Even as we acknowledge that COVID-19 is yet to be fully understood, we believe this "black swan" event is more likely to last for months than for years. We expect an economic recovery after the relaxation of social mobility restrictions, but the shape and speed of such recovery is likely to vary among sectors, companies and countries, with mid to high-income consumers likely see faster recovery than mid to low-income consumers.

In our Q4 2019 letter, we wrote about a continued tug of war between growth deceleration and accommodative economic policies in large economies. What we did not foresee was a full-blown escalation of such “war” between a pandemic shock and mother of all “helicopter money”.

As we write this Q1 letter, we continue to see rolling outbreaks of the COVID-19 virus across the globe. The resulting containment measures are causing extensive economic disruptions. A glimmer of hope, however, is emerging, as parts of Europe are believed to have reached the apex of new cases, while China is seeing green shoots of economic recovery after relaxations of quarantine measures. These “first in-first out” models may provide a rough blueprint for things to come, as back-to-work plans are being sketched in places such as the United States and Peru. Upcoming data on earnings disruptions and the path to recovery could support more accurate asset pricing. A separate yet related oil price war added salt to the wound, compounding the risk to markets especially in oil producing countries.

Figure 2: Fed’s balance sheet change, rolling 10-week change
Figure 1: Global GDP, the eighth global recession since 1990

It is important to put the speed, magnitude and scale of the economic shock in a historical context. Economists estimate that global GDP contraction this year could be the worst since WWII (Figure 1).[1] On the other hand, concerted monetary and fiscal stimulus eclipsed those in previous financial crises (Figure 2 and 3), something that is likely to carry far reaching implications beyond the life cycle of the pandemic. In many ways, previous crises are no perfect analogies, as the current recession resembles a shock from a large natural disaster more than to a financial bubble burst, although there exist elements of both.

 

 

 

 

 

 

 

 

Source: FRB, Haver, UBS

 

 

 

 

Source: National News, UBS Global Economic Note: Fiscal stimulus tracker
Figure 3: Global fiscal stimulus announced as % of GDP

 

 

Figure 4: Global assets and EM equity price correlations at historical high

 

The effect on asset prices was significant, driven by 1) drastic increase in asset price correlation (Figure 4), 2) foreign fund outflow from local debt and equity markets of unprecedented scale and velocity (Figure 5) and  3) fundamental impact on earnings.

 

Note: Global assets include 36 assets covering Developed Markets (DM), DM Government Bonds, DM Corporate Bonds, DM Currencies and Commodities. EM equities include equities across 25 main/liquid countries. Source: Bloomberg, The Rohatyn Group

History shows the magnitude and speed of indiscriminate selling are likely to be short lived and unsustainable in the medium term. As it happens in times of uncertainty, market values ceased to represent fair present value of long term expected cashflows but are mere reflections of the immediate emotional response to events. While the reality is not rosy, asset price dislocations during panic selling of similar scales usually breed outsized return potentials as signs of normalization ensues.

Figure 5: Foreign fund flow from emerging market equity and debt market

 

 

 

 

 

Source:Deutche Bank Research

 

In the short term, a fundamental impact to earnings is undeniable, but it is quantifiable, and likely to be short term in nature.  Ironically, in many cases, the very characteristics of emerging and frontier market investment themes are exactly the ones that make them vulnerable in a pandemic: population density, low penetration of goods and services (including medical services), rising mobility of people and capital, to name a few. While we made realistic adjustments to our earnings expectations, we believe that a natural disaster-induced cyclical shock does not deny long-term trajectories of these same dynamics. This is particularly true for those companies and countries that can survive the shock bearing minimum permanent scars.

Our baseline assumptions underlying our market outlooks are as follows:

