COVID-19 impact on Emerging Markets
Paolo Bascelli, Milan, 12/05/2020
In a context like the one in which we find ourselves today and which unites us all on a global level, with few differences, trying to make forecasts in the economic-financial field is an even more risky and difficult task than it already is in normal conditions.
However, starting from economic data already visible today and using the recent past as a trace, it is possible to try to identify some possible evolutions of the impact that the coronavirus will have on emerging countries, especially as regards the financial markets.
At the present what is happening and what are the consequences?
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Expansive monetary policies applied by all central banks globally: although there is no margin on interest rates, central banks will implement Quantitative Easing programs which will be accompanied by expansive fiscal policies aimed at supporting the entire economic fabric. Furthermore, in many cases, measures to prohibit the distribution of dividends and the prohibition of buybacks have been adopted temporarily (difficult to estimate how long they will last), so that companies retain as much liquidity as possible. The latter two prohibitions will inevitably have a negative effect on the stock market price in the near future.
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Decline in global demand and production: a global recession scenario is taking place, the magnitude and duration of which are difficult to estimate, with a high probability that a deflationary spiral would start which would be lethal. Evidence in this sense is provided by the drop in the prices of raw materials and commodities for industrial use which seriously damage export-oriented economies, such as those in emerging countries;
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Increased risk aversion on financial markets: very strong increase in the volatility of the financial markets that affected all asset classes and rebalancing of portfolios from risky assets, such as equities and corporate high-yield bonds, to less risky assets and safe haven assets such as short-term government bonds American term and gold (the trend of the gold futures price is shown in fig. 1);
Fig.1. Gold futures price (source: Investing.com)
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The health, economic and social crisis of Coronavirus is currently not managed in a coordinated way globally and also within some states: this will necessarily entail enormous problems in the future, especially from a supply chain perspective with production sectors (for example, automotive) which risk being blocked due to the inoperability of some nodes in the chain (lack of specific components from certain countries on whose production system is only partially operational).
It is very difficult to predict what will happen to the financial markets in the future, especially for those in emerging countries. The only reasonable indications can be drawn if one looks at what happened on the occasion of the previous double crisis (subprime mortgages in 2008 and sovereign debts in 2010/2011) and on the occasion of the Taper Tantrum. Assuming that what has occurred previously may be valid even now, although the triggering cause of the current crisis is totally different, 3 phases will probably follow (the first, in part, is already happening now):
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Joint effect of investors' search for safe and easily liquidated assets (gold and short-term government bonds such as 1-3 year Treasuries) and the purchase of government bonds, covered bonds and corporate bonds by central banks as envisaged by the recently announced Quantitative Easing strategies. Consequences for emerging markets: on the one hand, the dollar appreciates because it is a safe haven currency; on the other hand, the dollar depreciates as a result of QE maneuvers, emerging debt denominated in US dollars becomes less expensive, products exported from emerging countries become relatively more "expensive". At the moment the first effect definitely prevails, with consequent capital flight from emerging countries, a strong decline in exports (especially of raw materials) and a massive depreciation of all EM currencies (fig.2);
Fig.2 The graph of the MSCI Emerging Markets Currencies index which shows the trend of the 25 major currencies of emerging countries against the US dollar (source: Investing.com)
2. Once the turmoil will be overcome and a new trend of strong and stable growing demand and consumption will take place, in conjuction with an improvement of businesses sentiment indexes (like IFO, PMI to make a couple of examples), investors will be more inclined to invest in emerging markets, due to the possibility of obtaining higher returns compared to those obtainable investing in developed economies, even tolerating, inevitably, a higher, but at the same time moderate, risk (not because of particular intrinsic positive characteristics of certain emerging markets economies, but for the safety net constituted by the liquidity that will be injected into the global economic system through the various QEs and the financial support of institutions such as the International Monetary Fund and World Bank). Consequences for emerging markets: the best strategy that emerging countries can pursue at this stage is to use the financial resources that will be made available to them by the IMF and the World Bank, to reduce the previous debt contracted at higher interest rates, to put in place field investment plans and apply an expansive fiscal policy, accumulate gold and currency reserves in hard currencies (US dollars) that can act as a buffer in the event of future exogenous shocks;
3. World central banks will begin to reduce liquidity injections into the economic system and will gradually increase interest rates in line with a rise and approach of inflation rates to the target value of around 2% and with a decrease and approaching the unemployment rate at the target value of the natural unemployment rate. It is good to remember that the Federal Reserve according to its mandate pursues both the objectives outlined above, while the ECB pursues, by mandate, only the target linked to the inflation rate. Consequences for emerging markets: will have to be found absolutely ready at this stage. On the one hand they must have created favorable conditions for the sustainable development of their economy (transparency, precise regulations, deep and liquid financial markets, well managed public accounts with no compromises on public debt and on public deficit), on the other hand emerging economies central banks must be vigilant and prepared to act fast in case of speculative attacks on EM currencies.
What general indications can investors draw from the above?
Investors will have to privilege virtuous emerging countries in terms of public debt management and the availability of gold and foreign exchange reserves, remaining far from emerging economies that resort to the devaluation of their currency as a tool to maintain price competitiveness. ETFs are the most suitable tool for obtaining diversified exposure to emerging countries. However, in recent years (starting from about 2018) emerging economies have statistically recorded an increase in the positive correlation with the trend of mature economies (the effect that this produces is a decrease in the benefit of diversification). A solution for investors could be investing in frontier markets, which will be specifically discussed in a future article, always here, on Algofj.
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Disclaimer: This article is the result of the opinions of those who wrote and supervised it. No compensation is received for expressing these opinions. It also declares that it has no commercial relationship with the companies and research bodies mentioned in this article.
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Note well: shares are a highly volatile instrument, therefore the share held by this instrument within the portfolio must be consistent with the investor's risk appetite. It is advisable to rely on a professional who can manage risk efficiently.