THE first couple weeks of the new US 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 US with its neighbors such as Mexico and Canada, as well as with key trade partners in Asia.
Where does that leave trade-dependent Asia and the other emerging markets, many of which count US 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 emerging markets at the moment.
First, emerging market growth is accelerating relative to developed market growth for the first time since 2009 and Asia is set to remain the biggest growth driver for the global economy.
Second, emerging markets’ equity market valuations are more attractive than those in developed markets after years of underperformance.
Third, many emerging markets, 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 emerging markets. Indeed, these factors arguably contributed to emerging markets’ equity outperformance over developed markets for the first time in four years in 2016.
Against these favorable trends, there are counter-balancing factors. Apart from the likelihood of trade frictions, the most significant risk facing Asia and emerging markets is that of rising interest rates in the US as Trump’s policies could potentially generate faster growth and higher inflation. Historically, higher US rates have tended to be a challenging environment for many emerging markets, 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 emerging markets have already faced significant capital outflows. This suggests the most susceptible components may already have left. Second, the gap between the low US rates today and fairly high rates in many emerging markets is quite high. This may offer an additional source of support for the emerging markets. Investors 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 emerging markets.
There could even be situations where US rates go up, but they are not detrimental to emerging market assets and currencies. For one, US interest rates could rise, but at a much slower pace than expected.
This would imply higher yielding emerging market currencies may be less vulnerable than lower yielding ones. Second, emerging market growth could continue to accelerate relative to developed market growth, which would underpin interest in emerging market equity exposure. Finally, emerging market 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.
Moreover, in equity markets, emerging markets have a valuation advantage over developed markets. On average, emerging markets are much more fully valued while emerging markets are generally more inexpensive when compared with their respective earnings expectations. However, there is a great deal of dispersion across countries.
Hence, for investors, a prudent approach would be highly selective, looking for the best rewards on offer for the risk taken. Globally, the US and Japan (currency hedged) remain our most preferred equity markets given their strong earnings outlook. Within Asia, Indian and Indonesian equities appear most attractive, in our view, given their domestic focus (which should shield them better against any trade frictions), positive long-term structural growth outlook, falling interest rates and continued reform efforts.
Chinese mainland and Hong Kong equities have delivered solid performances year-to-date as weakness in the US dollar helped emerging market equities generally. These equity markets are likely to be supported due to their reasonable valuation. Chinese banks, with their cheap valuation and high dividend yield, should be an area of focus for local investors. Elsewhere, China ‘new economy’ stocks are likely to do well, given their higher profit margins and better revenue and earnings growth prospects compared with the ‘old economy’ sectors.
Within bonds, prospects of higher Fed rates and inflation warrant a shift away from higher grade government and corporate debt to less rate-sensitive developed market High Yield corporate bonds and US floating rate loans. In Asia, though, we believe a focus on higher quality Asian USD corporate bond is prudent, given the risks around deteriorating credit quality. Within currencies, the Chinese Yuan is likely to continue to weaken gradually, as in past years, along with broad-based gains in the USD. However, the Indian Rupee, Indonesian Rupiah, Brazilian Real and Russian Ruble are likely to outperform other emerging market currencies.
As President Trump rolls out his agenda in the first 100 days of office, it is unclear to what extent he can deliver what he promised to his constituency. A lot depends on how well he can cut deals with his fellow Republicans in the US Congress and how successfully he fends off increasingly strident Democrat opposition to implement tax cuts, deregulation and increased spending on US infrastructure.
For investors in emerging markets, the prospects for trade protectionism remain a big unknown as many export-oriented emerging market could be at risk from an increasingly protectionist world. Regardless of how these risk factors pan out, several investment opportunities exist in this politically uncertain environment.