Emerging markets (EM) stock markets are enjoying their strongest crisis bounceback ever, as coronavirus (COVID-19) infections stabilise and governments remove two-month-long lockdowns.
Economies around the world have been hit by the shock of the pandemic and many have also suffered from a concurrent oil price shock sparked when Russia walked out of the OPEC+ production cut deal on March 6.
However, as economies open up again and oil prices have broken above $40 after almost halving in price in the last two months, investors have turned “risk on” again and are snapping up cheap shares ahead of their inevitable rebound.
“At this point in the rebound, this EM rally is now the strongest of any of the big-5 EM sell-off rebounds (1998, 2001, 2008, 2016, 2020) and with US, DM and safer (particularly Asian) EM equity markets having less than 10% to go before reaching pre-coronavirus (Jan-Feb) 2020 peaks, investors are being forced up the risk curve in search of potential returns,” Daniel Salter, head of equity strategy at Renaissance Capital (Rencap), said in a note on June 10.
Russia is in the vanguard as one of the “safe haven” markets thanks to its low debt and large reserves, and the economy is already showing signs of a rebound. Rencap saw it coming and marked the whole Russian market up to Buy in the first week of May, in what is now starting to look like a classic call, as bne IntelliNews reported at the time.
And right on cue funds started flowing back into exchange-traded funds (ETFs) this week that have become the main vehicle used by foreign investors investing into Russian stocks.
“Judging by equity ETF flows, last week was the second best for Russian stocks this year. Overall inflows amounted to $72mn – the largest weekly intake since the first week of January. Moreover, net inflows into GEM equity ETFs also resumed at a reasonable pace for the first time since COVID-19 hit the tapes in January,” Vyacheslav Smolyaninov, chief strategist and deputy head of research at BSC Global Markets, reported on June 11.
The average long position among the most liquid names traded on MOEX rose by a further 2.4% in the week ending June 10. Short positions are falling at a more aggressive pace – down c15%. ‘Smart money’ were net sellers for the second week in a row, albeit marginally.
“Flow momentum remains encouraging for speculators and further underperformance of EMs relative to DMs is being challenged. We continue to read positively into the data from a short-term, flow-driven, speculative perspective. Yet our bottom-up 12MF RTS index target stands at 1,400, corresponding to a Hold – the market is fairly valued overall,” Smolyaninov said.
BCS GM reports that the most popular stocks were Russia’s two biggest supermarket chains, X5 Retail Group and Magnit, that have been heavily sold during the crisis for obvious reasons. But it appears both stocks have reached the “too cheap to ignore” stage and brave investors are calling the bottom and buying again. Likewise, investors were buying mining company Norilsk Nickel enthusiastically, which suffered a catastrophic oil spill last week and was also heavily sold as a result.
Markets turned on May 13
Salter argues that the rally in EMs really started to take off on May 13 as investors became more confident that a recovery had started and began to shift investments from the safe haven EM markets to buy stocks in the more risky countries.
Investors into Russia are feeling especially relieved, as the country is one of those leading the EM pack out of the ruins. Despite losing nearly 40% of its value in the last months, the Russian stock market has rallied 10% in the last month. The RTS is currently down 22% YTD, but a few sectors have clawed back almost all the ground they lost since January.
As the recovery in the stock market becomes the consensus view, Sberbank CIB, the investment banking arm of the state-owned retail banking giant, just upgraded its year-end target for the leading dollar-denominated Russia Trading System (RTS) index to 1,500 on June 8, despite the index falling into the 900s in the bowl of the crisis.
EM weekly fund flows (% of AUM)
What has changed?
What is driving the growing confidence in stocks? The battle-hardened EM investors have been through multiple crises in the past and have become inured to the experience of seeing their portfolio’s collapse like a soufflé in a cold draft. Analysts have been at pains to point out that some of the biggest gains to be made in EM investing is to buy just after a crash. And the big difference with this crisis is that it has been a public health crisis and not a financial crisis, so apart from the stop-shock to commerce, not that much damage has been done to the financial system.
The longer the shutdown goes on, the more financial damage is done, but now that enough has been done to ensure health systems are not overwhelmed, most governments have decided to reopen their economies to prevent the nature of the crisis morphing into a wave of bankruptcies.
And there is a lot of spare cash sloshing around the system after governments pumped billions or trillions of dollars into their economies. As Igor Burlakov, the chief business officer of Sova Capital predicted in an interview with bne IntelliNews in April, investors have returned to the Developed Markets (DMs) first and then switched to the EMs after those rallied.
“The key is to go into top-quality assets and stay invested,” says Burlakov. “The DM economies should see a V-shaped recovery and it is even possible to see the financial markets reach new all-time highs. The EMs will have a more pronounced U-shaped recovery with a longer bottom. They will be slower to recover, as they have fewer fiscal and monetary tools to stimulate their recoveries,” Burlakov told bne IntelliNews in an interview.
And records there have been. The US Nasdaq stock market topped 10,000 for the first time ever this week, but investors say that its upside from here is limited.
“Equities globally (including EM) are becoming something of a TINA trade (There Is No Alternative) in a world where financial repression [governments channel funds from the private sector to themselves as a form of debt reduction] is expected to be long-lasting,” says Salter.
Salter goes on to warn that the so-called relief rallies that follow crashes can be unstable, as it takes much longer for real confidence to return that can sustain long-term recoveries. And as the charts below show, none of the markets have completed the "round trip" of regaining all the value they have lost between the fall from their January-February peaks to their March-June lows.
