Emerging markets: jumping the gun on Trump?
Emerging market assets sold off sharply after Donald Trump’s US presidential victory, as fears of a new era of global protectionism took hold. But is the threat to the EM universe exaggerated?
When asked about the impact of the French Revolution in 1972, the Chinese Communist Premier Zhou Enlai replied it was "too early to tell". One wonders what Zhou would make of the precipitate way financial markets have responded to the electoral success of Donald Trump.
“The new president will not be inaugurated until 20 January 2017 and Trump’s policy agenda remains unclear,” says Will Ballard, Head of Emerging Markets & Asia Pacific Equities, Aviva Investors. “Yet emerging market currencies, debt and equities have all come under pressure.”
The MSCI Emerging Markets Index fell by nearly seven per cent in US dollar terms between 8 November, when Americans voted, and its nadir on 14 November. It subsequently recouped much of the lost ground. Similarly, while the JP Morgan Emerging Market Local Currency Bond Index (in US dollar terms) had fallen by just over eight per cent by the time it reached its post-election low on 23rd November, it had recouped over a third of that fall by mid-December.
Liam Spillane, Head of Emerging Market Debt, Aviva Investors, agrees it is too early to assess the impact of a Trump presidency. “We have seen a knee-jerk reaction from investors. The initial concern appeared to focus on those countries, currencies and issuers perceived to be among the worst affected by the implementation of US trade barriers. However, we have subsequently observed that the underperformance in terms of currencies has not centred on those with US or China export exposure, with the obvious exception of Mexico, and has quite simply been a typical reaction of high-beta currencies such as Turkey, Poland, South Africa and Brazil,” says Spillane.
Figure 1: Performance of emerging market currencies versus the dollar 7 November to 15 November 2016, worst spot returns percentage decline
Source: Bloomberg as at 9th December 2016
Investor uncertainty centres on concerns Trump’s policies will boost inflation, forcing the Federal Reserve to raise interest rates higher and at a faster pace than previously expected, and that protectionist measures could materially impact the outlook for emerging market economies. Significantly higher US interest rates, if sustained, could undermine the case for investing in emerging market debt, where relatively higher yields have attracted investors searching for income. They could also drive up the dollar, which would impact broader investor sentiment and specifically impact those emerging economies, such as Turkey, that have long-standing structural concerns and notable US dollar-debt liabilities.
“In the immediate aftermath of the election investors were worried about any emerging market company or country that has significant exposure to the US, or which can be labelled a currency manipulator,” says Ballard. The worst-affected equity markets included Taiwan, Mexico and South Korea, while China has also been hit; though again some of those markets have subsequently reversed their losses.
However, there are reasons to believe the threat that a Trump presidency poses to emerging markets has been exaggerated. Further rises in US interest rates and the dollar could be difficult to sustain, given current expectations fiscal policy will not materially alter the structural dynamics within the US economy and that the dollar appears expensive on a long-term basis. There is also a strong argument that the implementation of Trump’s policy agenda will be slower and more challenging than some have predicted.
True, the president-elect has confirmed the US will withdraw from the Trans-Pacific Partnership, while there is also concern that US membership of the North American Free Trade Area is under threat. However, in office Trump may moderate his protectionist rhetoric once confronted with the realities of the US’ relationships with major emerging economies. It is likely Trump will try to renegotiate better terms on specific industries and goods, rather than target sweeping changes that would adversely affect global trade as a whole. Take the case of Mexico. The US buys around 80 per cent of Mexico’s exports. The peso, and the country’s equity and debt markets, sold off sharply following the election result reflecting Trump’s campaign pledge to impose 35 per cent tariffs on Mexican imports with companies that import those goods paying the tax at the border.
However, Ballard notes: “The cross-border trade is vast and complex and unravelling it could prove very difficult with adverse consequences for the US as well as Mexico”. Many auto parts, for example, are manufactured in Mexico and imported into the US, where they are processed further and sent back to Mexico for additional work before re-entering the US.
Ballard cites the example of the Mexican company Rassini, the monopoly supplier of the leaf springs used in the suspension of US trucks. “If the US imposes an across the board tariff on Mexican imports, that would simply be passed onto American truck buyers.”
Trump also threatened to impose a 45 per cent tariff on Chinese imports, adding he was “going to get Apple to start making their computers and their iPhones on our land, not in China”.
Such a move would make little sense, says Ballard, since the profits China sees from making the iPhone are miniscule in relation to the profits generated by Apple in selling the product.
Analysis by the Massachusetts Institute of Technology (MIT) supports Ballard’s view. An article in the institute’s Technology Review, published in June 2016, found that assembling the components of an iPhone 6s, which retails at around US$749, costs between $4 and $10 according to independent estimates. Currently this is done in seven factories, six in China and one in Brazil. But the profit margins in assembling the iPhone are wafer thin. Most of the earnings generated by the iPhone are created in the US in the form of intellectual content and branding.
Bringing production back to the US would also be complex. Apple has suppliers in 28 countries, according to MIT’s Technology Review, and relocating this sprawling complex of suppliers could prove impossible. Indeed, Apple has said the US lacks the manufacturing infrastructure required for the iPhone.
Moreover, manufacturing employment in the US has risen since 2010, according to the MIT Technology review, “reflecting the post-crisis auto boom and the relative strength of the nation’s advanced manufacturing industries”. It adds the total inflation-adjusted output of the US manufacturing sector is at a record high. The problem is that employment has been growing slowly, a reflection of the improved productivity from automation. In other words, one could argue the increasing use of robots rather than imports is the main reason why some American workers are suffering.
