pandemic, it crimps these countries’ future policy alternatives. And the debt problems could last longer than the virus itself. The currencies of South Africa, Brazil, Turkey and Mexico have all taken headers, exacerbated by a flight to dollars and oil’s collapse. This will hurt emerging markets’ abilities to pay off external lenders, especially in a foreign capital squeeze. Brookings put the emerging markets’ external debt at $11 trillion in mid-April, auguring a coming debt crisis. This puts capital-thirsty veterans of the old “Fragile Five,” now mainly South Africa, Brazil and Turkey, on even more dangerous ground.
Louis Lau, who oversees $4.5 billion in emerging markets assets at Brandes Investment Partners, says, “So a pecking order has developed with China being at the top, which is kind of ironic because that’s where the virus started.” China’s ability to respond meant that by April, most of the country had gone back to work, he says. “The expectation is that by the third quarter, consumption could return close to normal,” Lau says.
The next tier of countries in the pain regime would be South Asian countries like India, Pakistan, Bangladesh and Indonesia. These are countries with massive informal economies—full of unregulated street vendors, barbers, washers, and repairmen—with no contracts or benefits, jobs that require physical interaction and where people live more hand to mouth. “It could be the food industry, it could be manufacturing, it could be agriculture, where it’s very difficult to work from home,” Lau says.
Latin American countries including Brazil, Mexico and Argentina suffer even more in the hierarchy because they have more debt. “Brazil is 84% debt to GDP; Mexico is 54% but they have additional debt on the national oil company Pemex that they might have to support.” Lau adds these countries also lagged in their coronavirus response. Oil-dependent Brazil saw its stock market value cut in half in dollar terms in the first quarter, its currency losing 30% of its ground to the greenback—the government debt to GDP hampering its ability to salve these wounds.
Grenning says small and medium-sized businesses employ a lot of the global workforce, and the longer lockdowns will likely have a more pronounced effect on emerging economies. But he and other managers remind investors that these workforces often benefit from having younger blood and likely healthier populations than developed markets do with their chronic illnesses—co-morbidities like hypertension, diabetes and cardiovascular disease.
He says it’s useful to remember with equities that the top three countries in the MSCI Emerging Markets Index (China, Taiwan and South Korea) represent 64% of the benchmark while the top 10 countries represent 91%. “So if you’re an EM manager … you need to get the big countries right,” Grenning says. He reminds naysayers that there’s still promise China could actually grow GDP this year even as developed markets decline.
Oversold?
Despite the pain, Mexico and Brazil have impressive, well-managed companies that have been beaten up in the crisis, Grenning says. He mentions the bank Itaú Unibanco, the mining company Vale and retailer Companhia Brasileira de Distribuicao. “On any sort of rebound for activity globally, I think there’s really outsized returns that can be achieved in Brazilian stocks.”
In Mexico, there are also good companies that have become extremely cheap, Grenning says. These include Televisa, a Spanish language mass media company that owns a hefty stake of the Univision company in the U.S., which it provides content to and gets an attractive U.S. royalty from. He also likes FEMSA, the retailer and beverage company that owns the world’s largest Coca-Cola bottler. “These are opportunities where things are very oversold and high quality,” Grenning says.
Jin Zhang, an emerging markets equity portfolio manager at Vontobel Quality Growth, says Yum China, the company that runs the KFC and Pizza Hut franchises in China, is a good example of a company with a great supply chain that had come up with robust delivery capabilities years before the virus hit. “Like everyone else, [Yum saw that its] earnings did come down in the current quarter,” he says. “It’s going to be a down year. But the earnings power isn’t really diminished. … If you look out at a multiyear horizon, the true strength of the franchise is not really impaired.”
Tom Wilson, portfolio manager for the Hartford Schroders Emerging Markets Equity Fund, an active fund that seeks opportunities in both value and quality growth, says his fund has in the past invested in e-commerce, online entertainment, gaming and fintech—but also Russian oil companies if it sees a good risk-adjusted return. The long-term arguments for India, however, still don’t look persuasive for him.
David Dali, a portfolio strategist with Matthews Asia, says his funds have been more active buying than usual. “We’ve taken this opportunity to upgrade the quality of the portfolios. Companies that have been on our watch list for many, many months but were unattainable because of their price or valuations being too expensive have come back on our radar.” Some companies don’t deserve to be down 30%, he says, adding that the worst of the decline is behind the emerging markets, including the credit spreads.
Dali says he’s been adding China, Korea and Taiwan, and he thinks they are going to continue outperforming. He likes IT and communications services and says health care is one of the best long-term thematics. Other favorites include Brazilian and Indian financials—“two groups that have been severely beaten up.”
Conrad Saldanha, portfolio manager of the Neuberger Berman Emerging Markets Fund, said the selling has been indiscriminate: “There are good opportunities on the consumer/domestic side and financials as they are severely discounted and should perform well on the recovery.”