The first few weeks of the new U.S. administration have made one issue quite clear—President Trump is keen to deliver on his campaign promises. One of the cornerstones of his declared policy is to negotiate better trade deals for the U.S. with its neighbors such as Mexico and Canada, as well as with key trade partners in Asia. Where does this approach leave trade-dependent Asia and the other emerging markets (EM), many of which count U.S. as among their top three trading partners? And how should investors play the emerging trend?
To tackle this question, one needs to first examine the backdrop. There are a few factors favoring EMs at the moment. First, EM growth is accelerating relative to developed market (DM) growth for the first time since 2009 and Asia is set to remain the biggest growth driver for the global economy. Second, EM equity market valuations are more attractive than those in DMs after years of underperformance. Third, many EMs, especially outside Asia, are emerging from recessions and/or sharp downturns in their equity, bond and currency markets. Other factors such as increased commodity price stability, greater reform efforts and stability in China are also positives for many EMs. Indeed, these factors arguably contributed to EM equity outperformance over DMs for the first time in four years in 2016.
Against these favorable trends, there are counterbalancing factors. Apart from the likelihood of trade frictions, the most significant risk facing Asia and EMs is that of rising interest rates in the U.S. as Trump’s policies could potentially generate faster growth and higher inflation. Historically, higher U.S. rates have tended to be a challenging environment for many EMs, given the possibility of triggering capital outflows.
However, we believe capital outflows are not inevitable. There are three factors to keep in mind. First, that many EMs (including China) have already faced significant capital outflows. This situation suggests the most susceptible components may already have left. Second, the gap between the low U.S. rates today and fairly high rates in many EMs is quite high, which may offer an additional source of support for EMs. Finally, U.S. interest rates would most probably have to rise at a faster pace than what is already expected in order to trigger large-scale capital outflows. Markets are arguably already looking for at least one rate hike from the Fed this year, so an upside surprise from this baseline would likely be needed in order for markets to start worrying about EMs.
There could even be situations where U.S. rates go up, but they are not detrimental to EM assets and currencies. For one, U.S. interest rates could rise, but at a much slower pace than expected. This would imply higher yielding EM currencies (like the rupee or rupiah) may be less vulnerable than lower yielding ones. Second, EM growth could continue to accelerate relative to developed market growth, which would underpin interest in EM equities. Finally, EM currencies may have already priced in a significant portion of the risks, leaving less room for further downside. The Malaysian ringgit is a good example of this, given just how much it has already weakened over the past few years.