According to official Chinese data, economic growth is running at 6 per cent. But anecdotal evidence suggests this figure could be much lower. This risk could have flow-on effects to European economies in particular.
While the bulk of the near-term pain is clearly being felt domestically – the ramifications for global businesses with meaningful China exposure are quickly becoming apparent. Some of the larger global players in the luxury, restaurant, travel and tech industries have already flagged that earnings will be impacted by the coronavirus.
From an asset allocation perspective – the coronavirus has highlighted the inherent risks in two of the best known “growth sleeves” in global equities – large-cap growth (valuation risk), and emerging markets (macro and earnings risk).
In doing so, it also highlights two of the most compelling attributes of the global SMID asset class – they come with meaningfully less valuation risk, and as companies domiciled in developed markets – they tend to be more domestically focused.
So how does this look for investors?
The ramifications of coronavirus will be likely giving investors a good excuse to reconsider their “growth” allocations in their global equity portfolios. While these ramifications are still unfolding, the earnings and valuation risks related to all growth assets have heightened materially.
Emerging markets have always played a growth role in portfolios but have consistently disappointed over the last 10 years – lagging the MSCI World Index by 5.79 per cent annually. More recently, the valuation argument has been actively touted as the main reason for staying the course.
The unfortunate reality is that the onset of the coronavirus could well have a very meaningful impact on corporate earnings in China – which now represents a little over 34 per cent of the MSCI Emerging Markets Index.
In other words – the likelihood that emerging markets will have another poor year vs. developed markets has just spiked materially – as evidenced by the approximately 8 per cent decline in Chinese equities earlier this month.
The darling of the growth cohort has undoubtedly been the large-cap global growth names that have performed brilliantly in recent years. Generally speaking, many global portfolios have plenty of exposure to such names – which have also become very expensive.
At the end of January 2020, the MSCI World Growth Index was trading at a 10-year high, representing a 37 per cent premium to the rest of the market.
They could keep going, but history tells us that stock markets have a habit of overshooting and reacting to external events that don’t always have anything to do with the companies or sector themselves.
Now might be the time to fall out of love.
We believe that global SMID Cap equities still offer a very attractive growth alternative to emerging markets and large-cap growth. They are less crowded and expensive than large-cap growth and have materially less earnings risk than emerging markets.
It’s no secret that large-cap growth stocks, especially those with an emphasis on growth such as giant tech stocks, have accounted for much of the recent gains in equities. As such, many portfolios have become even more heavily skewed towards the larger-cap end of the market.
This is opening up opportunities to invest in the global SMID space as investors look to diversify away from large and mega caps and gain exposure to a significant part of the global equity market that can provide growth.
The chart below is a good depiction on valuation and finding good “value for money”. The MSCI World SMID Cap Index is now trading at the smallest premium to the broader market in 10 years – food for thought for investors.
Ned Bell, chief investment officer and portfolio manager, Bell Asset Management
