We believe that the worst is now behind us, and that the resilience of some of the least developed nations has been clearly underestimated. As consumption recovers and policy responses become more balanced - aimed at protecting livelihood as well as lives - there is no evidence to support the future collapse of the offline economy.

Global emerging and frontier markets continued to regain lost ground during the third quarter. Compared to 2Q, however, individual performance among countries was more mixed. As figure 1 below shows, activity levels across emerging and frontier markets started to converge this quarter, as “first in, first out” countries began experiencing a second wave of outbreaks, while “last in, last out” countries continued to recover from the first wave. Such recovery “waves” could continue to ripple through the next months and quarters, driving market volatility and performance rotations. When we neutralized the index weighting effect and excluded China, we found that median market performance of emerging and frontier markets actually deteriorated somewhat from the second quarter. In this context, our portfolio returned 1.8% on a net basis, compared with 0.5% for the MSCI EM Horizon Index, and 8.3% for the MSCI Frontier Market Index. MSCI Frontier Market index’s outperformance this quarter was driven by renewed interest in Kuwait ahead of its upcoming MSCI Emerging Market index inclusion in November. A few other frontier market laggards regained ground this quarter, namely Bangladesh (+24%), Sri Lanka (+18%) and Nigeria (+12.6%). Bangladesh and Sri Lanka had prolonged market closures during the heat of the pandemic from March to May, essentially a quasi-capital control. FX restrictions make Nigeria’s performance irrelevant, with trapped foreign capital and artificially elevated currency causing dollar shortages. These capital control-like measures may unfortunately make it difficult for foreign investors to be meaningfully involved for some time.

Figure 1: Mobility trend progression and market returns

Source: Google Mobility Reports, Bloomberg

We believe damage to the economy and earnings may have peaked in the second quarter. Such prognosis – that the worst is behind us – was reflected in many earnings result briefings and corporate meetings we had in the past few months. Over the course of the quarter, our team conducted over 70 virtual meetings with corporates. Overall, we sensed a stabilization of sentiment and continued resilience, in part driven by the relief that capital markets remain liquid and open, and that government stimulus checks have buffered consumers’ household cashflow in many countries. This allowed the vast majority of companies to tap into credit facilities, and even equity markets, to buy time and insure against continued uncertainties. It is a stark contrast with the immediate aftermath of a financial crisis, when liquidity and financing tend to freeze.

The resilience of some of the least developed countries surprised us on the upside, contrary to earlier assessments that linked economic impact from the pandemic to economic and infrastructure development. For reasons most likely related to young demographics, low prevalence of lifestyle diseases, and other factors that are yet to be understood, many countries with sub-par healthcare and social economic infrastructure fared a lot better than feared. As one contact in Bangladesh recently told me, “For sure, the cases have to be much higher than reported, but luckily the death rate somehow was truly very low, and people bounced back rather quickly.” Similarly, we were worried about how a country like Egypt would fare in the pandemic – like Bangladesh, its city centers are densely populated, commerce is informal and hard to regulate, and healthcare is undersupplied. And yet, with no strict form of lockdown, the country was able to flatten the infection curve and ease restrictions within two months. When asked why small, non-digital clients are so resilient, the CEO of a micro finance bank operating in frontier markets recently explained to us: “initially we feared that it’s going to be a ‘massacre,’ but it turned out to be the opposite. There is an underestimation of the resiliency of the clients. Keep in mind that in our markets, the person is the business. Generally, they have no staff. They will do whatever they can to survive…They have seen many calamities, and they always bounce back.” A bank CEO in in Egypt told us that for their clients, the pandemic is not even among the top five most challenging periods they have had to endure, having lived through the Arab Spring and massive currency devaluations within a decade.

In contrast, some more developed countries fared worse. Latin America as a region, for instance, continued to struggle at the nadir of mobility levels despite being relatively more developed, as can be seen in in figure 1. The same conclusions can be drawn about many developed countries. The good news is that even for countries experiencing a “second wave”, we are seeing “higher lows” in terms of economic activity. This is not necessarily driven by infection case numbers, which remain elevated, but rather by different policy responses. There are now more balanced approaches to protecting both lives and livelihoods, particularly in emerging markets where governments do not have infinite fiscal and monetary resources.  We have seen such a balanced policy response in Indonesia as a prime example during the third quarter.

There are caveats, however. We are observing a K-shaped recovery among emerging and frontier markets. Some of the resilient markets mentioned above have been able to rebound from the shock unscathed and may be boosted further by ultra-low interest rates and ample liquidity. We have heard multiple times in the past few months that, as foreign investor participation diminished and outflows increased, local liquidity has been driven into the equity market amidst historically low bank deposit rates. In Bangladesh, for example, the time deposit rate has dropped to 3% versus a 10-year average of ~8%. Some countries were even able to push through hard fought reforms, driven by a higher incentive to drive growth and investments – Indonesia, for instance, passed the “Omnibus Law” that includes provisions aimed at making labor laws more friendly to business owners.

On the other hand, countries that entered the year with already fragile domestic and external deficits are further squeezed by constricted funding sources (tourism, remittances etc.). This situation is exacerbated when domestic policies are unorthodox and therefore unappealing to foreign portfolio investors. Turkey, Argentina, Sri Lanka and Nigeria are among those fragile countries. We do not see risk-reward as favorable despite an already cheap market valuation, as the downside could be non-linear.

Lastly, despite a brief tech-led sell-off in September, the overall valuation gap between growth, which is dominated by EM and US big techs, and value continued to widen to unprecedented levels (figure 2). Major emerging market indices have become extremely “top heavy” as a result.  As one report neatly summarized it, “the largest four stocks in MSCI EM are all from Asia tech and…their aggregate weight is roughly equal to the tail of nearly 25 entire countries: i.e. from South Africa down to Singapore[1]”. As the market rebound has been narrowly driven by sectors with almost haven like quality, we continue to see a long runway towards a full recovery in asset prices in the vast majority of “brick and mortar” sectors.

Figure 2: EM value and growth divergence

Source: Bloomberg

[1] “Emerging-Frontier Equity Monthly, July: Large EM joins Tech lead, FM lags”, Hasnain Mali, Tellimer, July 28, 2020

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