Emerging markets Trumped

In a recent column, Louis Gave argued that despite the renewed strengthening of the US dollar over the last couple of months since the US election, there has been no generalised flight out of emerging markets. Sure, Turkey appears to be experiencing a classic emerging market currency crisis. But as Louis noted, the collapse of the lira has been driven by peculiarly Turkish factors.

There is little or no risk of contagion spreading to the broader emerging markets. On the contrary, EM assets as a whole have held up remarkably well through the latest bout of US dollar strength. Nevertheless, even though a number of stars are coming neatly into alignment for emerging Asian equities, there are good reasons why investors should be cautious.

In a normal cycle, current conditions would be strongly positive for the Asian EMs. Cyclical indicators in the developed economies have turned upward and are gaining momentum, as shown by last week’s release of the OECD latest composite leading indicators. Historically, such an upturn in the developed world has been a reliable signal for identifying the turning point of the Asian growth and profit cycle. And sure enough, the regional upswing promised by recent business surveys in the West is now unfolding. Countries across Asia are reporting stronger-than-expected export growth, with Korea’s shipments up 6.4% year-on-year in December, while Taiwan’s exports grew 14%.

Nor is the improvement in conditions confined to trade; other cyclical factors are also supportive. The worst of the belt-tightening which has constricted growth in emerging Asian economies over the last few years has passed, and stronger commodity prices are providing a welcome tailwind for much of the region. As a result, Citi’s economic surprise index for the Asia-Pacific is now at its most positive for six years.

Moreover, almost three years after the US currency began to appreciate, and with the US dollar close to its strongest in 14 years, at this stage of the cycle it would be normal to expect the US current account deficit to begin to widen. That would pump plentiful dollar liquidity into the rest of the world, and see the US currency peak. The resulting marginal easing of international financial conditions would complete the virtuous circle, keeping global demand strong and the trade cycle going. The last time conditions came together like this, in the early 2000s, over the following five years the US current account deficit almost doubled relative to gross domestic product, the US dollar fell by a third, and the MSCI EM index gained 400%.

The problem this time around, of course, is that the expected cyclical widening of the US trade and current account deficit would crash head-on with the promise made by president-elect Donald Trump to return America to manufacturing and export greatness. In this cycle, the greater the positive economic surprises among Asian exporters, the greater the likelihood that the incoming US administration will aggressively protectionist stance.

More specifically, the risks for Asia could unfold in three distinct ways:

- Trump’s policies could succeed. Corporate tax cuts coupled with proposals for a “destination-based cash flow

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an tax” could succeed in making US manufacturing more competitive. This would incentivise onshoring to the US and detract from Asia’s future export growth. The US current account deficit would narrow, restricting dollar liquidity in Asia.

- Trump’s policies could fail. Naked protectionism, for example outright tariffs on manufactured goods imports to the US, could push up US consumer prices, damage demand in America, and trigger a retaliatory trade war, with few if any offsetting benefits from onshoring. The result would be a crippled Asian supply chain, and global recession.

- Trump’s policies could have little domestic impact. Tax changes intended to advantage US exporters and penalise imports could simply lead to an offsetting appreciation of the dollar that would make US exports more expensive abroad and imported goods cheaper in America. In theory, the result would be neutral for US trade. However, a strong dollar environment is seldom favourable for risktaking in Asia, and further US currency strength from here would heighten risk in the EM corporate bond markets.

Given Trump’s picks for key trade appointments, it would be rash to dismiss the threat of substantially increased US protectionism. So, even though the current cyclical upswing would appear to promise an earnings recovery, emerging Asian assets will continue to carry a sizable Trump risk premium. As a result, at this point it would be hard for investors to look for anything better than low single digit returns from Asia in 2017. And the risks remain skewed to the downside.