By Rob Balkema, Senior Portfolio Manager
Van Luu, Head of Currency & Fixed Income Strategy
Gustavo Galindo, Senior Portfolio Manager
Up until November 8, the year 2016 seemed like The Year of Emerging Markets (EM): year-to-date, EM equity (Russell Emerging Markets Index) was up 14.7% in local currency terms, U.S.-denominated emerging market debt (Bloomberg Barclays Emerging Markets USD Aggregate Bond Index) was up 12.3%, and EM currencies (JPMorgan Emerging Markets Local Index) had rallied 6.8% relative to the U.S. Dollar. After three years of poor returns, positives were beginning to stack up in EM’s favor:
- Value: EM valuation was quite depressed with currency valuations cheap on most metrics (Purchasing Power Parity, for instance).
- Cycle: The currency depreciations undertaken in previous years were starting to show rewards, current account deficits were recovering. Exports were improving, Chinese activity was picking up and earnings revisions were at their highest level in years.
- Sentiment: Flows were starting to move towards emerging markets and investor sentiment was improving. Momentum even started to turn positive. Fears around rising interest rates, a headwind for EM nations due to capital flows, were calmed by a cautious Federal Reserve, giving emerging markets time to strengthen.
Emerging markets hit hard since November 8
Then the Trump card was played, surprising nearly everyone and bringing profound change to the markets. After S&P500 Index futures fell limit down -5% the night of the election, the S&P 500 Index rallied nearly 6.5% off the intraday low on November 9. MSCI Emerging Markets futures, on the other hand, sold down dramatically (a roughly -7% drop) within the first 24 hours after the election. The 10-year U.S. Treasury yield jumped nearly 50 basis points in the first week following the election, making it the largest increase in a week’s time since the Taper Tantrum in 2013.
Of the many promises made during the campaign, the market appears to have priced them in like this for the time being:
- higher U.S. earnings growth (based on a campaign pledge for lower corporate taxes)
- higher inflation (based on campaign promises of trade protectionism and economic stimulus in the form of infrastructure spending, corporate tax reductions, repatriation of overseas assets and income tax relief)
- pain in emerging markets (as a result of lower exports to the U.S. and falling global trade in response to campaign rhetoric of tariffs as high as 45% on some imports and exits from long-held trade partnerships like NAFTA)
Russell Investments’ outlook for emerging markets
Markets appear to have priced in quite a bit of certainty around pain for emerging markets, but we are more cautious that the full slate of campaign promises will be enacted given that many free trade advocates remain in the Republican Party.
Based on our investment analysis, we believe that:
- Sentiment for emerging markets is oversold in the short term, but likely to be worse overall than prior to the election.
- Valuations for emerging markets are currently some of the most compelling anywhere in the world.
- Cycle impacts are quite mixed, with positives from reflation offset by protectionism and rising rates.
Our watch points for emerging markets during the Trump presidency include:
- Uncertainty risk premium – Markets do not like uncertainty. In light of the current policy uncertainty of the Trump administration, emerging markets have quickly priced in an “uncertainty tax.”
- Treasury yield increases – interest rate rises typically hurt EM assets in the short term, as capital exits emerging markets in favor of U.S. assets with now higher yields. “That said, the real yields in emerging markets, as measured by the JP Morgan GBI-EM Global Diversified, are similar to levels seen in 2013 during the Taper Tantrum, and they continue to have a large spread versus the U.S. This should help buffer the outflows, but the headwind will persist if U.S. bond yields continue to rise at this quick pace. We think that is unlikely.
- Reflation – Rising U.S. interest rates are partly due to the prospects of reflation. As mentioned above, stimulus and protectionism are both inflationary in the short term, especially later in economic cycles when the output gap tends to be smaller. But reflation and stimulus are net positives for growth, and emerging markets have historically benefitted from stronger growth and inflation in the U.S.
- Trade and protectionism – Although it’s unclear at this point which of its campaign promises in this area the Trump administration will follow through on, the rhetoric points towards action that would put pressure on emerging market countries that depend heavily on the U.S. market for their exports. However, even in this scenario, the difference in impact on emerging market manufacturers vs. commodity exporters has been substantial since Nov. 8: For instance, the Rouble and Russian equity markets (commodities exporter with low U.S. dependency) have rallied on the news of the Trump election (the Russell Russia Index is up 2.2% in U.S. dollar terms, and up over 4% in local currency terms as of Nov. 18, 2016). The Mexican Peso and Mexican equity markets (manufacturer with high U.S. dependence) have sold off dramatically (the Russell Mexico Index was down over -16% and the Peso was off roughly -10% against the dollar from Nov. 8-18, 2016).
The bottom line
Overall, we continue to look favorably at emerging markets based on our Cycle, Valuation, Sentiment analysis. The mixed impacts across this diverse group of countries’ equities, bonds and currencies means being targeted and active in exposures today matters more than ever.