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The spread of COVID-19 has upended the outlook for the world’s economies and generated violent market moves. We provide a framework designed to identify where it makes sense to invest now.
The past quarter has been brutal for risk assets: equity markets experienced one of their worst sell-offs in history, with the MSCI Emerging Markets (EM) declining by 23.6% and some markets falling by as much as 50%. This primarily owed to the spread of the novel Coronavirus from China to the rest of the world and the related lockdown measures plus, to a lesser extent, the sudden flare-up of an oil price conflict between Russia and Saudi Arabia.
Such radical price moves are seemingly opening up new opportunities. Although the trailing P/E discount of the MSCI EM to the MSCI World remains in line with its long-run average (at 27%), the cyclically-adjusted P/E (CAPE) of EM has fallen to 10.9, 14% below even the March 2009 level. To identify investment opportunities amidst the fog of market uncertainty, our framework focuses on four factors: 1) more than usual, the change in valuation metrics, 2) the cyclical position and dynamics of each country prior to the outbreak, 3) the status of infections and public health policy in each country and 4) the economic policy response.
1. Valuations: Several countries which have mostly weathered the outbreak (China) or addressed it effectively (Taiwan) already trade at higher P/Es than their long-run average. Others are now 2-3 standard deviations below their historical average. In cyclically-adjusted terms, some countries like Brazil trade at a P/E far higher than their historical minimum, despite a ca. 50% market decline. Others, like Korea or Turkey, have CAPEs as much as 20% below their March 2009 low. What is more, South Africa and Malaysia are also at all-time historical lows in terms of their CAPEs.
2. Cycle: Most EM countries entered the year on a weak growth footing. That is, they were growing below potential (e.g. Mexico, Brazil, South Africa, Malaysia, as well as China). Despite this, some economies were stabilising (e.g. Korea and Russia), while others were gaining momentum towards year-end, such as India. Others yet were gathering significant steam and expanding above potential, such as Turkey and the Philippines.
3. COVID-19: The response to the spread of the virus is key for the outlook, not least because it determines both the duration and the depth of the economic impact. While much remains uncertain about contagion dynamics, broadly speaking, aggressive early containment measures deepen the recessionary impact in the near term, but may also shorten it. Unfortunately, several (often autocratic) leaders in EM have long denied the severity of the crisis and thus delayed the policy response, aggravating the problem. They include Brazil, Mexico, India, the Philippines, Turkey and, to a lesser extent, Russia. To better assess each country’s vulnerability to the spread of COVID-19, we have created an index that aims to provide a comprehensive measure. We assess each country’s medical resources (hospital beds, number of physicians, testing capacity), demographic characteristics (age structure, malnutrition), living conditions (urbanisation, slum dwellings, household size) and economic structure as far as it affects susceptibility to infection (size of the informal economy, population below the poverty line). The main results for some key emerging markets are presented in Chart 1. Our index identifies India and Thailand as being particularly vulnerable, whereas Russia and Turkey are comparatively better placed.
4. Economic Policy: Many emerging economies have to deal not only with a double supply shock thanks to supply chain disruptions and a commodity price drop, but also with a sudden slump in demand for their exports. What is more, they are faced with capital outflows worse than during the 2008-09 global financial crisis. As a result, the EM policy response arrived swiftly and radically, even though it is constrained by the low starting level of interest rates and limited fiscal space. This has required resorting to unorthodox policy measures. Nevertheless, to a surprising extent, policies in EMs are broadly similar, differing primarily in timing and scale.
*The publication reflects asset performance up to 31 March, 2020, and macro events and data releases up to 8 April, 2020, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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