CITY OF LONDON Emerging Markets Quarterly Outlook · 2020-04-24 · Emerging Markets Quarterly Outlook April 2020* CITY OF LONDON Investment Management Company Limited *The publication

Overview

A Whole New World

The spread of COVID-19 has upended the outlook for the world’s economies and generated violent market moves. We provide a framework designed to identify where it makes sense to invest now.

The past quarter has been brutal for risk assets: equity markets

experienced one of their worst sell-offs in history, with the MSCI

Emerging Markets (EM) declining by 23.6% and some markets

falling by as much as 50%. This primarily owed to the spread of

the novel Coronavirus from China to the rest of the world and

the related lockdown measures plus, to a lesser extent, the sudden

flare-up of an oil price conflict between Russia and Saudi Arabia.

Such radical price moves are seemingly opening up new opportu-

nities. Although the trailing P/E discount of the MSCI EM to the

MSCI World remains in line with its long-run average (at 27%),

the cyclically-adjusted P/E (CAPE) of EM has fallen to 10.9, 14%

below even the March 2009 level. To identify investment oppor-

tunities amidst the fog of market uncertainty, our framework

focuses on four factors: 1) more than usual, the change in valua-

tion metrics, 2) the cyclical position and dynamics of each country

prior to the outbreak, 3) the status of infections and public health

policy in each country and 4) the economic policy response.

1. Valuations: Several countries which have mostly weathered the

outbreak (China) or addressed it effectively (Taiwan) already trade

at higher P/Es than their long-run average. Others are now 2-3

standard deviations below their historical average. In cyclically-ad-

justed terms, some countries like Brazil trade at a P/E far higher

than their historical minimum, despite a ca. 50% market decline.

Others, like Korea or Turkey, have CAPEs as much as 20% below

their March 2009 low. What is more, South Africa and Malaysia

are also at all-time historical lows in terms of their CAPEs.

2. Cycle: Most EM countries entered the year on a weak growth

footing. That is, they were growing below potential (e.g. Mexico,

Brazil, South Africa, Malaysia, as well as China). Despite this,

some economies were stabilising (e.g. Korea and Russia), while

others were gaining momentum towards year-end, such as India.

Others yet were gathering significant steam and expanding above

potential, such as Turkey and the Philippines.

3. COVID-19: The response to the spread of the virus is key for

the outlook, not least because it determines both the duration and

the depth of the economic impact. While much remains uncertain

about contagion dynamics, broadly speaking, aggressive early

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containment measures deepen the recessionary impact in the near

term, but may also shorten it. Unfortunately, several (often auto-

cratic) leaders in EM have long denied the severity of the crisis and

thus delayed the policy response, aggravating the problem. They

include Brazil, Mexico, India, the Philippines, Turkey and, to a

lesser extent, Russia. To better assess each country’s vulnerability

to the spread of COVID-19, we have created an index that aims

to provide a comprehensive measure. We assess each country’s

medical resources (hospital beds, number of physicians, testing

capacity), demographic characteristics (age structure, malnutri-

tion), living conditions (urbanisation, slum dwellings, household

size) and economic structure as far as it affects susceptibility to

infection (size of the informal economy, population below the

poverty line). The main results for some key emerging markets

are presented in Chart 1. Our index identifies India and Thailand

as being particularly vulnerable, whereas Russia and Turkey are

comparatively better placed.

4. Economic Policy: Many emerging economies have to deal not

only with a double supply shock thanks to supply chain disrup-

tions and a commodity price drop, but also with a sudden slump

in demand for their exports. What is more, they are faced with

capital outflows worse than during the 2008-09 global financial

crisis. As a result, the EM policy response arrived swiftly and

radically, even though it is constrained by the low starting level

of interest rates and limited fiscal space. This has required resort-

ing to unorthodox policy measures. Nevertheless, to a surprising

extent, policies in EMs are broadly similar, differing primarily in

timing and scale.

Some policy responses have arisen out of necessity, such as the FX

interventions in Russia, Brazil, Mexico and Egypt. Encouraged by

the unprecedented policy response in the US and other developed

markets (DM), emerging market economies also began to experi-

ment with their own version of QE: Korea, the Philippines, Poland,

South Africa, Chile and Colombia all announced such plans. Fiscal

policies mostly focus on tiding businesses and households over the

lockdown period: they offer interest and loan forbearance, loans

or guarantees to small businesses and income support to needy or

critical segments of the population. They do not at present aim to

provide economic stimulus beyond the lockdown period. In this,

fiscal and monetary policies are becoming increasingly intertwined

and some countries are straddling the limits of monetary deficit

financing (e.g. India). Some countries have announced very large

fiscal support packages (5% of GDP or more) such as China and

Korea, others have announced merely large ones (2-3.5% of GDP)

Emerging Markets Quarterly OutlookApril 2020*

CITY OF LONDONInvestment Management Company Limited

*The publication reflects asset performance up to 31 March, 2020, and macro events and data releases up to 8 April, 2020, unless indicated otherwise.

2

such as Brazil, Turkey, Russia, Thailand and Malaysia, whereas a

third category has only taken the first steps so far (1% of GDP or

less): India, Mexico, the Philippines and Indonesia.

Market StrategyIt is worth noting that the recently released economic outlook by

the IMF foresees a global economic contraction of 3.0% in 2020

(much worse than the -0.1% contraction during the GFC), com-

prising a 6.1% decline in DM, but only a 1.0% contraction in EM.

What is more, only 10% of all countries are expected to experience

growth this year (compared to 40% during the GFC), although

they include the two most populous, India and China.

This range of conditions and their policy responses provide a

challenging environment for investment decisions. Our allocation

framework is designed to systematize this assessment. As such, it

will require continuous updating as the virus spreads and health

and economic policies adapt. At present, we have made the follow-

ing changes to our country allocation:

• Downgrade China A-shares to underweight: Despite early

success in containing the virus, A-shares are not cheap enough

to reflect the prospect of a global recession.

