“We see a broadening of growth beyond the U.S. benefiting emerging markets and limiting risks from dollar appreciation. This makes local currency debt more attractive to us,” he said.
But there is a caveat, which is of course the windfall gains emerging market debt investor already enjoyed since early 2016 (see graph below).
“We see selected opportunities, but high valuations keep us neutral overall. We like markets with positive fundamentals and reform momentum, such as India. The upside is limited as spreads have compressed.”
Protectionism
That leaves us with the final risk to be considered, one that only emerged after the election of Donald J. Trump as America’s 45th president: U.S. trade protectionism. The fear that Trump would introduce punishing tariffs on EM imports initially rocked emerging market debt, but markets quickly moved on to price out the ‘Trump risk’ as no concrete action was taken.
But both Dehn and Bareau believe protectionist measures aren’t on the cards. The so-called Border Adjustment Tax (BAT) is a major risk, as according to the current proposal every imported product will incur a 20% tax, making all imported goods 20% more expensive. But the effects the introduction of this tax will have on the dollar and on the American economy make it unlikely it will be implemented, says Dehn.
“When goods get 20% more expensive, Americans will buy less of these products so there will be less dollars flowing out of the US, making dollars more expensive,” says Dehn. And this contradicts the US administration’s commitment to weaken the dollar, says Bareau.
“Another consequence of the BAT would be inflation going up to 2.5%, prompting the Fed to hike more aggressively, which will raise a serious recession risk. Presidents who are confronted with a recession in their first term are unlikely to be re-elected,” adds Dehn.
