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The recent pullback in Emerging Market equities has mainly been due to rising concerns of the impact of the coronavirus over the world economy. The markets retreated another 4% in the first week of trading in March following Russia’s refusal to agree to further oil production cuts. The drawdown in markets has been dramatic and a reflection of blind investor panic leading to oversold conditions across the board. We are in a situation where EM valuations are now trading well below their historical average.
Recent interesting data points show that of the 80,000 or so cases in China, fewer than 20,000 remain affected which indicates that China has been successful in its efforts to limit the spread of the virus. In parallel, the Chinese authorities remain determined to support the economy and have introduced a range of stimulus measures. Economic activity in China is likely to rise back over 70% in the coming weeks as the country emerges, likely first, from the crisis.
Amidst this backdrop, the Milltrust Global Emerging Markets Fund came out relatively unscathed in February, down -2.07% versus the MSCI EM Index down -5.27%. We remain very confident in the long-term story and fundamentals of Emerging Markets. We recognise the short-term pain, but we also believe this volatility will create opportunities to re-allocate to stocks that have been unfairly punished and have the potential to rebound significantly. An important rule of thumb during these times of heightened volatility and investor panic is it to ensure investors stick with high-quality names which is a key focus for our EM strategy. Our portfolio consists of companies with strong return on assets, solid long-term earnings growth and less indebted balance sheets, all of which re-enforce the high level of quality in the fund.
Economic and market impacts are rarely synchronised, so as evidence of stabilisation of the virus spread comes through, markets are likely to rebound even if the economic effects have yet to play out.
The following points list the different actions we have taken in the portfolio over the past days/weeks given the volatility of the markets:
– We raised our cash levels at the end of January which then hovered between 6% to 10% during February. We still have a 7% cash level at the time of writing in early March.
– We trimmed some exposure to the higher beta markets who are more sensitive to global flows like South Korea and South Africa. We had been underweight South Africa for some time but reduced it further while cutting back our South Korea exposure from 11% down to 5%. South African equities were down nearly 13% while the South Korean equities were down 7.4% in February. We also cut exposure to some parts of South East Asia, including Thailand, whose key tourism industry will suffer in the months ahead.
– We reviewed all the positions in the portfolio to determine sensitivity to the Covid-19 impact and we remain very bullish on the companies we own. In China, our large positions in property management and high education are likely to see very limited impact due to their nature of business. Our Food & Beverage holdings will see limited impact as well. Sportswear is observing some pressure due to traffic drop; however, we are expecting a quick recovery once things are normalized due to pent up demand.
Meanwhile, we will be increasing exposures to countries and companies that will benefit when the panic stops, particularly in Brazil and South Korea, two countries that are attractive from both a long term macro and micro perspective. In Brazil, we believe some important reforms will still be approved this year; the economy still has a lot of room to grow, a big unemployment buffer and all-time low interest rates. Our investment team has therefore been using this opportunity to increase our exposure to names correlated to the Brazilian economy (like Magazine Luiza and Cogna) and also commodity names that aren’t linked to infrastructure investments in the world, like the pulp and paper sector. The team is not worried about the drop in early March, we saw a similar move in the Brazilian markets in 2018 with the Truck Drivers Strike and it proved to be temporary.
In South Korea, we have shifted our focus to the small and mid-caps and away from the more global mega caps. The small to mid-cap companies offer tremendous upside at attractive valuations.
In terms of oil exposure, we have been overweight Russia (6.5% weight vs index weight of 3.5%) for the last 18 months or so as the fundamentals have looked extremely attractive. The market was also up +50% in 2019 so we have benefited from our overweight position. It is difficult to predict the outcome of the dispute between Russia and Saudi Arabia, but our Russia team has been closely monitoring the situation and their analysis continues to show that profits in the Russian oil sector will be more resilient than other producers and that cash flows will be sufficient to support investment debt service and dividends. Meanwhile, the Russian equities still look attractive in our asset allocation models.