• Upgrade Malaysia to overweight: The market is the cheapest

in EM on a CAPE basis, while the policy response has been

vigorous.

• Upgrade Vietnam to overweight: There has been a good

public health and economic policy response. Valuations are

attractive against solid fundamentals.

• Upgrade Turkey to neutral: Equity valuations are at a historical

low while the economy has bounced back.

• Downgrade Romania to neutral: Financial and health measures

have been mediocre, with room for further fiscal easing limited.

• Upgrade South Africa to neutral: Valuations are cheap. The

health response has been good, including lockdowns and

flight bans, and financial policy has also been strong.

Chart 1: CLIM Virus Vulnerability Index (VVI)*

Source: City of London Investment Management

Asia

ChinaUnderweight (↓)

The economy is vulnerable to a global recession despite China’s success in containing the disease.

*Required Deposit Reserve Ratio for Major Banks. **US$ total return relative to MSCI EM. Source: Bloomberg

COVID-19 abruptly halted a tentative recovery that the Chinese

economy had enjoyed on the back of a Phase 1 deal between

China and the US. That said, China has managed to contain the

virus with strict measures such as the lockdown of Hubei prov-

ince, nationwide mobility restrictions and social distancing. Daily

reported infections peaked as early as the first week of February.

After plummeting in January-February (Chart 2), economic activ-

ity gradually normalised in March with workers able to return to

factories. While the lockdown-induced supply chain disruption

has faded, China faces two demand shocks due to the pandem-

ic. First, domestic demand for services (e.g. in-mall shopping,

catering, leisure, tourism and passenger transport) is recovering

only slowly from a depressed level as people exercise caution and

certain mobility restrictions remain in place to impede imported

COVID-19 cases and a potential second wave of local outbreaks.

Second, export orders are plummeting as the lockdown in most of

Europe and the US induces suspension of economic activity and

a global recession.

Large policy support has been put in place since the virus out-

break, and more is expected to come as China braces for a global

recession. As early as February, the central bank (PBoC) deployed

unconventional measures such as re-lending and re-discounting

facilities of RMB 1.8trn ($256 bn) to lend cheaply to manufac-

turers of medical supplies and daily necessities. This was followed

by a liquidity injection of at least RMB 3trn ($427 bn) into the

banking sector as well as various policy rate cuts (short-term

reverse repo rates, the medium-term lending facility rate and

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3Y history

GDP, % yoy 6.0 Q4

PMI, index 52.0 Mar

CPI, % yoy 5.2 Feb

Policy rate, %* 12.50 Mar

MSCI China** 13.4% Q1

EPS, % yoy 1.4 Mar

Trailing P/E 12.6 Mar

Latest

*Where 100 indicates the highest score (most vulnerable) and 0 the lowest (least vulner-able). Expressed as deviation from the baseline at 50.

3

required reserved ratios). The Ministry of Finance has also stepped

up fiscal spending, tax reliefs, local-government bond issuance and

infrastructure investment (e.g. 5G and urban transport).

However, it is worth emphasising that the monetary, credit and

fiscal easing this time looks different from that seen in 2008/09

and in 2015/16 for three reasons. First, the decline in global

demand in 2020 may be more severe than previously. Policy

stimulus may at best help boost Chinese economic growth to

around potential in H2 2020 as opposed to above it, as was the

case in 2008/09 and 2015/16. Second, easing is more targeted

and calibrated towards COVID-19-affected sectors this time, and

hence broad credit growth is unlikely to jump substantially as in

the previous two episodes. Third, real estate has become the least

favourite channel of easing due to concerns about housing afford-

ability and financial instability. That also suggests a more modest

growth boost given the importance of real estate in the economy.

All in all, consensus expects GDP growth to fall to around 3% this

year from 6.1% in 2019, the biggest annual drop since the GFC.

Chart 2: Chinese Economic Activity

Source: National Bureau of Statistics of China, Bloomberg

Market Strategy: The trailing P/E ratios of MSCI China and

MSCI China A are at a 6% and 26% premium, respectively, to that

of MSCI EM, higher than the five-year average of an 8% discount

and 21% premium, respectively. We downgrade A shares to under-

weight while remaining neutral on the rest of Chinese equities.

A-shares significantly outperformed other equity markets in Q1,

and ChiNext (an equivalent of Nasdaq in China) was the only

bourse in the world delivering a positive return over the period.

This was driven by China being the first to contract and, crucially,

contain COVID-19 as well as retail investors’ optimism about

Chinese tech companies. That said, valuations look unattractive

given the backdrop of a global recession. Indeed, a halving of

GDP growth from last year would resemble an economic “hard

landing” scenario that analysts have long feared and would have a

severe impact on company earnings.

South KoreaOverweight

Successful virus containment, policy stimulus and resilient memory prices support stock prices.

*US$ total return relative to MSCI EM. Source: Bloomberg

South Korea’s economy had been recovering on the back of easing

trade tensions and stabilising memory prices prior to the COVID-

19 outbreak. The outbreak of the virus led to a lockdown in

China and a disruption to the Asian supply chain before spreading

to South Korea, hitting domestic economic activity. In response,

the Korean public health authority implemented a comprehensive

policy of testing, tracking and treating COVID-19 patients. The

measures, while short of imposing a nationwide lockdown, have

successfully contained the spread of the virus: daily reported infec-

tions declined from 850 at the beginning of March to merely 100

most recently among the 51 mn population.

