Greetings from a safe distance. I hope this finds you and yours, as well as your colleagues and friends, all in good health and safety as we navigate these uncharted waters. As it has been several weeks since the onset of the COVID-19 crisis, we can start – and I emphasize start – to discern patterns and opportunities within the world of emerging market investing which are worth noting. The purpose of this note is to highlight our thoughts across some of the asset classes we follow most closely.

First some macro observations:

  1. For many emerging markets, especially outside Asia, these remain the early innings of the crisis. Given the diverse nature of emerging countries, however, there are both reasons for optimism and caution to be found. On the one hand, more fragile health systems, high density living conditions, and limits on the capacity for public response argue for caution. Younger demographics, greater ability to shut down sectors or entire economies in some cases, the more temperate climate of the Southern Hemisphere for others, and the widespread prevalence of the BCG vaccine, primarily used against tuberculosis, may offer some additional immunological resistance, lowering mortality rates; all are reasons for cautious optimism. Finally, we assume the spread of the virus follows US and European contagion patterns, thus we are a few weeks away from peak infection.
  2. The ability (and in some cases willingness) to cope with the crisis varies radically across emerging markets. Some in Asia and Latin America are handling it well, and to good results including Taiwan, Vietnam, China, and Singapore in the first group, and Chile and Peru in the latter. Others will clearly have more difficulties along the way such as India, Brazil, Mexico, Russia, and Indonesia.
  3. Having higher monetary policy rates at the onset of the crisis provided emerging markets with more traditional monetary policy space than developed markets. But now after aggressive interest rates cuts, global emerging markets central banks are left with far less monetary room. In particular, countries with lower institutional commitment to inflation targeting have weak capabilities to provide ample liquidity to the financial system and corporations in need. In this scenario, countries run the risk of de-anchoring inflation expectations. While Argentina is the most obvious example, this risk could also extend to others such as Brazil and South Africa.
  4. Increased levels of fiscal debt in the wake of the global financial crisis, paired with the inability to fully fund deficits in their own currency, limits fiscal capacity in emerging markets compared to developed markets. Countries and corporations’ balance sheets will emerge weaker from this crisis. We expect higher default levels going forward.
  5. We expect emerging market economic activity to be driven by the pace of US and Chinese recovery. Each nations’ economic rebound will be a function of their domestic infection path and policy responses. At the same time, external impulses will play a key role in the strength and sustainability of the economic cycle. Despite the likely deepening of the deglobalization trend, the US and China are the main trading partners for most emerging markets and will continue to play a significant role.

Second, some big picture market observations before we dig into individual asset classes:

  1. Emerging markets had a fairly classically patterned risk-off reaction with very limited differentiation. Correlations spiked across asset classes and countries with steep corrections across the board.
  2. The bounce from the bottom has been far less pronounced in emerging markets than in developed markets. This is in part driven by the unique capability of developed market central banks to provide direct access to liquidity to their financial systems and financing to corporations. As a primary example, the US Federal Reserve can now buy domestic investment grade and even high yield ETFs.
  3. There has been much more focus on developed markets assets and markets than emerging markets as they represent a much larger share of a typical investor’s portfolio.
  4. After periods of high correlation, dislocations abound, and differentiation begins. Opportunities can now be segmented into logical risk / return buckets as markets have settled.

Finally, before we start our tour d’horizon, the views that underpin our projections are:

