Trump presents a conundrum for emerging market investors
While financial markets in the developed world responded positively to the election of Donald Trump, the reaction in emerging markets (EMs) was mostly negative.
The majority of equity markets have recovered most of their initial losses, but performance has lagged developed markets considerably. Currencies have suffered too, and in particular the Mexican peso and Malaysian ringgit.
There are three interconnected channels through which the Trump presidency could harm emerging economies:
- American protectionism and a paradigmatic shift away from
- changes to the pattern of global capital flows; and
- the effect a strong US dollar could have on EM funding costs and commodity prices.
Figure 3: Vulnerability to the US We have ranked 19 EMs in order of vulnerability to the three main ways in which the Trump presidency could affect them
We have ranked 19 emerging economies in order of vulnerability to these channels (figure 3 to the left). To do so, we assess their export exposure to the US and the importance of manufactured goods to their economies, which are more likely to be subject to high tariffs under a protectionist scenario. We look at how volatile cross-border capital flows have been, which makes an economy’s financial markets more susceptible to a shock, as well as the size of each government’s foreign exchange reserves, which can be deployed as a shock absorber by policymakers when faced with a sudden outflow of international capital. Finally, we look at foreign funding requirements and the proportion of foreign currency denominated debt due to be repaid over the next year. High scores here leave an economy very susceptible as US interest rates or the US dollar rise.
The overall scoring explains more than 70% of the variation in the behaviour of these economies' exchange rates since the US election (if we exclude Brazil, which is still reeling from its deepest recession in more than a century). This is surprisingly high, given the fairly simplistic nature of the analysis, and suggests that EM investors are being far more circumspect about the policies that Mr Trump might pursue than investors in developed market equities and bonds. The Mexican and Malaysian currencies have weakened the most, and their economies have by far the worst vulnerability score. Turkey, Venezuela and South Korea are the next most vulnerable, and these three are also experiencing political unrest of their own.
If Mr Trump abandons his promises of flat-out protectionism and successfully initiates a large public infrastructure programme and stimulates private sector investment by way of tax reform, EM investments should perform well as they tend to correlate with improving global growth. Metals exporters with good financial positions as set out above, such as Chile and Peru, are perhaps among the best placed to benefit.
Mr Trump aside, EMs started to look more and more attractive last year. EM equities started to outperform their developed market counterparts as EM GDP growth started to rise relative to that of developed markets. The latter process appears to have started in mid-2016 and, although it is too early to call the trend definitively, the leading indicators still point in the right direction. Some investors believe that rising US interest rates are bad news for EM equities. This is not empirically accurate: EM equities have outperformed through the past three Fed tightening cycles. As long as the dollar doesn’t soar (and our fundamental analysis, which helps us to assess where currencies may trend over the long term, suggests that the dollar is already quite overvalued versus many EM currencies), financial conditions shouldn’t pose too great an impediment.
As a result, investors face a conundrum. Should they continue to invest in EMs as the fundamental case firms up, or should they protect themselves against the possibility that Mr Trump pursues policies that make life very tough? It’s too early to know, but as our lead article explains, we believe there is a risk that US equity investors in particular are being too sanguine about Mr Trump’s likely policies. That will make 20 January (when Mr Trump will be inaugurated) and the days afterwards particularly nerve-wracking for investors who believe Mr Trump is cast in the mould of President Reagan.