The government has been innovative with respect to its economic

policy response. On top of a 50bps cut in the base rate, the Bank

of Korea (BoK) pledged an unlimited amount of purchases via

open market operations (OMO), expanding the list of eligible

OMO participants and collateral as well as purchasing treasury

bonds (1.5trn Korean won). The BoK also opened a $60bn swap

line with the Fed and eased FX regulation for the banks in order

to stabilise the currency market. Meanwhile, President Moon

announced a financial stabilisation plan worth 5.3% of GDP, cov-

ering lending to SMEs, corporate bond purchases, money market

financing and stock market purchases. Fiscal expenditure is expect-

ed to increase by 11.4% yoy in 2020.

Market Strategy: MSCI Korea’s P/B ratio of 0.7 times is the

lowest in almost 20 years. Its CAPE ratio has hit an all-time low

and is 11% below the March 2009 level (the trough in the GFC).

Memory prices have been resilient - DRAM up 17% ytd and

NAND up more than 25% ytd – on the back of increased demand

for online services during the pandemic. We remain overweight

South Korea on the back of very cheap valuations, the successful

containment of the virus, the economic policy stimulus and resil-

ient memory prices.

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Retail sales, cumulative yoy %Fixed asset investment, cumulative yoy %

3Y history

GDP, % yoy 2.3 Q4

PMI, index 44.2 Mar

CPI, % yoy 1.0 Mar

Policy rate, % 0.75 Mar

MSCI South Korea* 1.2% Q1

EPS, % yoy -48.4 Mar


Latest

4

TaiwanUnderweight

The Taiwanese market is vulnerable to a global recession.


Sino-US trade tensions last year led to an adjustment of the

regional supply chain such as re-shoring and increased investment

in Taiwan. Output was also better than expected in Q1 2020 as

companies increased production in Taiwan amidst the factory

lockdown in Mainland China. This temporary boost faded as fac-

tories in China resumed work. Now, instead, Taiwan is braced for

a global recession induced by Europe and the US.

Taiwan has not been spared from the pandemic. However, the

public health authority has drawn valuable lessons from the SARS

outbreak in 2003. They were alerted about COVID-19 as early

as December 2019 and since then have implemented compre-

hensive social distancing, tracking and treatment measures. Only

five patients have died to date from the pandemic. The economic

policy response has been modest and slow relative to the public

health response, with the special budget amounting to less than

1% of GDP. Apart from a 25bps rate cut in March, a large and

comprehensive relief package was not announced by the cabinet

until April. The package could involve salary subsidies and loans

to industries affected by the pandemic.

Market Strategy: MSCI Taiwan declined by approximately 21%

in USD terms from the peak in January, but its CAPE ratio is still

40% above the level in March 2009. Meanwhile, Reuters reported

that the US administration was drawing up new rules effectively

forbidding Taiwanese companies from supplying chips to Huawei

and other Chinese firms currently sanctioned by the US. Such

rules, if implemented, would weigh on the revenue of Taiwanese

I.T. firms and cause new uncertainty around the Asian tech supply

chain. Therefore, even though Taiwan has successfully contained

COVID-19, we remain underweight as valuations do not fully

reflect the impact of a global recession and the continued tech

rivalry between the US and China.

MalaysiaOverweight (↑)

The economy is likely to slip into recession, but the strong policy response is set to limit the downside.


Malaysia’s economy was decelerating prior to the outbreak of

COVID-19 and now faces a recession in 2020. The fall in global

trade as a result of various lockdowns along the supply chain will

likely be a significant drag for the economy, with trade accounting

for 131% of Malaysia’s GDP. Household consumption (57% of

GDP) is also set to contract. The median private sector estimate

is for a 1.5% yoy GDP contraction in 2020, which would match

that experienced during the GFC. However, estimates vary widely:

from a 5.8% fall to a 1.3% rise. The central bank’s (BNM) forecast

ranges from -2.0% to +0.5%.

Monetary and fiscal stimuli have been significant, which should

cushion the blow from the virus. BNM cut its key policy rate

by 50bps to 2.5%, which is still 50bps above the historical low

reached during the GFC. Further rate cuts are likely. BNM has

attempted to ease liquidity concerns too. The Bank lowered the

statutory reserve requirement from 3% to 2%, which will allow

banks to have a liquidity coverage ratio below 100% and declared

a six-month moratorium on all bank loans. A fiscal package worth

2.3% of GDP was also announced. This was mainly aimed at sup-

port for SMEs and welfare programmes, including cash handouts,

rent exemptions and reduced energy prices.

Other policymakers have also responded strongly, with a nation-

wide lockdown implemented in March. COVID-19 testing more

than trebled from 422 per million inhabitants on March 20 to

1,456 on April 3. This should better inform policy decisions and

augurs well for containing the virus.

Market Strategy: Valuations for MSCI Malaysia are cheap. The

CAPE is 10% below its historical low and given the robust pol-

icy response, the market offers value in our view. We therefore

upgrade our allocation to overweight.

3Y history

GDP, % yoy 3.3 Q4

PMI, index 53.1 Mar

CPI, % yoy -0.2 Feb


MSCI Taiwan* 4.5% Q1

EPS, % yoy -6.9 Mar


Latest3Y history

GDP, % yoy 3.6 Q4

PMI, index 48.4 Mar

CPI, % yoy 1.3 Feb


MSCI Malaysia* 4.4% Q1

EPS, % yoy -0.6 Mar


Latest

5

IndonesiaNeutral

Cheap equity valuations reflect a relatively muted fiscal and public health response to COVID-19.


Indonesia’s already weak economy took another hit as a result of

the pandemic. Retail sales had been stagnating at the beginning

of the year before contracting by 5.3% yoy in March. House prices

are declining in real terms. Domestic demand and credit growth

continue to slide despite monetary easing, liquidity injections

and the central bank’s intervention to stabilise the bond and FX

markets.

