Trump win casts shadow over emerging markets’ prospects

The unexpected election of Donald Trump has brought to a halt the strong performance of emerging market (EM) assets this year. EM valuations and fund flows dropped, as investors fear an “America First” policy will favour the US dollar and protect US markets from cheap foreign imports. 

The sequence of new highs reached by the dollar and US stockmarkets over the past few weeks is testament to the shift in global portfolios, as investors anticipate a new era of tax cuts and infrastructure spending, expected to stimulate economic growth and fuel foreign investments. 

A sharp rise in market inflation expectations has driven an increase in US government bond yields, as investors are spurred to dump bonds. And the Fed is largely expected to hike interest rates at least twice next year, after the rise in December. 

Moreover, President-elect Trump’s fiercely protectionist stance, although partly toned down since the election, generates risk and uncertainty. 

“A rising dollar, protectionism and higher rates do not make a very attractive cocktail for emerging markets,” acknowledges Didier Saint Georges, managing director, member of the Investment Committee at Carmignac Gestion. “But this Trump threat has probably been overplayed on some of the emerging economies, creating entry points.” 

Mexico, which exports 70 per cent of its manufacturing goods to the US, has been perceived as the “obvious victim” of Mr Trump’s programme, with the president-elect vowing to tear apart the North American Free Trade Agreement (Nafta), under which US and Mexico, along with Canada, have enjoyed a broad trade relationship. Recently, Mr Trump’s transition team seems to have backpedalled on his claims.

Meanwhile, the Mexican peso has depreciated 10 per cent, and its equity and bond markets have also been significantly hit. But low valuations, the enhanced competitiveness of the economy thanks to the weak peso and potential yield compression make the “Mexican currency, bonds and equities all look very attractive”, says Mr Saint Georges. 

Equally, Brazilian bonds present an attractive carry, as real rates are very high and most likely to come down, while investing in equities might be more challenging, given recession fears for the economy next year. 

Investments in emerging markets, however, should be accompanied by hedging on the Chinese currency, which could weaken further, as a stronger dollar could put further pressure on capital outflows from China, expects Mr Saint Georges. 

The part of Mr Trump’s programme most likely to be “watered down” are his protectionist measures, he believes. 

With the dollar getting stronger, protectionism would further hurt the competitiveness of US companies, which source manufacturing goods at cheap prices from abroad. President Trump will have to make some kind of trade-off, between maintaining his promises to the electorate of delivering growth and jobs and defending the interests of US corporates.

Fundamentals in emerging markets have improved, and EM assets’ negative performance over the past few weeks is mainly related to currencies, observes Didier Borowski, co-head of strategy and economic research at the largest European asset manager Amundi. 

However, until the new Trump administration clarifies its position in trade, and especially on import tariffs, investors should be careful. “Any rhetoric against trade may still impact emerging markets, in the short term,” he warns.

Although the upward pressure on US bond yields will continue to negatively impact EM currencies and market performance, the situation is very different from the one that led to a rapid sell-off in the 1997 Asian crisis. 

EM currencies are not overvalued today, says Mr Borowski, and capital inflows into EMs, and re-appreciation of currencies should not be ruled out in the coming 12 months. 

While seeking entry points both in the equity and debt markets, Amundi believes hard currency EM debt is attractive from a risk reward perspective, compared to debt in developed economies.

The reduction of global trade volumes, notable when compared to before the financial crisis, may also be seen partly as a positive factor for EMs. “Growth in emerging markets is today fuelled by domestic demand, and we see a lot of divergences in economic cycles within the EM space,” he says. 

Asia vs Latam

Markets have already largely discounted the Trump effect on EM currencies, observes Didier Duret, CIO at ABN Amro Private Banking.

Investors should only be negative on EMs if the US currency and yields rise further. In the meantime, the bank is quite positive on developing economies, and particularly Asia, led by China, which is “the big global power house in terms of economic growth and fiscal initiatives, together with the US”.

“Asian valuations are extremely cheap and investors are under invested. This is normally a good time to gain exposure to equities, while bonds are more vulnerable to higher yield,” says Mr Duret. 

Protectionism will be less of an issue. China will increase its regional trade, continue “to court” Russia and improve its relationship with India. 

The Chinese government recently warned Mr Trump it is “seriously concerned” after the president-elect questioned why the US should continue abiding by the “one-China policy” – under which Washington  does not recognise Taiwan as a sovereign state – unless Beijing is prepared to enter some kind of bargain. But Mr Duret is positive on recent developments too. Both the US and China are “extremely pragmatic”, he says, although their approach is different.

Finally, Mr Trump’s talks on trade protectionism on goods are kind of anachronistic and just rhetoric, states Mr Duret. “The next step in globalisation is that of services, through social media and e-commerce platforms, the globalisation of ideas and media.” Profiting from the connected world is a key investment theme for ABN Amro, which predicts above average earnings growth for social media, online video and e-commerce platforms, compared to the MSCI world index.

Despite clients’ requests to increase allocation, BNP Paribas expects pressure on emerging markets to increase and has maintained a neutral stance after Mr Trump’s election, explains Florent Bronès, CIO at BNP Paribas Wealth Management. “We believe the dollar will continue to be strong and prefer to wait for better entry points into emerging markets, both in equities and fixed income,” he says. 

