17 April 2020

We have all seen the evidence that investors have deserted Emerging Markets in the wake of the Covid-19 pandemic. Indeed, the following Chart illustrates the liquidation of EM assets has been considerably larger than in past episodes, including the Global Financial Crisis (GFC).

As a result, the following Chart illustrates that EM equities have underperformed even the developed markets. As risk appetites evaporated, fears of a deep global economic spread, and commodity prices declined sharply, many Emerging Markets currencies virtually have collapsed.

In the coming days, the World Bank/IMF will almost certainly agree to a large-scale Covid resue plan for the world’s most impoverished nations. In addition to the G20’s plan to delay debt servicing for the world’s poorest 75 countries (amounting to temporary relief of $15 billion), the World Bank is expected to make $160 billion available to these IDA nations.

Will this be enough to tempt investors back towards Emerging Markets? I doubt it. To be sure, the IMF’s recently revised global economic forecast now appears more realistic for the advanced economies — projecting a 6.1% GDP contraction this year followed by a 4.5% recovery in 2021. However, I believe their forecasts for emerging nations still are not pessimistic enough: contracting only 1% in 2020, followed by a sharp 6.5% recovery next year. I expect the EM recession not only to be deeper than during the GFC, but more comparable to the 1998 Asia crisis. Furthermore, the likelihood that the Coronavirus eventually spreads widely in the EM nations, many of whom are ill-prepared to cope, poses additional, serious risks.

EM Recession: Worse than GFC

Why will the EM recession be more severe than the GFC slump? First of all, as I discussed in an earlier blog entitled “Covid Forecast: Don’t Suffer a Lack of Imagination”, the downturn in the Advanced Economies will be deeper than the previous downturn. This is now a widely held view. The 2009 global recession featured a steep decline in international trade (Chart above), followed by a sharp snapback in 2010. However, the deeper recession expected in the Developed markets is likely to lead to even sharper declines in world-wide trade in 2020.

In addition, China will not be able to be the engine of growth this time. China’s enormous fiscal expansion led to a quick resumption in GDP growth following the GFC, which cushioned the global economy. As a result, the earlier Chart indicates the slump in Asian exports was modest relative to the rest of the world.

Not this time. The Chart above illustrates that China has become more integrated into the global economy in recent decades. And, following its draconian economic lockdown, China will experience a sharp slowdown in 2020. Indeed, the release of China’s Q1 GDP data indicates the severity of the downturn. Rather than an engine, China will be a drag on global growth. Further, China has so far been reluctant to adopt large-scale fiscal stimulus, perhaps as government debt is now much larger. Asian economies will be most exposed to China’s slowdown, and weaker global trade this time (next Chart).

The evaporation of investor interest in Emerging markets adds to the economic risks, especially in countries reliant on capital inflows. The following Chart illustrates that external borrowing requirements (relative to the level of international reserves) is particurly large in Turkey, South Africa, Argentina, along with other countries. No surprise that several of these currencies have depreciated sharply recently. Financial market volatility both reflects, and adds to downside economic risks.

Slumping commodity prices will hit Latin America and Africa especially hard. Likewise, the collapse in oil quotes will take a toll on Russia.

However, along with their counterparts in developed economies, EM policymakers have adopted stimulative fiscal policies to offset these risks. However, the policy response has differed considerably. In Latam, Peru, and Chile have moved agressively, while Mexico and Brazil less so (perhaps reflecting Brazil’s fragile public finances). Singapore, Japan, Malaysia, the Philippines and Thailand have fired bazookas, while the reaction in India and China (especially) have been relatively cautious.

Putting some of the pieces together, I expect 2020 will be much tougher in Asia than the IMF is now forecasting. Indeed, GDP could decline more than 5% in the ASEAN nations compared to the IMF’s -0.6% projection (I do agree with the meagre 1.2% and 1.9% advances in China and India respectively). Likewise, I expect sub-Saharan African output will contract more than the IMF’s 1.6% projection (for reasons that will be evident soon), especially as the bulk of the decline emanates from regional heavy-weights Nigeria and South Africa.

Aren’t Markets Priced for Bad News?

Given the under-performance of EM markets, perhaps the bad news is discounted already. Yes, but not enough. First of all, as I discussed in an earlier piece entitled “Covid-19 Strategy: Sifting Through the Rubble”, I believe the upside in the major markets is limited following the recent rebound. Indeed, I expect only low single-digit returns in the S&P 500 over the next 12 months, as both EPS growth and the anticipated H2 2020 GDP recovery will prove disappointing.

