Emerging Market Equity in the Face of Increased Protectionism

Despite a risk of increased protectionism in the US, investors should not be concerned about the impact on Emerging Markets (EM). According to a recent report by Lombard Odier Investment Managers titled Rethink Your Emerging Market Equity Exposure, EM countries have been favouring their own domestic economic dynamics since the Global Financial Crisis (GFC) and this is expected to grow

 

From an investor’s standpoint, when doing business in Emerging Markets, care should be taken to avoid companies that rely heavily on exports, as they are likely be affected by targeted protectionism. Instead, investors should look for companies with high-quality business models that focus on domestic trading. 

 

The shift towards internal domestic trade

Trade dynamics have evolved since 2000, when advanced economies were the destination of 80% of EM exports. Today, intra-EM trade has almost doubled in proportion. While it may have slowed recently due to falling commodity prices, intra-EM trade was not affected by the GFC.

 

Internal domestic dynamics (both consumer and government spending) in key EM countries have generally been a key driver of growth compared to international trade since 2010 as EM economies sought to protect themselves against the effects of the GFC through decreased dependence on external markets.

 

The only exceptions are Taiwan and South Korea who have weaker domestic trade contributions; however, these markets more closely resemble Developed Market (DM) economies such as Germany with their ageing population, relatively high purchasing power and highly urbanised population.

 

In comparison, India’s export and internal trade are being balanced by taxes imposed on gold exports. The recent replacement of the INR 500 and INR 1000 bank notes improved the structure of the economy by targeting the Indian shadow economy, estimated at 25% of the formal economy, and will help fight corruption, enlarge the government’s fiscal base, demonetise the economy and drive more savings into the banking system.

 

Resistance to US protectionism views

As a result of increased domestic trading, many EM countries have the resources to withstand the transition to more protectionism in the US. Current account gaps have improved since mid-2013 (Fed’s taper tantrum) and their external debt levels are relatively low compared to DM economies. Furthermore, an average of 85% of EM debt is held in local currencies, making these economies less directly exposed to USD appreciation.

 

Anti-global sentiment was certainly true at the APEC Economic Leaders’ Meeting in Lima in November 2016 shortly after the U.S election where Chinese representatives at the meeting stated that APEC will capitalise on the opportunity of the Lima meetings this year to push forward the FTAAP process. The representatives assured meeting attendees FTAAP shall serve as a rejection to anti-globalisation and a means to strengthen Asia-Pacific regional integration.

 

While the U.S. administration’s view on globalisation is unlikely to morph into a fully-fledged trade war, some form of protectionism is to be expected, and will have wider impacts on the global economy. However, EM countries are likely to continue favouring their own internal dynamics (domestic consumption, government spending and/or infrastructure spending) to support their growth and as such, protectionism is unlikely to have a huge impact on the future of their economies.

 

Investor Outlook

While the world watches closely the US and its move towards protectionism, investors should not be concerned about the impact such policies will have on EM countries. Instead, investors should remain diligent and pay close attention to companies who are reliant on exports, as these companies will be heavily affected by tariffs and levies imposed by protectionist policies. Taiwan and South Korea were singled out in the report as their sales figures point to high exposure to the US. It will be interesting to see how these countries navigate the changing global landscape in the coming four years.

 

While investment in EM economies may not seem like a safe bet in today’s climate, investor enthusiasm remains high - January was the best month for the MSCI Emerging Markets Index in almost a year – and with EM’s favouring domestic trade, EM countries are becoming even more attractive (and safe) to investors.  

 

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