Emerging Markets – Fund Manager Market Update
From the North of South Capital team
As news of COVID-19 and market volatility continues to evolve at a rapid pace, the North of South Capital team provide their latest views. They analyse how today compares to 2008, give a detailed round-up of the emerging market sector, discuss how the portfolio is currently positioned and why we may be being presented “once-in-a-lifetime” opportunities to buy inexpensive equities.
It is now becoming clear that at least from a market volatility perspective 2020 is comparable to 2008. As all of the North of South investment team experienced the previous crisis (as well as 2001 and earlier for most of us), the environment is not unfamiliar to us.
How does it compare to 2008?
We are very aware of the dangers of attempting to time markets by sitting on cash – the vast majority of returns after a crisis come in the space of a few days. Instead we aim to use the volatility to position the portfolio into the most attractive opportunities.
The 2008 crisis originated in the financial sector and was a result of excess leverage – the resulting contraction in liquidity spilled over into the real economy. Today, setting aside the humanitarian cost of the disease, the key risk is of a cash flow crisis in the real economy. Measures implemented to halt the virus are having an unprecedented impact on consumer and business spending, leading businesses with ongoing operating or financial expenses to struggle to pay bills. This of course risks spilling over into the financial sector as well, although that is something central banks and regulators have been preparing for over the past decade.
In 2008 the financial system was patched up through a series of interventions by governments and central banks and gradually resumed functionality. This time, central banks have less influence on the source as they cannot directly stimulate consumers and small businesses affected by various lock-downs and bans. Targeted government interventions and messaging will be far more important.
This is not specifically an Emerging Market crisis
The starting point today is that, even though the virus appears to have originated in China, this is not specifically an EM crisis. A common feature with the past has been a flight to the dollar, the world’s reserve currency. Historically this would have kicked off a series of currency and debt crises in our markets. However, most of our countries are in a more solid fiscal position than they used to be – we have written at length of the measures that the Russian and Brazilian governments and corporates have taken in recent years to reduce reliance on external funding. Meanwhile Taiwan and South Korea are coming off the back of years of record current account surpluses and boast solid reserves.
Which companies are likely to emerge stronger?
The real issue is more likely to arise at a micro level where containment measures imposed by governments are bringing economic activity to a standstill. Businesses that have significant financial leverage or ongoing fixed costs such as rent or lease payments are most vulnerable here if such measures last a long time. On the flipside, cash rich businesses that have the ability to manage costs are likely to emerge stronger once activity resumes.
Our process tends to lead us towards strong balance sheets. Almost half of our current holdings have more cash than debt. In some cases that net cash holding already exceeds their market capitalization. Only 15% of non-financial companies that we own have a ratio of net debt to EBITDA above 2x. Our weighting in financials is less than half that of the index and they are mostly state backed institutions. As always, we are aiming to minimize the risk of permanent loss of capital by owning businesses that have the ability to make it through difficult times.
China learning to live with the virus
Countries that are able to emerge from economic paralysis relatively quickly should benefit. China, whether we believe the sharp decline in infections or not, is clearly on the path to resuming economic activity. Traffic levels in Beijing and Shenzhen are broadly back to normal, as are inland pollution levels – indicative of economic activity normalizing. Many social distancing and self-quarantine measures remain in place, but the country is essentially learning to live with the virus.
We are watching Korea and Taiwan particularly closely in this context. Both appear to have handled the virus quite effectively so far, with Korea stifling an initial outbreak through aggressive measures while Taiwan has been able to insulate itself by tight border control and encouraging self-quarantine where appropriate – it has reported fewer than 100 cases, all of which imported. In Korea, anecdotally, the leisure sector remains weak but much of the population has resumed work. Manufacturing in the technology sector is picking up, especially in areas where demand remains strong such as servers and server components. Meanwhile some Taiwanese companies have told us of struggling to meet demand as clients try to replenish inventories. Clearly many businesses will continue to be affected especially by weaker demand from Europe and the US, but in such a scenario they are likely to be more defensive than developed markets.
While these three markets account for over 70% of our portfolio, we also see opportunity in countries such as Brazil and Russia which have been hit particularly hard by the recent sell-off. Declines approach or exceed 50% in USD terms for many stocks in these markets.
Improved Balance Sheets in Russia and Brazil
Although Russia is still reliant on oil for a big part of its budget, it benefits from years of conservative fiscal policies. This leaves it with net foreign currency reserves and a large rainy-day fund to underpin government expenses. Corporates have been forced by years of sanctions risk to also reduce dependence on foreign financing. In Brazil corporates have been repairing their balance sheets following a 2015-16 recession while the government has put in place significant reforms to fix structural deficits. Both countries benefit from the weakness in their currencies that should help their current accounts and budgets.
Fund has a yield of about 5%
Once the virus is contained or becomes part of daily life, investors will be looking at a world with no fixed income yield for some time to come. In this context equities should offer value even if we assume some pressure on dividends - our portfolio currently has a forward yield of 5%.
It is also likely that major Central Banks will do whatever they can to avoid a deflationary outcome for the Global economy. In this regard, we would not be surprised that we eventually see a fairly aggressive monetisation of fiscal deficits, which ultimately could lead to a weaker dollar and the outperformance of value relative to growth. The irony is that the virus could actually hasten what we have long thought would be the likely endgame of the monetary experiments of the past decade.
Opportunity to buy inexpensive equities
Looking back at 2008, the market dislocation provided significant opportunities to acquire businesses at extensive discounts to fair value. At the time it took our fund 13 months to recover to its pre-crisis high-water mark. While we may find that the inflection point comes sooner this time - perhaps with the appearance of warmer weather in the Northern Hemisphere, we see that once again we may be being presented “once-in-a-lifetime” opportunities to buy inexpensive equities.
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