Global equities have been shaken this week as investors, who were already grappling with the economic impact from the coronavirus, were hit unexpectedly by a tumbling oil price. With markets already fragile – February saw the S&P 500 experience its fastest 10% fall since the Great Depression as covid-19 escalated from a temporary regional shock to a global phenomenon – Monday saw the largest one-day losses since the financial crisis as Saudi Arabia launched an oil price war against Russia.
Markets stabilised on Tuesday to recover some of their losses and we continue to monitor the situation and its impact on our holdings closely. While many unknown factors remain and investors are understandably nervous, based on what we do know and what's gone before, we believe there are several reasons to be reassured.
1. The market impact looks overdone
Emerging markets have inevitably been sold-off in the global panic (although slightly less severely than developed ones) and have fallen around 16% year-to-date. Last week the OECD estimated that covid-19 will slow global economic growth from 3.9% to 2.4% in 2020 with the largest downward revisions for China and other emerging markets. While Chinese factory closures, travel restrictions and quarantines have reduced output – the manufacturing purchasing managers' index dropped from 50 (neutral) to 35.7 in February – it seems to have been effective in reducing the virus transmission. New reported cases have been falling (see figure 1) and the OECD predict that although the impact on the Chinese economy will be significant, it will be short-lived. It expects 2020 GDP growth to be 0.8% lower at 4.9% but 0.9% higher next year at 6.4% as lost output is regained.
We know that markets are swayed by sentiment (both positive and negative) but the limited long-term economic impact of coronavirus means that the current market panic is probably overdone. Similarly, the market reaction to the oil price fall this weekend has been extreme. Against a backdrop of coronavirus fears, this is understandable although the long-term impact is unknown. Some analysts see Saudi Arabia's decision to increase supply when demand is falling as an attempt to force Russia back to the negotiating table, particularly as cheap oil isn't in the Kingdom's long-term interests.
2. Stimulus is coming
The OECD has urged governments to act “swiftly and forcefully” to overcome the coronavirus and its economic impact, calling for monetary and fiscal support. In addition to public health measures and income protection for vulnerable groups and businesses, this includes macroeconomic policies and fiscal spending to restore confidence and support incomes.
Chinese authorities have cut lending rates and pumped billions of yuan into the banking system to make it easier for lenders to extend credit, in addition to reducing taxes and pledging to adopt more proactive fiscal policies. Meanwhile, as the coronavirus has spread internationally, so has the central bank response. The Federal Reserve last week joined Canada, Australia and Malaysia in cutting borrowing rates, which should be supportive for emerging markets. Lower US interest rates have historically driven capital flows to higher yielding EM countries and supported their currencies. We are also likely to see further fiscal stimulus which will boost emerging markets via co-ordinated tax cuts and government spending to stimulate demand.
3. Valuations are a good indicator of future returns
As equity investors, history tells us that valuation is a strong indicator of returns. Before the latest sell-off, emerging markets traded at 1.7x P/B which since the turn of the century has been followed by average 5-year annualised returns of 12.5% (see figure 2 below). This has now fallen to 1.5x while the SKAGEN Kon-Tiki portfolio is cheaper still, trading at a weighted P/B of 0.9x, signalling the potential for significant gains ahead.
We have also seen historically that the larger the discount to developed markets, the higher the probability of superior relative performance over the subsequent period. EM are currently around a third cheaper than DM (P/B 2.2x), which is similar to 2002 when the SARS disease had broken out and EM traded at a 39% discount. In the following period to the end of 2007, EM equities returned over 150%, outperforming DM stocks by over 140%.
4. The long-term economic growth story remains compelling
Emerging markets have delivered higher economic growth than developed markets every year this century and produced similar or higher return on equity over the same period. Even following the recent coronavirus downgrades, developing markets will remain the long-term engine of the global economy. Kon-Tiki is well positioned to exploit this with a portfolio of attractively valued companies diversified by sector and geography. We also have less direct China exposure than the benchmark index (22% vs. 37%) so should be well-placed on a relative basis to withstand short-term Chinese headwinds.
5. Volatility creates opportunity
The coronavirus outbreak has seen volatility return to equity markets with the current VIX 'fear gauge' only exceeded three times previously since the financial crisis. It will likely remain high until there are signs that the outbreak has been contained or we see additional financial stimulus. The panic has triggered a relatively indiscriminate sell-off but markets exposed to Asia or commodities have fallen the most, while the energy sector has been hardest hit as the oil price has fallen nearly 50% since the turn of the year. For equity investors, this creates opportunities to enter attractive companies at discounted valuations. Our broad mandate, active approach and value focus mean that are we are especially well-placed to capitalise.
In conclusion, we appreciate that market events will have been unsettling for clients, particularly in light of the fund's recent relative return which has been impacted by the broader underperformance of EM (relative to DM), value (relative to growth) and small-mid cap companies (relative to large). Be reassured that the team will continue to monitor the portfolio and associated risks from the coronavirus and oil market turmoil carefully, and we strongly believe your support will be rewarded as the panic subsides and sentiment gives way to company fundamentals.
 Source: MSCI in EUR as at 09/03/20. MSCI EM Index -16.4%, MSCI World Index -16.8%
 OECD Interim Economic Assessment, Coronavirus: The world economy at risk, 02/03/2020
 J.P. Morgan Asset Management, 13/01/2020. 60-month annualised total returns measured monthly since 31/12/1999 in USD
 29/03/2002 – 25/12/2007
 As at 29/02/2019