Asset Allocation

Why Covid is bad news for passive EM investors

Discover the state of play of the virus across emerging markets and how they look set to recover.
June 2021

Keith Balmer

Director, Portfolio Manager, Multi Asset Solutions

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The Covid crises that are continuing in India and Brazil have been well documented, but so has the sharp recovery enjoyed by China in 2020 from the virus-induced economic lows. So, what is the state of play across emerging markets and how do these nations look set to recover versus developed economies?

Despite being the first country to suffer from the virus, a swift and strictly enforced lockdown meant that the spread of infections was kept under control, and the Chinese economy was the first to emerge from the global recession caused by the pandemic, recording growth in 2020. Although China continues to set new records – for the first quarter of 2021, Chinese GDP growth recorded a spectacular 18.3% year-on-year*, the fastest rate since quarterly records began thirty years ago – this masks a slowing trend and a disappointing Q1 when considering a quarter-on-quarter basis. In addition, the stellar year-on-year Q1 growth recorded by China is a temporary feature from a low base, and there is data to suggest that in fact there is a longer-term slowing trend. And as Chinese companies account for more than a third of the market cap of emerging market (EM) equity markets, this does have a material effect on the broad return of EM markets as a whole, in the short term. Countries such as India and Brazil, where Covid cases and deaths remain at alarming levels, will not be able to quickly recover from the crisis and they still count for a reasonable proportion of EM market cap.

*National Bureau of Statistics of China

Covid new cases: divergent patterns in EM

Chart 1 shows that although some EM countries seem to have a handle on the spread of the virus, Brazil and India’s new cases per million are at worrying levels. Even though new cases in Brazil and India appear to have peaked, they remain at alarming levels that put huge pressure on healthcare systems already at breaking point.

Covid new cases divergent patterns in EM

 

Source: BMO Global Asset Management and Bloomberg as at 3 May 2021

China activity has already bounced back

As impressive as the year-on-year 18% growth number is, it is measured against Q1 2020 which saw a notable contraction in the economy. Looking at quarter-on-quarter growth, Q1 2021 was barely positive. And there is more data to help us understand the rates of economic activity. The Purchasing Managers’ Indices (PMIs) are regarded as a good indicator of economic health and the PMIs for China suggest that the bounce back has already happened and March data show signs of weakness.

EM PMIs are falling behind DM

 

Source: BMO Global Asset Management and Bloomberg as at 4 May 2021

Whilst retail sales remain robust, industrial production, which has been a key support for China’s recovery from the Covid lows of last year, slowed in March, and there are reasons to believe that this is not temporary. Although analysts still forecast that China’s economy will grow to be bigger than the US later this decade, in the nearer term, economic growth rates look set to be higher in the US than in China this year; something last seen in 1976.

“The pandemic is a global crisis, and developed nations have begun to understand that they need to help other countries tackle the virus.”

In addition, March of this year saw the annual meeting of the National People’s Congress, where future plans are set out, credit policy has already started to be tightened and although currently this is only small, it is likely to grow and will have a negative impact on economic growth and in particular the construction industry. As more evidence of slowing activity comes through, concerns about China GDP growth rates will grow. This is unlikely to turn into renewed fears of a ‘hard landing’, but from a relative perspective, the ever increasing huge fiscal support in the US, as well as other countries only just beginning to benefit from lockdown easing, set against the withdrawal of fiscal support in China plus the fading effects of their economic rebound will have a negative effect on sentiment for China.

What does this mean for EM investing?

The pandemic is a global crisis, and developed nations have begun to understand that they need to help other countries tackle the virus. Vaccines are being sent to those countries that have had supply issues and this can give us hope that cases around the world should start to decline and the risks of new variants should lessen. Although this is great news socially, financially there remain many reasons why investors should tread carefully in emerging markets. Not least are rising bond yields, which are generally seen as bad for EM economies. Whilst this puts additional pressure on emerging markets, it does not mean investors should shun this market completely, but they should be more selective. India and Brazil will bear long-term scars from this crisis and China’s stellar performance is likely behind us, but in all these nations, there will be individual companies that are better placed to survive the challenges, and indeed to prosper as EM does finally emerge from the pandemic.

In our asset allocation, we have been cognisant of the extremely challenging conditions for emerging markets, and we reduced our overall EM equity weighting earlier this year. However, this was not a complete exit of EM, and we still believe there are many positive investments to be made in the right companies. Fundamental research and active allocation can identify these bright spots, versus a passive approach, which could lead investors into struggling sectors and miss out on the best opportunities.

Sustainable opportunities

Furthermore, whilst there may be volatility in the short term, there are many companies that will benefit regardless of the pandemic and are emerging as globally competitive businesses, offering exciting opportunities for investors. One example is Indian banks that are at the forefront of financial inclusion, committed to providing access to investing and borrowing for rural communities. Another theme is focusing on secular trends that were growing before the pandemic and are set to accelerate even further now, virus or not. An example here is the semiconductor space, which has been an attractive area for EM investment, particularly as more people are working from home. This shift has necessitated an increase in devices, while online communication and e-commerce have grown massively in the last year; some of the world’s largest semiconductor manufacturers that power PCs and global technological advancement are based in emerging markets. The shift to remote working has pushed up demand at the same time that supply has dropped due to factory closures and social distancing measures. This shortage in semiconductors means that demand will remain strong for some time.

Risk Disclaimer 

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.

The value of investments can go down as well as up and investors may not get back the original amount invested.

For more information on the low cost active Universal MAP range, please get in touch with the BMO sales support team.

Risk Disclaimer

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

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