Just as the slowing global economy appeared to be regaining at least some of its footing after a volatile year of trade wars and protests, China announced the emergence of a new hurdle to overcome: the outbreak of a new coronavirus, 2019-nCov. First detected in Wuhan City within the Hubei Province, the unknown virus has spread rapidly across borders. While the narrative changes on a daily basis, concerns remain the same, both on a humanitarian level as well as an economic level. We are finding ourselves at the wait-and-see stage of how this virus will impact global growth. However, we are seeing more definitive numbers materialize as it relates to the influence the virus may have on emerging markets.
A surprising blow to emerging markets, but not how you would expect
China is the world's second largest economy and as the country reacts to the growing pandemic, two trends emerge within emerging markets (EMs). The first we are seeing is the negative effects this outbreak is already having on those countries economically connected to China. Namely, Asian EMs whose close physical proximity to China and ties in trade are feeling the pressure of border closures and other measures China is taking to contain the virus. The top five travel destinations within Asia: (excluding Hong Kong and Taiwan) Thailand, Japan, South Korea, Indonesia, and Vietnam, are reporting a sharp drop in Chinese inbound tourists, especially during the recent Chinese New Year (Spring Festival) when travel is typically at its highest all year.
The second trend we are witnessing is the sharp decline in commodity prices. A protracted health crisis combined with disruptions in economic activity will weaken demand for commodities. Any benefits from the US-China phase one deal in the second half of 2019 have been negated by the emerging health crisis. Oil and broader commodity prices were starting to soften in early January and accelerated downward when capital markets began to factor in the severity of the coronavirus on Chinese growth and broadly, the outlook for global growth (exhibit 1). As a result, we believe we are not likely to see global trade rebounding until the situation in China and the global growth forecast stabilize.
Exhibit 1: The CRY Index falls as the coronavirus drives uncertainty in the markets. The CRY Index is currently made up of 19 commodities (crude oil, gold, copper, natural gas, soybeans, etc.) as quoted on five exchanges. Source: Thomson Reuters/Bloomberg. As of February 2, 2020.
Should EM investors worry?
While this is a concerning time for global markets in general, should emerging markets investors be more worried than others? We contend that this depends entirely upon whether investors hold emerging markets equity or fixed income. We believe that there will be a differentiated impact across emerging markets.
For EM equity investors, there are several factors to consider that may negatively affect the EM equity market. For one, Asia makes up roughly two-thirds of the EM equity market cap with China making up roughly 34% of that—the highest market weight—as measured by the MSCI Emerging Markets Index (exhibit 2). Another concern for EM equity investors is the significant exposure to financials, information technology and consumer discretionary sectors, which are 50% of the index. Lastly, supply chain and services sectors continue to be adversely affected as a result of the measures China has taken to shut down vulnerable parts of its infrastructure and contain the contagious virus.
Exhibit 2: China makes up approximately 34% of Asia equity within emerging markets. Source: MSCI. As of January 31, 2020.
Seeking shelter in EM fixed income
We believe that EM fixed income will emerge relatively unscathed after all is said and done. We believe there are a number of reasons that support this position. For one, Asia makes up a relatively small percentage of the market cap with just around one-third of EM fixed income. That said, China is one-fifth of the USD-denominated investable benchmarked EM universe, and zero in the local currency space. Foreign investors are looking to include China government bonds denominated in Yuan this year. Another reason points to sovereign and other government-related debt, which represents approximately 75% of the EM fixed income market cap and is typically lower beta and resilient to negative headwinds. Lastly, EM USD investors have not historically been impacted by currency devaluation and, therefore, we do not see this having an adverse effect on EM fixed income. We expect EM USD fixed income to be generally insulated as any further escalation of the coronavirus impact will enable further central bank easing and flight to safety in US dollar-denominated assets anchored to US Treasury yields.
Exhibit 3: Country weights within the EM USD Index. Source: Bloomberg. As of February 7, 2020.
Exhibit 4: Country weights within the EM Local Currency Index. Source: Bloomberg. As of February 7, 2020.
What the coronavirus means for emerging market investors
Short term, we believe the coronavirus will have a negative effect on emerging markets growth. Particularly, we expect Chinese GDP growth to sharply decelerate in the first quarter, with continued softness persisting in the second quarter. It will also impede growth in other EMs within Asia, given their proximity and close trade ties to China. In the medium term, though, we believe this is only a temporary setback. Global growth momentum was obviously slowing down in 2019 and is only just beginning to benefit from various global central bank accommodative monetary policies. The coronavirus fallout may cause delays in the global recovery and with that, a delay in the re-acceleration of global growth.
We are confident that there is a light at the end of the tunnel given the work done so far and fiscal policy that is in place, including the monetary stimulus provided by the People's Bank of China, along with the low interest rates offered by first world countries. Furthermore, we believe that any sharp contraction in China's first quarter growth as a result of measures that effectively control the spread of the coronavirus will lead to a sharp rebound in the coming quarters. We would argue that EMs may be more resilient after this given that, in the past, countries learn from these adverse experiences (e.g., SARS and MERS).
That said, we are in solidarity with the lives that have been touched by the coronavirus and understand this is so much more than an economic impact story. It is our hope that China, and emerging markets, will come out of this recent development with better controls in place and the appropriate infrastructure to react more swiftly should something similar occur again.