Protectionism, Trade Wars, and the Emerging Markets

A few days after President Trump won the November 2016 elections, and when emerging-market (EM) risk assets saw declines due to concerns related to protectionism, we shared some thoughts with our team in an internal memo. Below we re-purpose those thoughts, with only minor edits for clarity purposes. The parenthetical comments/observations are based on more current analysis and/or data. We often refer to what we thought and wrote in the past, in part to assess whether our view has changed and, if it has, why it has changed. This helps us revisit our original thesis and stay intellectually honest about what we know and cannot know. If nothing material has changed then it would once again highlight the fact that macro developments most often don’t really impact longer-term cash flows at the company level. But we want to make sure we are always analyzing and questioning our views and factoring in new data and analysis.

The relative behavior of EM is not a surprise and to some extent is warranted given Trump’s protectionist leanings. There’s no reason why we should assume he will behave materially different from what he has said he believes in, especially given the Congress is in Republican control. So, protectionism and de-globalization—these forces have been rearing their head since the GFC, as some commentators have argued, but they may be intensifying now—may be part of our investment environment in the future, although we can’t be certain it will be; Trump may not be able to enact the policies the way he wants to. While protectionism is a negative in our view for emerging markets, as it will be for most if not all risk assets, there are some offsetting factors when it comes to the EM allocation in our portfolios.

Protectionism may impact US companies, especially the larger ones, more negatively than EM companies. This is because US corporations have benefited tremendously, in our opinion, from free trade and globalization via access to cheaper labor and efficient and cost-effective global supply chains. This effect can be seen in the historically high margins US companies have achieved in the past decade-plus.

[More recently, we saw another data point. According to Capital Economics, in 2015—the latest year for which data have been published—the sales of the major foreign affiliates of US multinational corporations in China exceeded $350 billion. This number was roughly China’s goods trade surplus with the United States last year, a fact that irritates the Trump administration. But in a full-blown trade war, unwinding US companies’ investments in China will be extremely difficult, we hazard to guess! China’s exposure in the United States through its foreign affiliates is only a small fraction of this number. US companies’ linkage with China and the rest of the world is an important reason why we believe the likelihood of a full-blown trade war is relatively small. It could happen, though, given there are so many other variables that can impact outcomes: we just cannot be sure. But if the likely case plays out, then investors’ concerns about global growth should abate in our view. That said, the longer trade-war fears loom, the greater the risk this business cycle ends prematurely and we enter a recession sooner than we would have without these fears.]

Regarding our current small tactical overweight in EM stocks, first, to some extent some of the concerns have already been priced in. Also, US stocks are expensive relative to EM stocks, and that gives us a margin of safety, at least when we look out over the intermediate- to long-term horizon. So, at this point we are not thinking of unwinding our EM fat pitch, although we will obviously be monitoring developments.

Fast forward to the present and we don’t find the need to change the view we shared internally with our research and client-facing teams in November 2016. Then too protectionism and its impact on emerging markets was a concern in investors’ minds, but those concerns abated and last year EM stocks outperformed US stocks significantly. Now those concerns have reared their heads again. We think they are likely to abate this time too. The fact remains it’s in both the United States’ and China’s interest to negotiate and prevent this trade tussle from becoming an all-out trade war.

The underlying reality is that China is fast becoming a major competitor in some key industries, such as solar and robotics, and aims to become one in other high-tech industries. In his article, “U.S.-China rivalry will shape the 21st century,” Martin Wolf in the Financial Times states that in 2017 China’s GDP was 119% of US GDP, measured in PPP terms, and their R&D spending as a % of GDP is similar (a gap of less than 1% versus the United States). This alone suggests to us that China will continue to make progress on its “Made in China 2025” vision. The developed world will have to adjust to this reality, but it also sees this as a threat and rightly wants to see greater trade interdependence from China. As Wolf points out, and we agree, trade tensions will be with us for a while. In the end, very likely in the long run it will turn out fine, especially if China makes a successful transition from fixed-investment-led growth to consumptive growth. In such a world it will be even more important to think globally versus locally as investors.

Aside from protectionism, investors appear to be concerned with EM external debt levels. These headlines tend to return when EM currencies are weak. In a few countries that does seem to be a problem, but for most it’s not. According to William Jackson, a senior EM economist at Capital Economics, estimated EM FX reserves (most of which are denominated in foreign currencies, including the dollar) are, in aggregate, about the same size as emerging markets’ external debts now, whereas they were only about 30% of the size of external debts in the late 1990s. So, EM countries now have better debt coverage. Second, at the aggregate country level, most EM debt is in local-currency terms (external debt measures include local debt held by foreigners, according to Capital Economics). So, there is less of a currency mismatch between borrowings and payments at the country level.

Private sector debt denominated in US dollars on the other hand does appear to be relatively high. It’s a question we raised and looked at several years ago. There are a few mitigating factors though. Some EM exporters have a natural dollar hedge. And a lot of private sector dollar-denominated debt is concentrated in places like China, which we believe we have already factored adequately into our base-case scenario. (We’d expect strains at the company level but expect our active EM stock pickers to navigate the risks there.) In addition, the fact most EM countries have floating rather than fixed currencies helps release pressure in their economies (i.e., it lowers the likelihood of sharp FX declines that result in deep and sudden crises). Maybe that’s why we haven’t yet seen major debt defaults in EM countries despite the EM FX weakness since the Fed taper tantrum.

We’d therefore argue emerging markets are fundamentally better placed today than they were in the late 1990s. Looking out longer term, currency declines should ultimately help “reflate” EM economies if the rest of the world continues to grow at a decent clip. If EM stocks start pricing in a late 1990s EM environment, we are more likely to be buyers than sellers. If global growth craters, EM stocks will probably underperform in the short term (or they may outperform, as they did in the early 2000s, as they are a lot cheaper than US stocks), but growth will recover in the long term and help realize EM stocks’ long-term earnings power.

As a reminder, the key reason why we are slightly overweight EM stocks versus our strategic allocation is because we believe EM companies in aggregate are underearning relative to their normalized potential, and this is not priced into their stock prices. (They trade at about half the Shiller P/E ratio that US stocks do, according to Ned Davis Research). US stocks on the other hand are overearning slightly and are expensive. From the outset, we have managed the shorter-term downside risk stemming from EM stocks in our portfolios by having only a modest overweighting there.

As always, we will continue to look at new data and analysis and go where the weight of the evidence takes us. If it suggests we should change our minds with respect to our weighting in EM stocks, we shall do so. For now, we remain confident in having a modest tactical overweight to emerging markets.

—Rajat Jain, CFA (6/21/18)

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