From the desk: EMD HC resilience underappreciated due to EM label

Entering the era of Trump 2.0, the President and his administration have introduced measures that significantly impact the investment landscape, with tariffs being a notable example. The administration’s approach, framed within the context of national security and aiming to recalibrate trade relationships with both allies such as Mexico and Canada, as well as competitors like China, reflects a strategic shift in economic policy. This move has sparked discussions on its implications for global trade and how emerging market assets may fare in such an environment.

Although trade concerns were the stated primary focus, it’s becoming clear that tariffs are being utilized more as a negotiation tool to further Trump’s wider goals. This was demonstrated by the recent tariff threats to Colombia, which maintains a trade deficit with the US, to address immigration issues.

The ripple effects of tariffs are complex and far-reaching, impacting individual countries and the global economy at large.

When a country faces tariffs, its local markets come under pressure and the main adjustment valve is typically a weakening of its currency. Tighter financial conditions put downward pressure on economic activity beyond the tradable sector. Of particular relevance in the near term given elevated and rigid inflation, this adds inflationary pressures and prompts central banks to tighten monetary policy, which could further hinder growth prospects.

Moreover, tariffs impair the efficiency of global trade, inevitably driving up costs and fostering inflation over the long term. An additional channel that can affect the overall asset class more broadly is how the Fed responds to increased policy uncertainty and potential higher prices on imported goods. Clearly the Fed has already turned more cautious and while we see a high bar for the Fed to actually start hiking, an environment of interest rates being higher for longer looks increasingly likely. The fiscal outlook of the US is also likely to influence the thinking of the Fed, adding an additional layer of uncertainty.

What does this mean for EMD HC investment?

The imposition or threat of tariffs on countries with which the US has significant trade deficits, such as China, Mexico, and Canada, highlights Trump’s strategy of exploiting the limited retaliatory capabilities of some nations to enhance his position in future trade negotiations.

However, Trump’s sensitivity to domestic stock market fluctuations and inflationary pressures – particularly given the role the recent exit from an inflationary period played in his election victory – suggests that tariff policies are likely to be country-specific or more narrowly focused on certain sectors.

From the lessons of Trump 1.0, we’ve observed a shift towards ‘friendshoring’, with Mexico surpassing China in export volume to the US in 2023, and other nations like South Korea, Thailand, and Taiwan benefiting from the US-China trade realignment. This suggests that while tariffs on one country may pose challenges, they can also create opportunities for others.

This highlights the strength of the EMD HC asset class as it has a diverse range of countries, making it less vulnerable due to its smaller individual country exposure while offering diversification opportunities across more than 72 countries.

Potential vulnerable countries under Trump 2.0 may include those that gained from exporting rerouted from China, many of which are concentrated in the ASEAN region. These countries, initially benefiting from the shift in trade dynamics, now face the risk of becoming targets themselves or suffering from broader geopolitical tensions and trade disruptions.

The geographical breakdown of different JP Morgan emerging market debt indices shows considerable variation; the hard currency sovereign index has lower exposure to countries in Asia and elsewhere that are at risk from tariffs. This is shown on the following two charts below where we compare country exposures for Local Currency (LC) Sovereign (left), Hard Currency Corporates (middle) and Hard Currency (HC) Sovereigns (right).

Global macro-backdrop

Given Trump’s focus on inflation and financial market performance, these will likely serve as policy constraints. While the Federal Reserve has adopted a more cautious stance, we see the threshold for resuming a rate-hiking cycle remains high.

Meanwhile, improvements in the credit fundamentals of EMD HC have enhanced its resilience to an uncertain and challenging external environment. Despite policy uncertainties in the US, we do not anticipate the US policies will significantly alter the expected slowing of the US economy and a resilient EM growth outlook. However, current US policies do introduce increased downside risks for the global economy, especially for countries outside the US.

Looking ahead

In the long term, the US’s current treatment of its allies and adversaries could risk destabilizing many relationships, potentially leading to increased regionalization. This shift away from efficient globalization towards a more regionalized approach could compel countries to reassess their relationships with the US in favour of closer, more amicable nations. Such a scenario may not bode well for the US economy, particularly at a time when it faces a diminishing birthrate and a shrinking workforce.

In summary

In conclusion, as we navigate the complexities of international trade under Trump’s administration, it’s evident that tariffs will likely continue to serve as Trump’s primary tool in negotiations with various countries. This strategy, while effective from a negotiation standpoint, introduces a layer of uncertainty that affects all trading partners and is poised to have a global impact that leans towards the negative.

The potential resilience of EMD HC to these new challenges is somewhat underappreciated thanks to its broad country composition and the significant improvements in fundamentals observed in recent years. The higher level of underlying treasury yields today provides some advantage by providing an offset to wider credit sovereign spreads, should the outlook deteriorate from here.

Fixed income securities are subject to interest rate, inflation, credit and default risk.  The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.