The combination of an abrupt rise in demand and a contracting investment environment leads to inflows, which in turn lend themselves to strong technical market dynamics. Together with the attractive fundamentals discussed above, these significantly bolster the appeal of the asset class.

OpinionDecember 2016

The Post-Trump Case for Emerging Markets

On the long list of things for which a Donald Trump presidency is said to be bad, you will find ‘Emerging Markets’. The reasons are well-known, but bear repeating. In a bid to put a rocket under the U.S. economy, Trump proposes to tear up foreign trade deals and replace them with tariffs, he expects to borrow to fund growth, spurring inflation, accelerating U.S. interest rate rises and a stronger dollar. Such policies and their effects could destabilise dollar indebted emerging market sovereigns and corporates by depriving them of cheap capital, in our view. And the resultant economic growth from which will be less beneficial for developing nations because of Trump’s protectionist policies.

However, lately opinions have begun to shift back in favour of emerging markets amid a sense that the Trump-inspired EM doom could be overdone. So could there be positive effects for developing countries from his presidency? We happen to think so. Because, if you consider the effects of his more likely policies, while taking the view that some others may only materialise in heavily watered-down forms, or not at all, then the future for emerging markets looks far brighter. Here’s why:

Warren Hyland, MSc, CFA

Portfolio ManagerBased in London, Warren Hyland has 20 years’ investment management experience and joined Muzinich in 2013. Warren came to Muzinich from Schroders, where he was a Global Portfolio Manager and later, the Senior Portfolio Manager for Global Emerging Markets.

Warren manages the Muzinich Emerging Markets Short Duration strategy, the Muzinich Global High Yield strategy and the Muzinich Global Tactical Credit strategy.

By Warren Hyland, Portfolio Manager, Muzinich

Taxation

Trump has pledged to cut taxes. Consumption makes up 68% of U.S. GDP and people will consume more if they have more to spend as a result of tax cuts.1 And where does a lot of the stuff that people buy come from? Emerging markets. The iPhone bears a sticker proclaiming ‘made in China’, Abercrombie & Fitch makes clothes in Philippines, Nike makes most of its products in China, Indonesia and Vietnam - and so on. If cutting taxes has the desired effect of increasing economic growth and putting more money in U.S. consumers’ pockets, then that will be good for the factories of the world, many of which can be found in emerging markets.

Infrastructure Spending

Building things is what Trump’s done throughout his business career, so it’s no surprise that infrastructure projects are a major part of his fiscal stimulus plans. In order to build things, you need commodities and these tend to come from emerging markets, particularly in South America, South Africa and Russia. So U.S. infrastructure spending will be supportive for commodity prices, in our view. This policy could bring greater long-term stability to commodity prices, helping commodity exporting nations to develop, grow and modernise their own economies, which would also bring regional benefits to neighbouring EM economies.

Trump’s apparent admiration for Vladimir Putin and expected more constructive relationship with Russia than the outgoing administration could bring many benefits – to emerging markets and the wider world more generally.

Russia is a major engine of the emerging markets. If sanctions against it were lifted, which have starved its huge oil and gas industries of technology and access to international capital markets, the economic benefits for Russia and its trading partners, in the East and West, would be significant.

Russia

1 Source: Bloomberg, as at 30/09/2016

The combination of an abrupt rise in demand and a contracting investment environment leads to inflows, which in turn lend themselves to strong technical market dynamics. Together with the attractive fundamentals discussed above, these significantly bolster the appeal of the asset class.

OpinionDecember 2016

The Middle East/Syria

If you leave aside the politics and personal views on the regimes involved, a more co-ordinated approach in Syria, or at least one where U.S. backing for Syrian rebels ends and a negotiated settlement is sought (if possible) and civil war ended, should help bring much-needed stability to the Middle East. This may then mean the threat from ISIS can be more effectively dealt with – an achievement for which Trump would clearly like to claim some credit, while also delivering on his promise about reducing U.S. involvement in foreign conflicts.

Stability in this economically-important, oil-rich region, is clearly desirable for emerging markets and the developed world too.

