According to Goldman Sachs Asset Management, Donald J. Trump’s victory in the US election has fuelled three main concerns for Emerging Markets (EM): potential protectionist trade policies, rising rates and a strengthening US dollar. The surprising result created uncertainty for EM, which is reflected in equity market performance and flows since the election: the MSCI EM Index is down 5%, underperforming developed market equities by almost 7% and suffering the worst week of underperformance since the financial crisis. EM equity flows have also sharply reversed; outflows hit $7bn in the week following the election – equating to one third of YTD inflows.
The firm believes the initial market reaction is underappreciating the diversity of the EM opportunity set and the wide- ranging impacts of trade policy, rising US interest rates and a strengthening dollar on each of the 23 economies in EM. They also think investors may be overestimating the potential for campaign promises to become actual policy.
In their view, the long-term case for owning EM equities – portfolio diversification and alpha potential – remains intact.
The Possibility of Protectionism
EM has been the low-cost manufacturer to the world since the early 1990s. If the US introduces protectionist policies, most likely in the form of tariffs on imported goods, many EM economies could be negatively impacted. Crucially, the US may also experience sizeable repercussions. In fact, the introduction of tariffs – and resulting retaliatory measures from countries like China – could cause up to a -0.7% hit to US real GDP growth.
The firm is not convinced that tariffs would bring trading partners “to the negotiating table” – as is often cited using the example of Ronald Reagan’s 45% tariff on Japanese motorcycles in the 1980s – they would more likely result in trade wars and counter-protectionist acts. The Chinese government has already suggested that it is open to letting the country’s US dollar peg relax and is threatening to stop the import of key US products – actions that could further undermine growth in the US.
The firm could see aggressive government concessions for firms willing to keep manufacturing in the US and tariffs in specific industries where US manufacturing has suffered most. If the Trump administration is slightly more pragmatic than the market has assumed then investors may feel more assured that the EM growth model is still intact. They believe there could be a difference between campaign rhetoric around protectionism and actual implementation as policy makers may be constrained by economic realities such as negative consequences to US economic growth. The introduction of unilateral tariffs could have lasting negative consequences for the US and could undermine what has been widely considered part of President-elect Trump’s mandate: to improve the economic position of the US working class.
The Risk of Rising Rates
Since the election, inflation expectations and US government bond yields have increased. Rising US interest rates will mean higher funding costs for EM debt and increased pressure on EM economies. In addition, higher US rates and a waning search for yield could reduce foreign investment into EM, which has lowered funding costs and supported increased consumption and lending in EM economies. These are clearly headwinds for EM growth.
An end to the ‘low rates, low growth’ environment may not be as negative for EM as markets may be suggesting. If rising rates are the result of an improving growth backdrop in the US, it should be supportive for EM economies. Since 1980, EM equities have outperformed developed markets on average by 11% during Fed rate hike cycles, including three of the past four cycles. This scenario played out during the last Fed hike cycle between 2004 and 2006 – the Fed raised rates by 425 bps in less than two years, but it coincided with a strengthening US and global economy that supported a sustained rally in EM equities.
The debt profile of EM countries has also changed meaningfully in recent years. In 2000, the vast majority of debt issued by EM countries was in US dollars. Today, over two-thirds of all EM sovereign debt is in local currency. This typically reduces any potential instability and should make EM more resilient to rising rates. There will be greater headwinds for those countries and companies that have only been able to drive growth in recent years because of cheap, easy money in developed markets. In our view, companies with more sustainable long-term growth models can differentiate themselves in this environment.
Rising rates will highlight fragilities in EM and put pressure on companies with weaker governance practices who have attempted to take advantage of the lower rate environment in the US. However, if the cyclical recovery in earnings and return on equity that has materialized in 2016 can be supported by a better global growth backdrop, then there is reason to be constructive on EM equities going forward.
The 1980s Dollar Revival?
A further concern post-election has been the idea that we are once again in a bull market for the US dollar.
Many commentators have compared the prospects for the dollar to what was seen in the Reagan years of the 1980s, namely a multi-year, close to 100% rally. Goldman Sachs AM believes the US dollar has scope to further strengthen, but the magnitude may not mirror the 1980s because the starting points are very different. When Reagan came to power in 1981, the US was trying to pull itself out of recession, inflation had reached almost 15% and the dollar had fallen by roughly a third over the prior decade. More recently, the backdrop has been years of consistent dollar strength. In fact, following almost nine years of depreciation, EM currencies are trading at a discount of ~15% relative to fair value.
Furthermore, the primary driver of EM equity returns historically has been corporate fundamentals, not currency. In fact, over the past fifteen years, EM FX has been a slight detractor from total returns, but this has been comfortably offset by earnings growth. We see encouraging signs that EM earnings and returns on equity are picking up from cyclical lows and continue to believe that this can be the major driver of the asset class going forward, offsetting any potential currency headwinds.
Outlook and Opportunity: Stay the Course
EM has taken the brunt of the post-election fallout in light of Trump’s rhetoric around implementing protectionist measures, the impact of rising rates on funding costs for EM debt and a strengthening US dollar. The firm´s view is that these risks will not be as prevalent as initially feared.
Despite increased uncertainty, the key reasons for investing in EM, namely the diversification and alpha potential, are both still intact. In fact, they believe these benefits are potentially enhanced given that the market appears to be discounting the diverse, heterogeneous nature of the asset class.
Fundamentals are recovering
Fundamentals in EM are also far stronger than at the time of the 2013 Taper Tantrum when the asset class sold off following the Fed’s tapering of quantitative easing, although the market reaction has been similar.
The growth premium relative to developed markets has begun to reappear, external imbalances have been reduced, inflation remains benign and EM FX is more attractively valued than it was in 2013. Finally, we have seen the earnings and returns cycle turn positive in the past six months and earnings expectations continue to support a mid-teens earnings outlook for 2017. Historically this has been the key driver of EM outperformance.
Valuations are attractive
On a forward price-to-earnings basis EM still trades at a 25% discount relative to developed markets. In absolute terms, EM appears to be returning to its long-term average, though we believe this is largely the result of significant earnings declines over the past few years, which have inflated the multiple. This is most apparent when observing a cyclically-adjusted price-to-earnings ratio, which shows EM is comfortably in the bottom quartile relative to its long-term history.
As such, while it is reasonable to argue that EM is not extremely cheap, the firm believes that long-term investors are able to access the market today at an attractive level for what could be cyclically suppressed earnings.
Selectivity is critical
EM has taken the brunt of the post-election fallout in light of Trump’s rhetoric around implementing protectionist measures, the impact of rising rates on funding costs for EM debt and a strengthening US dollar.
Their view is that these risks will not be as prevalent as initially feared. EM equity returns have historically been driven by corporate fundamentals rather than currency, suggesting the uptick that we have seen in earnings and ROEs suggests that there is significant growth potential for the asset class. In their view, an actively managed investment approach, focused on mitigating the structurally-impaired parts of the EM universe, is a potentially effective way to access this growth potential over the long-term.
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