Slapping a 45 per cent tariff on Chinese imports would hit Americans hard in their pockets. It could drive up US retail prices on those most heavily imported goods, notably technology and clothing, by an average of about 10 per cent, according to the economics consultancy, Capital Economics. It adds there are few alternative sources for the main goods China produces. China supplies about 70 per cent of the world's mobile phones, laptops and tablet computers.
“While it seems safe to assume Trump will adopt some protectionist measures, it is difficult to assess the extent of the overall threat. Our initial view is that material changes to global trade policies and tariffs will prove unlikely,” says Spillane.
In practical terms, the mutual dependency derived from approximately US$600 billion of trade in 2015 between both countries and the US$1.2 trillion of US government bonds held by China are just two examples that suggest a more moderate and pragmatic outcome than the current headlines suggest. “President Xi has already stated a very clear intention to work together. However, Trump’s stated desire to take a more unpredictable approach could well make for further headline-grabbing comments in the months ahead,” adds Spillane.
Be wise, don’t generalise
Moreover, any Trump effect on emerging markets is likely to vary drastically by countries and sectors. This highlights that the recent indiscriminate sell-off was not entirely rational. As well as being worried about exporters, investors have taken a pessimistic view of the domestic economies in many emerging markets. The growth of consumption, linked to the continuing rise in income levels, population growth and the expansion of the middle classes, is one of the key long-term drivers of emerging markets. The rebalancing of the Chinese economy towards consumption and away from exporters has also become a major investment theme in recent years. Yet the consumer discretionary sector has been among the worst affected since Trump’s victory.
However, investors have taken the opposite view of stocks tied to raw materials. “There is an expectation that a surge in spending on infrastructure in the US will suck in raw materials from the rest of the world,” says Ballard. He highlights the spike in the price of commodities, such as copper, and materials stocks, including Vale and Kumba Iron Ore, since Trump’s victory as evidence.
Ballard believes there is little foundation for these gains. “Most of the infrastructure spending in the US, if and when it goes head, will consume a large proportion of recycled materials from the infrastructure it replaces. By contrast, spending in China, which created the last commodity price boom, was directed towards new projects that consumed vast amounts of imported raw materials.”
Moreover, it could be years before the diggers start work. “China has the autonomy to quickly press ahead with huge infrastructure projects,” says Ballard “In contrast, the US government has to respect the rule of law and property rights, as well as consult interested parties before work on any project can begin.”
Ballard further believes that investors are overlooking a potential threat to demand for commodities. “Over the past year or so, China has taken measures to support economic growth, which have boosted demand for commodities such as iron ore. But Beijing is now worried that the property market is overheating and may seek to rein in the market, quelling construction and demand for raw materials.”
Filter out the noise
While Trump’s protectionist comments have damaged valuations in the short-term, if he pursues a reflationary policy mix that boosts global growth, it could be somewhat positive for emerging markets. Spillane says investors need to filter out the current noise and look at a number of positive indicators. “We focus on the growth differential between emerging and developed economies. That has started to move back in favour of emerging economies in recent months and has been a good historical pre-cursor for capital flows. If the new administration does adopt aggressive protectionist policies, it would be harmful for the growth outlook but that is not our expectation. Early estimates suggest a very moderate downgrade to growth expectations from emerging markets.”
In addition, Spillane believes long-term valuations across emerging market debt remain attractive, particularly in the local currency sector. “Most emerging market currencies are trading significantly below long-term averages on a real effective basis. Yield spreads to core markets are near their widest level in both real and nominal terms, providing a good cushion against further volatility,” says Spillane. Hard currency valuations are less compelling given spreads are in the middle of recent ranges and valuations require a more selective approach to unlock opportunities in the medium term.
While much of the recent sell-off has been attributed to Trump, it could – at least in part - be framed in the context of more typical end of year positioning. Emerging markets have seen sizeable inflows this year, and some investors may have used Trump’s poll win as an excuse to take profits.
Figure 2: Emerging markets have seen large inflows in recent years, US$ billion
Source: Bloomberg, November 2016
Spillane believes the recent selling of emerging market assets will present opportunities for investors and the current environment reaffirms the importance of taking a balanced approach to investing in emerging market debt. “This is an asset class that naturally carries some level of risk and volatility. However, understanding that volatility, looking beyond the headlines and assessing risk and rewards presents significant opportunities,” adds Spillane.
For now, however, he believes the current uncertainty will remain in place until there is greater clarity on US policies and official appointments. “That will allow us make the key calls on the likely direction of emerging market debt and the US dollar and enable us to identify those opportunities. As we have clearly seen at the start of 2016, market sentiment and direction can change quickly and the ability to realise attractive long-term valuation opportunities in emerging market debt may occur sooner than we think,” concludes Spillane.
 Bloomberg, 13 December 2016
 The All-American iPhone. MIT Technology Review 2016
 The All-American iPhone. MIT Technology Review 2016
 Manufacturing Jobs Aren’t Coming Back, MIT Technology Review, November 2018
 Capital Economics, China Watch – How much would a Trump tariff hurt China, 29th September 2016
 Office of the United States Trade Representative
 Bloomberg, November 2016
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 14 December 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.