Protectionist measures, geo-political relationships between the US and its allies, and the independence of the Fed are three key factors to monitor under President Trump, says Mr Bronès.

The French bank likes China and India, where growth is mainly domestically driven, but is still cautious on commodity exporters Russia and Brazil, which have trade relationships with the US. BNP expects oil price to remain in the $45/bbl and $55/bbl range in the next six months. Above that level, US firms would increase shale oil production, offsetting Opec’s attempts to diminish output.  

Citi Private Bank prefers Latin America to Asia, in the EM space. 

Despite the recent rally, the global bank continues to have an overweight position to LatAm equities and bonds, a call the institution made earlier this year, which is driven by a number of factors still in place.

“LatAm valuations are not expensive, politics and structural reforms are progressing in the right way, and several LatAm countries are benefiting from firmer commodity prices, especially oil,” explains Jeffrey Sacks, Emea capital markets strategist at Citi Private Bank. In addition, institutions’ ownership levels of both equity and fixed income are still quite low in LatAm. Apart from Mexico, which is expected to continue to be under pressure, LatAm assets, and especially dollar-denominated debt, continue to look appealing and unaffected by Mr Trump’s presidency. 

On the contrary, the bank “slightly reduced” its weighting in Asian equities, fearing the negative impact of protectionist measures. Also, several Asian currencies are linked, or partly linked, to the US dollar, and the steady higher US currency, expected under Mr Trump, would be negative for their exports, explains Mr Sacks.

There is “high risk” associated to currencies of countries that have benefited from selling manufactured goods into the US, such as the South Korean won and Mexican peso, says Peter Fitzgerald, global head of multi-assets at Aviva Investors. 

While economies with large account surpluses have historically been seen as stable, today they might come under pressure. 

“But we need to differentiate between current account surplus generated by manufactured goods and that generated by exporting raw materials and commodities.” 

And in fact, countries with current account deficits might be more attractive, on a forward looking basis, given the potential regime change, says Mr Fitzgerald.  

Within a broader overweight to equities relative to bonds, believed to be more attractively valued, EM equities are UBS’ top pick in the equity space for 2017, together with US stocks.

After years of underperformance versus developed markets, EM equities have outperformed in 2016, and although political uncertainty could drive short-term volatility, are expected to perform next year too. EM growth pick-up is driven not just by middle-class domestic demand growth, but also improved terms of trade, while commodity producers should benefit from stable or rising commodity prices. The bank forecasts Brent prices will climb to $60/bbl next year.  

“We are now starting to see earnings momentum in EM equities as a whole, the commodity complex is potentially coming back and growth seems to be stabilised in China, particularly ahead of the party congress at the end of next year,” says Mark Haefele, global CIO at UBS Wealth Management. 

And China is definitely “not without tools to express dissatisfaction with US trade policy”, states Mr Haefele. The country could “change the fix on their currency overnight, with profound impact on risk markets,” and sell US treasuries, which it holds in large quantity.

If the US pulled out of the Trans Pacific Partnership talks and agreements, it “would play into Chinese hands, as a steadier partner for trade in Asia”. 

Although it is important to monitor the evolution of US trade policy under the new government, EM fundamentals are strong enough to win out against uncertainty, says UBS. Also, investors are currently under-allocated to EMs, and a sudden stop in capital flows due to interest rates rise appears reasonably contained.

A weaker dollar?

A key factor supporting UBS’ positive view on EM assets is its outlook on the dollar.  “The dollar has risen tremendously, but we struggle to see why it should strengthen considerably from here,” says Mr Haefele. 

On a purchasing power parity basis, the dollar is overvalued versus the euro. Also, a large increase of US debt to GDP does not support further strengthening of the US currency. Finally, Mr Trump’s fiscal policy is going to push up inflation which is not necessarily supportive of a stronger dollar, explains Mr Haefele, also considering Fed chair Janet Yellen’s willingness to run a more “high pressure” economy. 

Therefore, UBS expects the dollar to soften next year, as investors price in a gradual pace of US interest rate increases. This would effectively cheapen debt, as many EM corporates generate sales in local currencies but service debt in dollars, and offer a potential boost to corporate earnings.

EM currencies, which were among the big winners in 2016, will continue to be attractive in the coming year, supported by the low-yield environment, attractive valuations, and a turnaround in the economic outlook, helped by rising commodity prices. 

UBS recommends an overweight position on a basket of EM currencies, including the Brazilian real, the Indian rupee, the Russian ruble and the South African rand, equally weighted. Since 2006, UBS’ basket has depreciated 60 per cent versus the dollar, leaving them at “fair value”. 

In order to reduce downside risk, deriving from a potential slowdown of global growth or rise in protectionism, this basket should be paired with a basket of equally-weighted developed market currencies – the Australian dollar, Canadian dollar and Swedish krona.  

What is clear is that differentiation within the EM asset class should persist, believes Gene Frieda, global strategist at Pimco. “Winners and losers may vary dramatically depending on which of the potential combinations of US monetary, trade and fiscal policy play out.”