Economic imbalances and the relatively muted public health and

fiscal responses to COVID-19 limit the success in containing the

disease and any economic recovery. Persistent current account

and fiscal deficits as well as small domestic savings mean that

the economy relies on external financing. That, in turn, prevents

the government from borrowing substantially in the market and

launching a sizable fiscal stimulus amidst the pandemic – so far the

fiscal package amounts to less than 0.5% of GDP. Capital outflows

have led to a rise of more than 100bps in 10-year government

bond yields despite the 50bps interest rate cut, further limiting

fiscal space. Meanwhile, the public health response has been slow

to contain the spread of the disease. Indonesia has the highest

case fatality rate among the major ASEAN countries, suggesting

a poor medical system and inadequate antigen testing amongst its

264 mn population.

Market Strategy: The Indonesian market’s CAPE ratio at the

end of March was 31% below the March 2009 level (the trough

during the GFC). However, the financial (banks, real estate) and

consumer (staples and discretionary) sectors make up 70% of

MSCI Indonesia, and both face significant headwinds. A limited

fiscal and public health response also suggest that it may take a

relatively long time to contain the disease in Indonesia while the

post-pandemic recovery may be weak. Therefore, we remain neu-

tral on Indonesian equities.

PhilippinesOverweight

A sharp slowdown could be cushioned in H2 by infrastructure build-out.


The Philippines had a strong growth outlook going into 2020.

However, uncertainty began to rise in January when President

Duterte and, significantly, his administration spoke of renegoti-

ating government contracts with a broad range of private sector

companies. The outlook was then severely hit by COVID-19, with

case numbers rising nearly tenfold in the two weeks to April 6. The

central bank (BSP) estimates growth could slow to 5.0-5.5% this

year, from 5.9% in 2019, but this appears optimistic. Private sector

estimates range from -3.5% to +4.0%, with the median of 1.7%

seemingly more realistic given a partial lockdown of the country

and the weak external backdrop.

BSP has cut its key policy rate by 75bps in 2020 to 3.25%

and reduced the RRR for banks by 200bps in March. It also

announced its first quantitative easing programme, worth PHP

300 bn ($6 bn) and equivalent to around 1.6% of GDP. Fiscal

stimulus has been small so far (0.2% of GDP), but a further and

larger package is expected. This will help cushion the economic

downside from COVID-19, while plans to speed up infrastructure

buildout could provide a boost in H2.

Health measures to contain the virus have been good, with a

lockdown of Luzon island, which contains half the population,

through end-April. Only Filipino citizens and those with perma-

nent residency can enter the country. Given a large number of

overseas workers in China, one key measure has been a mandatory

14-day quarantine for Filipinos returning from Greater China.

However, testing levels are low and need to improve to aid policy

decisions.

Market Strategy: MSCI Philippines’ P/E premium over EM is

low, at 2.5 standard deviations below its five-year average. We

believe this is sufficient to keep the Philippines at overweight given

generally positive policy responses.

3Y history

GDP, % yoy 5.0 Q4

PMI, index 45.3 Mar

CPI, % yoy 3.0 Mar


MSCI Indonesia* -16.0% Q1



Latest 3Y history

GDP, % yoy 6.4 Q4

PMI, index 39.7 Mar

CPI, % yoy 2.5 Mar


MSCI Philippines* -8.6% Q1

EPS, % yoy 11.6 Mar


Latest

6

ThailandUnderweight

A steep contraction is expected and while stimulus measures should help, health policy has been weak.


Various economic indicators in Thailand had been deteriorating

even before the virus outbreak. The trade-dependent economy is

set to contract in 2020 with COVID-19. Recent private sector

estimates have a median of -3.7%. This would be the worst decline

since 1998, during the Asian Financial Crisis. The key drags will

likely be the severe disruption to global supply chains and the col-

lapse in external demand, as a quarter of Thai exports are destined

for the US and Europe.

The central bank (BoT) estimated that without a policy response

GDP would decline by 5.3% yoy in 2020. As a result, BoT eased

policy, cutting its key rate by 50bps in Q1 to 0.75%. Given that

CPI fell into deflation in March, there is likely room for further

easing. The Bank also eased liquidity pressures by providing

low-interest loans and relaxing debt repayment conditions.

Support has also come from fiscal stimulus worth some 3% of

GDP, with measures including cash handouts and targeted tax

reductions. More stimulus is expected in Q3, with financial mea-

sures set to blunt the impact of the virus.

However, measures to contain COVID-19 have been weak. Strict

travel restrictions were put in place but lockdowns have only

been partial. A state of emergency was only declared at the end of

March, by which time cases had risen by more than tenfold from

10 days earlier. Moreover, testing has been low and rising slowly.

This implies that case numbers may be underreported and could

be one reason that the policy response has been slow thus far.

Market Strategy: MSCI Thailand’s CAPE is just below the his-

torical low, but its trailing P/E premium is close to its long-term

average. We do not believe this is sufficient to compensate for the

lacklustre health response and ongoing virus vulnerabilities, so we

retain our underweight allocation.

IndiaUnderweight

India stands at the beginning of the virus outbreak, but its population and economy are uniquely vulnerable.


India’s economy is particularly ill-placed to cope with the fallout of the coronavirus spread. While other economies such as Mexico are growing at a lower headline rate, India’s economy has suffered one of its most severe slowdowns before the outbreak hit. True, PMI readings picked up at the end of the year and into 2020 and industrial production recovered to a 2.1% yoy and 4.5% yoy pace in January and February, respectively. But GDP growth recorded only a lacklustre 4.7% yoy in Q4 2019.

