Local Currency Emerging Market Debt sold off by 7.8% after the election of Donald Trump to U.S. president. However, Van Luu, Head of Currency and Fixed Income Strategy at Russell Investments thinks that the rise in U.S. Treasury yields, which is detrimental to such debt, will slow down significantly.
“The president-elect’s economic policies are not universally detrimental to the economic prospects of emerging market countries. His plans for increased infrastructure spending may even benefit economies that mainly export raw materials, like Brazil, South Africa or Russia.
Trade policies have the greatest potential long-term effect and are more likely to impact countries which mainly export manufactured goods to the U.S. Mexico is one country that may suffer from protectionism, but the commodity exporters like Brazil, Russia and South Africa may even benefit from a reflationist president emphasising greater infrastructure spending.”
U.S. Treasuries are heavily oversold
- “U.S. Treasury yield rises typically hurt EM assets in the short term, as capital exits emerging markets in favour of U.S. assets with now higher yields.
- That said, the real yields in emerging markets are similar to the levels in 2013 during the Taper Tantrum and they continue to have a large spread versus G3 Treasuries. This should help buffer the outflows, but the headwind will persist if U.S. bond yields continue to rise at this quick pace. We think that is unlikely, as Treasuries are now heavily oversold.”
Threat of protectionism and rise in Treasury yields drove EM sell off, not global risk appetite
- “Developed-country equity markets dropped sharply in the first few hours of election results coming in, but then recovered strongly when the clear result of a Trump victory took shape.
- However, EM assets continued to sell off in the days after 9 November, which suggests that the divergence between developed and EM asset prices is driven by the threat of protectionism and the rise in Treasury yields rather than a drop in global risk appetite.”
US reflation historically benefits emerging markets
- “Rising U.S. interest rates are partly due to the prospects of reflation. As mentioned above, stimulus and protectionism are both inflationary in the short term, especially later in economic cycles where the output gap is smaller. But reflation and stimulus are net positives for growth and EMs have historically benefitted from stronger growth and inflation in the U.S.”
Greater restrictions on international trade – the winners, and the losers
- “Mr Trump has supported greater restrictions on international trade, which, if implemented, are likely to hurt EM economies and could weigh on their currencies. The Mexican peso fell sharply after the election because Mexico is seen as particularly vulnerable to a possible repeal of the North American Free Trade Area (NAFTA).
- “Of the countries represented heavily in the JP Morgan GBI-EM Global Diversified, we think only Mexico’s economy warrants a significantly more negative view. More than 70% of Mexico’s exports go to the US, a high share that has been growing since the beginning of NAFTA.
- “Mexico is also most vulnerable because it mainly exports finished manufactured goods to the US, including machinery and transportation equipment. These are exports that a protectionist President could try to substitute with domestically produced goods.
- “At the other end of the spectrum is a country like Russia – though other commodity exporters like Brazil and South Africa are similar, which exports very little to the U.S. and mainly trades raw materials. Such countries could even be beneficiaries of a reflationist President Trump.
- “What needs monitoring is whether the improvement in EM countries’ balance of payments over the past 6 months – after suffering from a worsening for three years – is sustainable or whether these economies slip back into a negative cycle of capital outflows, interest rate rises, currency depreciation and economic slowdown.