“Almost all the gains were wiped out at one point during the 2001 and 2008 rebounds,” says Salter. “A second wave of the virus in the autumn or a flaring up of the trade war ahead of the US election could be triggers [this time], though we believe the amount of fiscal and monetary firepower that has been unleashed globally should prevent the March lows being retested.”
Index performance (US$) for MSCI EM countries – fall from high, rebound from low and round-trip
Index performance (US$) for MSCI FM countries – fall from high, rebound from low and round-trip
Index performance (US$) for MSCI EM sectors – fall from high, rebound from low and round-trip
Timing is everything
Within the EM universe there are some big differences. Rencap recommends Russia and Central Europe within the traditional Europe, the Middle East and Africa (EMEA) patch. Vietnam and Kazakhstan are the bank’s favourites amongst the Frontier markets. “And for those sure of a V-shape recovery, add more South Africa (and Brazil/Latam/Indonesia) to the mix,” says Salter.
The hall market of EM investing is getting the timing right. From the crisis lows, the US (S&P 500) is up 43%, DM equities are up 41%, EM is up 32%, and Frontier up 16% as of June 10, according to Rencap.
“Until mid-May, the EM rally was dominated by ‘self-help’ countries, the relatively safe names with low bond yields and manageable budget deficits (or those exiting the virus earlier) – so Korea, Taiwan and Thailand in Asia, Russia in EMEA and Chile in Latin America,” says Salter.
“But a shift started within EM on 13 May, when EM currencies started to rebound and with it more ‘risky’ EMs started to outperform, such as Brazil and Colombia in Latin America, Indonesia and the Philippines in Asia and Turkey in EMEA. And since 28 May, EM itself has started to outperform DM as confidence builds that coronavirus [COVID-19] is under control in DM and much of EM (China, Korea, Taiwan and Thailand are essentially virus free and make up two-thirds of EM), while several of the poorer EM/FM countries are seem as more likely to ease restrictions given relatively youthful (and less vulnerable) populations vs the costs of keeping lockdowns in place,” Salter adds.
None of the EM markets have completely won back all of their YTD losses, but most of them are in striking distance and Rencap speculates that returns on investments made at the start of this year will be flat in many markets in the coming weeks.
“You can see this at the country level within EM. Up until 13 May, the rally had been led by the relatively safe Korea, Taiwan and Thailand in Asia; Russia in EMEA and Chile in Latin America,” says Salter. “But this has now shifted, with relatively more risky Brazil, Colombia, Argentina outperforming strongly in Latin America, Indonesia and the Philippines in Asia, and even Turkey starting to perform in EMEA. Not all ‘risky’ markets are participating, with Pakistan (0.02% of the MSCI EM index) up just 3% and Egypt (0.12% of the MSCI EM index) down 1.5% since the start of the ‘risk-on’ rally on 13 May.”
The story is the same if you look at sectors rather than countries. Unsurprisingly, the healthcare sector is the only one to have booked gains this year, but analysts say that healthcare has overshot its fair value and now looks expensive.
The other sectors remain undervalued and their stocks cheap. Industrials are a good bet, says Rencap; however, financials and consumer stocks are a lot more exposed to the effects of the virus and so more dangerous.
“Energy offers 33% upside to its Jan-Feb peak, financials 31% and real estate 28%. But healthcare would have to fall 10% to reach its Jan-Feb peak, and communication services has just 2% upside,” Salter says.
Potential upside ($) if MSCI emerging market country indices return to Jan-Feb 2020 pre-coronavirus sell-off peaks
Where does the market go from here?
Is it too late to get into the market? Unfortunately we are in uncharted territory here, says Rencap, as the strength of the recovery is unprecedented. Following the 2008 crisis the Ukrainian investment bank Dragon Capital did a survey of previous recoveries and found they typically take between 3.5 and 4 years to regain previous highs, but according to Rencap EM stock markets around the world stand a good chance of regaining their January levels before the end of this year.
“Unfortunately, previous recoveries don’t give much of a signal at this point,” says Salter. “77 days after the low and with EM equities up 32% from the lows, this is now – just – the strongest recovery of the five major EM collapses – where MSCI EM has fallen by more than a third in dollar terms. At this stage post-98 low, EM equities were up 31%; post-01, 29%; post-08, 21%; and post-16, 18%.”
Compared to previous crises from here, previous recoveries saw two consolidations before further rallies in 1998 and 2016, one decline to within 5% of the lows (2008) and one further rally before dipping to within 5% of the lows (2001).
Salter spells out the details of each recovery:
• 1998’s recovery consolidated at this point around current levels for three months (which would take us to mid-September 2020) before resuming the rally.
• 2001’s recovery saw a further 15% rally over the next four months (taking us to mid-October) before giving almost all of the gains up to end up just 4% above the crisis lows ten months from now (equivalent to April 2021) and even after that the recovery was lumpy.
• 2008’s recovery gave up almost all its gains from this point over the next 50 days (taking us to the equivalent of end-July) to end up just 4% above the crisis lows before beginning a more sustained recovery.
• 2016’s recovery consolidated around these levels for 9 months (taking us to February 2021) before resuming the rally
As ever with EMs, the stock markets remain unpredictable, as most are missing the foundation of institutional investors like pension funds and insurance companies that make very large and very long-term investments that provide some stability to prices. All the markets remain prone to shocks. And there are plenty of potential shocks in the works: a second wave of the coronavirus, a breakdown in the OPEC+ deal, a new trade war between the US and China as the November US presidential election approaches and now even a “coloured revolution” in the US does not look entirely impossible.
Recoveries from the big-5 EM equity collapses (1998, 2001, 2008, 2016, 2020) in $, rebased to 100 at market low