16th November 2016
Jan Dehn, head of research at Ashmore, believes that if Trump follows through on his election promises, there are good reasons to believe that the 35-year rally in developed market fixed income is over. He explores the implications of a Trump victory on EM, asserting that the EM sell-off was nothing more than a market over-reaction, and that it will soon abate and buyers will return – attracted by the sudden cheapness.
The material moves in Emerging Markets (EM) asset prices and currencies following the Trump election victory are due to the market overreacting. Overreactions of this kind are, of course, common to the asset class – as we warned in a publication prior to Trump’s election victory.1 As in previous such episodes we believe investors are likely to be proven wrong if they sell and be rewarded handsomely if they put money to work at the better entry levels.
Markets are likely to take some time to form a consensus about America’s path under a Donald Trump presidency. Trump has not yet had time to be very specific about his policy priorities. Most of his team has not yet been appointed and his ability – or otherwise – to work with Congress remains to be determined. Pending more explicit policy prescriptions from President-elect Donald Trump we think the following broad features can be expected:
Trump’s messages on social issues during the election campaign were divisive but effective. Now that he is in power he will have to deliver improvements in actual living standards for hard-working American families. This, of course, cannot be done by persecuting minorities, because they were not the root of the problem in the first place. The only way to improve the economy is to address the economy. Hence, expect the social rhetoric to be toned down and the focus to shift to economic issues.
The hard reality facing most US presidents is that their political capital peaks in their first term, which is why they focus on domestic policy issues first. Foreign policy is almost always relegated to the second term, when there is no more political capital to push reforms through Congress. Trump will face the same constraints. Given that Trump is likely to have an extensive domestic policy agenda, we think his focus will very much be on domestic matters and not, as many think, imminent trade wars and other foreign policy related issues. Trump’s domestic policy objectives include whole and partial repeals of financial regulation, climate change commitments and Obamacare in addition to corporate tax reform and infrastructure spending programmes. On the external front, we expect TPP not be ratified, which should not surprise anyone. Apart from that we expect protection to be afforded mainly to selected inefficient American industries with large labour forces, such as steel.
President Reagan’s fiscal expansion is likely to be an inspiration for Trump, who has borrowed and built all his life. However, Trump will face three challenges when it comes to spending more. First, the US economy is already at full employment and inflation already exceeds the Fed’s 2% target (core CPI is 2.2% yoy). Second, debt levels are twice as high as when Reagan began to spend. Reagan started his spending spree with a total US debt stock of 161% of GDP and eventually took the total debt stock to 262% of GDP by 1989. Trump starts with a debt stock of 331% of GDP. Hence, his room to stimulate fiscally may not be as big as many expect.
Thirdly, Congress is full of fiscal hawks. One way around the Congressional hurdle is to roll out the fiscal stimulus at State level instead of Federal level. This would satisfy Tea Party Republicans, who famously dislike Federal Government spending (except on the military) and would like to see more power at local level.
A fiscally-induced boost to demand will only have a lasting effect on private sector demand if the private sector can borrow to invest alongside the government. This means that banks must be able to take more risk, so Trump is likely to execute a partial reversal of much of the bank regulation that was put in place after 2008/2009.
Fiscal stimulus and greater private sector spending will push up inflation. Never before has the Fed allowed the US economy to reach full employment with the policy rate at just 25-50bps. The Fed cannot reach neutral for several years given the underlying fragility of financial markets, negative productivity growth and the overvalued Dollar. Indeed, San Francisco Fed’s Williams’ argument from earlier this year rings ever more true: the Fed ought to have raised the inflation target earlier this year, because then the Fed would look at if it was meeting its target rather than falling behind when prices rise.
The problem with inflation is that long yields rise as markets price in an inflation risk premium. Trump may well be forced to give the long end of the US yield curve special attention to prevent serious bear steepening, which could blow up everything from the stock market through to housing. Japan looks ahead of the curve having already shifted to direct yield targeting at the long end of the curve.
The rise of inflation in the context of negative real policy rates and repressed long bond yields should mean lower real rates, which in turn means a lower Dollar. A weaker Dollar would also help American producers versus overseas competitors and push up US GDP growth by stimulating net exports. The currency, rather than a trade war, may be the most effective way for Trump to favour American business interests over foreigners.
We do not see Trump tackling America’s tougher supply-side problems, such as the enormous debt burden, unfunded healthcare plans and unfunded pension deficits. Deregulation may boost productivity temporarily, but it could just as easily result in more bubbles. More debt and selective protectionism will certainly worsen productivity. On balance, we do not see US trend growth rise materially.
As Trump’s America retreats from the global stage to focus on domestic matters we see China continuing to advance in Asia, while Europe will be forced, whether it likes it or not, into closer ties with Russia on account of Europe’s dependence on Russian energy. No wonder Putin strongly supported Trump during the campaign.
Against this menu of likely policy preferences, we think the EM sell-off will soon abate and buyers will return, attracted by the fortune of sudden cheapness.
In conclusion, we see no fundamental reasons at all to be worried about EM at this juncture. EM’s growth premium is improving and technicals are good. EM has proven its resilience by successfully weathering major shocks in recent years, including the Taper Tantrum, a massive fall in commodity prices, a sizeable Dollar rally and the start of the Fed hiking cycle.