Less Bank Regulation

The ‘dismantling’ of the wide-ranging Dodd-Frank banking regulation, introduced in the wake of the financial crisis and resulting in much tighter lending controls and capital requirements placed on banks, is one of Trump’s policy aims. Any moves that would free-up capital and allow banks to lend more should result in increasing economic growth in the U.S. This is likely to have a positive knock-on effect in emerging markets. And capital always flows to where it is most needed, so some of it would find its way, directly or indirectly, into emerging economies.

Trade War Rhetoric

It’s not possible to make a positive case about the economic effects of Trump waging trade wars. However, many feel the tough talking is unlikely to translate into hard-line policy. There are good reasons why not – primarily that such policies would be ineffective and likely damage the U.S. economy and those of its historic allies, as much as they would their intended targets. According to recent analysis by Deutsche Bank1, China – the country often singled out by Trump – only accounts for some 16% of the U.S. trade deficit, not the 50% suggested by the headline figures. The difference between the figures is accounted for by the many intermediate countries that import parts to China, which are then used to manufacture goods that are later sent to the U.S. So tariffs on Chinese imports would be damaging to a wide range of third-party countries, particularly Taiwan, South Korea and Japan – all key U.S. partners, as well as many U.S. companies that are involved in the global supply chain.

“ Trump has pledged to cut taxes. Consumption makes up 68% of U.S. GDP and people will consume more if they have more to spend as a result of tax cuts."

China’s response to a trade war must also be considered. China is a huge importer of U.S. goods and services, particularly agricultural products, electronics, machinery, aircraft and cars, worth billions of dollars a year to the U.S. economy. China would likely hit back by targeting some of these sectors with its own tariffs and trade restrictions, which could be very damaging for the U.S. economy.

1 Date: as at 28 November 2016.

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About Muzinich

Muzinich & Co is a privately owned, institutionally focused investment firm specialising in public and private corporate credit with over $28.1 billion of assets under management (as at 31 October 2016). The firm was founded in New York in 1988 and also has offices in London, Frankfurt, Madrid, Manchester, Milan, Paris and Zurich. As a corporate credit manager, we offer expertise across the full corporate spectrum including high yield, crossover investment grade, senior loans, and middle market loans. A global perspective prevails through dedicated US, European and Emerging Markets teams.

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This document has been produced for information purposes only and as such the views contained herein are not to be taken as advice or recommendation to buy or sell any investment or interest thereto and the material should not be relied upon as containing sufficient inform tion to support an investment decision.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment as of December 2016 and are subject to change without notice. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

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It’s also worth considering that making more things in the U.S. will not necessarily create significantly higher employment. A 2015 academic research paper (The Myth and Reality of Manufacturing in America, Hicks & Devaraj) showed that between 2000 and 2010, 88% of U.S. manufacturing job losses where due to productivity gains – i.e. the greater and more efficient use of machines in production. So robots (probably designed and built in Asia), not people, would get the jobs.

In short, talk of trade wars may have impressed some U.S. voters, but turning words to action may prove to be at least ineffective and probably damaging to the U.S. economy and those of its allies.

Growing emerging market economic resilience

The final reason for greater optimism about emerging markets, in our view, is that they are considerably stronger financially and economically today than they were just a few years ago. In a nutshell, emerging markets have been preparing for higher interest rates since “Taper Tantrum” in 2013, we think. Emerging markets have undertaken wide-ranging political and economic reforms and implemented more business-friendly policies designed to shore up their economies. On a range of measures that we use to access sovereign vulnerability, emerging market economies are much better off today than they were in 2013, we have observed: positive real interest rates, higher foreign currency reserves cover, lower inflation and credit growth, while current accounts have turned to surplus and currencies are now fairly valued. This is further reflected by consensus economic forecasts for emerging economies’ GDP, which is expected to accelerate next year.

What does all this mean for asset allocation?

From a fixed income asset allocation perspective, Trump’s policy points to rising interest rates and a period of uncertainty. In this environment we would recommend short duration strategies with emerging markets offering considerable value.

Emerging Markets Risk: Risk that Emerging Markets may be more risky than more developed markets for a variety of reasons, including—but not limited to—increased political, social, and economic instability; heightened pricing volatility and reduced market liquidity; potentially small issue sizes; less transparent information standards; heightened currency exposure; reduced legal protections and enforceability; and less developed systems for transaction settlement and custody.