Emerging Markets Quarterly Outlook
Emerging Markets in Trump’s World
The prospect of a Trump presidency turned many expectations for this year on their head. As investors began to price in faster economic growth following the November 8th election, the S&P 500, the Dow Jones Industrial Average, the Nasdaq Composite and some other indices all hit new highs. At the same time, the yield on the 10-year US Treasury jumped from a low of 1.32% in July to 2.6%, driving the US dollar to a 14-year high. What is more, the election intensified a rout in developing country assets that led to the fastest redemptions from bond and equity funds since the 2013 ‘taper tantrum’ and drove the Mexican peso and Turkish lira to record lows. Only Russia appeared to escape the trend, thanks in part to an expected improvement in relations between the US and Russia.
But is this double rotation – from bonds to equities and from EM to DM equities – too much, too soon? Prior to the US election, emerging markets were judged to be on the mend, with growth expected to accelerate to 4.3-4.5% in 2017 from 3.8% in 2016, while disinflation was set to end. True, part of this improvement reflects the end of recessions in Brazil and Russia, but it is nevertheless noteworthy given the simultaneous deceleration in China’s and India’s economy. Similarly, the Citigroup Economic Surprise Index for emerging markets is now at its highest level since 2011. In addition, developing countries have made important strides in adjusting their external balances since 2013 and the majority now have foreign reserve cushions well in excess of the IMF’s reserve adequacy measure (Turkey, Malaysia and South Africa being the main exceptions).
While the exact details of Trump’s economic policies remain unclear, the broad outline and their effects on emerging markets are discernible. The key channels through which emerging markets are affected are 1) a looser fiscal/tighter monetary policy mix in the US, 2) its stance on trade policy and 3) the effect on commodity prices. If the US manages to boost growth further (even if only temporarily), this would benefit EM, all else equal. However, the effect is counteracted by a tightening of US financial conditions (as the US moves beyond potential and thus risks a rise in inflation) and a strengthening of the US dollar. Indeed, the US could experience tighter financial conditions and no acceleration in growth at all as the wider fiscal deficit resulting from revenue-reducing tax cuts increases the government’s financing needs. The economy’s momentum, adverse base effects on inflation and rising commodity prices alone could suffice to boost 10-year rates towards the 3% level. In turn, EMs have a total of $300 bn of USD-denominated debt maturing during each of the next three years. However, half of this amount is concentrated in three highly developed Asian economies (Hong Kong, Singapore, Korea), plus China. The majority is owed by non-financial corporates, implying that debt is likely mostly in the form of loans, making it easier to roll over. The countries with more than $10 bn maturing outside these are Mexico, Russia, India, Brazil and Turkey. Only in Turkey is the debt owed mostly by financial entities.
A shift towards a more protectionist stance would be another factor denying EMs the benefits of rising US demand. Mexico and China stand at the top of the list for the US but any kind of trade restriction could be highly disruptive for Asia’s exporting nations as trade represents an important component of their GDP and many economies already suffer excess capacity. In addition, tax and regulatory changes could also affect the flow of direct US investment into emerging markets. Latin America enjoys the highest stock of US investment, but FDI also represents an important source of capital for Asian economies.
Emerging markets strongly outperformed developed markets in the period up to November 2016: MSCI EM recorded a gain of 16.3% whereas the MSCI World gained only 4.2% (USD total return). However since then, EM strongly underperformed, with a 1.4% loss from November to date and a 5.5% gain for MSCI World.
In our view, while the risk of a more protectionist stance is real, the outlook for emerging markets is not as dire. In addition to the fundamental improvements mentioned earlier, light investor positioning due to muted capital flows over the past three years suggest that adverse shocks have a more dampened impact on asset prices. In addition, EM equities have appreciated much less than other equity markets, let alone credit markets in 2016 and stand just below their 10-year price average. In P/E terms, the EM/DM ratio is also close to the long term average.
Our allocation has undergone a few changes, some due to the Trump presidency, some reflecting domestic developments and some valuation considerations. We downgraded Brazil to neutral as the economy has failed to recover more rapidly and political malaise still prevails. We also downgraded the Philippines to neutral as the President’s outbursts risk deterring capital inflows just when financial conditions are tightening and the external surplus is vanishing. And we moved Mexico to underweight as its economy is highly exposed to trade with America and it has few options to defend itself against a more hostile US stance.
Click download to view the full report.