05 October 2020
This report has been prepared by Northcape Capital, the underlying investment manager for the Warakirri Global Emerging Markets Fund.
Emerging Markets Performance
The strong bounce in markets from the COVID lows in March, finally took a breather in September. The past month saw the EM US$ index fall -1.8%, taking the 2020 YTD return to -2.9%. The US$ DM index, which has had a sharper recovery than EM, corrected by -3.6%. As such the DM index YTD 2020 return was reduced to +1%. For the September quarter the EM index rose +9%, well outperforming the DM index’s +1%. The risk off month of September saw the US Dollar index (DXY) gain +2%, whilst the EM FX index fell -2%.
September’s correction in capital markets reflected the negatives around the following themes (mostly centred on the US, Europe and China):
China’s H and A shares stock market indices fell -5% and -6% respectively over the past month.
For EM we are still seeing rising COVID cases – although in most countries the growth rates of new cases are slowing (even with increased testing). For example, in India cases grew +68% MoM in September to 6.5m (down from +123% MoM in Aug), Brazil +25% to 4.9m (down from +44% MoM in Aug) and Mexico +25% MoM to 0.8m (down from 42% MoM in Aug). The main exception is Indonesia where cases rose +71% to 0.3m in September (up from +62% MoM in Aug). Indeed, there has been renewed lock downs in Jakarta/West Java over September with some hospitals running out of capacity. Whereas, all other EMs (for now) appear to be pressing on and relaxing COVID lockdown restrictions and reopening their economies, despite new case numbers rising, albeit at a lower rate.
In the wake of the global COVID-19 economic slump, the breadth of central bank easing across global capital markets is totally unprecedented with a net 174 policy rate cuts over the past 8 months alone, since COVID-19 became a pandemic in February.
In advanced countries, widespread policy rate cuts have been matched by equally aggressive bouts of money printing (referred to as quantitative easing, QE) and new fiscal policies (including direct loans to companies, and substantially increased unemployment benefits).
The aggressive policy response to COVID-19, especially QE, continues to be led by the US, Europe, Japan and many other developed markets.
Away from rate cuts, EM policy initiatives in terms of GDP continue to be comparatively restrained. We reiterate that EM central banks are acutely aware of potential currency vulnerabilities if they attempt aggressive QE – without “reserve” currencies.
Additionally, many EM governments have a general commitment to conservative fiscal policy (some dictated by legislation), typically a result of past experiences during episodes of economic/fiscal crises. In sum, this has led to a much milder monetary and fiscal response from EM to the economic shock of COVID-19 relative to DM.
As first mentioned in our March report on COVID-19 – and continues to be the case with limited unemployment benefits (and/or subsidies to businesses) and inability to control social distancing for sustained periods, EMs’ working population will go back to work almost by necessity, otherwise there is a risk of widespread unrest/rioting. Further, given EMs’ much younger populations (median age 28) the death rate would seem to be materially lower in any case at this stage, given approximately 92% of COVID-19 deaths continue to occur in people over 55 years and 79% above 60 years (Source: US Centres for Disease Control and Prevention).
Accordingly, despite rising cases and tragic deaths, lockdowns have materially eased across most EM countries. Even the worst hit COVID-19 countries of Brazil, Mexico and India continue to exit lockdowns. Whilst we do not rule out the possibility of national lockdowns recurring (under second wave risks) – our base case for EM is no significant lockdowns, rather at most surgical/localised restrictions to try and limit the economic fallout.
We also sense the political and electoral will in DM countries for widespread lockdowns has also reduced, which in our opinion may have long-term negative public health risks. (This additionally reinforces our rationale for the strong overweight position in PPE stocks.)
As with equity markets, economic activity globally has started to recover over the past 5 months. Year on year growth is still in decline, but sequential months are improving – in some cases sharply. Although it is very clear from our September data that the rate of improvement has tailed off. By way of illustration the EM composite manufacturing PMI only rose to 52.1 in September from 51.6 in August. In terms of the individual country manufacturing PMIs it is interesting to observe that over September there was a recovery across 10 out of 14 major EM PMIs that we monitor, with the largest improvement from India 56.8 from 52.0 – despite strong increase in COVID cases. There were also 8/14 countries with PMIs above 50 – indicating sequential expansion (month-on-month).
There were US$1bn of net subscriptions into the EM equity asset class over September – the third inflow of this magnitude over the past 3 months. Total EM equity outflows for 2020 YTD stood at -US$46bn. EM bond funds continue to fare considerably better than EM equities with US$31bn of inflows over April to September. Total equity and debt redemptions at August YTD were -US$56bn, which is equivalent to the peak GFC outflows in late 2008.
We reiterate these severe outflows (and only small inflows of late) have naturally had a large negative impact on some EM currencies. Although the EM MSCI FX weighted index has fallen only -4% 2020 YTD and Asian currencies have been quite resilient, many others have been very weak 2020 YTD; BRL -28%, TRY -23%, ARS -22%, RUB -20%, ZAR -16% and MXN -14%.
However, we continue to note the deflationary forces of COVID-19 are material, by enlarging existing and creating new output gaps (primarily excess supply from mass labour shedding). The shock to income security is seeing households save a lot more, being much more careful, thrifty and risk averse. Higher saving rates, if sustained, are very negative for long-term consumption, investment and GDP growth and have a profound deflationary impact. The onset of COVID second waves in Europe and the US, and associated lockdowns, will only harden households resolve to save more as we move into 2021.
And when added to the structural deflation impact of aging demographics in advanced countries and relentless march of labour-saving digital disruption – inflation risks, globally are clearly to the downside. This is despite all the COVID-19 monetary stimulus, in our view, and implies the current low interest rates will be here for a long time.
Importantly, we stress again the onset of deflation and low bond yields will make those companies that can grow their cashflows in real terms over the long-term even more valuable. This underscores the value an active fund manager can provide by essentially investing in EM companies that can “structurally grow” their cashflows in an environment of global deflation.
Occasionally such coveted structural growth companies can be indiscriminately sold off during periods of liquidation – as we saw with the COVID-19 exogenous shock in March. We will continue to take advantage of future volatility to further lift our clients’ returns over the long-term by acquiring these companies at very attractive valuations.