Trumpeting emerging markets

Despite widespread nervousness, emerging markets could yet do well out of a second Donald Trump presidency. First, over the longer term his global gamesmanship is likely to weaken the US dollar, which would be good for emerging market assets. At the same time, poor US debt dynamics – which, in all likelihood, Trump will make worse rather than better – will increasingly shine a positive light on emerging market sovereign debt.

To be sure, there’s bound to be heightened volatility over the near term. The first months after his inauguration will almost certainly cause significant pain, not only for countries in Trump’s crosshairs but globally. And while some countries will be quick to make trade and other concessions to avoid the worst of his promised tariffs, others – like China – are likely to bear the brunt of any trade war Trump starts.

Part of that pain will be felt through the currency markets. The more severe the tariffs, the more the dollar is likely to appreciate – at least initially. Currency devaluations elsewhere will put a strain on foreigners who borrowed in dollars, and particularly those in emerging economies. Trump is likely to use tariffs as a weapon to extract concessions from trade partners – the art of his international dealings. But he is also keen not to drive the dollar too high. Bringing manufacturing home is one thing, but making the US globally uncompetitive is also not what he wants. The result could be the first step to a new currency management agreement. A Bretton Woods II is unlikely, but something closer to Ronald Reagan’s Plaza Accord, designed to weaken the dollar, is possible.

A dollar depreciation, reversing what has been a 15-year bull cycle, would prove the ultimate positive catalyst for emerging market fixed income outperformance. It would set off a virtuous cycle for the credit worthiness of emerging world sovereign and corporate issuers, improving currency dynamics and boosting asset prices generally.

Meanwhile, there’s the US’s fiscal balance. Notwithstanding Trump’s promise to make government more efficient and to cut red tape, his hands are politically tied on the biggest slices of government spending, like Social Security. At the same time, he’ll be pushing to cut taxes. The Congressional Budget Office estimates that the US is running a debt burden equivalent to 100 per cent of GDP, and expects it to rise to 143 per cent if Trump’s policies are implemented. The US deficit is already among the highest in the world.

If Trump manages to goose growth, the deficit could come down proportionately, but that’s a big if.

Without doubt, a US debt crisis would be destructive to assets worldwide, but we think global self-interest prevents an extreme outcome, as Pictet’s Maria Vassalou argues in a recent paper. Instead, our base case is for continued erosion of the US debt position, steadily making the US less attractive for global savers. On balance, this should be a positive for emerging markets assets, which increasingly have the key attributes to attract global savings.

That’s because emerging markets are increasingly substantial in a global context. For one thing, emerging markets make up 58 per cent of global GDP. And its asset markets are starting to reflect that. Emerging market fixed income has an aggregate market capitalisation of some USD7 trillion, while their equity counterparts are worth some USD7.6 trillion. Collectively these asset classes are both deep and relatively liquid albeit with a significant way to go to catch up to those of developed markets – the S&P 500 index alone has a market cap of some USD48 trillion.

Emerging economies are set to keep growing thanks also to a number of factors. Their institutions are increasingly credible – central banks across the developing world were, on balance, quicker to respond to the spike in global inflation and have since been in a better position to relax monetary policy. Debt metrics and fundamentals look better than they do in developed markets. Emerging economies have lighter debt burdens, faster growth rates and a better demographic outlook.

These factors are already starting to register with professional investors: for instance, sovereign wealth funds are increasingly shifting their portfolios towards the emerging world. In effect, they're responding to a shift in the world order.

Erosion of faith in Treasury bonds is likely to push investors into seeking alternatives. With other developed market governments also struggling under big debt burdens, the choice falls to emerging market sovereign debt and developed market credit as substitutes. 

A steady deterioration of the US's debt position would tend to drive up Treasury bond yields and rising US interest rates have historically been bad for emerging market assets. But developing world sovereign debt fundamentals – reliable central banks, prudent policymakers, tightly controlled national budgets etc – have made their bond markets less sensitive to US yields than in the past. And the evolution of those fundamentals, including the expansion of domestic demand for bonds priced in local currencies, suggest that they’ll be ever less sensitive in future. So subject to how protectionist the world becomes and how local trading blocs develop, emerging economies should benefit from flows that shift out of US assets.

Deteriorating debt fundamentals challenge US exceptionalism. This exceptionalism has, in turn, underpinned the dollar, which has been able to hold its value well above the fair value estimated by our economists. Eroding the former should weaken the latter. 

The US’s vast debt load can’t continue to grow at its recent pace forever – or even for too many more years without some sort of reckoning. We expect that reckoning to fall short of a catastrophic halt. In which case and on balance the resolution should be good for emerging market economies and their asset classes. But that’s the long term. More immediately, although Trumpian policies are likely to foment volatility in emerging assets, we think they’ll emerge as winners once the dust has settled.