How vulnerable are Emerging Markets to Trade Wars?

Emerging Markets Portfolio Manager Claudia Calich analyses the potential effects of an escalation of the US-China trade tensions on Emerging Markets. Despite the diplomatic rows and all the column inches written, Claudia discusses how popular products such as French wine and cheese will always find their way to the end consumer, no matter how many barriers along the way. Calich also explains which countries may win or lose in the present environment and which EM government and corporate sectors look more attractive.

Q&A with EM Portfolio Manager Claudia Calich

There are various channels that can be impacted by trade wars: imported goods may become more expensive; currencies of exporting countries may depreciate and investment decisions could be postponed until there is more clarity. Trade wars may also reduce consumption if the higher prices are not absorbed by firms. And we could also see a tightening of financial conditions if Foreign Direct Investment is reduced or if the risk premia on bonds or equities increases. All these factors could reduce economic activity.

But at this point, it is difficult to quantify the precise impact of the ongoing tensions because production plants and global supply chains cannot change or shift countries overnight. A new tariff may be imposed, but paying it might be cheaper than moving an entire production process around the world. It is yet to be seen whether US companies will be able to pass on the extra costs to their consumers, or whether those consumers will be willing to accept higher prices. There could be ways around the tariffs: we recently saw that when Russia put barriers on certain Western products, French wine and cheese found their way through different countries to reach the end destination. We may also see third-party effects: for example, trade barriers on Chinese goods may help Mexican exports to the US. Some US car makers, such as Ford, already have substantial operations in Mexico.

Commodities have recently edged down on concerns that the trade tensions could weaken Chinese growth, and therefore reduce demand for metals – do you expect further declines?

We could see more weakness if there was a big decline in Chinese growth. But let’s not forget that China’s current account surplus barely accounts for 1% of GDP now, far less than 10% ten years ago, as the country shifts its economy towards a consumption-led model rather than a manufacturing and export one. The commodities that China imports tend to be used in infrastructure projects – more dependent on domestic growth – whereas the tariffs are mostly on manufacturing products. Therefore, demand for commodities may not fall as much as some people expect – unless China’s growth suffers a major slowdown because of the trade wars and/or we see a policy response from the Chinese authorities that creates financial instability.

What is your view on those countries that export significantly to China?

This needs to be looked at on a country by country basis. Copper-producing Chile, for instance, has very little debt, a floating exchange currency and no major current account deficit concerns. If copper prices collapse, the central bank would have to hike interest rates and may be forced into running fiscal deficits in the medium term – but they would have the tools to defend themselves.

Other countries, however, may be much more vulnerable. Zambia, for instance, has a large twin deficit, giving it less flexibility in an extreme scenario.

Countries with larger US dollar-denominated debt would also suffer if an escalation of trade tensions led to a stronger US dollar.

What is the worst that could happen?

China’s response will be crucial. If they, for example, started using the currency as a negotiation tool – forcing a devaluation – this would add more tension and perhaps lead to financial instability. One can never rule out the fat-tail probabilities of an extreme scenario happening, which would most likely lead to a risk-off environment, with rising spreads and bigger deficits, but this is not my base case scenario.

However, China has reiterated its commitment to financial stability and to not using its currency as a tool. Like in China, other EM central banks have improved their governance and credibility over the past few years, so as long as their response is adequate and well communicated, their credibility – and stability – may not be hugely impacted.

We have seen several rate hikes in EMs so far this year – is this a reaction against a rising US dollar? Do you expect more rate increases in EMs?

They all have their own catalysts: Turkey and Argentina raised rates to defend their currencies because they had to, given their large current account deficits and financing needs. In Eastern Europe we have seen higher rates because countries such as the Czech Republic, Romania and Hungary are showing signs of overheating, which will cause inflation to rise.

But given the recent softer data in Europe and parts of Asia, and mixed US data, most EM implied future rates are pointing towards an increase.

Are higher EM interest rates already priced in?

What is your main worry in the EM space?

Some countries, especially weaker credits such as Sub-Saharan Africa sovereigns, Argentina or Bahrain are dependent on high growth or low refinancing yields to keep their debt levels stable. While we have seen a broad-based reduction on current account deficits in many EM economies and we can say that that part of the rebalancing process is complete, we have only started to see improvements on their fiscal deficits. Higher growth will help, but in some cases, there is still much more to be done.

Where could investors find opportunity in EMs at present?

Following the sell-off in Chinese credit, spreads have reached levels that may be attractive, especially in the real estate sector. We also favour local market exposure in countries where real or nominal rates look attractive, such as Brazil and Uruguay, or where it is likely that inflation has peaked, such as Mexico. In the corporate space, we favour quasi-sovereign oil and gas issuers with sound fundamentals and certain consumer businesses in Peru and real estate firms in Mexico. In terms of local or hard currency debt, we had a positive view on locally-denominated debt after 2015 as we viewed the US dollar rally was basically done. US-dollar denominated debt is more attractively priced now than it was earlier this year as spreads have widened and we are starting to find pockets of value in this space. As ever in EMs, it’s a cherry-pickers’ market.

Learn more from Claudia: watch her recent YTD review and outlook.