COMMENT: The trillion dollar bill of US protectionism

COMMENT: The trillion dollar bill of US protectionism
Many investors follow the slogan of Trump supporters that the president needs to be taken "seriously, but not literally".
By Peter Szopo of Erste Asset Management March 21, 2017

Both the election of Donald Trump as the new US president and the immediate market reaction came as a surprise. Immediately after the election, US securities including the dollar soared, safe haven assets such as gold and German government bonds weakened, and risk indicators such as VIX, a widely watched volatility gauge, fell to levels last time seen in mid-2014.

Probably the only asset class that reacted as projected by market pundits before the election as emerging market (EM) securities. The JP Morgan EM bond index fell almost 6%, the EM currency index dropped 5%, and the MSCI EM equity index underperformed its developed market counterpart by 10% over the first six weeks after the election (see Fig.1). 

The main reason for this massive correction was a fear that the newly elected president would deliver on the protectionist rhetoric he used throughout the campaign. Given the fact that the business model of emerging markets to a large extent depends on exporting goods and commodities to the advanced world and opening their economies to foreign direct investments, any attack on globalisation would necessarily have a negative impact on EM growth and wealth.

EM equity markets shed US$560 billion after the US election

It is tempting to see the correction of EM equities after the election as an indication of what a protectionist turn of US trade policy would mean for emerging economies. In dollar-terms the MSCI EM stock index lost about 7% within five trading days, which translates into a wealth destruction of about US$560bn. Of course, this is a massive sum (it is larger than the GDP of Argentina or of Poland, for example), but it is less than 2% of the total GDP of emerging markets. Surely, nothing to cheer about, but also not a disaster.

Fallout from protectionism much higher

Unfortunately, there are at least three reasons to assume that the ultimate impact of the United States' adopting a protectionist policy stance would be much more costly.

First, as in any counterfactual event study, the observable response – in this case the drop in stock prices – tells only part of the story. The other, often more significant part, is how the world would have evolved without the event. The question, therefore, is: how would EM stock indices have performed without a new US president pursuing a protectionist agenda?

One clue comes from the performance of what the investment community calls "style factors", which normally are highly correlated with EM stock returns. When economic growth starts accelerating and the outlook generally brightens – as we saw in 2016 – cyclical stocks tend to outperform their defensive peers. Typically, during such market periods also EM equities tend to strengthen relative to their developed market peers. And in fact, this is exactly what happened in 2016. Starting in the first quarter, cyclicals strongly outperformed defensives, and in line with historical patterns, EM equity indices beat their developed market peers.

Immediately after the election this pattern broke down. While cyclicals stocks continued their steep upwards climb in absolute terms and relative to defensive sectors, EM stocks started to heavily underperform. (Fig.2).

A similar picture is shown if one looks at the relative performance of value stocks (unexciting but cheap stocks) relative to growth stocks (expensive stocks with expected superior earnings growth). Typically, the relative performance of EM stocks tends to move in line with how value stocks perform relative to growth stocks. Again this historical pattern was disrupted after the election. In contrast to EM equities, value stocks maintained their strong momentum, on the back of growing risk appetite among investors (Fig.3).

Both the performance of cyclicals versus defensives and of value versus growth stocks suggest that EM stocks underperformed by about 15% in the six weeks after the election. Over the same period, in advanced economies stocks rose on average by about 4%. Taking both facts into consideration – the underperformance of EM stocks plus the rally in developed markets – implies that the Trump-fallout resulted in a 20% wealth destruction, corresponding to an absolute sum of US$1.6trn. This figure – 5% of EM's total GDP - is only slightly smaller than the combined GDP of Russia and Poland, for example.

The second reason why the immediate stock market reaction may not fully reflect the wealth impact of a protectionist turn of US trade policy is uncertainty over whether President Trump will ultimately deliver. While many investors - in line with the slogan of Trump supporters that the president needs to be taken "seriously, but not literally" – fear that Trump will deliver on the core themes of his campaign, others are still having doubts that the new administration will be able to significantly alter the country's free trade bias. Therefore, the actual stock price reaction after the election was the weighted outcome of those expecting a protectionist backlash and those who are more optimistic. In case the former prove to be right, EM equities will come under pressure again and the impact could be much higher than the US$1.6trn mentioned above.

Finally, it needs to be noted that the listed corporate sector only represents a part of the EM (or any other) economies; non-listed companies will also be affected by a less favourable trade backdrop. Thus the fallout from a negative shock to globalisation is not fully captured by its impact on stock prices.

However, despite all the risks related to growing protectionism, 2017 has been rewarding for EM equity investors, so far. Year-to-date (to March 17), the MSCI Emerging Markets Index gained 8% in local currencies and almost 12% in US dollar terms. A number of developments that have worked in favour of emerging markets since early 2016 helped to overcome the negative election shock: global growth has rebounded; the gap between annual economic growth in the developing world and advanced countries is widening again; commodities have staged a recovery; and fears of a global deflation, which weighed on markets at the beginning of 2016, have evaporated. That said, these cyclical tailwinds may be tested again if President Trump get serious with his protectionist agenda.