By Gene Frieda, Global Strategist at PIMCO
Gene Frieda, Global Strategist at PIMCO.
For much of 2016, a unique alignment of push and pull factors has driven strong performance in emerging markets (EM). The election of Republican Donald Trump and Republican majorities in the US Congress on 8 November, however, represents a pivot point: These factors may become more divergent and create a more challenging landscape for EM, with the potential for fiscal stimulus in the US, a more hawkish Federal Reserve and protectionist trade policies.
Some investors have reacted already: EM valuations and fund flows dropped quickly in the days after the election. In our view, however, the implications of the US elections for EM are more nuanced. Differentiation within the EM asset class should persist, and the winners and losers may vary dramatically depending on which of the potential combinations of US monetary, trade and fiscal policy play out.
One thing seems certain: Investors will need to be agile to manage the trickier backdrop.
Where we are
At present, the Fed shows no signs of moving away from its gradual policy of normalization, recognizing that fiscal stimulus remains hypothetical and will nonetheless take time to implement. Against this backdrop, higher-yielding EM countries with improving external accounts should continue to perform well, while low yielding EM countries with below-trend growth should continue to underperform.
The potential for a substantial fiscal stimulus, which President-elect Trump promised during his campaign, has market participants wondering if we’ll see a more hawkish Fed prompted to raise interest rates as inflation and the US economy heat up. This would be a mixed bag for EM: the potential positive implications of rising US demand for imports versus the negative implications of rising US rates, which would likely strengthen the US dollar and complicate the picture for EM assets.
Although there has yet to be any explicit mention of protectionist trade policies in the early commentary from President-elect Trump, they were an important part of his campaign platform, and global trade growth has been a seminal driver of EM performance in past economic cycles. Given that tensions around trade are rising across jurisdictions, the uncertainty about US trade policy is enough to cast a shadow on the EM asset class.
Looking at the scenarios for EM
The table illustrates four combinations of policy that could unfold assuming fiscal policy expands, and their potential effects on EM assets.
Source: PIMCO.
The top right scenario in the table, showing US fiscal policy expansion combined with benign trade policy and a dovish Fed, would be the most similar to the environment today, with EM performing well generally.
If the fiscal stance in the US becomes more accommodative and the Fed becomes modestly less accommodative, mean performance in EM need not decline dramatically. But the more that US fiscal policy forces the hand of monetary policy, the greater the likelihood that the US dollar will strengthen further as US monetary policy diverges with the rest of the world. Under this scenario, shown in the top left quadrant of the table, our bias would shift in favour of EM mid- to low-yielding countries with relatively strong external balances and reduced linkages to the US Countries with larger current account deficits would probably suffer most.
If trade policy turns protectionist, EM asset class returns are likely to decline more markedly. But even under such a scenario, high-yielding EM countries with less open economies could outperform if the negative supply shock were mitigated by a continuation of loose monetary policy (see bottom right quadrant in the table). Smaller, more open economies would suffer most in this scenario, not least because China would suddenly become a primary target of policy, and the spill-over would hurt the prospects for smaller countries.
In the worst-case scenario for EM, trade protectionism intersects with looser US fiscal policy and prompts the Fed into a more rapid response to counter the higher aggregate demand and negative supply shock (see bottom left quadrant in the table). Mean returns would almost certainly be negative for the EM asset class under this scenario. In our view, selective investing geared to avoid the risk around the threat of protectionism, in particular, may lead to significant pockets of long-term value within the EM asset class.
A stronger starting point for EM
The good news is that EM assets face these complicated scenarios from a relatively attractive starting point. First, EM valuations remain attractive on a relative basis. And second, while investment flows have returned to EM and increased since February, the inflow has been modest compared to past cycles. As a result, with improving external balances and weak domestic demand in EM countries, the traditional threat to EM ‒ a sudden stop in capital flows born of a more hawkish Fed – appears reasonably contained.