by David Ruff
CFA, Global Portfolio Manager
A recent piece by CGTN (China Global Television Network) highlighted the city of Wuhan. Ostensibly to feature the city’s cultural and culinary reputation, but no doubt, this was also an effort to move the ongoing news narrative away from the city being the COVID-19 birthplace to project the idea that business is getting back to normal. The latter does indeed appear to be happening. Economic indicators point toward business activity normalization, and this is confirmed by our discussions with several companies who are dependent on China for sales and production inputs. As of this writing, the U.S. and much of the rest of the world are still under some degree of lockdown. Impacting close to four billion people, the business disruption and economic fallout has been severe. With China recovering first, however, we should experience a sharper global economic recovery when the rest of the world reopens for business. Looking forward, we believe this portends less risk aversion by investors and better foreign equity performance.
The virus could not have picked a more economically sensitive location for an epicenter in the world than Wuhan. A conglomeration of three cities–Wuchang, Hankou, and Hanyang–and their conurbations, Wuhan is situated at the junction of the Yangtze and Han rivers, an ideal location for ports, railway and transportation hubs. This geographical advantage engendered rapid growth of factories, trading firms, and import/export distribution centers connecting the cities of Shanghai, Hong Kong, and Tianjin with China’s industrial heartland. Truly, this “Chicago of China” region developed into the country’s preeminent industrial entrepôt. No wonder its shutdown slammed China’s economy to the tune of a 6.8% first quarter collapse, marking the country’s first contraction since 1976. Although China’s road to recovery has been bumpy thus far, with March data continuing to shrink, the rate of decline moderated substantially. For instance, China’s industrial production slipped just 1.1% year over year in March after cratering 13.5% in the first two months of the year. Other data, such as consumer spending and investment, show slower rebounds, but work resumption picked up steam with each passing week in March and accelerated with the ending of Wuhan’s 10-week lockdown on April 8th. For the country overall, large industrial enterprise operating rates reportedly have returned to 99% and even the slower-to-recover small companies’ work resumption measures 84% for the week ending April 17th. In Wuhan, over 90% of employees are back at work in the key electronics and steel industries.
Such revelations have not been lost on China’s equity market. Indeed, China’s equities have outperformed all other major equity markets year to date as indicated by the CSI 300, an equity index consisting of companies listed on the Shanghai and Shenzhen stock exchanges, down merely 8.7% year to date through April 21st. (All returns are expressed in U.S. dollar currency). Compare this to the 14.8% loss for the S&P 500 and the 22.1% decline for other non-U.S. developed markets as measured by the MSCI EAFE Index. This is a very telling comparison and quite a reversal from February 3rd, when Wuhan was at the height of its COVID-19 infection, and the year-to-date returns measured +0.68% for the S&P 500 and -10.7% for the CSI 300.
China’s equity market’s outperforming the U.S. year-to-date is the exception. Most foreign markets have lagged the U.S. Europe epitomizes this weaker performance. Unless you lack mainstream media access (a blessing in my opinion, given the obsessive disease coverage), you’re aware that outside the U.S., Europe has been hit hardest by COVID-19, and equity markets reflect this fact. Europe as measured by the iShares Europe ETF suffered a 24.4% decline year to date through the first three weeks of April. Disease ravaged Italy ( 32.78%) and Spain ( 30.91%) headline the carnage, but even countries with apparently more disease immunity show significant declines, including Germany ( 25.33%), Ireland ( 27.69%), and Norway ( 32.19%). Indeed, the economic devastation has been substantial, as indicated by some European economic metrics reflecting a magnitude four times the decline during the 2008/2009 Global Financial Crisis. Our management discussions and earnings call reviews consistently show Europe the weakest link in companies with global operations. However, we note the better relative labor resiliency in Europe compared to the U.S. where job losses total more than 26 million over the past five weeks. This suggests consumer spending will be better maintained in Europe vis-à-vis the U.S. Another positive, the European Central Bank announced quantitative easing programs worth more than $8 trillion, and like the U.S. have implemented aggressive fiscal stimulus measures. Moreover, with the EU being China’s biggest trade partner, Europe should receive the biggest boost from China’s recovery. This trade relationship has only strengthened with the ongoing U.S./China trade friction. Indeed, we’re hearing of European companies now resuming operations as their China supply-chain comes back online.
In addition to Europe, a major part of the non-U.S. equities’ drag year-to-date has arisen from the currency effect. That is, the strengthening greenback against most foreign currencies has subtracted 3.4 percentage points from foreign equity performance for U.S. investors through April 21st. This compares the iShares MSCI ACWI ex U.S. ETF to the S&P 500. In times of panic, investors pile into safe haven currencies, led by the U.S. dollar but also including the Japanese yen and Swiss franc. With the coming global economic recovery, we expect these capital flows to reverse. The normalization of risk appetite and the increased competitiveness of weaker currency countries induces capital to flow to where it can be used most productively. For example, companies favor India, with cheaper wages and a well-trained technology workforce, for software development. This dynamic won’t change soon with the rupee weakening another 6.5% recently, making India investment even more attractive. We also note that many emerging markets have better fundamentals compared to their positions during the Global Financial Crisis. This includes higher foreign currency reserves, better external debt to GDP fundamentals, and more diversified economies.
In summary, as Wuhan, once again enables China to be the “world’s factory,” we expect it to help drive Europe’s recovery once the virus runs its course. Combining this with a partial reversal of distorted U.S. dollar strength creates a very attractive total return potential for international equities. We believe our International ADR strategy is ideally positioned to capture these developments.
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