  1. We project the current virus outbreak cycle (outbreak escalation à social mobility restriction à new cases peak à social mobility relaxation) in each affected country, to last months, not years. This is of course, a very rough assumption and reflects the current lack of understanding of the new pathogen, how it interacts with climates, demographics and social mobility policies. However, countries with an earlier outbreak have already provided some guide paths: China took one month from an escalation sometime in January to a peak of new cases in the second week of February. It later took a little over a month for the country to relax some of its quarantine measures. Korea saw an escalation in mid-February and new cases peaked in less than a month. Italy saw case escalating between late February and early March. It took around one month for new cases to peak, which happened at the end of March. We are yet to hear about “exit” strategies in countries that entered the escalation stage after February, and realities vary greatly according to countries’ healthcare systems and policy responses, but we believe a realistic expectation is business closures lasting two to three months. In a recent CNBC interview aired on March 24, the CEO of Starbucks stated that “Starbucks have reopened 95% of the stores in China and it took about 45-60 days before stores start to reopen…And that is what gives us confidence that we know how to manage through this (in other countries).”[2]
  2. We expect an economic recovery after the relaxation of social mobility restrictions, but the shape and speed of such recovery is likely to vary among sectors, companies and countries. A shock of this magnitude will leave scars, but countries with resources to cushion mass bankruptcies and permanent job losses will see better normalization. In addition, we believe mid to high-income consumers will see faster recovery than mid to low-income consumers. We also believe brands and services that have strong market positions are likely to come out stronger after the shock and are also poised to see faster recovery and market share gains. China’s recent experience provides a perhaps imperfect glimpse of what lies on the other end. A recent survey by Bain & Company saw “non-essentials”, “consumer durables” and “consumer services”, the segments most impacted by quarantines in China, recovering 75% to 93% of losses weeks after the relaxation of quarantine measures (Figure 6).[3]
Figure 6: Consumer spending change in different product categories

 

 

 

 

A recent Barclay’s research note on Nike Inc. claimed that “China’s COVID-19 cycle shows evidence of brand strength during store closure and heading back to 100% brand recovery post COVID-19…In approximately three weeks since stores have slowly been reopening in the China region, sales have meaningfully recovered with double-digit week-over-week improvement, and some stores reaching 100% productivity from before the…closures. NKE expects Q4 Greater China revenue to be flat YoY as demand recovers.[4] Similarly, Salvatore Ferragamo’s CEO Michaela Le Divelec Lemmi was quoted as stating that “after a month and half of closures and restrictions, there is a will to come back and have a real life.”[5]

  1. We do not expect all emerging and frontier markets to come out of this crisis unscathed. Currency weakness in certain fragile economies will determine the level of “permanent” damages during the process. Although all our countries have sufficient FX reserves to buffer unprecedented fund outflows for a few months, we penciled in various degree of currency depreciation in our return expectations and steer away from countries with particularly fragile starting point. In March, FX losses accounted for ~2% of our loss.
  2. We expect the debt burden assumed by governments around the world, developed and developing markets alike, will mean different degree of fiscal tightening in the medium term, which is likely to hamper medium-term growth. We do not expect higher than historical growth on a normalized basis and project that lower for longer interest rate will benefit stocks with high dividend yield.

Within our universe, we see the best risk-reward in a group of small, beyond BRICS emerging markets. We estimate that median P/B for countries in the MSCI Emerging Market Index is merely 1% over their Global Financial Crisis (GFC) trough. While all but one of the BRICS trade above their GFC trough, nine small emerging countries already traded through their GFC trough. The below chart (Figure 7) illustrates such valuation comparisons. This reaffirms our tactical bias towards liquid names in small emerging markets.

Figure 7: P/B premium (discount) to GFC trough

 

 

 

Source: Bloomberg. Data as of March 24, 2020

Lastly, we want to reiterate that we do not believe in timing the market. There is a history of asset prices bottom before associated defaults, bank failures and delinquencies started to improve, and market has the tendency to “look across the valley” when there’s a glimpse of the light at the end of the tunnel. We do not know when this will happen.

On the other hand, downside risk from here could be a scenario where “black swan” begets “black swan” - such as potential social unrests, big corporate defaults or a 2018-style idiosyncratic collapse of countries’ financial system that could trigger additional risk-off behavior. Afterall, pandemics have historically sparked riots and redrawn maps, among other disruptions.

At the end, “what doesn’t kill you makes you stronger”. Our target is to own a portfolio of companies that will be “made stronger” at the other end.

[1] “The old familiar sting: Despite rebound, losses to remain” by Bruce Kasman, JPMorgan Chase Bank, March 30, 2020

[2] https://www.cnbc.com/2020/03/24/starbucks-ceo-says-us-experiencing-similar-coronavirus-path-to-china.html

[3] “COVID-19 Webinar for UBS: Scenarios and implications for global consumer markets” – Bain & Co. March 30, 2020

[4] “Nike.Inc: FY3020 Review: China as the Recovery Blueprint” – Barclays, March 24, 2020

[5] “Starbucks and Coronavirus: Lessons for all retailers from the company’s response in China” – Forbes, March 13, 2020

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