2017 Outlook: What's ahead for emerging markets?

12-20-2016

Unlike in the U.S., equities in emerging markets (EM) sold off sharply following Trump’s presidential election. While one may ascribe this post-election slump to Trump’s rhetoric and protectionist views, one would only be partially correct. The other influence on EM performance came and still comes from the Federal Reserve (Fed). As expected, it raised the target rate last week and signaled possibly three more hikes in 2017—the only question being, how fast will it act? The answer to some extent will depend on just how much of (and again, how fast) the Trump administration’s pro-growth “Make America Great Again” agenda is enacted. Growth, after all, comes at a price of higher inflation, leaving less room for the Fed to sit and wait before the next rate hike.

So what does this have to do with EM? History shows that higher interest rates, usually accompanied by a strengthening dollar and rising bond yields, tend to draw capital flows to the U.S. and out of EM. (Frankly, most currencies are expected to depreciate as well under this scenario.) Then we should avoid EM … or should we? Not necessarily. The opportunities in the EM are numerous if one knows what to look for. For example, there are several hundred foreign companies operating within the U.S. that employ Americans to produce goods for American consumption. These goods can be either intermediate products in the supply chain, like in the automotive industry, or they can be final goods for sale, such as food.

Two paths to EM investing
Did you know that Sara Lee, Thomas’ English Muffins, Stroehmann and countless other consumer goods are all made in the U.S.? Of course you did, but you probably didn’t know that a Mexican company owns those brands. A different Mexican food company has 20 tortilla plants and 6 corn flour mills in the U.S. that employ over 10,000 Americans (more than half of its entire global workforce) and sell finished products to supermarkets and Chipotle nationwide. These are just two examples of the opportunities to invest in EM companies with a strong presence and boots on the ground, if you will, in the U.S. These are “good hombres” Trump will not kick out. And if Trump and the Republican Congress lower the U.S. corporate tax rate, these foreigners also will benefit as the savings trickle down to the bottom line.

The other approach to EM investing is to seek those opportunities sheltered from potentially protectionist U.S. trade policies. Such opportunities typically fall in the infrastructure and consumer spending arenas. Just like the U.S., EM countries need new and better roads, bridges, airports and the like. Spending on them puts money in consumers’ hands, either directly as construction workers and resource suppliers get paid or indirectly as the additional dollars turn over in the economy, generating more growth. Fiscal policy? Check that box. Moreover, many EM countries are still in low inflation environments, prompting their central banks to cut rates throughout 2016 with some more room to go in 2017. Lower rates induce additional and cheaper borrowing for spending by corporations and consumers. Monetary policy? Check this box, too. In sum, the stars are aligned for faster EM growth. In fact, many EM countries have higher GDP growth rates than the U.S.

Brazil and Russia improving
To know where you’re going, you have to know where you’ve been. Such is the case in Brazil and Russia, which are still in recession but whose fortunes are turning brighter as the worst of darkness has passed. While the MSCI Brazil Index has yet recover to its 2014’s year-end level, it has moved well off its lows, boosted by positive news flow, sentiment and higher commodity prices. Brazilian politics has been a soap opera, to be sure, with a never-ending cast of characters (politicians and business leaders) being hauled off to court. However, the rubber is about to meet the road as its house gets cleaned up and the focus shifts toward supporting its recovery. While newly elected President Michel Temer admits “there is no magic wand that can recover overnight an economy that was beaten by years of mistaken policies,” Brazil is expected to eke out fractional GDP gains in 2017, ending a period of contraction and rising unemployment.

While the Russian stock market and economy are getting help from higher oil prices, which have jumped to mid-2015 levels on promised production cuts by OPEC and non-OPEC producers, additional support may come from expectations that relations with the U.S. will get warmer following Trump’s inauguration. However, be mindful that Russia has pursued austerity, fiscal consolidation and monetary orthodoxy since the 2009 financial crisis. In short, Russia had a conscious policy to limit dependence on external financing, unlike many governments. That said, Russia stands to benefit from higher commodity prices, particularly in energy.

Will 2017 be a repeat of 2016?
International investors, in general, are underweight EM. Yet this asset class is outperforming developed markets year-to-date, and by a wide margin prior to the U.S. election. Why? Because many of the fundamentals are improving and that hasn’t changed just because of the election. Sure, the Fed’s planned rate increases and Trump’s tough talk on trade can’t be ignored. But if the New Year begins like this past year, when EM markets took a tumble before climbing back, maybe it should be viewed as an opportunity, not a warning.