Like many autocratic leaders, PM Modi has been slow to respond to the outbreak, declaring a three-week lockdown only on March 24 when infections had already begun to rise rapidly (although numerous restrictions were already in place). This meant that India found itself in the stage of “community transmission” before it had a chance to implement widespread testing, which runs at one of the lowest rates in EM. As the second-largest country in the world with a population of 1.4 bn, India risks incurring millions of infections as 78 mn people live in slums with poor sanitation and no access to healthcare while hundreds of millions work without formal jobs (Chart 3). What is more, the medical infrastructure is poor as India ranks lowest on hospital beds per inhabitants. And while the population is young with half below the age of 25, pollution and poverty mean that health conditions are poor and large segments of the population are thus nevertheless vulnerable. A rapid spread of the virus amidst such a large population would inevitably also pose risks for the surrounding region and the wider world.

The central bank (RBI) responded by cutting the country’s repo rate by 75bps to 4.4% at an extraordinary meeting, the lowest rate since its introduction. The RBI also cut reserve requirements from 4% to 3%, announced regulatory easing, a moratorium on all loan repayments for three months and injected massive amounts of liquidity into the financial system. It has also increased the limit

3Y history

GDP, % yoy 1.6 Q4

PMI, index 46.7 Mar

CPI, % yoy -0.5 Mar


MSCI Thailand* -10.2% Q1



Latest 3Y history

GDP, % yoy 4.7 Q4

PMI, index 51.8 Mar

CPI, % yoy 6.6 Feb


MSCI India* -7.5% Q1

EPS, % yoy -5.0 Mar


Latest

7

on overdrafts for states by 30% until September, among a raft of other measures.

The finance ministry on March 26 announced a fiscal package of income support measures, valued at approximately 0.8% of GDP. Its key elements are in-kind distributions (food, cooking gas) and cash transfers to lower-income households, insurance coverage for workers in the healthcare sector and wage support to low-wage workers. These measures supplement an earlier announcement made by PM Modi of an additional Rp150 bn for the health sec-tor (0.1 % of GDP). The expenses are part frontloaded, part to be paid from an existing welfare fund and partly financed by an earlier increase in excise taxes.

The measures primarily provide income support, but are pres-ently not designed to stimulate business activity more broadly. Further measures may yet be introduced, but in the short term, the economic fallout is nevertheless likely to be severe. Already in March, the services PMI fell to 49.3 from 57.5 in February, the second-highest decline ever. The manufacturing PMI did not yet fully capture the effect of the lockdown and eased just to 51.8 in March. The eventual economic impact will depend on the extent of contagion in the population, the will and capacity to implement tests and lockdowns and the mitigating policy measures, all of which are highly uncertain. While current market forecasts remain sanguine, a more dramatic deceleration to near-zero growth remains plausible.

Market Strategy: India scores as one of the highest countries on our VVI index and is likely to suffer a severe economic impact from contagion. Its equity market declined 31.1% in Q1, thus underperforming the MSCI EM by 7.5% points. While the sell-off appears dramatic, it outperformed other markets whose economies are arguably less vulnerable. Indeed, India’s P/E of 17.9 is some-what cheap compared to its usual premium relative to the MSCI EM, but on a cyclically adjusted basis, India’s P/E remains above previously achieved lows, unlike many other emerging markets. Given these negatives, we maintain our underweight allocation.

Chart 3: Informal Economy, % of GDP

Source: Medina and Schneider (2019), IMF

Latin America

BrazilNeutral

Brazil is ill-placed to weather the spread of the virus and the economy started the year on a weak footing. Increasingly fractious politics limit reform hopes.


Brazil entered this year with considerable market goodwill: it had just passed a landmark pension reform bill saving billions of dollars over the next decade, an achievement that had eluded countless previous administrations. It was about to further its reform drive, engaging on fiscal and administrative reform as well as on granting the central bank formal independence. Yet, improving business sentiment failed to translate into increased activity and growth continued to underperform market expectations. At the same time, the popularity of President Bolsonaro began to weaken. Brazil thus faced the onset of the virus spread on a weak footing: GDP growth recorded a mere 1.7% yoy in Q4 and industrial pro-duction had contracted for several months into year-end. Inflation has remained well-behaved and sharply below target at year-end.

Brazil has been slow in accepting the severity of the health crisis. With President Bolsonaro repeatedly dismissing the threat, mock-ing opponents and mingling deliberately in large groups of people. He went as far as launching an official campaign urging people to carry on with their lives as normal. As a result, several former allies have broken with Bolsonaro, such as the governors of Sao Paulo and Rio de Janeiro state and have introduced their own region-al lockdowns. Other social distancing measures (such as school closures and a prohibition in public events) have also been intro-duced after a rise in street protests against both Congress and the President. Brazil’s economy is particularly vulnerable to the spread of the virus as it has a large informal economy (making shutdown and containment difficult), a high degree of urbanisation (con-tributing to population density, Chart 4) and a poorly developed public health system.

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GDP, % yoy 1.7 Q4

PMI, index 48.4 Mar

CPI, % yoy 4.0 Feb


MSCI Brazil* -26.6% Q1



Latest

8

Economic countermeasures have been put place, even if the scope to do so is more circumscribed than elsewhere. The central bank (BCB) cut the Selic rate by 50bps to 3.75% in March and announced liquidity injections worth up to Brl1.2 trn. It also intervened heavily in the FX market in support of the real, which nevertheless lost 16.4% against the USD during March. It also reduced reserve requirements and opened a facility to provide loans to financial institutions backed by private corporate bonds. Congress is currently considering whether to allow the BCB to purchase bonds in the secondary market.

The government also announced a series of fiscal measures, which include the early payments of social benefits, the deferral of tax payments, an increase in social spending (expanding the Bolsa Familia to over one million additional beneficiaries) and the provision of credit lines to firms to protect employment. It lowered taxes and import levies on essential medical supplies and introduced new transfers to state governments to support higher health spending. The totality of the measures is said to amount to 3.5% of GDP, even if most of this represents reallocations within the 2020 budget. Nevertheless, the government has invoked the escape clause of the constitutional expenditure ceiling to accom-modate additional spending. While implementation constraints could become an issue, the primary deficit is likely to expand by several percentage points of GDP this year.

