Just as the slowing global economy appeared to be regaining 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. Many, ourselves included, are hesitant to place our bets; 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, we are seeing two trends emerge within emerging markets. The first we are seeing is the negative effects this outbreak is already having on those countries economically connected to China. Namely, Asian emerging markets 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 SAR and Taiwan ROC) 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 began a sharp drop in early January when capital markets began to factor the negative impact of coronavirus on Chinese growth and broadly, the outlook for global growth (exhibit 1). As a result, we believe we are likely to see global trade coming to a slowdown until the situation in China and the global growth forecast stabilizes.
Exhibit 1: The CRY Index falls as the coronavirus drives uncertainty in the markets
Source: Bloomberg, Thomson Reuters. 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 emerging markets 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 in order to contain the contagious virus.
Exhibit 2: China makes up approximately 34% of the Asia equity within emerging markets
Source: MSCI. As of January 31, 2020.
Seeking shelter in EM fixed income
It is not all bad news for emerging markets. We believe that emerging markets fixed income will emerge relatively unscathed after it is all said and done. There are a number of reasons that support this position. For one, Asia makes up a relatively smaller percentage of the market cap with just around one-third of EM fixed income. That said, China is roughly 20% of the Barclays EM USD Aggregate Index and accounts for zero percent of the Barclays EM Government Local Currency Index due to the capital account convertibility inclusion methodology; meaning, the Chinese Yuan can be converted into foreign exchange without restrictions (exhibits 3 and 4). However, investors benchmarked to the J.P. Morgan GBI-EM Global and Narrow Indices, liquid Chinese Government Bonds (CGBs) will be included beginning February 28 and phased over a ten-month period. This will increase the exposure to China, but primarily for dedicated local strategies. 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 more central bank easing and flight to safety in US dollar-denominated assets anchored to US Treasury yields.
Exhibits 3 & 4: Country weights within the EM USD Index and EM Local Currency Index
Source: Bloomberg. As of February 7, 2020.
Short term, we believe the coronavirus will have a negative effect on emerging markets. 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 for those emerging markets 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 slowing down in 2019 and 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 reacceleration of global growth.
We are confident 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. Further, we believe that any sharp contraction in China's first quarter growth as a result of measures taken to effectively control the spread of the coronavirus will lead to a sharp rebound in the coming quarters. We would argue that emerging markets 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 swiftly should something like this occur again.
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