We are now witnessing a market panic as the continued spread of the coronavirus is threatening a global recession. The impact on global equity markets has been severe in recent weeks, and, combined with the oil price war, volatility has escalated. Equity markets are clearly reacting negatively to the number of cases reported, uncertainty over whether containment measures that we have seen in China will be effective elsewhere, and whether some countries, such as Italy, have the healthcare systems to cope with the outbreak.
While it is difficult to predict how long this pandemic will last, we do know that most cases have been mild. However, testing has generally been poor and only recently rolled out in countries such as Japan, Iran, and even in the US. As testing increases, more cases will be reported, which should result in a lower fatality rate (currently between 3% and 4%). In Korea, where testing has been implemented extensively, the fatality rate is 0.5%. And even in China (excluding Hubei province) the fatality rate is below 1%. Markets are, however, reacting to an increase in the number of cases reported and concerns on policy response, which is why they have not bottomed. Hence, we are being incremental in our portfolio moves.
Recession risks have certainly increased – in the first half of this year we may see a technical recession in Europe and Japan, and a significant slowdown in the United States. If the number of reported coronavirus cases continues to increase through the warm weather, particularly in the Northern Hemisphere, we could see a prolonged recession. But if the number of cases materially decelerates in the summer, we would expect to see a relatively strong recovery in the second half of the year, particularly given the supportive stance by central banks.
Global monetary policy response should cushion the extent of a recession. While it is still relatively early, central banks have aggressively increased stimulus as the U.S., Australia, Canada, and China have all cut rates. The European Central Bank has just expanded quantitative easing and Italy, Thailand, and China have introduced fiscal packages. There is speculation that the U.S. is also looking to put through a fiscal package.
We believe our portfolios are well positioned to weather a recessionary environment. We seek to invest in high quality businesses that are leading dominant franchises, have high returns on invested capital, and low leverage – companies that tend to be more resilient during economic downturns. This is reflected in the downside capture of our strategies. Over the past ten years, the downside capture of our global and U.S. strategies has been 67% and 69%, respectively. Historically during drawdown periods, our strategies have tended to outperform the market. In our view, our strong downside protection has been a result of our overweight to leading quality consumer staples and healthcare companies, exposure to select defensive industrials businesses, low exposure to financials, and lack of exposure to energy. Our portfolios have benefited from the recent correction in oil prices, due to both lower demand and increasing supply as a part of Saudi Arabia's response to the dispute with Russia. We have long maintained a zero exposure to oil given low predictability and low returns on invested capital in energy companies.
Adjusting portfolios to take advantage of market dislocations
We are incrementally making changes to our portfolios given the continued market volatility, adding positions on a very selective basis, while taking advantage of lower valuations. In each situation, we assess whether or not there has been any material change to the 5-year valuation of the businesses we own, or are looking to buy – even accounting for what could be significantly lower earnings for 2020. We now need to look to 2021 valuations and 5-year forecasts to assess the underlying growth in a business. In the majority of cases, we believe that valuations have not been materially impaired and that the strength of the competitive advantages of the companies we own will endure, supported by strong returns and healthy balance sheets. In our global equity strategy, for example, we are seeing opportunities in areas such as luxury, athletic footwear, and online travel segments. We are also seeing opportunities in defensive companies within the medical technology industry where valuations have come down and investors were concerned about single-payer risk. To fund incremental opportunities, we have trimmed some relatively expensive names in the industrials sector. In emerging markets, we are looking past the short-term price declines and adding to areas where we see long-term secular growth, such as online entertainment and games and athleisure.
We have been gradually reducing our exposure to financials as we expect that, in the aftermath of this pandemic, rates will remain low globally. That said, we remain invested in banks in India, which we feel is a much better market. Interest rates in India are still meaningfully higher than in developed markets. And, the low penetration rate indicates that the growth trajectory is intact. Our Indian financials holdings are conservatively managed businesses that have been gaining market share from weakening competitors, such as institutions like Yes Bank, an Indian private sector bank that was recently bailed out by a consortium led by a state bank of India.
We remain conservatively positioned in emerging markets. While we did not foresee the coronavirus outbreak, volatility is inherent to emerging market equities. From a country allocation perspective, we aim to be conservatively positioned and avoid countries with weak fundamentals. We do not have any investments in Russia, Saudi Arabia, Argentina, or Turkey.
China, the largest weight in the MSCI Emerging Markets benchmark, is now seeing a decline in reported coronavirus cases and its supply chain is on the road to recovery. For example, at the deepest point of the decline about a month ago, coal consumption was down approximately 40% year over year. It is currently down roughly 20% year over year. Another indicator to watch is subway utilization, which is still only a quarter of its pre-virus level. People are returning to work, whether they are driving or gradually using subways again, which does present the risk of local outbreaks.
In our international equity strategy, we have increased our weight to industrials, which has been one of the greatest drivers of strong relative performance year to date, even in light of the volatility. Industrials is not typically an area where we find quality opportunities due to the cyclical nature of many companies in the sector. But our bottom-up approach leads us to companies that tend to have a high degree of predictability During downturns, they tend to do better than the economy. With the recent sell off, we are also adding on the margin to some quality defensive franchises that are global leaders in their markets.
Resilience in information technology and e-commerce
Software companies like Microsoft, SAP, and Adobe have improved their business models, shifting away from one-off license sales to cloud-based subscription models. The result is more predictable cash flows and a high degree of visibility into future upgrade cycles. We believe this will make them more resilient during a recession, even though growth will undoubtedly slow. For example, during the 2008-09 financial crisis, SAP’s retention rates remained high, indicating how critical SAP is to a business’s ability to operate.
In terms of longer-term consumer behavior, we believe there will be a shift in demand in e-commerce, particularly in everyday items like fresh food. Names like Alibaba and Amazon should be well-placed to benefit from this. Even businesses like Nike and Adidas, which have been rolling out an omnichannel e-commerce model and have e-commerce revenues close to one third of their sales, are expected to be well-placed to benefit from growth in e-commerce. Online gaming should benefit, where Tencent is well positioned, and for home entertainment there could be an increase in demand for streaming services like Disney Plus.
Steadfast in our investment approach and sensitive to changing market conditions
Our investment approach remains unchanged, focused on identifying high quality growth companies trading at sensible prices. We believe this time-tested process has enabled our clients to perform well over the long term with less risk than the benchmark. A key element of executing this approach is stress testing companies' resilience to economic shocks. This exercise cannot be carried out on the fly in the midst of a panic. It takes years of research efforts by analysts who are experts in their areas of coverage. And, at Vontobel, our experienced research team has made that investment, which can pay off in times like these.
The MSCI Emerging Markets Index (net) is a free float-adjusted market capitalization-weighted index designed to measure equity market performance in the global emerging markets. The index is calculated on a total return basis with net dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.