Nevertheless, the economic impact will likely be felt sharply and the first indicators paint a bleak picture: the services PMI plunged to 34.5 in March and overall growth is likely to contract for the year.

Market Strategy: Brazil has been one of the most severely affect-ed markets during Q1, underperforming the MSCI EM by 27% points. This reflects the country’s vulnerability to the virus, its exposure to commodity prices, close relationship with China and the deteriorating political climate, which bodes ill for the reform outlook. While a current P/E of 10.2 represents a sharp adjust-ment, in cyclically adjusted P/E terms, Brazil has cheapened less than other, more robust EM economies. Given that Brazil fares poorly in our four-factor framework, we maintain our allocation at neutral.

Chart 4: Urban Population, % of Total Population

Source: World Bank

MexicoNeutral

Starting the year on a weak growth footing and with a delayed response to the virus outbreak, the economy is highly vulnerable.


Mexico started the year with one of the weakest levels of activity in the EM space as activity failed to pick up meaningfully in spite of the renewed trade treaty with the US and the demand recovery in its northern neighbour. Indeed, GDP contracted 0.5% yoy in Q4 following a 0.3% contraction in Q3. Expectations had built that manufacturing activity and exports could recover following the end of last year’s auto sector strikes and that oil production would stabilize given the government’s expansion policy. However, both manufacturing reading and industrial production overall have con-tinued to contract on an annual basis during the three months up to and including February.

In parallel with his Brazilian counterpart, President López Obrador (AMLO) has been in acute denial of the severity of COVID-19, dismissing all warnings and urging the population to carry on life as normal. More worryingly, Mexico has the lowest level of hospital beds in the OECD (Chart 5) and was already suffering a shortage of medicines before coronavirus. It stands at the low end of testing compared to other countries and accordingly scores as one of the most vulnerable countries in our proprietary Virus Vulnerability Index. AMLO belatedly announced a set of piece-meal distancing measures, but it remains questionable how well they can be implemented given the structure of Mexico’s economy which contains a large informal sector and has almost 50% of the population living below the poverty line. Unsurprisingly, March activity data already pointed to a sharp slump: manufacturing PMI dropped to 45 and the more important services index slumped to 34.9, a record low. While the government previously assumed a 1.5-2.5% expansion in 2020, it now appears that Mexico is headed for a contraction at least as severe as that experienced during the 1994/95 Tequila crisis or the GFC.

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GDP, % yoy -0.5 Q4

PMI, index 47.9 Mar

CPI, % yoy 3.7 Feb


MSCI Mexico* -11.9% Q1

EPS, % yoy -2.1 Mar


Latest

9

Against the backdrop of weak US demand, Mexico’s looming recession could well last as business sentiment and investment activity could be permanently damaged from AMLO’s recent decision to uphold the results of a people’s poll that called for the cancellation of a $1.4bn Constellation Brands brewery in Mexicali, which is already two-thirds built.

The President has announced a series of lacklustre initiatives to dampen the economic fallout of the health crisis, including increased social transfers, subsidies and credit for small- and medium-sized enterprises. However, the emphasis remains on the pre-existing plans to boost infrastructure spending and the announced measures are widely deemed to be insufficient to fore-stall a deep recession. The government has already made changes to the Fiscal Responsibility Law in order to allow it to tap addi-tional resources, but it has also had to abandon its primary surplus target. A large fiscal deficit will likely force the government to increase its public debt, something AMLO had famously promised not to and which is likely to trigger a ratings downgrade from the current A3/BBB.

In response to these developments, Banco de Mexico decided to cut its reference rate by 50bps to 6.5% in an extraordinary meet-ing. It is likely to ease further as economic conditions deteriorate but it stressed that the policy rate was near neutral and that fiscal and health policies would be more effective tools in this crisis. Inflation remains muted for now, at 3.7% yoy in February. It will likely be depressed by a widening negative output gap and the decline in commodity prices. A sharp depreciation of the peso by up to 27% (partly reversed since), may counteract these dynamics somewhat.

Market Strategy: Mexico lost 35.5% during the past quarter, underperforming the MSCI EM by 11.9% points. This has taken the market’s P/E to 10.5, significantly cheaper than historical standards. However, on a cyclically-adjusted basis, the case is more mixed and unlike other markets, Mexico’s CAPE sits above its long-term low. With valuations thus less compelling than else-where, where either the adjustment has been greater or the out-look better, we maintain a neutral allocation to Mexico.

Chart 5: Hospital Beds, Per 1,000 Inhabitants

Source: World Bank

Emerging Europe and Africa

RussiaOverweight

The Russian economy was on the road to recovery but is now subjected to two simultaneous shocks.


Russia entered the outbreak of the crisis with different dynamics than other economies. First, GDP growth had accelerated to 2.1% yoy in Q4. Second, it has ample fiscal resources to dampen the eco-nomic impact of the outbreak. Yet, it faces a second economic shock in the form of the oil price conflict with Saudi Arabia and the US.

President Putin did not initially dismiss the threat of the virus like other autocrats, but claimed that it had been brought “under control”. Indeed, early closing of international travel led to a slow initial rise of infections, even if the reliability of official figures may be questionable. This was followed up by the announcement on March 30 of a week-long (paid) “national holiday,” which was later extended until end-April. Russia is somewhat better placed than other EM countries with its better medical infrastructure and higher testing rate. However, the President later stepped back from the frontline, leaving critical lockdown decisions to mayors and regional governors.

