The coronavirus is proving to be a black swan event – unpredictable and with massive consequences

Justin Leverenz examines the long-term impact the virus outbreak could have on economies, sectors, and companies.

After a decade of reasonable tranquility — and disappointment — global equity markets have hit another “black swan,” and trust me I use that word with fearful caution. The coronavirus is truly a black swan in the sense of being both unpredictable and an event of massive consequence. I believe it is also likely going to significantly change behavior and approaches at fractal levels across society and culture, including demand for greater state capacity and governance. As Nassim Taleb explained to us in his book The Black Swan, history is seemingly smooth and linear, until it is not. And when it is not — black swans are responsible for much of what we call history, those large disconnects where big change happens. 

Healthy stressors are vital for developing less fragility (or anti-fragility). The suppression of these stresses has been occurring for decades, since the tenure of “The Greenspan Put,”1 by trying to avoid healthy recession. This has been further amplified in the aftermath of the Global Financial Crisis (GFC), with central banks around the world suppressing natural interest rates levels along with other fiscal stimulus in the big economies such as the US and China. This has created fragility by constraining volatility against nature, depriving markets and corporations of the ability to be stronger and more vigilant. It also has encouraged complacency, buybacks by professional CEOs and leverage. One can easily find the analog in public health care — where efficiency has trumped preparation for pandemics and now, we are witnessing the dire consequences.

Although I am an investor, I can also be a speculator about the broader world. Beyond elections and markets, I imagine that many, many things may change in response to this Black Swan event. At the level of global relations, we can hope for greater collaboration and understanding. Perhaps a renewal of the Pax-Americana era, which followed the demise of the Soviet Empire, an era of globalization and liberalization, with more equitable and tolerant leadership in an increasingly multi-polar world. My bet, however, would be the opposite, and that the endogenous forces of national chauvinism and parochial interest we have witnessed over the past decade will get further reinforced. But outside of obvious triage improvements in public health, I suspect the most profound changes at the abstract level are likely going to be about a big shift in the orientation of capitalism. I see a few potential developments:

  1. The pursuit of shareholder capitalism will come under greater attack. A milder form of capitalism, with less pronounced focus on meritocracy (a “winner take-all” approach), and a greater focus on fairness: re-establishing an ethos of equality of opportunity (which is not the same thing as equality of outcome). After the second massive economic crisis in a decade, the pendulum will shift in the ongoing balance between the state and the market. I also suspect that social demands for greater accountability of governance will grow as state capacity expands. I believe we are moving towards a better world, where redundancy will be more appreciated vs the MBA-orientation of efficiency at all costs. 
  2. Oligopolies will be under pressure. This implies not just technology, which has some level of meritocracy associated with it, but also politically prominent oligopolies which under-deliver innovation and unfairly tax society.
  3. Corporate empires will face internal pressures to find focus. The behemoths will struggle to overcome the inevitable diseconomies of scale that lodge in as corporate complexity overwhelms efficiency gains. Bureaucracy and process at extreme scale overwhelm competitiveness as these behemoths get disrupted. Leverage is often a catalyst and a bane amongst such companies. Glencore, HSBC, and Anheuser Busch are not in many ways different than Citi and GE at the turn of the century.

Beyond speculation about the world, I have some thoughts on some likely proximate consequences for emerging market equity investors. 

1. Contrary to conventional wisdom, Russia may just be one of the great places to invest now.

Russia is the strongest of any major oil economies with a fortress balance sheet, strong fiscal position and a flexible currency (and cost structure).

Figure 1: Russia is better positioned to cope with US$30/bbl oil price

Source: Central Bank of Russia, Ministry of Finance, Sberbank, CEIC

While oil at $30 will be uncomfortable for Russia, where inflation is estimated to rise to around 4% resulting in lower real incomes, it will be devastating for the Gulf economies. Saudi in particularly could run double digit deficits and see its net debt to GDP soaring to 53% in 3 years.

Figures 2-4

Source: IMF, Kingdom of Saudi Arabia Ministry of Finance, as of 12/31/19. Bernstein Estimates for 2019-2023). Past performance is no guarantee of future results. Estimates may not come to pass. Subject to change.

Ironically, the ultimate losers of this price war will likely be the biggest recent growth producers – the US shale firms, whose breakeven price lies between $48 and $54, according to a Dallas Federal Energy survey. By taking advantage of all major OPEC price stabilization while sitting on a mountain of debt, the shale oil industry has lost its ability to weather the black swan moment. As the capital market is turning off its tap on the US shale producers, the number of bankruptcies rose 50% to 42 in 2019, from 28 in 2018. At $30 oil, there will likely be a lot more US shale producers going belly up this year.