  1. A pause in the global economy through Q2 due to strict lockdowns, social distancing and overall health policies implemented across the world with intermittent inter and intra country volatility thereafter driven by spikes in infection or COVID-related political fallout. At the end of the day, health policies and the evolution of the disease will dictate the shape of the economic recovery for each country.
  2. Return to pre-crisis levels of earnings, GDP, and employment by year end 2022, consistent with updated IMF projections for the global economy that expects a 5.8% GDP expansion in 2021 following a 3% contraction this year, netting to a GDP level 2% above 2019. If earning elasticities are stable to the downside and upside, then earnings should recover with these activity numbers. This is one of the greater uncertainties of our forecast however as it assumes the pandemic fades in the second half of 2020, allowing a gradual lifting of economic restrictions. If this process is delayed, the U-shaped recovery path may extend from 2021 into 2022, with earnings then not fully returning to pre-crisis levels until 2023. In either scenario, earnings will be well below where they would have been in the absence of the COVID-19 shock. The IMF calculates that the output loss (relative to the pre-COVID growth path) will be approximately 4% lower by 2021.
  3. In the short run, we expect the deflationary impact of weak domestic demand to outweigh disruptions in the productive capacity of the global economy. We believe significant deflationary shock will keep inflationary pressures subdued and global interest rates near the zero lower-band. This can generate incentives for risk taking and inflows to emerging markets any time volatility decreases and puts a ceiling on the value of the US dollar globally.
  4. Finally, continued deployment of massive fiscal and monetary stimuli beyond the life of COVID-19. When the virus passes, political and economic pressures will make it hard to reverse the policies put in place to cushion the shock. The medium to long term inflationary implications of this dynamic present another key point of uncertainty in our forecasts.  Clearly, keeping fiscal and monetary policies looser than optimal as the virus recedes risks generating global inflationary pressures. However, developed market central banks undershot inflation targets for the entire post GFC period despite unprecedented stimulus and thus may instead face outright deflation depending on the path of global demand. Specifically for commodity producing emerging markets, falling commodity prices and the resulting decline in government revenues has constrained the amount of fiscal stimulus that can be rolled out without creating more pressure on debt, so we do not expect the recovery to be strong enough to elicit inflationary pressures.

Now a look at emerging markets asset classes, risk / return, timing, and approaches with our top 6 ideas ordered by volatility expectations:

  • Investment Grade Corporate Bonds represent one of the more compelling emerging markets opportunities at the moment, particularly for investors with a more conservative appetite for risk. The key features are a) a spread widening that is significant in historical terms due in part to the inefficiencies of this asset class, b) the investment grade nature of the underlying corporates, c) dollar-denomination of the bonds, thereby eliminating currency volatility, d) relatively short tenor and duration of around 5 years, and e) the gravitational pull over time of the support being given to developed market corporate bonds. An approach that efficiently parses the large number of issuers into a cogent portfolio, with limited turnover to minimize the large friction costs due to wide bid-offer and efficient execution, is projected by TRG to generate gross returns[1] of 13-17% per year for the next 12 months. For more on our thinking and approach, please follow this link.
  • Local Currency Government Bonds have also become interesting in terms of value, albeit with more potential volatility. It all starts with FX which, driven in part by hedging flows, has depreciated to, by our estimate, 20% under-valued relative to a basket of developed markets currencies and 35% to the U.S. dollar. Add to that a 5.5% current yield and we believe this all can lead to a recovery in three parts: a beta snap-back once the consensus of a bottom is reached, then a period of meaningful idiosyncratic and relative value opportunities, followed by further gradual appreciation as the impact of a global flood of hard currency and low rates move emerging markets into more clear favor. We started to see the first signs of stabilization/consolidation on valuations that support the idea of building exposure to the asset class progressively, taking advantage of what we expect will continue to be a volatile environment to increase exposure over time. We project this asset class to return between 15% and 25% gross[2] over the next two years depending on entry point timing. In addition, there are elements of our approach to this asset class which we think are particularly advantageous. You can learn more about it here.
  • Multi-manager investing is particularly well suited to an environment with a vast array of dislocation opportunities. Our track record vis a vis the MSCI is excellent both in term of outperformance and volatility for almost ten years. We project the strategy to generate 20% gross[3] per year for the next two years, but importantly with only roughly 10% volatility due to a process that rests on a) choosing market opportunities carefully, be they country, style, or asset based, b) identifying and backing managers, who are frequently local, best suited for those opportunities, c) syndicating to these managers the ability to find local sources of alpha and react quickly to local events due to their presence on the ground and d) diversifying investment exposures and styles which can mitigate volatility and point of entry risk. For more on our approach, please follow this link.
  • Emerging (non-BRIC) and Frontier Equities: This is a subset of emerging markets equities in which we have a specialization. It is useful in this context given how much China, India, Russia, and Brazil weigh on the overall index, thus turning a broad emerging markets discussion into one about four countries’ indices. Taking out the BRIC countries leaves us with a broad universe of markets which have been significantly battered in the current crisis, due to the FX depreciations mentioned above, the generally lower level of liquidity of these markets, individual country and company issues, and the general “ baby-with-the bathwater “ effect of the current steep sell-off. Relative equity valuation at this stage is most attractive in small emerging markets as price to book value is already below Global Financial Crisis levels, in stark comparison to BRIC countries that are still trading at close to a 20% premium. As is often the case in such situations, glaring opportunities become available for managers who have a good handle on individual country and, more importantly, company fundamentals. Examples include a basket of dominant consumer retail franchises in Southeast Asia that entered the pandemic with net cash on their balance sheet and now trade at valuations as low as two times net cash in some cases. Elsewhere, the Egyptian market is trading at valuations last seen during the Arab Spring. This is a higher return / higher volatility / lower liquidity opportunity that we project to generate a 25-35% gross return[4] per year and where the combination of liquidity and volatility argue for at least a 24-month holding period. Our approach is described here.
  • Private investing: It is early days to come to conclusions about where the various forms of private investing styles and opportunities will be as we come through this crisis, so we will just comment on two areas. First, we expect private credit to continue to be in great demand and offer significant returns for exposure higher in the capital structure. Senior secured credits, in dollars, for 3-5 years, we project to generate 10-14% gross[5] annually and in some cases higher depending on the structure. Secondly the traditional private equity market, already under duress due to weak returns over the last decade, enormous fragmentation, and recent lackluster fund-raising results, will have absorbed another body blow due to this crisis. Hence we think the greatest opportunity in this area will involve a focus on the secondary market, be it on portfolios or individual investments, and structured solutions for private equity portfolios, such as fund-level credit or mezzanine investments, accompanied by an eventual consolidation among managers. This is an approach that we project to yield 25-35% gross[6] over the next 3-5 years, and which we are exploring actively. More to come in this area.
  • Co-investing in individual ideas: For the brave in search of outsized returns, while bearing the implied concentration risk, there is an opportunity to invest in single opportunities on a one-off or more structured basis. TRG has identified a growing pipeline of opportunities capable of generating returns a multiple higher than our diversified strategies, commensurate with the higher risk. As an example, we detail the above noted Southeast Asia retail basket opportunity here. We are working on a structure which would give investors access to this set of investment opportunities, generated by our investment professionals and also the managers we have invested in globally via our multi manager fund.
  • Forestry: Finally, while it is not a pure EM category, investing in timber is another of TRG’s areas of expertise. There is a lot to be said for this asset class in a world of ultra-low interest rates and in which elements like climate mitigation, sustainability, and local impact are increasingly valued by investors of all stripes. Our experience here is over the course of two decades, across multiple continents, and with a particular expertise in specialty woods and in developing markets (for the products). There has been a lot going on in this sector, including disruptions unrelated to COVID but rather the similarly small and virulent spruce bark beetle, which will be the subject of a follow-up note, but in the meantime should you wish to learn more, please do not hesitate to reach out.

