Almost a year and a half after the first reported cases of a new “SARS-like” virus in the city of Wuhan, China, we can now look back at a period of some of the most dramatic volatility since the Asian Financial Crisis (AFC) and the Global Financial Crisis (GFC). Even a year ago, it was unclear what set of policy responses would be best to contain the growth of the virus and maintain economic stability.
The COVID-19 pandemic came on the heels of a still-unresolved U.S.-China trade war and the beginning stages of a restructuring of global manufacturing capacity to accommodate new trade patterns – whether re-shoring to the United States, moving to lower cost countries in Southeast and South Asia, or retooling Chinese capacity to fulfill growing domestic demand in China.
China and the U.S. stand out from other countries in their fiscal/monetary and industrial policy response to the COVID-19 pandemic. China’s policy decisions focused on maintaining domestic productivity and employment with as little disruption on the demand side as possible. Manufacturers were given liberal access to capital to maintain operations and specifically incentivized to retain staff without layoffs through social security tax and unemployment insurance refunds. The Central Bank lowered its reserve requirements and removed blocks on certain loan extensions and renewals. Investments were made in traditional infrastructure projects like housing and transportation, as well as accelerated spending in the nationwide 5G network. As a result, China moved from having a GDP contraction of almost 6% for the first quarter of 2020 to being the only major world economy to print a positive GDP growth number for 2020.
From an Emerging Markets perspective, the most important parts of the U.S. policy response to the pandemic has been the growth of the fiscal balance sheet and the U.S. Federal Reserve’s accommodation of this expansion through easy monetary policy. While this response has not (yet, at least) brought unemployment back down to pre-COVID-19 levels, it did allow for a sharp reduction from the almost 15% unemployment seen in April 2020.
The expansion of the U.S. balance sheet led to weakness for the U.S. dollar through much of 2020, but it also appears to have finally stimulated real inflation in the U.S. economy. The increase in inflation has led to talk of tightening (through tapering of the asset purchase programs, if not increased rates), which should lead to strengthening of the U.S. dollar. There is less confidence in the policy responses of other major economies, particularly Europe, which further increases the likelihood of a stronger U.S. dollar moving forward.
Historically a stronger U.S. dollar was negative for Emerging Markets because of the increasing burden from U.S. dollar-denominated debt. While U.S. dollar strength is much less of a factor today than before the AFC and GFC, it is still true that a stronger U.S. dollar can dampen growth prospects in some Emerging Markets economies.
A stronger U.S. dollar will likely benefit firms that sell commodities into U.S. dollar-denominated markets, as long as there is global demand for the commodities. This is part of the dramatic outperformance we have seen from steelmakers, iron miners, commodity chemical companies, and even coal producers.
The demand behind this outperformance is not, however, part of the same sort of super-cycle seen following China’s admission to the World Trade Organization and the investments in capacity and infrastructure that came from its transition into the so-called “world’s factory.”
Even as some of this capacity is being moved to other countries in the context of trade realignment, the overall demand for commodity materials is not in the same league as two decades ago. We are seeing a short-term build-up of inventories — all the way through the product cycle from raw materials to finished goods — that reflects more ‘new normal’ uncertainties about tariffs and pandemic lockdowns than broad, sustainable demand growth.
Although these dynamics are almost certainly near term and should subside in the medium term, they do attract speculation that disrupts the market. Since, in the absence of significant inflows, there is a conservation of capital within the Emerging Markets asset class, these sharp and transitory shifts get funded by parts of the market that have outperformed — in this case ‘growth’ companies and particularly those in China. In this sense, China has been a victim of its success dealing with the pandemic in 2020 as some investors look to lock-in gains.
These sharp transitions do not signify, in our view, a change in the long-term view for Emerging Markets and the types of firms that create and capture value for shareholders. Even with an aging population, China remains the large economy with the outlook for sustained higher-speed growth. The continued growth of the middle class offers opportunities for investment in education, real estate services, and world-leading innovative technology platforms that enable consumption. The size and scale of the domestic market should also make it more robust and less susceptible to external volatility than other markets in the asset class.
What these sharp transitions do offer is potential to invest in the best long-term opportunities at more attractive valuations than normal market conditions afford. The key is to maintain a disciplined research and investment process based on building an intimate understanding of businesses and their fundamental drivers. Following management teams over different cycles, whether we’re invested in the company or not, helps make us feel more comfortable deciding if we should allocate capital during periods of volatility. With an investment process built around looking for opportunities that provide, in our view, a reasonably good margin of safety as well as potential investment returns over the long run, we feel we can approach these sorts of periods with confidence.