Figure 5: Average Breakeven Prices in U.S. Range from $48 to $54 per Barrel

NOTES: In the March 2019 Dallas Fed Energy Survey, executives from 82 exploration and production firms answered the question, “In the top two areas in which your firm is active: What WTI oil price does your firm need to profitably drill a new well?” The survey collection period was March 13–21. WTI refers to West Texas Intermediate crude oil.
SOURCES: Energy Information Administration, Federal Reserve Bank of Dallas.

2. China will be reasonably fine.

While the coronavirus has hammered China’s economy, which grounded to a near standstill in February, it has a strong and pragmatic state that acted fast and decisively to contain the spread of the virus.

Source: https://www.worldometers.info/coronavirus/country/us/

In response to the outbreak, China has spent roughly 1.2% of GDP ($150B) — excluding infrastructure investment – on a myriad of targeted support, including granting waivers and reduction of social charges, lowering value-added taxes (VAT) for some enterprises, and electricity and gas fees for corporate users.

Structurally, China has a lot more ammunition in its monetary policy. It has developed its antifragility out of a host of inherent stressors in the system – including its skimpy pensions and health insurance system – which have reinforced its high levels of domestic savings. The culturally rooted fiscal conservatism has harnessed China for it to emerge stronger from crisis.

Figure 8: Rates table (China vs. US): China was in no rush to follow aggressive global interest rate cuts

Source: Bloomberg, as of 03/17/2020. Past performance is no guarantee of future results.
Source: Morningstar. Past performance is no guarantee of future results.

3. Latin America will continue the funk.

The economic history of Latin America involved cycles of high expectations followed by disappointment. The region’s volatile and uninspiring growth path has been marked by financial crises and contractions caused by repeated debt defaults and hyperinflation. While Latin America rode out the previous black swan crisis of 2008 with only a brief economic dip and little damage to its banks, the region has been in low-growth doldrums since 2013, with GDP growth averaging 0.8%.

The epidemic is casting fresh light on the region divided by cruel inequalities of wealth and political clout. But beyond aspirations for overarching reforms, Latin American countries like Brazil have never moved upstream to tackle the structural vulnerabilities perpetuating the cycle – including low levels of savings, clumsy states and the prohibitive cost of capital that has been crowding out private investment for years. At 38% of GDP, Brazil’s fiscal expenditures topped all major EM countries in 2019, while its private capital investment has been steadily falling in the last decade – now hovering around 15% of GDP2.

Figure 10: Major Latin American economies have lagged behind their EM peers in the last decade

Source: EM Advisors. Data as of 12/31.19. Past performance is no guarantee of future results.

4. The strong — not the oligopolies — will survive and thrive.

The unprecedented non-wartime economic disruption of social distancing this virus has thrust on us will be painful to all competitors in multiple industries, and not all will survive. Many marginal players will face bankruptcy. Others will have to make fateful decisions to reduce investment in capacity, product development, brands, and talent. Either way, the strong will emerge even more competitive, gathering market share and likely gaining higher profitability against more anemic competition.

The old adage “cash is king” is more applicable now than ever. Companies that have been relying on cheap funding – consequences of central banks’ excessive monetary interventions – to expand their balance sheets will likely crumble under liquidity pressure.  And a few privileged companies with strong balance sheets will be able to capitalize on real non-organic opportunities, which occur when prices are cheap.

In the consumer discretionary space, luxury powerhouse Kering, restaurant operator Yum China and lodging innovator Huazhu are cases in point. The luxury goods industry is in for enormous cyclical stress as travel restrictions and a collapse in wealth hit near term earnings. This – alongside major structural forces of new consumers, new communications, new channels and new technologies – will further separate competitively advantages players from the long tail of struggling and under scaled brands. Kering has demonstrated its ability to revive a dynamic suite of iconic brands, including Gucci, Saint Laurent, Balenciaga and Bottega Veneta. In addition to in-house brands, Kering can also benefit from M&A at attractive valuations.

Similarly, despite concerns over the high operating leverage inherent in the restaurant and hotel businesses, the market has failed to appreciate how resilient leading players like Huazhu and Yum China may emerge even more competitively advantaged out of this black swan moment. As stand-alone hotels close in droves amid China’s national lockdown, the survivors will place even greater value on the risk mitigation benefit of joining large brands than before. Yum China will also be able to garner space and “stomach share” after this current emergency subsides.

5. Irrational competition — particularly in “disruptive technology” — will likely become far more rational.

Cheap capital and unbounded ambitions have created unsustainable business models within the technology sector. If the WeWork debacle was a warning sign, the upcoming displacement in the real economy, as well as in financial markets, should end the tech world’s obsession with often spurious numbers (such as Total Addressable Market, or TAM)3, many of which are used to justify ever higher valuations. Of late, we have seen the unique spectacle of businesses in the “sharing economy,” where growth is clearly slowing, but profitability remains stubbornly out of reach. Such excesses are likely to face a reckoning, as will reckless capital allocators, such as Softbank, who have been harbingers of capital and governance related malfeasance, in our view. We believe that more moderately behaved competitive behavior in China will emerge and could benefit companies like Alibaba, Tencent and Meituan Dianping. More rational competition in the Brazil fintech space could benefit companies like Pagseguro Digital, Mercadolibre and Stone. And we can imagine a possible merger between Grab and Go-Jek, which could help to reshape ridesharing and” super-app” platforms in South East Asia.

