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Biden President, What about the emerging markets ?

Introduction The United States’ Presidential elections are one of the most awaited events around the globe. Its influence on the […]

Introduction

The United States’ Presidential elections are one of the most awaited events around the globe. Its influence on the global stage is a crucial determinant for world dynamics. It determines the balance between developed, emerging and frontier economies, internal and external relationships between G7 and much more. Specifically, how emerging Market assets react, something we will be discussing shortly. We will go through their potential responses to key US macroeconomic metrics like GDP growth, inflation, and interest rates.

This article aims at discovering the potential of emerging markets, especially Asian economies, post-elections. To assess the influence of elections on emerging markets, we will examine three key variables: the US macroeconomic setting, trade policy, and geopolitics.

In the forthcoming term, the US trade policy approach will be consequential in an era where emerging market nations’ spur in domestic demand and global presence post-COVID. Possibly, even laying out the groundwork for the coming decade. Hence, studying trends in emerging markets have become critical, as countries have become more intertwined than ever before. Today, emerging markets are a primary driver of global economic growth, and are home to some world’s most innovative technology and a growing consumer class.

Why Emerging markets look attractive

Emerging Markets (represented by MSCI Emerging Markets ETF- $EEM) has been underperforming the S&P500 on a relative basis since the late 2010s. The global storyline has evolved tremendously since then. Though sounds like contrarian bet, the current dynamics favour EM. The article will go through US macroeconomic setting, what President-Elect- Joseph Biden brings to the table, trade policy and situations, and Geopolitics concerning the US and Asian Economies.

Figure 1- $EEM underperformance relative to $SPX and $URTH`

In Emerging markets universe, the Asian economies stand out the most due to their consistent and broad-based performance. Just about 73% of the $EEM comprises China, Taiwan, Korea and India. Signifying the broad-based presence of Asian emerging economies in the space. We will focus on the Asian EMs in this piece. Figure 2 is a precise depiction of outperformance of $EEMA (iShares MSCI Emerging Markets Asia ETF) relative to $EEM

Figure 2- $EEM ETF relative to the $EEMA ETF

US Macroeconomic Policy and Elections

This section will determine the current US macroeconomic setting and how the forecasted macroeconomic backdrop will impact emerging economies. We run over metrics like inflation, fiscal policy, exports and imports.

Inflation and EM

An extended period of low-interest rates in the US is inclined to cause investors to look afield in a quest for yield, the weakening of the US dollar accompanied by rising outflows. Historically, this has been a fruitful environment for the relative outperformance of EM assets.

Recently, the FEDs policy to maintain an Average Inflation Target (AIT) over the long-term, adds spice to the EM picture. AIT implies that policymakers will actively seek to generate excess demand to create higher inflation, driving EM exports.

Strong US demand will mainly boost Mexican and Asian markets that produce a notable portion of the US’s value-added imports. While these percentages look smaller in individuality, they could plausibly lead to emerging market outperformance on a collective scale.

On the flip side, emerging economies with loose macroeconomic policy and weak domestic supply potential will lead to larger current account deficits. Markets may ultimately fear that the Fed will aggressively tighten their policy to prevent high inflation expectations from becoming inherent in the economy. In this situation, economies using short-term financing to run large current account deficits would be vulnerable to an abrupt halt in capital inflows. They are often a trigger for EM crises, like the taper tantrum of 2013.

Perhaps a more convincing reason is that continued low-interest rates will divert the “big money” to EM. The dynamics of AIT are still vague and clouded. With quantitative easing, the consequence is likely to be that the Fed will keep monetary policy accommodative. Possibly anchoring treasury bonds yields at low levels for a prolonged period – and even negative in real terms. As investors hunt for yield, driving short-term capital inflows to EM. Historically, this has led to lower treasury yields. Short-term flows are the sum of portfolio flows into bond and equity markets and banking flows. Inflows are likely to continue if yields remain at rock bottom levels for a long time.

Figure 3- Relation between inflows to EM and annual change in 10Yr US treasury yield

Relative performance

Emerging market stocks have outperformed some of the largest US household names, displaying increased risk-taking and growth opportunities in these spaces.

Debates are going around regarding Tesla’s unexplained valuations and price rise- a whopping 697% YTD. Only some realise that their Chinese Competitor Nio Ltd. posted an 11-fold increase. While Electric Vehicles have gained tremendous momentum, there are other places where emerging markets outperformed. Amazon.com’s 72% rise lagged the Latin American e-commerce sensation MercadoLibres Inc. ($MELI) 392%, whereas Southeast Asian online marketplace Sea Ltd. ($SEA) climbed four-fold. Tencent, a Chinese social-media power, outperformed Facebook 45.5% to 30.

Figure 4- Outperformance from the Emerging Market companies relative to their US competitors

This growth-stock alpha explosion is driving optimism and displaying increased risk-appetites. Emerging markets have low penetration rates than developed economies; this untapped nature further improves these names’ growth prospects. But, the vertical valuation climbs are far from reality and might breed scepticism.