As you can see, there is a lot going on here at TRG, which is as it ought to be for a global, multi-asset class investor such as ourselves. There will be more to come, particularly on the private investing side of things, in the coming weeks. We focused here mostly on liquid market opportunities as they tend to be the most time sensitive. We hope the above is of interest and value to you as you consider the current and prospective emerging market exposures in your portfolio.

[1] Projected returns allow the manager to differentiate amongst investments with varying risk and return characteristics. No assurances can be made that investment objectives will be achieved, and the projected returns herein should not be viewed as an indicator of likely returns to investors. The projected returns do not reflect any fees and expenses, which are expected to be material and adversely affect returns. Projections are subject to great uncertainty.  TRG cannot guarantee returns, and projected returns are included herein for informational purposes only.  Please see the linked presentation for additional important information, including but not limit to, important information on projected returns. Furthermore, please see the end of this document for important information.

[2] Ibid

[3] Ibid

[4] Projected returns allow the manager to differentiate amongst investments with varying risk and return characteristics. No assurances can be made that investment objectives will be achieved, and the projected returns herein should not be viewed as an indicator of likely returns to investors. The projected returns do not reflect any fees and expenses, which are expected to be material and adversely affect returns. Projections are subject to great uncertainty.  TRG cannot guarantee returns, and projected returns are included herein for informational purposes only.  Please see the linked presentation for additional important information, including but not limit to, important information on projected returns. Furthermore, please see the end of this document for important information.

[5] Ibid

[6] Ibid

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