Trump vs. Emerging Markets: Who might win?
The initial slump of Emerging Markets assets following Donald Trump’s election appears to be waning. The apparent recovery indicates that not all of President Trump’s economic policies are bad for Emerging Markets (EM) countries. Those which depend on exporting manufactured goods to the U.S., like Mexico and China, may suffer. Other developing nations, in particular exporters of raw materials like Russia and South Africa, may benefit from the reflation effect of tax cuts and infrastructure investments. Lastly, many EM assets—such as equities, bonds and currencies—boast attractive valuations, which can support asset prices, even if the global political environment appears hostile.
In the first 5 trading days after Donald Trump's surprise election win, EM equities and local currency EM bonds had sunk by 6.1% and 6.7% respectively,1 measured in U.S. dollars. After this first wave of somewhat indiscriminate selling, there has been greater divergence in the returns of EM assets. For example, the Turkish lira continued weakening and is down 14.3% against the U.S. dollar in the three-month period leading up to February 3, 2017, while the Russian ruble is up 7.8% in the same period.2
In our view, these kinds of divergences are justified. Not all of Mr. Trump’s policies are equally bad for all countries. Some proposals could even be good for some emerging markets.
Trump’s Economic Program and the Potential Impact on Emerging Markets
The president’s economic program can be broadly divided into four areas:
- International trade policies
- The so-called border tax,
- Personal and corporate tax cuts
- Infrastructure spending
Russell Investments strategists believe that protectionist trade policies and the border tax are likely to hurt economic growth and lead to higher inflation in the U.S. On the other hand, we expect that tax cuts and infrastructure spending may boost economic activity and inflation. In other words, they are reflationary.
But these are broad-brush global effects. Let’s take a look at the diverse impact that the Trump policies could have on different EM countries and asset classes.
Protectionism hurts Emerging Markets exporters of manufactured goods
On his first Monday in office, the president withdrew the United States from the Trans-Pacific Partnership, a proposed free trade agreement between North American and Asian countries. Mr. Trump has generally supported greater restrictions on international trade, which are likely to hurt EM economies and could weigh on their currencies. The Mexican peso fell sharply after the election because Mexico is seen as vulnerable to a repeal of the North American Free Trade Agreement (NAFTA). According to United Nations trade data,3 more than 70% of Mexico’s exports go to the U.S., a high share that has been growing since the beginning of NAFTA. Other economies which are generally believed to be dependent on exporting finished goods to the U.S. include Canada, China, Korea, Taiwan and Malaysia.
The so-called border tax proposed by the House Republicans could have a similar effect as protectionism. Under the border tax, exports by U.S. firms are not taxable, but import costs cannot be deducted for the calculation of corporate profit. This should make it less attractive for U.S. companies to shift production and corporate profit abroad. The border tax is similar to imposing an export subsidy and an import tariff. Emerging market countries that are reliant on exporting apparel, electronics, cars and other manufactured products to the U.S. would potentially be hurt by the border tax.
What’s more, the proponents of the border tax (which include House speaker Paul Ryan) argue that it would lead to a sharp appreciation of the U.S. dollar by as much as 25% against the currencies of America’s trading partners. If the border tax were to come in alongside other protectionist actions, it could be a double-whammy for the assets of some EM countries: (a) Stock prices in countries heavily dependent on exports of manufactured goods could suffer and (b) EM currencies in general may fall precipitously against a surging U.S. dollar, if the champions of the border tax are right.
However, we are more sanguine about the border tax and its exchange-rate impact. First of all, it is uncertain whether the border tax will make it through Congress. Depending on their roles in international trade, different states would likely either win or lose. Elective representatives from the losing states are likely to strongly lobby against the border tax. Even if the border tax ends up being implemented, the exchange rate effects are more uncertain than the one predicted by economic models. Recently, Mr. Trump and his trade advisor Peter Navarro have both tried to talk the U.S. dollar down, arguing that it is already overvalued.
Reflation could be a boon for all Emerging Markets, particularly commodity exporters
While protectionist policies are almost certain to dampen global economic growth, Mr. Trump is also putting forward policies that go in the opposite direction. In fact, world equity markets have reacted positively to the prospects for tax cuts and infrastructure spending in the US. Emerging markets economies and markets have historically benefitted from reflation in the U.S.
A good example of a potential Trump winner is Russia, which exports very little to the U.S. (less than 4% of exports) and mainly trades raw materials.4 Commodity exporters like Brazil and South Africa could also be beneficiaries of a reflationist President Trump. As it happens, these countries are quite heavily represented in the index commonly used to track the Local Currency Emerging Market Debt (LCEMD) asset class. These are bonds issued by countries like Russia and Brazil in their own currencies, rather than U.S. dollars or euros. At Russell Investments, we think that LCEMD is one of the few asset classes that are outright cheap in a world where most asset prices are elevated.
Cheap Emerging Markets valuations are a buffer against adverse Trump policies
We have seen that the U.S. president’s policies are not universally bad for EM countries. Some developing nations, in particular exporters of raw materials, may benefit significantly from the reflation effect. Last but not least, many EM assets have fallen in value or have been lagging the performance of developed-market assets in recent years, not only since the presidential election.
In many areas, we therefore see EM assets as being attractively valued—the price-to-pay is low relative to the expected cash flows or the economic fundamentals of the asset. Our strategist team monitors the economic and corporate data flow on a country-by-country basis and notes that bottom-up data has been improving.
Favorable valuations and bottom-up fundamental strength can support EM asset prices even if the global political environment appears hostile. Just some examples of where to find good value in emerging markets:
- EM stock markets are attractively valued, in our view. The ratio of price-to-earnings (using 12-month predicted profits) is now just under 12, an attractive level compared to history. At the same time, profit margins in developing nations continue to firm and earnings estimates are holding steady.
- Our proprietary valuation model of currencies suggests that, on aggregate, EM currencies are about one standard deviation below their fair value relative to the U.S. dollar. This means they are more likely to appreciate over the next 3-5 years.
- According to our calculations, EM bonds in local currency boast inflation-adjusted yields that are on average about 3% higher than those of the U.S., the Eurozone and Japan. This is also at the higher end of the historical range, suggesting that the return potential for EM bonds is better than that of developed markets.
Favorable valuations are by no means a bulletproof shield against negative policy shocks, but the low prices of EM assets provide a useful buffer against further bad news.
We believe that if investors know where to look, emerging markets may not be the “no-go” area they appeared to be immediately following Mr. Trump’s presidential victory.
1Source: EM equity returns are represented by the MSCI EM index and local currency EM bonds by the JP Morgan GBI-EM index, respectively.
2Source: Thomson Reuters Datastream.
3Source: MIT Observatory of Economic Complexity, accessed via web 2/21/2017.
4Source: MIT Observatory of Economic Complexity, accessed via web 2/21/2017.