Emerging Markets: Wake Me Up When COVID-19 Ends

When looking at the most recent leading indicators of economic activity, a U-shape global recovery scenario is the one that has the highest probability right now. However, this recovery will not be proportional, but instead, it will be different in terms of timing and magnitude across regions and asset classes. One of the most discussed questions among asset managers and investors in recent days has been associated with when it would be a good moment to reinvest in Emerging Markets (EM) securities. This question makes sense after considering that the MSCI EM index has plunged more than 34% YTD, while the sovereign (EMBI) and corporate (CEMBI) fixed income indices have dropped nearly 20% and 30% YTD, respectively. Considering these numbers, is it the right moment to invest in EM? To answer this question, it is essential to pay attention to three criteria: valuation, fundamentals, and inter-relatedness within EM asset classes. Overall, an additional drop between 10% to 15% in EM fixed income and equities in the next 3-6 months will create a safer path to start buying.

First, if we look at valuation metrics such as the Shiller PE ratio for EM equities, or the historical evolution of bond spreads of the CEMBI or EMBI indices, these indicators are now between 1 to 1.5 standard deviations away from their fair value levels. The previous time this happened was back in 2015, 2008, 2001, and 1998 (See graph below). Thus, based on valuation criteria, EM securities are quite oversold at current levels and might represent an attractive entry point for managers that have a long-term investment horizon (3-5 years). However, these metrics might not represent a strong call for short-term horizon investors since they will still be exposed to higher volatility and asset price pressures in the following months.

Second, to analyze the fundamentals of EM asset prices is relevant to watch three crucial drivers: global economic prospects, deleveraging process, and profits outlook. Although EM economies are applying fiscal and monetary measures, including unimaginable quantitative easing policies by countries such as Poland, Colombia, South Africa, and the Philippines, policymakers reacted lateand significant damage has already been created. Thus, global economic growth will be even worse than in 2008-2009 due to the pervasive effect of lockdown measures. Moreover, in China, the recovery is still happening below the previous year levels, and this time the Chinese consumer will not save the day, given the high levels of indebtedness of these agents relative to their disposable income (close to 100%). 

At the same time, a deleveraging process started three weeks ago. This process was severe in Asia, where high net worth individuals who owned High Yield bonds and Chinese corporate bonds started to unwind their positions. Additionally, the other deleveraging process occurred in the overall ETF market, in which the selling by investors was concentrated in sovereign bonds and equities. Finally, the profits of companies in the region will be disastrous as a result of worsening in inventory and cash management, besides supply and demand destruction. In summary, the restart of the global economy will take time and not be as easy as expected. This context is because the world has experienced shocks in different fields such as globalization, debt dynamics, central bank dynamics, and productivity.

Third, there is a close relationship between EM currencies/fixed income performance and EM equities performance. Thus, both asset classes (currencies and fixed income) are still at risk, and as they continue to sell off, it will be difficult for equities to move higher. In the case of EM fixed income, as explained above, the unwinding process started three weeks ago, so it is too short for this sell-off to stop, so EM fixed income still has more room to fall further. In terms of EM currencies, its performance is linked to commodity prices. As long as commodity prices continue to fall, EM currencies will follow the same pattern and will depreciate even more.

To conclude, the restart of the global economy after the COVID-19 phenomena will not happen very soon, and the post-crisis scenario will be different. In this context, it would be better to avoid vulnerable industries such as hotels, airline carriers, mining, and oil and gas in EM equities. In EM fixed income, it would be better to have a portfolio that favors sovereigns over corporates. Within sovereigns, select the countries with the best macroeconomic fundamentals, whereas within corporates, select the bonds of highly solvent and liquid companies that present sustainable cash flows. When COVID-19 ends and the global economy starts to recover, the world will have so much stimulus that for high-quality equity/credit segments, this will represent a tailwind in terms of an increase in demand and an increase in prices as well. 

Gino Beteta