President Trump’s potentially inflationary policy agenda has understandably put emerging markets investors on edge, writes Lazard Asset Management’s James Donald.
As President Trump prepares to boost infrastructure spending, cut taxes, and loosen regulation, US inflation and nominal interest rates could easily rise.
Along with this, uncertainty relating to specific policies has created a sense of insecurity among emerging markets investors.
Time will tell if the President will continue to emphasise protectionism and the sovereignty of nations.
However, we think it is likely that some of the President’s more controversial proposals will be watered down for pragmatic reasons, including some relating to the economic interdependence between the US and its trading partners, many of which are emerging markets.
We believe that emerging markets investors remain most concerned with Trump’s protectionist statements on trade (specifically higher tariffs) and immigration.
Trade: A two-way street
The US maintains free trade agreements with 20 countries, with China and Mexico its largest and third-largest trade partners, respectively.
In 2015 alone, total two-way trade with these countries was valued at US$598 billion and US$531 billion, respectively. In the weeks following the election, the Trump team discussed the use of traditional trade barriers, enforcement cases, tariffs and even a destination-based cash-flow tax, similar to a value-added tax.
While China and Mexico, along with other countries in the emerging markets, will undoubtedly feel the effects of such trade policies, the US has much to lose from any potential trade disruption or trade war.
In 2015, nearly 16 per cent of total US exports of goods, US$236 billion worth, were bound for Mexico alone, while 8 per cent, or US$116 billion worth, went to China. Retaliation from these countries could have negative consequences for the US economy.
What is more, by imposing tariffs on certain trading partners, we believe Trump will, in effect, implement a regressive tax on poorer Americans as they may be forced to pay more for imported goods, such as clothing, electronics and automobiles.
China will remain a strong economy
Although China is likely to feel the effects of weaker trade under a Trump presidency, it may benefit from US withdrawal from the 12-nation Trans-Pacific Partnership (TPP) as it was previously excluded from the scuttled deal.
With its share of global GDP surging from 4 per cent in 2000 to 15 per cent in 2015, China is positioning itself to assume a greater role in promoting regional and global trade agreements and the free flow of investment.
At the Asia Pacific Economic Cooperation summit in November 2016, President Xi Jinping offered China’s answer to the TPP, the Regional Comprehensive Economic Partnership (RCEP), which intentionally excludes the US, and spoke of broadening the Free Trade Area of the Asia-Pacific.
Although the RCEP may not be as ambitious as the TPP in reducing nearly 18,000 tariffs and trade barriers, it is the only major Asian trade deal that is up for negotiation.
Any reduction in Chinese exports to the US could trigger more fiscal policy support from the Chinese government to stabilise its domestic growth.
Any potential trade shock could also accelerate China’s reform and economic rebalancing process, causing China to speed up its transition away from low-end manufacturing exports.
Trump’s focus on bringing back jobs to the US could also hurt some Asian economies to the extent that his policies impede the growth of the business process outsourcing (BPO) sector.
Trade with Mexico
While campaigning, Trump stated intentions to exit or, at the very least, renegotiate the North American Free Trade Agreement (NAFTA), which eliminates tariffs and governs trade between the US, Mexico, and Canada.
Though difficult to quantify, the economic impact on Mexico will depend on how quickly trade tensions escalate between both countries as manufactured products are Mexico’s main export, accounting for nearly 90 per cent of its total exports.
US exports represent more than 25 per cent of Mexico’s GDP and account for 80 per cent of its total exports.
The Trump team has focused on narrowing the $60.7 billion trade deficit the US maintains with Mexico by levying tariffs and trade barriers.
However, Mexico could counter with its own retaliatory tariffs that would be just as disruptive to many US-based companies with complex supply chains that run through Mexico.
Mexican officials have stated that they are willing to modernise NAFTA, including adding rules on e-commerce, but are hesitant to agree to export quotas and tariffs.
To prepare for any trade disruptions with the US, Mexico could look to add to its 40 existing trade deals with other countries and may even sign on to a smaller version of TPP or another regional trade agreement.
While the uncertainty of a Trump presidency has weighed on emerging markets, particularly on the subject of trade protectionism, immigration and foreign policy, the general consensus across our emerging markets equity team is that some of Trump’s most controversial proposals will be tempered.
As a result, expectations of higher inflation and tighter monetary policy in the US due to the President's pro-growth stance may also be exaggerated.
Although a sharp increase in US interest rates would be challenging for emerging markets as a whole, we believe many of these countries can withstand gradual US interest rate hikes, keeping in mind that these also reflect a certain measure of confidence in global growth prospects, which is favourable for emerging markets.
James Donald is a portfolio manager and analyst at Lazard Asset Management.
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