Executive Summary
As Covid-19 continues to dominate headlines around the world, we have been working to develop a methodology that will help us position our portfolios as we deal with the current and coming shocks to Emerging Market economies. We believe assessing the unique risk factors that the virus brings along with understanding a country’s ability to mitigate those risks is key to determining how well that country will navigate the current crisis. This paper introduces the framework we have developed to further help us make the best decisions for positioning our portfolios.
We thought long and hard before adding to the reams of Covid-19 related reading material our clients likely have littering their virtual desks. Yet, the lack of a coherent framework to address the vulnerability of the Emerging Market (EM) equities asset class during this crisis compelled us to write. It is well understood that Covid-19 will impact economic activity, but there has been far less focus on the capital market fallout of the pandemic, which will be particularly acute in emerging markets. Of course, not all EM countries will be affected similarly given these nations vary in their resilience and ability to respond and bounce back. As investors, it is critical to understand the factors that both contribute to and detract from a country’s efforts to move forward once the imminent danger of this pandemic has receded.
In our 2013 paper, “Health is Wealth,”1 we argued that resilient domestic consumption is a function of effective public spending on health care, and we have been using this premise over the years as a key input in our top-down ESG models. In this paper, we present observations from our proprietary “Covid-19 Risk Assessment” framework, which identifies where EM countries fall on the vulnerability scale. We then couple these findings with information gleaned from our “Ability to Respond” framework, which uses several factors to determine the strength of a country’s ability to combat and recover from the virus. Using this methodology, we are able to identify the “clusters” of countries that we believe will be more resilient as this crisis and its aftermath unfold.
Key Takeaways
The headline results regarding EM vulnerability/ability to respond to Covid-19 derived from this new methodology, which is described more fully in the sections that follow, are:
- About 60% of the MSCI EM index comprises countries that rest in what we define as a “safe cluster.”
- Countries falling in the “high risk cluster” represent 14% of the index.
- There is significant variability among countries in their ability to respond to a crisis.
- It is very difficult for EM countries to implement measures like “social distancing” when per capita incomes are one-sixth those of Developed Markets (DM); a “daily” wage sustains 20% of the ex-China EM working population.
- Unlike previous crises, when index composition was poor, we now think EM countries are better-equipped to manage severe drawdowns. (Recall that drawdowns were 60% during both the 1997 Asian Financial Crisis and the 1998 Russian Financial Crisis.)
Covid-19 Risk Assessment Framework
Our framework distributes 15 factors across 4 broad categories: data reliability, lockdown effectiveness, social distancing effectiveness, and medical system (see Exhibit 1). For each factor, we assign a score of 0 to 10, with 0 being the best and 10 being the worst. Our scoring methodology incorporates inputs from individual country analysts, local social media analysis, and Google mobility data.
EXHIBIT 1: COVID-19 RISK ASSESSMENT FRAMEWORK
Source: GMO
The inputs for each of the factors grouped into categories in the framework are briefly described as follows:
- For data reliability, we look at test intensity (measured by positive results as a percent of total tests administered) and signs of underreporting/undertesting. For example, in Korea each citizen is entitled to a set of three tests free of charge. As of early April, approximately 1 of every 100 in a population of 51 million has been tested. Taiwan is also noteworthy, and we recommend reading a recent article by Wang, et al.2
- We place significant emphasis on countries that impose lockdowns given the fragile medical systems in many of these regions.
- Social distancing is a luxury in a number of countries. India and Indonesia, respectively, have 24% and 15% of their labor force constituted by casual workers who effectively depend on daily wages, making extended lockdowns extremely difficult. We also take into account that heads of government in several countries continue to exhibit a very cavalier attitude toward virus mitigation recommendations.
- Lastly, we look at the medical system from the perspective of the protection of medical workers, quality and quantity of medical supplies, and, most importantly, whether or not home quarantine is practiced when infection is confirmed.
Experience in DM has taught us that once the early window for virus detection is missed, it might be too late. We took this into consideration after we developed a methodology for arriving at a Covid-19 risk score. This ranks each country by how many cases of Covid-19 exist per million within that country’s population. DM experience once again shows that once this number rises above 100 infections, the spread of the virus is difficult to contain. Exhibit 2 shows the risk scores of EM countries at two points in time: March 22 and April 2. Though this data is very fluid, it is clear to see which countries face the greatest challenges and which countries have been able to better reduce risk.
EXHIBIT 2: COVID-19 RISK SCORE
Source: GMO
Note: Below 3 = Low Risk; 3-5.5 = Medium Risk; Above 5.5 = High Risk
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