With the election of Donald Trump as president of the U.S. we face new uncertainties with respect to our outlook for Emerging Markets (EM) credits. The most important ones, of course, are whether Trump indeed will implement strict protectionist trade policies and how big his fiscal stimulus package will be (and, of course, whether this will be approved by Congress). We believe he will take an aggressive stance on both fronts. Protectionism, in our view, will not be positive for the U.S. economy. Maybe new jobs will be created but U.S. consumers will pay the price for those jobs. The impact of fiscal policy on economic growth depends on how and where the money is spent. Making rich people richer is not going to help the economy, so an effective fiscal policy should put money into wallets of lower- and middle-income class citizens, for example by lowering tax rates on incomes below USD 100k. A policy focused on reviving the housing market (new construction), which has been weak since the financial crisis, could be effective. Another possibility is to invest in America’s rickety infrastructure (roads and bridges, for example), although this probably takes longer to flow through the economy.

Protectionism obviously is negative for Emerging Markets, most notably for Mexico and China which are specifically targeted by Mr. Trump but also for large suppliers to China (Korea and commodity producers). There is a negative feedback loop, especially for Mexico as about 40% of the import value from Mexico actually is sourced from U.S. companies (see our blog “Trading Places”). An aggressive stance against China would probably be met by retaliatory measures, which could potentially trigger a global trade war. Very negative, indeed.

No more golden showers for Emerging Markets…

A fiscal stimulus may be positive (at least, in the short term) as money probably will flow to large infrastructure projects, requiring metals (copper, iron ore, nickel), and economic growth could pick up from a currently low level. However, both protectionism and a large fiscal stimulus could result in higher inflation (very likely, in our view, as unemployment is low), triggering the Federal Reserve to hike interest rates. Higher rates coupled with a stronger dollar generally is bad news for Emerging Markets (lower commodity prices, higher debt levels and debt service; partially mitigated by higher exports, subject to the protectionist measures taken). Rates already have jumped and the dollar has strengthened in the 4th quarter. Further increases could destabilize Emerging Markets, in our view, as investors may find the yield pick-up not sufficient anymore in comparison to U.S. assets and repatriate funds to the U.S. This is bad news for countries with twin deficits and a reliance on dollar funding (or where a high portion of local currency bonds are held by foreigners) like, for example, Turkey. Turkey’s case is made worse by the market-unfriendly utterings of its increasingly authoritarian leader, Recep Tayyip Erdogan. Introduction of capital controls is a real risk here if monetary and fiscal policies are not adjusted.

Apart from “Trumponomics”, many EM economies face home-made headwinds as well. China’s economy is slowing down, although in the last couple of months the commodity price recovery has revived old economy industries somewhat. Despite touting its economic reform credentials, the Chinese government continues to stimulate the economy by allowing credit to grow in an unsustainable way. The transformation of the economy from export-led manufacturing to consumer-led services is progressing at snail pace. We still expect a relatively hard landing, i.e. economic growth well below 6.5%, but the Chinese can postpone the day of reckoning given the closed nature of China’s economy (which recently became even more closed as measures were taken to reduce capital outflows, including restrictions on foreign M&A and offshore dividend payments). A crash should be bad news for the bubbly property-related sectors. Clearly, slowing growth in China is bad news for EM credits in general (specifically for commodity exporters in Latin America and Asian countries that supply Chinese factories). After the rally in 2016 (see graph below), risks don’t seem to be priced in. Credit spreads are at their lowest level since mid 2007.

Another large EM economy that seems at risk is Brazil. The likelihood of a continuation of the recession well into 2017 is significant. Brazil needs to address its fiscal deficit (9% in 2016 with a primary deficit of 2.7%) by reforming its social security system (lowering pension pay-outs etc.). Current measures taken and planned may not be sufficient to bring Brazil on a sustainable debt trajectory (according to Citigroup, public debt is 73% of GDP and expected to rise to 80% in 2018) and it is not at all certain whether president Temer will get the buy-in from Congress for the required spending cuts. Pork-barrel politics is ingrained in Brazil: we expect the social security reforms to be watered down, thereby becoming less effective in addressing Brazil’s growing debt mountain. This year will be key as presidential elections are scheduled for 2018, which generally is not an opportune moment to announce and implement painful expenditure cuts. The stronger dollar and high inflation at home will mean that the real must depreciate in the course of this year, which net-net probably is good for export-focused businesses but bad for domestic businesses, specifically for those with high dollar debts.

Not everything is doom and gloom in EM. We remain constructive on India and Indonesia as well as Peru and, to a lesser extent, Argentina and Colombia. Also Russia’s prospects are improving. The Russian economy is slowly recovering from a deep recession caused by the collapse in oil prices and sanctions. The government’s finances are highly dependent on hydrocarbons although Russia could cope with the oil price collapse given its ample FX reserves and low public debt. In any case, the recent surge in oil prices is welcome. The government is using an oil price of USD 40 (Urals) in its 2017-2019 budget. Clearly, the country needs to transform its economy and become less dependent on hydrocarbons. Even though Alexei Kudrin, a respected former finance minister and free market cheerleader, has been asked to draw up a plan for reviving Russia’s economy, we think that it is not likely we will witness a significant change as politics and disregard for property rights and justice stand in the way. Sanctions may be relaxed once Trump is in office, which could be a stimulus for the economy (2017 growth expectation is 2% without lifting of sanctions). The government is still forecasted to incur a fiscal deficit of about 2.5-3%. Higher oil prices might reduce efforts to address this shortfall, especially in the run-up to the presidential elections in 2018.

We believe 2017 will be a difficult year for credits in general, given where we are in the credit cycle, and for EM in particular, given Trump’s tweets about protectionist measures, rising interest rates and the strength of the dollar. Best strategy, in our view, is to invest in higher quality (BBB-BB rated), lower-duration credits and wait for events to unfold.