Daniel Graña and Matthew Culley from the Emerging Market Equity Team explain the importance of examining each emerging country individually to determine how they are likely to weather the COVID-19 storm, and why some of these countries are likely on the cusp of a transition toward more value-added growth drivers.
- Emerging markets dependent upon commodities exports face headwinds as global growth stalls, while less-developed countries may see their public health infrastructure tested as illnesses rise.
- Slowing global trade will hurt export-driven countries but the next stage of emerging market growth is likely to be defined by value-added industries and developing digital infrastructure.
- In such times of economic uncertainty, investors must make a strong effort to understand the country, currency and governance risk present in emerging market equities.
While the COVID-19 coronavirus has severely impacted emerging and developed economies alike, the dispersion of advancement among emerging market (EM) countries means that some are likely better equipped to confront the pandemic, while others may face unique near-term headwinds.
Countries already on a tenuous economic footing are most vulnerable to the threats posed by COVID-19. Brazil had been emerging from recession when confronted by this crisis. With demand for its commodities exports – chief among them, oil – slashed, efforts to maintain economic growth have been overwhelmed.
The vulnerabilities of other countries are rooted in their low levels of wealth and poorly developed institutions. We believe that neither Indonesia nor India – with their large migrant workforces and ill-equipped public health systems – are well prepared to handle a surge in COVID-19 cases.
We do not disaggregate country risk from currency risk, and our reasoning for this approach has been on display during the COVID-19 outbreak. Investors have been shunning riskier assets, and global bond markets have seized up, forcing many fixed income investors to hedge their holdings by shorting local currencies. This has placed acute pressure on EM countries dependent upon capital inflows to fund current account deficits as the risk of capital flight increased. This dynamic has aggravated the challenging environment brought on by the rare occurrence of simultaneous supply and demand shocks.
Conversely, some EM countries were better positioned to absorb the shock. Asian countries that experienced the SARS outbreak in 2003 initiated a more effective response to COVID-19. As a result, some investors may perceive these efforts as placing those economies on a faster track toward recovery. China, which was forced into action early and has a system of governance that allowed for draconian containment efforts, is largely viewed as nearing the end of the tunnel.
The era of value-added growth drivers
For years, growth in emerging markets was defined by the drive toward globalisation and the benefits it bestowed upon export-based economies. With the greatest incremental contribution from this likely behind us, emerging economies must rely upon new sources to expand gross domestic product. Several countries with large domestic markets have achieved a level of wealth where consumption is becoming a greater contributor to growth. Complementing this – and on display during the virus outbreak – is the growing role that technology plays in economic activity. China has been a leader in e-commerce and social media engagement, but we expect future innovation will emerge from more value-added intellectual property as the country further adopts cloud computing and artificial intelligence.
A digital future
We also expect the crisis to be a catalyst for the wider adoption of digital platforms. Several cohorts that had yet to fully engage in e-commerce and social media had no choice but to do so during the pandemic. We also believe investment in digital infrastructure in finance, industry and other sectors will become national priorities. An area where we see considerable promise is digital payments. And it is not just in China but increasingly in Africa and the Middle East.
In the shadow of the trade war
In the wake of the crisis, we expect to see a push for diversifying supply chains. Corporations were already revisiting their reliance upon individual suppliers and countries due to last year’s trade war, and we expect these initiatives to accelerate. In conversations with management teams, we are hearing stories of companies establishing additional channels for key production inputs and end products.
Different lenses reveal different prospects
When applying our lenses of company, country and governance, we see other challenges. Countries with large current account deficits and foreign-denominated debt may continue to be at risk of capital flight, especially as they reach the limits of monetary and fiscal policy aimed at supporting their economies during this unprecedented demand shock. On the corporate level, highly leveraged companies are likely to continue to be shunned. On governance, the nature of this crisis has led to calls for companies to commit to ’national service’ – a directive by the domestic government to act on its behalf. While these endeavors have their place, we worry that such initiatives can run contrary to the interest of minority shareholders.