Despite the impact of the current crisis on GDP likely being the worst in decades, EMs 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 three 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 nine vulnerable economies including countries such as 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 (See: The new heavy-weight champion).
2. China, which constitutes 40% of the MSCI EM Index, is safer and still has dry powder for stimulus
Despite the commonly predicted China hard-landing scenarios, we are less worried than most analysts. For the past three decades, China has shown that it has the fiscal and monetary wherewithal to rebound from temporary economic setbacks. In the past 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: Cutting the umbilical cord). To contextualise China’s growth with some numbers, let’s look at China’s internet sector. At $1.4 trillion market cap, this sector alone accounts for nearly half the EM aggregate market cap of a decade ago. Today, it 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. 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 global financial crisis — 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 US has spent 13% of its GDP to date in response to COVID-19 compared to 6.5% spent during the GFC.
3. Sector composition has moved from cyclical sectors to IT and consumer sectors
In 2010, 30% of the Index was in cyclical sectors such as energy and materials. Today, the weight of these sectors has dropped to less than 15% with significant improvement in balance sheets. At the same time, the weight of internet and technology has steadily increased over the past decade and today accounts for one-third of the Index (See: Tech it the right way).
4. While financials remain a significant constituent of the Index, their “quality” has improved with China financials accounting for 36% of the financials Index
With a market cap above $5.0 trillion and total assets of $67 trillion, financials comprise the largest sector in the MSCI EM Index. Given the leverage endemic to these banks, it is critical to understand the innate risks of this group to better assess the asset class. While financials have historically made up about a quarter of the Index, their composition has changed over time (See: The money-lenders). One key change has been that the weight of banks in the “vulnerable” country group as described previously has reduced from 46% to 10% of MSCI EM Financials.
5. Ability to respond to COVID-19 and higher growth prospects
In our April paper, we argued that the EM asset class is more resilient to the impacts of COVID-19 given the composition of the Index today (See: Winning the immunity race). Using several factors, we gave each country a COVID-19 “Risk Score” as well as a ranking for its “Ability to Respond” and rebound from the current crisis. Our analysis revealed that today, only 9% of EM countries are in the high-risk category. The conclusions from this analysis lead us to believe that the countries in the “Safe” cluster will withstand the crisis better while the recovery and reopening of the economies in the “Risky” cluster will be more challenging.
By virtue of a healthier Index today, we believe certain innate risks that have previously characterised EM have dissipated. However, the asset class is inherently home to a number of unforecastable events that we must acknowledge.
- With great weight comes great responsibility (and magnified risk). With China comprising nearly 40% of the Index, we need to be prepared for hitherto atypical risks such as the trade war with the US returning to the forefront of political and economic rhetoric.
- Beyond China, several of the larger EM economies are also witnessing their own power struggles and rising nationalism.
- EM governments today have limited revenue streams with much higher borrowing costs and do not have the luxury of a reserve currency.
- Poor healthcare infrastructure and “trimming” of other essential services. It should come as no surprise that pharma companies, R&D, and the sheer number of beds and accident and emergency facilities in EMs fall well below the standards of developed nations.
- Higher currency risk. Unlike some of their developed counterparts, central banks in emerging countries will need to toe a fine line between managing investor sentiment, prompting capital flight, and currency depreciation.
- Concentration and spill-over risks. A large part of the EM earning stream is tied to businesses related to technology and the internet. Therefore, there is an ironic “symbiotic” relationship between the US (S&P 500 and Nasdaq) and Chinese stock markets.
At 40% of the Index, we believe China is resilient and capable of long-term growth and capital appreciation. The Index is more stable in its composition as sectors like information technology and consumer discretionary have become “core” and the weights of more cyclical sectors have shrunk. While financials account for nearly a quarter of the Index, the majority are “safer” Chinese institutions that have demonstrated their ability to preserve capital. Given our analysis of the risks within the asset class, it is evident that some nations are better placed to withstand the current crisis. Today, despite the risks, our dedicated EM portfolios reflect the improved resilience of the asset class.
This is an excerpt from GMO’s Emerging Markets report. You can read the complete version at www.gmo.com