It's been a very volatile couple of weeks. How has it been working from home and keeping up communications with companies you invest in?
Obviously, business continuity is critical. In times such as these, proximity to the investment team has its challenges but we’ve been working from home for a couple of weeks now and communication levels are extremely high. Technology is working and information is flowing both across the investment teams and also with the companies we invest in. It’s been a huge effort on the part of our business and so far, it’s working seamlessly. We’re very lucky in that respect. We’ve also been able to take on the learning of our Asian offices who have been operating under this environment for some weeks now.
How does the current crisis compare to your experience in the Global Financial Crisis (GFC)? Are there similarities or it very different?
My first instinct, when we started to see declines like that, it felt similar to the GFC but as it progresses, we’re seeing a very different environment.
It isn't the same as The GFC which was a balance sheet crisis in the financial system, that created an economic recession. This is clearly not the case today. This is a classical demand shock which has the potential to lead to serious financial issues particularly because of the default risk that arises.
There are some similarities but also a number of key differences. The rate of market decline is definitely more severe than what we witnessed in 2008. And I think that is the exacerbated by a period of exceptionally low volatility and low interest rates coming into this.
There has been a significant reduction in economic activity across Asia, and this is now spreading across the globe. How does that impact the financing ability of companies you invest in and what does that mean for the portfolio?
When this crisis started to manifest itself, you go into crises management and that's about really understanding liquidity in a couple of key ways; from a portfolio perspective in terms of liquidity of the stocks that you hold, and then liquidity perspective in terms of their own balance sheet exposures. And then thirdly liquidity at a financial system level.
Now, if we start with financial system liquidity and look at what measures that were taken in Asia, particularly in China as this issue started to arise. We saw extension of state support to state owned banks, to keep credit flowing, debt forgiveness holiday capital lines being drawn down and early extension of monetary policy.
One of the key learnings from the GFC that policy makers have been able to implement particularly in counties such as China is the need for rapid extension of monetary liquidity into the system to keep markets functioning.
One of the key challenges we face at a portfolio level is managing overall portfolio liquidity. Business modeling around bear case scenarios, are proving to be not bearish enough because of the rate of the demand shock. It's very important to keep portfolio liquidity robust, so any changes that we make within the portfolio I need to ensure that we are not reducing overall portfolio liquidity, because we do not want to be as a situation where we have to start selling what we can rather than what we want to.
The third consideration is liquidity at a corporate level for the businesses that we've invested in. The Fidelity Global Emerging Markets Fund invests in high quality businesses with strong balance sheets so these businesses, generally speaking, have the ability to survive periods of draw-down. But we’re keeping a close eye on revenue generation as obviously this is posing some challenges to balance sheet structures.
What are the key changes you’ve made to the strategy positioning in the last few weeks in response of what's going on?
If we wind back maybe six weeks, we started raising cash within the portfolio as a consequence of just being more cautious around what we were seeing develop. So, the cash position is higher than in previous years.
Now we’re looking to take advantage of market dislocations as they present themselves. The speed of the decline has meant it's been very difficult during the last couple of weeks to actually significantly moderate any positions to preserve capital from an absolute perspective in in terms of the drawdown in individual stocks. So, what we don't want to be doing at this juncture is making short-term decisions that impair long term value creation potential, which is really how we manage the portfolio and a key point of the process.
We want to be buying more of the best businesses in emerging markets that increase market share as their competitors are having to retrench. And so, we want to be on the front foot in terms of our ability to do that now. There are certain areas that we’ve be watching for some time and haven't owned due to valuation concerns and now we have the opportunity to buy due to the lay-off in demand. As a case in point, 5G penetration and digital rollout in China has experienced a delay in terms of demand but it isn't permanent. And so, we’ve been able to add certain technology companies to the portfolio to benefit future opportunities.