Having eased the policy rate by a total 150bps in 2019, the CBR cut by 25bps in February. It adopted several other measures, albeit it on a small scale: it provided regulatory forbearance and created new financing facilities to support SMEs, households, and financial institutions. The government adopted a slew of fiscal measures to support incomes, ease the loan burdens of SMEs and defer taxes. They are said to amount to 1.4% of GDP, but repre-sent mostly reallocations of already planned expenditures. Indeed, the slump in the oil price is likely to lead to a large fiscal deficit in 2020, limiting the room for manoeuver.

Market Strategy: Despite the double shock to its economy, Russia is better placed than many peers to withstand them (e.g. breakeven oil price of $40/brl vs $80/brl for Saudi Arabia). We maintain our overweight allocation as diversification in case oil prices recover, despite CAPE-based valuations being relatively less favourable.

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GDP, % yoy 2.1 Q4

PMI, index 47.5 Mar

CPI, % yoy 2.5 Mar


MSCI Russia* -12.8% Q1

EPS, % yoy -3.8 Mar


Latest

10

TurkeyNeutral (↑)

The economic recovery and a relatively stronger health sys-tem currently support the outlook.


Turkey probably entered the year strongest amongst EMs, as it had made a swift recovery following its recession. After contract-ing for four consecutive quarters, it grew by 0.9% yoy in Q3, accel-erating to 6.0% yoy in Q4 (full-year growth 0.9%). This reflected a rebound in private consumption on the back of the credit impulse provided by the government. In the present environment, Turkey benefits from its large internal market, a low export ratio and, as an oil importer, also from currently low oil prices.

Like other autocrats, President Erdogan at first refused to impose a full nationwide lockdown, insisting that the economy had to “keep turning under every circumstance.” The government did shut down schools and universities though and imposed travel restrictions as well as a ban on leaving home for those aged over 65. But the President’s insistence on “voluntary quarantine” has led to a more rapid increase in infections and fatalities than in Italy or Spain. After a 48-hour lockdown was eventually imposed, the attempted resignation by Interior Minister Soylu exposed a rift within the government. While testing frequency in Turkey has improved, this came at a late stage. On the other hand, the country benefits from an improved health system and a young population.

The central bank responded by cutting its key policy rate by 100bps to 9.75% and introduced a series of liquidity measures. The government announced a package of measures, estimated at 2% of GDP, including the postponement of tax payments, tempo-rary tax cuts, temporary easing in lending conditions and one-off payments such as an increase in minimum pensions and cash assis-tance to families in need.

Market Strategy: Turkey is in a stronger cyclical position than other EMs and despite a sharp rise in infections relatively better placed during the outbreak. Its valuation metrics have dropped to record lows and as a result we upgrade our allocation to neutral.

RomaniaNeutral (↓)

A GDP contraction is likely this year, but robust testing is pos-itive for countering the COVID-19 outbreak.


Romania’s growth had been decent prior to COVID-19 but now the pandemic may lead to an economic recession in 2020. Manufacturing (20% of GDP) is set to weigh on activity, with a number of companies including Ford and Renault halting pro-duction at plants in the country. This is likely to halt real wage growth (5.0% yoy in January), which has been a key support for household consumption (62% of GDP) and GDP growth in recent years. Hence, recent consensus expectations are for a 3.5% yoy contraction in GDP. This compares to a 7.1% fall during the GFC and given the severe disruption from COVID-19, downside risks to current estimates remain.

Monetary and fiscal measures have been underwhelming. The central bank (NBR) cut its key policy rate by 50bps to 2.0% and has implemented quantitative easing. A fiscal stimulus worth 2% of GDP has been announced, including support for businesses and partial wage payments. However, room for further monetary and fiscal stimulus is limited as interest rates are low and the budget deficit was already wider than the EU limit of 3% of GDP in 2019. Rising debt levels also risk a downgrade of Romania’s sovereign rating (BBB-) to non-investment grade.

COVID-19 cases rose nearly tenfold in the two weeks to April 5. A national state of emergency was declared in March and extended through end-April, while measures like social distancing and travel restrictions have been implemented. Romania’s testing levels have risen impressively over the period, from 427 per million inhabi-tants to 2,113 and above the likes of Malaysia and Taiwan. This is likely to help Romania more effectively contain the COVID-19 outbreak.

Market Strategy: MSCI Romania’s trailing P/E discount to EM is 1.1 standard deviations below the five-year average. We do not believe this is sufficient compensation for a potentially severe downturn, so we reduce our allocation to neutral.

3Y history

GDP, % yoy 6.0 Q4

PMI, index 48.1 Mar

CPI, % yoy 11.9 Mar


MSCI Turkey* -6.4% Q1



Latest 3Y history

GDP, % yoy 4.3 Q4

CPI, % yoy 3.1 Feb

Policy rate, % 2.00 Feb

MSCI Romania* -7.2% Q1

EPS, % yoy 13.1 Mar


Latest

11

Saudi ArabiaUnderweight

The Kingdom faces the dual headwinds of a collapse in the oil price and rising COVID-19 cases.

*US$ total return relative to MSCI EM. **Tadawul All Share Index. Source: Bloomberg

Saudi Arabia’s economy faces two serious shocks this year, one

external (COVID-19) and one self-inflicted. The latter is the oil

price collapse, which was partly caused by OPEC+ not agreeing

to extend output cuts amid disagreement over how much to cut

output by. Saudi favoured more aggressive cuts whereas Russia

did not. It then declared a price war. Effectively, the Kingdom was

attempting to gain market share and has reduced its selling prices

significantly. This, along with the demand shock from COVID-

19, helped push the price of Brent crude below $23/barrel for the

first time since 2002. This is well below Saudi’s budget breakeven

price of $80.

COVID-19 is likely to raise this breakeven price further, as the

government announced a stimulus package amounting to 2.7% of

GDP in March to counter the impact of the virus. The net impact

on the budget is likely to be smaller though as the government

said it would cut spending on non-priority items by 1.9% of GDP

in 2020. The Saudi Arabian Monetary Authority cut its policy

rates by 50-100bps and is providing support for the private sector

worth 1.9% of GDP, including funding for banks to boost lending.

