If you ask me what keeps my mind busy at the moment, I can tell you that it is not market volatility. It is not global equities declining at the fastest speed ever seen or the S&P 500 Index bouncing back by almost 20% in the last two weeks. Markets have a way of going down and then up again. In the end, fundamentals, and more specifically the earnings, will level the playing field and determine the outcome of the game. What keeps my mind busy is trying to figure out what comes next for investors. Within equities, after the recent panic and subsequent bounce, the biggest question to ask is how to allocate our capital from a regional standpoint.
We have only seen a glimpse of what lies ahead, with the very first cuts to macro numbers and earnings revisions
Markets have a way of humbling us. We thought we had seen it all, or almost all, and then the ball comes out of left field. In the last quarterly, in the section ‘’What could go wrong”, we had mentioned geopolitical risk, but a global pandemic was nowhere near the top of our list. Kudos to Mr. Gates, who was far more prescient than us. Not that we are taking any of this lightly. No loss of life should ever be taken lightly. The tragedy that we are living in will stay firmly imprinted in our minds and hearts for the years to come.
Governments and central banks have taken unprecedented measures to deal with the coronavirus outbreak, limit its spread, and contain the impact on our livelihoods. The global economic shutdown that has ensued is unlike anything we have ever experienced in our lifetime. The restrictions on people’s movements, the so-called ‘lockdowns’, now affect more than half of the world’s population. The economic disruption from these measures will be enormous, with the flow of people and goods severely curtailed, and a global recession is all but inevitable.
We have only seen a glimpse of what lies ahead, with the very first cuts to macro numbers and earnings revisions. Earnings are a key driver of equity markets. Until now, it appears clear that first half 2020 earnings will be significantly affected around the world. However, countries that have been able to resume activity earlier than others should fare relatively better. This also explains the outperformance of the Chinese (CSI 300 Index), Taiwanese (TWSE Index) and Korean (Kospi Index) equity markets since the beginning of the selloff, as the three countries managed to tackle the coronavirus emergency and the impact thereof earlier than others, and have managed to go back to more normalized levels of economic activity and demand.
Taiwan and South Korea, in particular, learnt some important lessons from the SARS outbreak in 2002-2004 and were better prepared for another outbreak, facing even lesser economic disruption than China did. All three markets have outperformed the S&P 500 Index (in US dollars) since 21 February, although Taiwan and China lost some ground during the global rebound.
These three countries make up approximately 65% of the MSCI Emerging Markets Index. In comparison, the US, Continental Europe and the UK, where containment measures that severely affect economic activity are still being implemented, make up more than 80% of the MSCI World Index. This divergence is evident in the latest earnings revisions, which are currently far more negative in developed (-62%) than in emerging markets (-38%). It is also visible in GDP growth estimates for 2020.
Most economists that we follow still expect very modest growth for emerging markets (to the tune of around 1%), with China, Taiwan, and (barely) Korea still in positive territory. Meanwhile, for developed markets, a decline of close to 3% is now expected, with all major countries in negative territory. Of course, all of these forecasts are fluid at the moment and could continue to deteriorate. The EM-DM gap, however, is likely to remain.
So, does this mean that emerging markets as a region will outperform developed markets for the foreseeable future? It is here that lies my conundrum. Of the emerging investable universe, 65% – consisting of China, Korea and Taiwan – is back to, or in the process of, getting back to normal economic activity. Of course, all three countries are likely to suffer from a global recession but – arguably – less so than European countries and the US, which are still in lockdown. Looking at equity markets, we have had the selloff, and now the bounce. It is very unlikely that we will see a straight line up from here, and we should get ready for another correction.
We should expect more negative news: companies with refinancing issues in high yield markets, further or more persistent than expected spread of coronavirus, delays in policy response, possibly a second contagion wave. More importantly, we should also expect deteriorating fundamentals and poor earnings. Once earnings will be announced, they will affect stock performance and market volatility. And here is my conundrum: as we move into a global recession, the traditional outcome for equity markets is an underperformance of equities versus other assets classes and, within equities, an outperformance of the US stock market relative to other regions. Needless to say, this is due to the perception of the US as a safe haven and a preference for US dollar-denominated assets.
So, should we favor developed markets to emerging markets at this point, despite the differences in the economic outlook? Or are we perhaps too negative on emerging markets and should we continue to trust and follow the relative earnings expectations?
Country allocation will be an important discriminating parameter over the next couple of quarters; in fact, it will be more important than ever
The one answer that I believe makes the most sense is that we need to be more nuanced, and not simply look at EM as an homogeneous group versus DM. Country allocation will be an important discriminating parameter over the next couple of quarters; in fact, it will be more important than ever.
Favoring North Asia to the US doesn’t mean that all emerging markets will recover either quickly or soon. I am especially concerned about those countries where the policy response is proving to be rather slow (such as Brazil and Mexico), and/or where the country dynamics are such that a spread of the virus will be very difficult to contain, which is the case for India, and/or where fiscal constraints limit the government’s ability to intervene (South Africa).
‘Stay selective’ will be the name of the game, also from a stock viewpoint. Don’t think in broad strokes. Experience tells us that this is not a market to buy indiscriminately. We need to make sure that we are picking the right countries as well as the right stocks. In a rebound, the tide will lift all boats, but once the earnings impact becomes clear, we will start being able to distinguish the winners from the losers. Some companies will have more difficulties in recovering; some might never recover. We need to make sure that the stocks we hold in our portfolios can weather the current crisis. Their earnings outlook and liquidity/balance sheet risk are key aspects to monitor.
Some companies are ‘easier’ to read: companies that face bigger difficulties include those in seasonal businesses, where there are short periods for goods to be sold before these become inventory. Another example is those companies depending on complex and global supply chains that are facing disruptions. Demand may recover at some point, but supply could take longer to fall back into place. Other industries could see a significant and sudden recovery in demand, but the extent of the prior decline may have rendered them unable to operate.
Companies with weak balance sheets, that are unable to finance their working capital needs, might not survive. We are likely to see restructuring and consolidation ahead. For some other companies, risks will be less clear-cut: beware of companies that will have to do ‘social service’, such as banks, particularly public banks. These are likely to see their credit quality deteriorate. Also, beware of regulated sectors, as well as areas where taxes are low. Governments will eventually have to fill their coffers up again.
All of our investment teams have been gradually and selectively buying in the last few weeks. As long-term equity investors, we have learnt that the best strategy is to slowly and gradually pick our entry points. Picking the bottom is next to impossible, as it depends on many exogenous and difficult-to-predict factors, such as timing and content of policy decisions, and the progression of the outbreak.
Most likely, we will get another chance to buy at some point in time. News of the coronavirus spreading and the related economic impact, as well as further strains in high yield markets, could rattle equity markets further. Earnings estimates will also have to see another round of negative revisions. But we remain patient. While it is never fun to be in the midst of a market meltdown, we have learned that this is a good time to be long-term active investors.
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商号等： ロベコ・ジャパン株式会社 金融商品取引業者 関東財務局長（金商）第２７８０号
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