Debt problems in Emerging Markets

The whole new fiasco of governments releasing stimulus packages has further deepened public debt levels. While the central banks are bailing out the economies with fiscal and monetary policies, there are several limiting factors in the future:

  1. Increased public debt levels significantly reduce the power to stimulate the economy in the future.
  2. Higher debt levels could lead to a spike in interest rates on future bond issuances.
  3. Foreign currency-denominated debt increases the vulnerability to currency volatility. Asian economies like China, Thailand, and South Korea are in good health in this aspect.

Figure 5- S&P 500 Price Change by Presidential Term

Presidential Effect

Historically, US presidents have set the tone to global policies and play a crucial role in determining inter-economy relations. Empirically, democratic presidents have never yielded a negative S&P 500 price change. At the same time, they have been a part one of the highest single-term surges in S&P 500 history. The Biden effect is yet to be tested and a crucial part of the whole emerging markets puzzle.

Biden Entry 

Biden served as the Vice President from 2009 to 2017 under Barack Obama’s presidency. On his third run for the presidency, he finally made it and is announced the 46th President of United States. What Biden witnessed when he held office during Obama’s presidency, has completely transformed. He will arrive to a transformed Asia-Pacific region. As trade and technology gap widens between the US and China- export controls, many tariffs and market access restrictions are fundamentally mending this relationship. Additionally, Biden will arrive to a Phase One trade deal, a distressed trade relationship with rest of Asia caused by a sheath of tariffs and Trump’s decision to pull out of the Trans-Pacific Partnership.

Biden Policy

Under Trump’s presidency, there was a lingering cloud of uncertainty raging over markets and world economies. A Biden presidency will focus on restoring alliances and taking a multilateral approach to US-China policies. It could stabilise relations from the current pace of deterioration, but the rising competition’s undercurrents will likely remain. Overall, the Biden administration will likely provide some predictability, certainty and cooperation.

A systematic approach to trade will be more successful in decoupling the US from its heavy dependence on China’s supply chains. As we will explore shortly, this would affect the long-term performance of EM assets and economies.

Biden administration may welcome the end of social media diplomacy and a return to more traditional and predictable policy-making. Trade policy under Biden will become more strategic, predictable, and cooperative. While this does not guarantee success, but if well managed there is an opportunity for Biden to establish a trade legacy. Potentially by shifting US trade policy, reforming the multilateral system, and rebalancing US-China relations.

Trade Policy

Trade policy under Biden presidency will be a crucial determinant for trade blocs and their structure. Significant changes have taken place since Trump decided to pull out from the Trans-Pacific Partnership. This section elaborates on these specific changes and their implications.

Trade Blocs

The Biden administration will have to reimagine the future of US economic leadership in Asia-Pacific. Following two massive free trade agreements, Trans-Pacific Partnership and Regional Comprehensive Economic Partnership (RCEP), signed by countries in the region. Joe Biden will start term where the US is a party to neither the TPP nor the RCEP.

Obama administration negotiated the Trans-Pacific Partnership (TPP) but never received Congress’s approval. Immediately on joining, President Donald Trump pulled the US out of the TPP in 2017. The remaining 11 countries renegotiated and signed an Agreement for TPP a year later. Re-joining the TPP can be a possibility as Obama and Biden converge on their agendas. An indication that the US is ready to recapture its leadership role in the region, but Biden has not commented on re-joining TPP yet. However, it is improbable that re-joining the bloc and garnering support will be a swift conversation in Washington.

Regional Comprehensive Economic Partnership (RCEP) is a more recent trade bloc. It is the largest trading bloc globally, covering a market of 2.2 billion people and $26.2 trillion of global output — about 30% of world GDP.

Considering the two blocs, the world and the Asia-Pacific are in different health now. Notably, without interruption and disruption from the US, a visible character of cooperation has emerged. Changing trade patterns have provided displaced opportunities. Countries such as Vietnam, Indonesia, Korea have realised gains in GDP and international trade. Their approach to these trade blocs will define the US’s presence and future in Asia-Pacific.

Implications for Asian EM Countries

Now we look at individual countries and their implications with Joe Biden as the president. We delve into some background and the factors that make the country look attractive.

China

Figure 6- Weights in MSCI EM Index

China accounts for almost 40% of the MSCI Emerging Markets ETF ($EEM). China’s dominance in global supply chains and manufacturing has provided them with a moat. US’s heavy reliance on China is quite a story. US depends on active pharmaceutical ingredients, rare earth materials (the US imported 80% of rare earth materials exported by China from 2014 to 2017), 5G materials and much more.

US President-elect Joe Biden confirmed that he would not make any “immediate moves” to lift the tariffs imposed on imports of Chinese goods by the Trump administration. He will undertake a full review of the current phase one trade deal and consult with US allies. Displaying a more considered and a formal way of doing things.

