Since last week’s US elections, emerging market assets have been spooked by the possibility of higher US interest rates and greater trade protectionism. That this should result in sudden and broad-based losses for holders of all types of EM investments — including equities, local debt, external bonds and currencies — should not come as a great surprise.
What is unusual, however, is for such large losses to coincide with strong and highly differentiated performances in US stock markets.
Since the election, equities have soared and US government bonds have been sold off as traders have rushed to price in prospects for higher US growth and inflation. This has been driven in part by president-elect Donald Trump’s remarks since his win, which have emphasised deregulation, infrastructure spending and corporate tax reform.
Combined with noticeably little mention of tariffs on China and Mexico, or of the dismantling of arrangements such as the North American Free Trade Agreement, this has resulted in a shift in the markets’ macroeconomic paradigm — so much so as to also result in notable sectoral differences, including massive outperformance by banks relative to technology.
This strong and highly differentiated US stock market performance stands in sharp contrast to what is happening in emerging markets. There, concerns about deteriorating prospects for trade and capital flows — due to greater anti-globalisation pressures and spiking US bond yields — have led to a sharp and indiscriminate sell-off.
As is typically the case in this asset class, the selling has been amplified, both in scope and scale, by longstanding technical weakness. Most important among these is the extent to which crossover flows — or what I like to think of as “tourist dollars” as their reaction function is more flighty and sensitive to many influences that go beyond EM fundamentals — repeatedly overwhelm dedicated investors, “the locals”. As such, valuations typically overshoot, both on the way up and, in this latest case, on the way down.
Having said that, one cannot but notice the extent to which this EM sell-off appears to be inconsistent with some of the important drivers of the US equity rally. This is especially so when it comes to how markets are internalising a much lower probability of disruptions to trade regimes and how comfortable markets are with the view that the potential for stronger growth more than compensates for the risks associated with the reality of higher interest rates.
Yes, interest rates will rise, thereby undermining discounted corporate cash flows, but — according to US stock markets — the move will nevertheless be supportive of valuations overall as it is led by expectations of faster nominal growth in gross domestic product, and that translates into higher consumption, investment and corporate earnings.
On trade, US stock investors appear more comfortable than their EM counterparts with the notion that the protectionist rhetoric, which carries an anti-growth risk, will be put aside as Mr Trump continues to adopt a more conciliatory, inclusive and constructive approach. The why, how and when of the eventual reconciliation between these two views have important investment implications.
If the EM interpretation is the correct one, US stocks have some rough sledding ahead. If, however, emerging markets have misread the president-elect’s policy intentions, then these beaten down assets have more upside over the next year than that offered by US stocks.
Actual policy implementation will ultimately be the decider, including how the Trump administration works with a Congress influenced by more traditional Republican thinking.
In the meantime, a gradual repositioning of investment portfolios that include relative trades favouring EM over US assets warrants consideration. However, there are two qualifications: they may take time to play out given the scope for EM technical overshoots and one should not overdo the overall risk exposures to stocks, be they US or EM, in a world that is still subject to “unusual uncertainty” on account not just of political factors but economic, financial and institutional ones too.
The writer is chief economic adviser to Allianz and author of ‘The Only Game in Town’