COVID-19 cases rose tenfold in the two weeks to April 1.

However, various measures are likely to flatten the curve of new

cases. These include travel restrictions, 24-hour curfews in Mecca

and Medina, the suspension of prayers at mosques and the closure

of various places like shopping malls and schools.

Market Strategy: MSCI Saudi Arabia’s trailing P/E premium

over EM is just above the five-year average. Given the dual severe

headwinds of the oil price collapse and COVID-19, we are com-

fortable maintaining our underweight allocation.

South AfricaNeutral (↑)

A sharp fall in activity and a credit rating downgrade contrast with a strong health response to COVID-19.


South Africa faced anaemic growth prospects in 2020 prior to the

onset of COVID-19, which is set to tip the country into recession.

Consensus estimates a 2.3% yoy GDP contraction for this year,

which would be the worst fall on record. This has led the central

bank to cut its key policy rate by 100bps this year to 5.25% and to

start its first quantitative easing program.

Fiscal space is constrained, which may be why stimulus has been

limited to targeted measures including helping struggling busi-

nesses and households. South Africa’s foreign currency debt rating

was downgraded to non-investment grade (Ba1) by Moody’s in

March, with the ‘negative’ outlook maintained due to the impact

of COVID-19. All three major rating agencies have now assigned

the country a sub-investment grade rating. This means that South

Africa will drop out of FTSE’s World Government Bond Index at

the end of April, likely prompting capital outflows.

The first case of COVID-19 was confirmed on March 1, with cases

rising to 1,353 by month-end. South Africa has a young popula-

tion with only 5% over 65, potentially making it less vulnerable

overall. Testing for the virus has gone up markedly and this should

help guide policies to contain the virus. A nationwide lockdown is

also in place.

Market strategy: MSCI South Africa’s valuations are cheap. Its

CAPE is 10% below the previously-achieved low, while the P/E

premium over EM is 1.5 standard deviations below the five-year

average. A strong health policy response should help contain

COVID-19, which may enable a quicker recovery. These factors

are sufficient to make us raise our allocation to neutral.

The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements.

3Y history

GDP, % yoy 0.3 Q4

PMI, index 42.4 Mar

CPI, % yoy -0.5 Dec


MSCI Saudi Arabia* -0.4% Q1

EPS, % yoy** 8.5 Mar


Latest 3Y history

GDP, % yoy -0.5 Q4

PMI, index 44.5 Mar

CPI, % yoy 4.6 Feb


MSCI South Africa* -16.7% Q1

EPS, % yoy -7.0 Mar


Latest

CITY OF LONDONInvestment Management Company Limited

Contacts

Macroeconomic Analysis

Michael Hart, London OfficePhone: 011 44 207 711 1558 E-Mail: [email protected]

Lyndon Barreto, CFA, London OfficePhone: 011 44 207 711 1551 E-Mail: [email protected]

Mike Liu, CFA, London OfficePhone: 011 44 207 860 8318 E-Mail: [email protected]

London Office77 Gracechurch Street London EC3V 0AS United KingdomPhone: 011 44 20 7711 0771 Fax: 011 44 20 7711 0774 E-Mail: [email protected]

Philadelphia OfficeThe Barn, 1125 Airport Road Coatesville, PA 19320 United StatesPhone: 610 380 2110 Fax: 610 380 2116 E-Mail: [email protected]

Seattle OfficePlaza Center 10900 NE 8th Street, Suite 1414 Bellevue, WA 98004 United StatesPhone: 206 830 9986

Singapore Office20 Collyer Quay 10-04 Singapore 049319Phone: 011 65 6236 9136 Fax: 011 65 6532 3997

Dubai OfficeUnit 2, 2nd Floor The Gate Village Building 1 Dubai International Financial Centre P.O. Box 506695, Dubai, United Arab EmiratesPhone: 011 971 4 249 8402 Fax: 011 971 4 437 0510

Websitewww.citlon.co.uk

Important NoticeCity of London Investment Management Company Limited is authorised and regulated in the UK by the Financial Conduct Authority, registered as an Investment Advisor with the United States Securities and Exchange Commission and regulated by the Dubai Financial Services Authority.While City of London Investment Management Company Limited has used reasonable care to obtain information from reliable sources, no representations or warranties are made as to the accuracy, reliability or completeness of third party information presented herein. No responsibility can be accepted under any circumstances for errors of fact or omission. Some of the information in this document may contain pro-jections or other forward looking statements regard-ing future events or future financial performance of countries, markets or companies. These statements are only predictions as of the date of this document which could change without notice and actual events or results may differ.This document does not constitute an offer to sell or the solicitation of an offer to buy any securities. Nothing herein should be construed as investment advice to buy or sell any securities. Past performance is not a guide to future results. The value of an investment and any income from it can go down as well as up and investors may not get back the original amount invested.

Overweight Neutral Underweight

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don

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ron

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rket

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rate

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: B

an

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lga

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, C

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roa

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cua

dor

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na

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ma

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khst

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hua

nia

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kia

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rin

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Tob

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kra

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bia

.†

An

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ba

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whe

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Act

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per

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o gu

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fu

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ult

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*K

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rite

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Sou

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Blo

ombe

rg,

Cit

y of

Lon

don

In

vest

men

t M

an

age

men

t

KE

Y E

CO

NO

MIC

AN

D F

INA

NC

IAL

IND

ICA

TO

RS

Documents

CITY OF LONDON Emerging Markets Quarterly Outlook · 2020-04-24 · Emerging Markets Quarterly Outlook April 2020* CITY OF LONDON Investment Management Company Limited *The publication