That is not to say that Biden will be a soft touch. There is not much colour on how the incoming administration will approach the trade war with China. However, measures aimed at curbing China’s development have become popular on both sides of the aisle in Washington. Some early insights into Biden’s treatment to China are-

  • Trump and China had a rough relationship altogether. Under Biden presidency, this seems like a distant possibility. In a recent interview with the New York Times, Biden said the “best China strategy” was to get all traditional US allies in Asia and Europe “on the same page”, which will be his foremost priority “in the opening weeks” of his presidency. This would potentially involve cooperative pacts and treaties and harmony among nations.
  • Trump’s cold approach to global warming had worked mainly in favour of China on the global stage. However, Biden affirmed that he would reverse Trump’s decision to withdraw from the Paris Agreement. Climate policy will translate into an essential foreign policy tool under Biden. An alarming aspect for China as the world’s largest carbon emissions emitter. Biden opinionated that China must cease “outsourcing pollution to other countries by financing billions of dollars’ worth of dirty fossil fuel energy projects through its Belt and Road Initiative” (BRI). Hence, we can expect a US attack on BRI from the vision of environmental policy at par with economic and security concerns.
  • On the corrective side, Biden said his trade policies would focus on “China’s abusive practices”, including “stealing intellectual property, dumping products, illegal subsidies to corporations” and forced technology transfers.

On the macroeconomic side, its M1 supply has reached an all-time high, a leading indicator of the business cycle. Real M1 supply has become a reliable leading indicator of the earnings component of the MSCI Emerging Markets ETF ($EEM)- both on a trailing and a forward-looking basis.

Figure 7- Real M1 Supply of China

Another metric pointing to China’s relative outperformance to the rest of EM is the relative P/E ratio displayed in figure 8 below.

Figure 8- China’s relative P/E performance to EM

What China underwent under Trump’s perfectionist policy-making is about to change. Biden will likely include more dialogue with Beijing and cooperative decisions. We are still in the early days to confirm anything, but China’s outlook looks more positive than the previous term.

India

When Chinese securities whipsawed under Trump’s perfectionist policy-making, there were discussions concerning India’s increasing importance in the Asian picture—accompanied by a strong personal relationship between Prime Minister Modi and Trump. A shared interest helped in deterring China.

One of the major themes that make India a prospect is FDI. Many American companies were planning to move their bases out of China under Trump administration, but it gained momentum during the coronavirus pandemic. COVID buoyed the country with digital economy investments. Mega-cap companies like Facebook, Google and Walmart placing their bets on India.

The major contributor that drove up FDI was Jio Investments in 2020, but overall, FDI is still concentrated on the services, IT, and Telecom sectors.

Figure 9- Change in 2020 FDI inflows compared to 2019

On a global scale, FDI dropped 42% in 2020. Inflows declined for most of the major economies. India, China, Japan, and Saudi Arabia were the only G20 countries where FDI rose in 2020, according to UNCTAD.

India’s FDI increased by 13%, while China’s rose 4%, according to the UNCTAD report. Despite India’s higher increase in percentage points, the amount of money flowing to the two countries differs tremendously. India’s FDI rose to $57 billion in 2020, while China attracted an estimated $163 billion, highest in the world.

To add, the recent clash between China and India along the borders and India banning Chinese apps have added further geopolitical and economic dimensions. Implications of Biden presidency are still unclear. Still, India will remain one of the leading regional allies from a strategic perspective and remains a watch.

South Korea

A Biden presidency will likely stabilise the relationship between the US and South Korea for two reasons.

Firstly, a Biden presidency will be interested in mending relations with allies and relations between allies. It will attempt to bridge the differences between Japan and South Korea on concerns such as trade.

Secondly, Biden is predicted to return to a more conventional and predictable, US policy concerning North Korea, centred around deterrence. South Korea’s tech sector has made a meaningful advance in recent years and will continue to do well in the coming year. Still, a more robust growth recovery requires a more sustained turnaround in the global economy.

Japan

Japan is no longer an emerging economy. It has been a developed economy for a long time now. But, its influence in the Asian EM puzzle makes it noteworthy.

Former Prime Minister Abe and President Trump shared a strong personal relationship. This stabilised US-Japan relationship, even as the two sides have not made much progress on bilateral trade. What President Biden will bring to the table is still a question mark.

Regardless, Japan will remain interested and focused on pursuing a broader regional trade pact with the US. From a macro perspective, Japan aims to lift growth—but it is twice tricky when the US and Europe are easing on an unusual scale. Outside some selected sectors, Japan’s growth recovery requires substantial global growth and some difficult reform choices.

Conclusion

There are various metrics, indicators and factors that point to an emerging markets outperformance in the coming decade. We have considered a broad spectrum of aspects and scenarios ranging from government policy and country-wise breakdowns in this piece. The Biden effect is still in the early days. As time passes, there will be more clarity with regards to the emergence of the emerging economies.

 

26 February 2021

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