The past weekend gave investors a pause to reflect on what has been the worst week in terms of price performance for many equity indices since the global financial crisis in 2008. For example, the S&P 500 lost 11.5% on Friday’s close, compared a week before. Emerging markets equity investors were also strongly impacted, as the MSCI EM lost 7.3% over that period.
Before sharing our thoughts, we first want to extend our sympathies to all those that have been affected by COVID-19.
While we take no view on the further spread of the virus as the situation is developing, we would like to share our perspective on Emerging markets equities with you, and update you how we think one should deal with the circumstances as an investor.
First, let us look at China, the country where COVID-19 apparently originated and an economy of high significance for EM investors. Towards the end of February, the disruption from the virus and the countermeasures against is showing in supply chains across all sectors. The Chinese purchasing manager index (PMI) released on Saturday, February 29th, came in at 35.7 much lower than expected (the consensus was 46) and significantly below the level of 50, above which an economic expansion is signaled.
The near-halt of economic activity in China, the clear deterioration of the situation in South Korea and the spread of the virus around the globe has investors wondering about the broader economic impact. The question is longer if economies will be impacted negatively, but which companies in which areas of the economy will be impacted by how much and for how long. We therefore performed further stress-test simulations on all holdings during the last two weeks. The resulting bear case valuations assume a prolonged negative impact. Not only did we try to assess the direct impact on customers, but also the disruption on the supply chain and distribution channels.
The outcome of the stress test was two-fold. Where the share price was high relative to our “stress” bear case valuation, holdings were trimmed, as the risk investors faced were still elevated. By contrast, if the stocks already traded close to the stress-tested bear case valuation, shares were held, given the limited downside potential.
The downside risks for markets are difficult to assess at this stage. That is why the markets sold off violently as the virus spread beyond China and turned from risk-on to risk-off mode. Chances are that the market is overreacting in specific areas and pushing the share prices of those companies too low relative to their intrinsic value. However, this is too early to assess. The market will only start pricing the risks correctly again once fundamentals show no longer a deterioration in the number of new cases outside of China. When exactly this will happen is difficult to estimate at this stage. It could be in one week or one month or six months. Given this uncertainty, it might be too early to step in and take advantage of these potential price dislocations. Rather, we believe the market will stay in risk-off mode coupled with negative earnings revisions and negative price momentum until a positive catalyst appears.
For us, the key catalyst to watch out for is the number of new infections outside of China slowing. Also, we need to see Chinese workers returning to work again, so that the Chinese economy can start to recover.