Hugh Young: Why Trump makes the case for emerging markets

Donald Trump’s first weeks as US president are turning out to be just as controversial as his bruising election campaign. A flurry of executive orders on border controls, trade and healthcare has dominated headlines, causing dismay and galvanising opposition.

The drama unfolding on a daily basis makes the modest comeback that developing markets have been enjoying all the more surprising. The MSCI Emerging Markets index has risen more than 4 per cent since the US election on 8 November, even though it fell nearly 5 per cent that month in part on fears Trump’s policies would wreck global trade.

What has caused this change of heart? Clearly US stocks have given global markets a helping hand, with the Dow Jones Industrial Average index crossing 20,000 for the first time. Investors are hoping looser regulations, including the possible repeal of the Dodd-Frank Act, will help beleaguered banks, in particular.

But flows to dedicated emerging market equity funds, excluding China A-shares, turned positive last month after outflows in November and December, suggesting interest in the asset class on its own merits too.

Across the emerging markets, corporate profitability has been improving: net income margins for non-financial companies surpassed those of their counterparts in the developed world last year. Emerging market return-on-equity, another measure of profitability, is superior to the ROE of European and Japanese companies.

Higher profitability has been helped by a recovery in commodity prices, amid a modest pick-up in global trade that has shown up in stronger exports. What is more, lower capital expenditure has freed up cashflow to the benefit of balance sheets and, possibly, dividends.

The upturn is partly cyclical, as well as reward for years of hard work and corporate discipline. The measure of this opportunity is evident in asset allocations and valuations: global equity funds’ asset-weighted average exposure to emerging markets has fallen to some 8.5 per cent, from a 10-year high of around 16.5 per cent at the start of 2012. Emerging market equities are trading at some 1.5 times book value, almost 16 per cent below the 10-year average.

Divided world 

Part of the problem is that investors see a world divided between “safe” developed markets and “risky” emerging markets. Following the shock results of last June’s Brexit vote and the US election, this distinction clearly needs a reappraisal.

Almost a decade after the US sub-prime mortgage crisis, the country’s debt has grown around 33 per cent to more than $45trn. Some members of the European Union are still one bailout away from going broke. Japan’s flagging economy defies all short-term fixes.

Meanwhile, the world’s fastest growing major economy is India: a country making great progress on business-friendly reforms. China, where domestic consumption accounts for around half the economy, has managed to restore stability even though concerns linger. Elsewhere, prospects for Brazil and Russia – emerging markets that have been battered in recent years – are also looking up on higher commodity prices.

Developing economies, on the whole, are in much better shape than they were even a few years ago. Economic and monetary policies are largely orthodox and paying off. Inflation is under control, or falling, so that central banks have room to cut interest rates to support growth. Their best companies have become experts at overcoming adversity.

If these frenetic first weeks of Trump’s presidency are a glimpse of what is to come – policymaking on the hoof, conflict over compromise, ego over evidence – then emerging markets are entering uncharted waters. Heightened uncertainty will make them vulnerable to further shocks – either from China, the Federal Reserve or other potential flashpoints.

Protectionism is likely to fuel inflation in the US by making goods more expensive, US companies will become less competitive and eventually US growth will slow. Higher government spending, despite lower tax revenues, will lead to a wider fiscal deficit. A trade war with China will hurt both countries.

One of Trump’s advisers coined the term “alternative facts” while defending the White House’s disputed assessment of the number of people that attended his inauguration. In a world where truth is subjective and orthodoxies are being overturned, emerging markets manage to look quite well grounded.

Hugh Young is managing director of Aberdeen Asset Management Asia