The first few 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 neighbours, as well as with key trade partners in Asia.
Where does that leave trade-dependent Asia and other emerging markets, many of which count the US among their top three trading partners? And how should investors play the emerging trend? There are a few factors favouring emerging markets at the moment that arguably contributed to their equities outperforming those of developed markets for the first time in four years in 2016:
- Emerging-market growth is accelerating relative to developed market growth for the first time since 2009
- Emerging-market equity market valuations are more attractive than those in developed markets after years of underperformance
- Many emerging markets, especially outside Asia, are still recovering from recessions and/or downturns in equity, bond and currency markets
- Many emerging markets are benefitting from increased commodity price stability, greater reform efforts and stability in China
Against these favourable trends, there are counter-balancing factors. Apart from trade frictions, the most significant risk facing Asia and emerging markets is 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 create a challenging environment for emerging markets, given the possibility of triggering capital outflows.
Capital outflows are not inevitable
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, suggesting the most susceptible components may already have left. Second, the gap between low US rates and fairly high rates in many emerging markets is quite high. Finally, US interest rates would probably have to rise at a faster pace than expected in order to trigger large-scale capital outflows, and markets are arguably already looking for at least two rate hikes from the Federal Reserve (Fed) this year.
There could even be situations where US rates go up, but are not detrimental to emerging markets. For example, US interest rates could rise, but at a much slower pace than expected; or emerging market growth could continue to accelerate relative to developed market growth.
Take a selective approach
Investors should be highly selective. The US remains our preferred equity market given its strong earnings outlook. Within Asia, India appears most attractive, given its domestic focus (a partial shield against trade frictions), positive long-term structural growth outlook and falling interest rates.
Hong Kong and China equities have delivered solid performances year-to-date as weakness in the US dollar helped emerging market equities generally. 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.
The Chinese yuan is likely to continue to weaken gradually, along with modest broad-based gains in the US dollar
Within bonds, prospects of higher Fed interest 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, we believe a focus on higher-quality Asian US dollar corporate bonds is prudent, given the risks around deteriorating credit quality. Within currencies, the Chinese yuan is likely to continue to weaken gradually, along with modest broad-based gains in the US dollar.
It is currently unclear if President Trump can deliver what he promised. A lot depends on whether he can cut deals with his fellow Republicans and how successfully he fends off Democrat opposition to implement tax cuts, deregulation and increased spending on US infrastructure.
For investors, the prospect of Trump’s trade protectionism policy remains a big unknown, as many export-oriented emerging markets could suffer. Regardless of how the risk factors turn out, investment opportunities do exist in this politically uncertain environment.