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16.02.2017 | 14:55

UBS: The unexpected rules

The unexpected once again happened in Q4 2016 with Mr. Trump winning the presidential election in the US. Moreover, the Republican Party retained a majority in the lower house and re-captured the Senate.

This was a significant shock to markets, which had priced in the opposite outcome based on the information provided by most political pundits and surveyors. US fixed income and equity markets reacted violently to the presidential elections result. Equity markets rallied 6.3% as measured by the Dow Jones index US treasury 10-year yields rose 62 basis points (bps) and the US dollar appreciated more than 4.5% since the election on 8 November versus other leading currencies.

Emerging markets asset prices weakened briefly after the election but have stabilized more recently, albeit at a weaker level in rates and currencies space in particular. In credit space, sovereign spreads (JP Morgan EMBI Global Diversified) ended up unchanged in Q4 at 340bps after widening some 50bps just after the election. In contrast, corporate spreads, as measured by the JP Morgan CEMBI Diversified index, tightened almost 40bps in Q4 to 325bps. Although excess returns were positive, total returns were negative in Q4 reflecting the sell-off in US treasuries. In the currencies and rates space, the JP Morgan GBI-EM Global Diversified index showed highly negative returns in Q4, driven mostly by weaker currencies but also by higher rates (60bps widening).

For the year as a whole, 2016 was a surprisingly good year for emerging markets, all the more so when put in the context of the highly uncertain global macroeconomic and political environment. All emerging markets asset classes showed a total return close to 10% in US dollar terms. Sovereign and corporate spreads tightened 76bps and 127bps, respectively, based on the corresponding JP Morgan indices. Emerging markets currencies did not contribute meaningfully to 2016 returns as they appreciated sharply in Q1 before depreciating sharply again in Q4, against the US dollar. Emerging markets rates tighten 30bps during the year to 6.8% as the Q4 sell-off could not fully undo the rally of the first three quarters of the year, based on the JP Morgan GBI-EM Global Diversified index.

Macro outlook: what to expect in 2017

As we start the year 2017, global economic activity is on a recovery path and market expectations have improved markedly in important centers, most noticeably in the US. Emerging markets countries have made further progress addressing their structural and macroeconomic fragilities and are starting to feel the benefits of a more stable commodity price environment.

Valuation-wise, emerging markets credit appears to be fairly valued. In our view, spreads are likely to remain in a relatively wide range centered about a slight tightening trend. As it was the case in 2016, duration management will be of paramount importance. We might see a 25bps tightening in spreads in 2017. Currencies and rates will be far more dependent on idiosyncratic factors and the impact of US policies.

The year 2017 will likely be dominated by the policies the new administration in the US may undertake and by further divergence in global monetary policies, particularly between the US, Japan and Europe. Our baseline scenario for 2017 includes higher rates in the US and a stronger US dollar but more of the same in Europe and Japan: quantitative easing and negative rates.

With currently available information, it is difficult to assess the potential impact of president-elect Trump policies on emerging markets. We understand that there are three main dimensions to president-elect Trump’s proposals*:

On the fiscal front: a tax reform – including corporate and personal tax simplification, lower tax rates, broader base, etc.; an infrastructure investment plan; and a tax amnesty for corporate cash abroad estimated at USD 2.6 trillion.

On the international front: a trade reform – including the potential renegotiation of existing free trade agreements (NAFTA among others), potential action on countries deemed as dumping goods on the US and, immigration reform.On the structural reform front: deregulation initiatives on the energy, health care and financial sector, among others, and reforms to the education and welfare system.

We lack specific details on any of the aforementioned initiatives and reforms but such an ambitious agenda is likely to be a multi-annual process. Furthermore, the final impact on emerging markets will depend on the type of fiscal reform president-elect Trump may choose – his own version as per the campaign or the more fiscally sustainable house republicans version* – and on how aggressive he decides to be on trade policies.

The best-case scenario for emerging markets includes a long-term sustainable fiscal and deregulation reform that generates a boost to US growth together with a measured trade policy. In this scenario, emerging markets growth could experience a faster and stronger recovery on the back of stronger US growth. The worst-case scenario for emerging markets includes an aggressive trade policy together with delayed deregulation and a longer term unsustainable fiscal policy that could be detrimental for emerging markets growth and external accounts. This is because such a scenario would likely depress international trade while failing to boost US growth.

Which emerging markets countries are likely to benefit or suffer under President Trump?

We believe that Mexico and China are likely to suffer the most were President-elect Trump to follow on his campaign promises to toughen the US international trade positions. President-elect Trump has said he will revise or even repeal the NAFTA, with a concomitant increase in tariffs and other potential restrictions on Mexico.

Around 80% of Mexico's exports are sold in the US.** Disruptions to that flow of trade will have a detrimental impact on Mexico's growth and inflation, and could further weaken Mexico's fiscal an external accounts. Expectations of changes to the current trade agreement are already having an impact on credit, currencies and rates in Mexico. Several Central American countries closely linked to Mexico's export sector are likely to suffer as well.

China is also likely to be affected were President-elect Trump to name it a currency manipulator and impose countervailing measures for unfair trade practices. In his campaign, Mr. Trump has threatened to impose a 45% tariff on Chinese imports. In such a scenario, almost 20% of Chinese exports sold in the US will be affected. China will suffer most of the impact but other Asian countries closely linked to China's tradable sector will also suffer.

In contrast, Russia is one country that could benefit from a more favorable geopolitical environment and better relations with the US. It is possible that in an effort to "reset" the relations with Russia the US may reduce or even eliminate economic and financial sanctions imposed after the Crimea annexation. Certain metal exporters – Peru and Chile, among others – could benefit from the massive infrastructure program advertised by Mr. Trump during his campaign.

The impact of a Trump Presidency on emerging markets asset prices

Financial markets seem to be pricing in a significant pick-up in growth and inflation on the back of fiscal expansion and deregulation in the US in 2017 and beyond. After the recent hike in December, markets are expecting at least two 25bps hikes in 2017. Furthermore, business sentiment improved quite dramatically on the back of expectations of market friendly policies.

In 2017, divergence in global monetary policies is likely to increase further with Europe and Japan still in easing mode – negative rates and quantitative easing – and the US in a hiking cycle that could surprise to the upside if US economic activity and inflation pick up under the new administration. Our baseline scenario is that President-elect Trump policies are likely to generate a boost to growth and inflation and a further sell-off in rates and strength in the US dollar in 2017. We expect most emerging markets rates and currencies (versus the US dollar) to remain under pressure – except for those high yielders with a positive structural story. We also expect credit spreads to tighten marginally as the positive income effect of higher US growth offsets the negative price effect of higher rates on emerging markets over time. Interest duration management will be paramount to protect returns in this scenario.

Duration management will be paramount to protect returns

The sustainability of the expected recovery and US assets price dynamics beyond 2017 will hinge on the quality and sustainability of the policies the new administration will implement. In a scenario in which the Trump administration successfully implements a sustainable fiscal expansion and measured trade policies, we expect terminal Fed fund rates to increase to levels not seen since before the great financial crisis. US treasury yields could adjust accordingly reflecting the return of a positive term premium. In this scenario, we expect the US dollar to be the dominant world currency and we do not discard an appreciation event similar to that experienced in the first half of the 1980s.

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