The other positioning change that has been ongoing over the last three or four months is a reduction in our exposure to financials. Financials have been one of the biggest positions in the portfolio over the last six or seven years. However, I personally feel that the significant reduction in rates that we saw in the second half of last year, which has only been exacerbated, will put pressure on net interest margins for even the best banks in emerging markets. And it isn't clear to me at least at this juncture, that we're going to see the kind of demand for credit improvement that banks need in order to offset that that reduction in interest rates. And so, I think we’re potentially entering a period of structurally lower profitability for those businesses, which will impair long term underlying returns on equity.
Other than that - we’re holding the line in terms of keeping quality businesses that we want to continue to hold despite the sell-down such as consumer discretionary which are currently suffering but are still great businesses.
How is the Fund performing given your focus on quality businesses and strong balance sheets? Do you see any particular factors that are driving performance other than sentiment?
So, let me address that in a couple of key areas. First of all, pre sell-off and then during sell-off. I think that is important to make a distinction between those elements. If we go back to the start of the year, and indeed December we were seeing a fairly positive environment in emerging markets, which was driving up the performance of index heavyweight stocks that we typically have less exposure to.
During the first half of January, the strategy was, underperforming the benchmark mainly as a consequence of large internet stocks doing very well. During the sell-off we’ve seen performance come back but we haven’t out-performed due to the performance of index heavyweights such as Chinese State-owned banks which we don’t own due to the philosophical approach we take to manage risk.
An underweight position in internet stocks which have been less impacted by store closures and the inability of people to go about their ordinary daily lives and have continued to trade relatively well has also impacted relative performance.
My focus at the moment is ensuring that the decisions we're taking today in the portfolio are decisions which over the long term will create significant value for clients rather than be too reactive to short-term events.
Many emerging markets are highly exposed to the US dollar. How will recent movements in the dollar be impacting EM companies?
The energy price decline that we've seen is having an impact on the dollar cost in emerging markets. So, less petrol dollars being generated has left all the liquidity sloshing around the system and so the dollar cost of capital is rising, despite everything that the Federal Reserve is doing to try and offset that.
If the dollar cost of capital rises, it creates challenges in emerging markets which are generally speaking importers of foreign capital and we’re seeing that across emerging markets now - particularly in the Middle East, Russia, Mexico and to an extent Brazil. This will create challenges in some emerging markets in terms of their ability to maintain low interest rates and not have inflationary issues. They will be importing inflation given the currency is so weak. Because demand is so weak due to the demand shock, imported inflation isn't going to show up immediately but as soon as a normalization occurs, I think it will do. So, we’re likely to see rates go back up in emerging markets when that happens.
If we look at emerging market compared to the developed world. Are there particular challenges for emerging markets or in turn opportunities?
There’s definitely some opportunities. China is very likely to benefit from being a first in first out type player in this as they took draconian measures early and so far, it appears to have been relatively successful. That goes for other parts of Asia - which is good news.
Others will suffer from indecision around economic containment and their ability to deal with a virus outbreak. It’s hugely challenging, given the healthcare systems of some emerging markets, I'll use Brazil as an example. We were talking to a Brazilian health care operator, just a few days ago - 25% of the population in Brazil have got access to private health care currently, but as job losses rise because of the economic destruction that number will decline as corporate health care plans account for much of this number. As it stands today more than 70% of the population don't have access to private healthcare and yet the private sector has as many hospital beds as public sector. So that just gives you a sense of how easily overwhelmed emerging markets healthcare systems are going to become as the situation worsens and something to be acutely aware of in terms of their ability to deal with this crisis.
So, I think that a major difference for developed markets is that enforcement and healthcare systems are going to be stretched, but they're not going to be as stretched as they are in emerging markets. On a more positive note when we do come out of this downturn, there’s naturally more pent up demand in emerging markets particularly in emerging Asia than in developed markets because penetration levels are at very different stages and therefore the ability to recover may be more apparent. This statement is theoretical and slightly speculative in nature, but I do think the ability to recover from a demand perspective and favourable valuation differentials will provide some positives to draw upon.
