Executive Summary
This paper highlights five reasons why Emerging Markets (EM) in aggregate are more resilient today than in prior periods. A “healthier” index composition in addition to four other reasons support our analysis that EM drawdowns will be significantly more muted than previous peak- to-trough drawdowns. The 30% rebound that the asset class has experienced since its trough in late March is in line with our thesis of a more robust index. In GMO’s recent Quarterly Letter, Ben Inker, Head of our Asset Allocation team, made the case for emerging stocks given their lower relative valuations.
We acknowledge the heterogeneity of the asset class but take comfort in China at 40% of the MSCI EM Index being resilient, with better growth prospects and plenty of residual dry powder. Not only has the weight of cyclical sectors like Energy and Materials shrunk (from 30% to 12%), there has also been a significant improvement in their balance sheets. Some domestic consumer-driven and growing sectors such as Information Technology and Internet/Media names are now nearly one-third of the index. In our April 2020 paper, “Covid-19: Risk and Resilience in Emerging Markets,” we provided a framework to assess the most vulnerable EM nations and those best placed to emerge less scathed than others from the pandemic. We identified only 9% of emerging countries as high risk vs. 66% as safe countries.
However, the EM asset class is innately characterized by risk – this paper discusses five such risks and cautions of other uncertainties that can morph into risk. While some traditional risks have abated, we discuss tensions from a renewed U.S.-China trade war, domestic power struggles in some of the larger EM countries like Brazil and India, constraints on the coffers of EM governments, and both currency and concentration risk. As we construct our EM portfolios today, we strive to take advantage of the lower volatility of the asset class while maintaining a defensive stance to mitigate the heightened risks in today’s environment. Net/net, however, we believe many of the EM-specific risks are navigable.
EM Performance Through Previous Crises
Table 1 highlights peak-to-trough drawdowns in previous periods of market uncertainty and the time taken to recover. Despite the impact of the current crisis on GDP likely being the worst in decades, EM fell peak-to-trough by 33%. This time, however, not only is the drawdown lower, but the recovery has been faster than in previous crises – a 30% rebound from the trough in less than 3 months.
We believe there are five reasons that explain this less painful drawdown and suggest why “this time is different.”
#1: THE WEIGHT OF VULNERABLE COUNTRIES IN THE MSCI EM INDEX HAS BEEN SIGNIFICANTLY REDUCED
At approximately 40% of the index today, China has displaced the weights of vulnerable economies in the EM index. We identify “vulnerable” economies as those that are highly dependent on foreign savings and, therefore, more exposed to external outflows. In 2012, over 30% of the index was made up of 9 vulnerable economies including countries like Brazil, Turkey, and South Africa. Today, the impact of these vulnerable countries has waned because the weight of China has increased and macroeconomic fundamentals in some of these countries have improved.
Exhibit 1 shows the index weights of these vulnerable countries and China across time. The dominance of the “vulnerable” country bucket has historically led to higher volatility and risk contagion across EM.
#2: CHINA, WHICH CONSTITUTES 40% OF THE MSCI EM INDEX, IS SAFER AND STILL HAS DRY POWDER FOR STIMULUS
Despite commonly predicted China hard-landing scenarios, we are less worried than most analysts. For the last three decades, China has shown that it has the fiscal and monetary wherewithal to rebound from temporary economic setbacks. In the last few years, China has transformed itself from an externally dependent economy to one in which the domestic consumer has begun to pick up much of the responsibility for stimulating the economy (see Exhibit 2). To contextualize China's growth with some numbers, let's look at the China Internet sector. At $1.4 trillion market cap, today the China Internet sector alone accounts for nearly half the EM aggregate market cap of a decade ago. Today, China's Internet sector is 17% of the MSCI EM Index while the BRICs countries (ex-China) are only 20% of the index.
We should not mistake the lack of China’s headline-grabbing stimulus plans to date as a signal of the State’s reluctance to use its resources. Exhibit 3 and Table 2 show that China still has the fiscal might to bail out its businesses and enterprise should it be necessary. It is likely, though, that a future stimulus will fall well short of the whopping 4 trillion RMB (>10% GDP) China announced during the GFC – a sum adequate to offer a lease not only to China, but also to much of the rest of the world. To date, China has spent only 5% of its GDP on fiscal stimulus compared to 11.5% spent during the GFC. For comparison, the U.S. has spent 13% of its GDP to date in response to Covid-19 compared to 6.5% spent during the GFC.
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