Our investment philosophy is driven by a long-term orientation and focus on differentiated research. We are deliberately not tactical as we attempt to restrain the team from decision fatigue, and hopefully poor decision making. In times like this we are reassured by our North Star compass, which guides us in an environment as turbulent and devastating as markets are today. We have been through a fair number of black swan events over the decades investing in emerging markets. And we trust that our focus on high quality companies with low capital intensity, resilient balance sheets and sustainable advantage will lead us in navigating this one successfully. 

Despite the near-team challenges that all of us are facing, we remain excited about the opportunity that emerging market equities can provide for investors. We believe the most compelling opportunity for investors is to avoid short-term tactical positions and macroeconomic calls and instead focus on companies that have the potential to deliver strong, long-term financial performance. Investors should focus on sustainable competitive advantages and real options that can manifest over time.  We look for companies that have innovative products or unique assets that capture demand domestically and/or outside their home economies and real options that can manifest over time. We look to avoid mean reversion4/pattern recognition; capital-intensive, cyclical industries; companies without sustainable advantages; firms whose fortunes depend on product cycles or gadgets; state-owned businesses or companies with other governance conflicts. We believe these types of opportunities offer investors the greatest potential for compelling results over time.

As of December 31, 2019, Invesco Oppenheimer Developing Markets Fund had assets in the following companies:  Glencore (1.05), HSBC (0.00%), Annheuser Busch (0.00%), Citigroup (0.00%), General Electric (0.0%%), Huazhu (2.73%), Kering (5.09 %), Yum China (2.57%), WeWork/The We Company (0.00%), Softbank (0.00%), Alibaba Group Holdings (6.97%), Tencent Holdings (4.89%), Meituan Dianping (1.03%), Pagseguro Digital (0.33%), MercadoLibre (0.29%), Stone Co. (0.44%), Grab (1.46%) and Go-Jek (0.00%).

As of December 31, 2019, Invesco Oppenheimer Emerging Markets Innovators Fund had assets in the following companies:  Glencore (0.00%, HSBC (0.00%), Annheuser Busch (0.00%), Citigroup (0.00%), General Electric (0.0%%), Huazhu (2.92%), Kering (0.00%), Yum China (3.25%), /The We Company (0.00%), Softbank (0.00%), Alibaba (0.00%), Tencent Holdings (0.00%), Meituan Dianping (0.00%), Pagseguro Digital (2.46%), MercadoLibre (0.00%), Stone Co. (0.00%), Grab (0.00%) and Go-Jek (0.00%).

Holdings are subject to change and are for illustrative purposes only and should not be construed as buy/sell recommendations.

Important Information:

  1. The Greenspan put was a trading strategy popular during the 1990s and 2000s as a result of certain policies implemented by Federal Reserve Chairman Alan Greenspan during that time. Greenspan was chairman from 1987 to 2006. Throughout his reign he attempted to help support the U.S. economy by actively using the federal funds rate as a lever for change which many believed encouraged excessive risk taking that led to profitability in put options.
  2. World Bank, https://www.theglobaleconomy.com/Brazil/Capital_investment/
  3. Total addressable market, also called total available market, is a term that is typically used to reference the revenue opportunity available for a product or service. TAM helps to prioritize business opportunities by serving as a quick metric of the underlying potential of a given opportunity.
  4. Mean reversion, sometimes referenced as reversion to the mean is a finance theory that states asset prices and historical returns eventually will revert to the long-run mean or average level of the entire dataset or population.

Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Investments in securities of growth companies may be volatile. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.

The opinions expressed are those of the author as of March 18, 2020­­­, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Justin Leverenz, Team Leader and Senior Portfolio Manager

Justin Leverenz is a Team Leader and Senior Portfolio Manager for the OFI Emerging Markets Equity team at Invesco.

Mr. Leverenz joined Invesco when the firm combined with OppenheimerFunds in 2019. He joined OppenheimerFunds in 2004 as a senior research analyst. Prior to joining OppenheimerFunds, Mr. Leverenz was the director of Pan-Asian technology research for Goldman Sachs in Asia, where he covered technology companies throughout the region. He also served as head of equity research in Taiwan for Barclays de Zoete Wedd (now Credit Suisse) and as a portfolio manager for Martin Currie Investment Managers in Scotland. He is fluent in Mandarin Chinese and worked for over 10 years in the greater China region.

Mr. Leverenz earned a BA degree in Chinese studies and political economy and an MA in international economics from the University of California. He is a Chartered Financial Analyst® (CFA) charterholder.

 

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