The pandemic is a true black swan event: unpredictable and with massive consequences, says Justin Leverenz.
After a decade of reasonable tranquillity, global markets are experiencing another black swan event, and I use that term with fearful caution. The coronavirus is a black swan in the sense that it is both unpredictable and an event of massive consequence that will significantly change behaviour.
For emerging market equity investors, there will likely be some proximate consequences:
1) Russia may be one of the great places to invest now
Russia is the strongest of any major oil economies with a fortress balance sheet, strong fiscal position and a flexible currency (and cost structure). While oil at $30 will be uncomfortable for Russia, it will be devastating for the Gulf economies, Saudi Arabia in particular could run double-digit deficits.
Ironically, the ultimate losers of this price war will be the biggest recent growth producers – the US shale firms, whose break-even price lies between $48 and $54, according to a Dallas Federal Energy survey. By taking advantage of all major OPEC price stabilisation while sitting on mountains of debt, the shale oil industry has lost its ability to weather the black swan moment.
2) China will be reasonably fine
The coronavirus brought China’s economy to a near standstill in February; however, its strong and pragmatic state acted quickly to contain the virus.
In response to the outbreak, China has spent roughly 1.2% of GDP ($150 billion) - excluding infrastructure investment – on a myriad of targeted support, including granting waivers and reduction of social charges, lowering value-added taxes (VAT) for some enterprises, and electricity and gas fees for corporate users.
Structurally, China has a lot more ammunition in its monetary policy. It has developed its anti-fragility out of a host of inherent stressors in the system – including a skimpy pensions and health insurance system – which have reinforced its high levels of domestic savings. Culturally rooted fiscal conservatism means China can emerge stronger from crisis.
3) Latin America will continue the funk
The economic history of Latin America involves cycles of high expectations followed by disappointments, marked by financial crises and contractions caused by repeated debt defaults and hyperinflation. While Latin America rode out the previous black swan crisis of 2008 with only a brief dip, the region has been in low-growth doldrums since 2013, with GDP growth averaging 0.8%.
Countries such as Brazil have never moved upstream to tackle the structural vulnerabilities perpetuating the cycle, including the prohibitive cost of capital. At 38% of GDP, Brazil’s fiscal expenditures topped all major emerging market countries in 2019, while private capital investment has been steadily falling in the last decade – now hovering around 15% of GDP.
4) The strong — not the oligopolies — will survive
The unprecedented economic disruption this virus has caused will be painful to competitors in multiple industries. Many marginal players will face bankruptcy. Others will have to make fateful decisions to reduce investment in capacity, product development and talent, and companies relying on cheap funding will crumble under liquidity pressure. The strong will emerge even more competitive, gathering market share and gaining higher profitability.
Restaurant operator Yum China and lodging innovator Huazhu are cases in point and the market has failed to appreciate how resilient these companies may emerge out of this black swan moment. As stand-alone hotels close in droves, the survivors will place even greater value than before on the risk-mitigation benefit of joining large brands. Yum China will also be able to garner space and “stomach share” after this current emergency subsides.
5) Irrational competition - particularly in 'disruptive technology' - will likely become far more rational
Cheap capital and unbounded ambitions have created unsustainable business models in the technology sector. If the WeWork debacle was a warning sign, the upcoming displacement in the real economy, as well as in financial markets, should end the tech world’s obsession with often spurious numbers. Of late, we have seen the unique spectacle of businesses in the “sharing economy,” where growth is slowing, but profitability remains stubbornly out of reach. Such excesses are likely to face a reckoning, as will reckless capital allocators. More moderately behaved competitive behaviour in China and Brazil will emerge and could benefit companies such as Alibaba, Tencent, and MercadoLibre.
Despite the near-team challenges that all of us are facing, we remain excited about the opportunity that emerging market equities provide. We believe the most compelling opportunity for investors is to avoid short-term tactical positions and instead focus on companies that have the potential to deliver long-term financial performance.
Justin Leverenz is senior portfolio manager for the OFI Emerging Markets Equity team at Invesco.
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