May the force be with you
at the fact that the world I STILL MARVEL is experiencing the biggest economic crisis in living memory and yet certain things are acting as if nothing has happened, like the stabilization in the global markets at large. With liquidity and positioning gradually normalizing, emerging markets are showing signs of decoupling. Asset pricing dynamics are clearly changing relative to a couple of weeks ago, where most assets classes traded driven by global factors and the evolution of the coronavirus outbreak in Europe and the U.S. There is a clear differentiation between Asia and those developed economies that are either flattening the curve and partially relaxing the lockdowns vs the emerging market economies that are lagging behind in the process and have seen their fiscal metrics severely deteriorated.
Despite the rally in global equities, which can be characterized as fragile and concentrated on tech industries, there is a clear breakdown in the correlation with emerging markets. Also, the market participants are underestimating the risks of a much more gradual normalization, while a possible correction in the markets will reprice the risks in emerging markets.
According to recent research from Bank of America Merill Lynch, Latin American countries stand as the most vulnerable. The global effect of the virus, coupled with the drop in commodity prices and the direct effects of the virus in the region, have created a perfect storm for a region that was struggling to grow even before the aforementioned negative shocks. The underdeveloped health systems coupled with high degree of labor informality worsens the trade-off for any lockdown policy. In addition, the sizable (for their own standards) emergency packages put in place make the region more vulnerable to a delayed U-shaped recovery as debt levels are expected to spike significantly. Brazil, Mexico and Colombia will be severely affected, according to the same research.
The only good news, at least so far, for emerging markets is the very benign inflation dynamics despite the massive currency depreciations. Market watchers need to be particularly wary of India, Russia and Canada, who are at the highest risk of a second wave. The risk is lower for the U.S. and Europe but still remains, with R estimates around the 0.8 mark. These economies should be careful of exiting lockdown too quickly. Also, experiencing the highest reproduction rate of the virus, signs of a premature exit in Brazil would be a major red flag for a second wave.
In terms of what this means for the global economic recovery, there is still risk of a “W-shape” recovery, if lockdowns are eased too quickly. May the force be with you.