However, the Chart above (supplied by my friends at Morgan Stanley) illustrates that the EM equity risk premium is very high, as is the case in the major markets. While this suggest equities may be tempting, the ERP is still not as high as during the GFC. Likewise, other valuation EM metrics are promising. The following Chart, however, illustrates the discount found in EM markets relative to the majors is only in line with the long term average (again, thanks to MS). Not attractive, given the risks!

To be sure, many EM currencies are very cheap (next Chart). There will be great opportunities eventually. With risks appetites low, and the outlook for both Advanced and EM economies so uncertain, I expect it will be another 6 months before EM regains investors’ attention.

Covid-19: Will Emerging Markets Be the Next Chapter?

Fortunately, developing countries have remained out of the headlines in the Coronavirus pandemic so far (China and Korea are important exceptions, of course). Some argue the lack of testing may mask the prevalence of the disease, but the low number of deaths suggests these nations have been spared (next Chart).

Again, I am not a scientist, but I am concerned (indeeed, I expect sadly) that this may soon change, and developing countries could be the next chapter in the saga. In a particularly well-timed study (published October 2019), John’s Hopkins developed a Health Security Index that allows an assessment of each country’s ability to cope with pandemics.

The index rates each country on its ability to prevent and detect outbreaks, the ability to respond to and mitigate the impact of an infection, and the health system’s ability to cope. The scale runs from 0 to 100, reflecting the degree of preparation. The study warned that no country is fully prepared — even top ranked USA achieved an overall score of 84. The overall world-wide average ranking is only 40, and the health care score of 26 reveals how woefully unprepared the world remains for health emergencies.

The map does indicate that some middle-income Emerging markets, e.g. Thailand and Korea, are amongst the world’s most able to cope with these health risks. However, there is no getting around the fact that the poor are the most vulnerable. In the western Hemisphere, Venezuela, Central America, Haiti, and Guyana (along with small island nations world-wide) score especially poorly. In Asia, North Korea, Afghanistan, Central Asia, and Papua New Guinea are worst placed. However, the bulk of the fragile nations are the poorest African countries.

Africa lags far behind on metrics for detection, prevention, and response/mitigation. However, perhaps the largest shortfall stems from the local health care systems’ ability to cope. For example, while the USA has 257 doctors per 100,000 citizens, Malawi has 2. The USA has 290 hospital beds per 100K of population (even Thailand has 210), while Mali has 10 beds. Top-rated USA’s health care system gets a 74% grade (showing the need for considerable improvement), but Somalia records a stunning 0.3%!

Given the importance of hygiene and social distancing here are a few other metrics worth considering. Of course, 100% of the population in developed economies have access to proper sanitation, but only 7% and 9% have access in Ethiopia and Chad respectively. To be sure, lower urbanisation in Africa may assist social distancing. However, of the world’s 50 largest cities, 42 are in emerging market countries — 19 are either in China or India.

Within the mainstream, investible EM markets, there is less extreme variation. Not surprisingly, however, the frontier markets, such as Nigeria, Angola, Ghana, and Venezuela, lag far behind. On the other extreme, Korean and Thailand score highly (the latter has the world’s second most ready health care system). Excluding the frontier markets, all EM nations enjoy a rank above the world-wide average. However, South Africa and Indonesia are weak on several metrics, especially health care. And, the high degree of urbanisation in mainstream EM countries would make social distancing more challenging.

Strategic Implications

• The poorest are always the most vulnerable in pandemics and recessions. The World Bank’s $160 billion program represents about 10% of GDP for the most impoverished 76 IDA countries. That’s a good amount, but rapid, efficient implementation will be a huge challenge. Beyond these nations, there are up to another 30 countries registering a John’s Hopkins index below the world-wide average of 40 (which is low to begin with).
• The EM recession will be worse than following the GFC, and more similar to the Asian crisis. If the Covid-19 pandemic spreads widely, additional downside risks could emerge, especially in the most fragile, frontier economies.
• EM equities are not expensive, but not cheap enough relative to developed markets to attract investors yet. Their time will come, but only after greater clarity about the global economic outlook emerges.
• Many EM currencies are now substantially undervalued. Eventually, attractive opportunities will emerge.