Red Wave washes over Emerging Markets

Emphatic Trump victory delivers further headwinds to a beleaguered asset class.

Image by DALL.E

I didn’t intend to write a note until the end of the year, but clearly, recent events are overwhelmingly significant for EMFX. This will be a brief update on my initial thoughts on the consequences of the Red Wave and the return of the now all-powerful Don.

My last note struck an optimistic tone. We had a compelling combination of macro dynamics with the potential to deliver positive tailwinds to some heavily beaten-up EM assets. This hasn’t been entirely washed away by the Red Wave, but much of it has been, at least in the short term.

In this note, I discuss the following:

1. Philosophical take on the result (feel free to skip this personal indulgence).

2. Summary of macro-economic hot takes.

3. EMFX performance review

4. Implications for EMFX and the framework.

5. The USD.

Philosophical Take on the Result

The election result has been distressing to many, though not surprising. To my mind, it’s further evidence of the chaotic times we’re living through. Centrist liberal politics has struggled to deliver results in the face of multiple headwinds. Demographic challenges, technological progress and pandemic spending have strained government budgets and increased inequality. The return of inflation to developed economies has affected cost-of-living pressures that squeeze the lower end of the income distribution. The internet and social media provide unprecedented transparency into the wealth and lifestyle gap, fueling envy. Incumbent parties have paid the price in elections across the globe, as voters crave change and protest the outcomes their leaders have delivered for them.

We’re in the early stages of adapting to our new media landscape, where information has exploded in volume but not in quality. In his recent book Nexus, Yuval Noah Harari draws a parallel with the invention of the printing press. He highlights that this innovation didn’t usher in the Enlightenment, as commonly assumed, but rather a period of religious wars and witch hunts. It was only with the founding of scientific institutions and the rise of academia that the Enlightenment—and its benefits—truly arrived. The complex and costly process of arriving at truths skews the odds in favour of simple fictions. Perhaps the AI revolution will eventually deliver tangible gains on this front, but for now, we have a sea of lies and half-truths to wade through.

In moments like these, financial markets have additional appeal. No matter how large the volume of information generated about a topic, the market processes it into a price change. This process is undertaken by organizations and individuals on a capital-adjusted basis, effectively giving more weight to those with a stronger track record of making accurate predictions. The market might not always deliver a convincing verdict, but it usually does an honest job of representing the direction of travel.

In turbulent times, we can seek refuge in markets as they interpret likely economic paths. Translating one’s views into trades and observing the market reaction as news unfolds is a great way to process events alongside millions of other participants—and with luck, make some money along the way. As financial markets adjust to the election outcome, there’s an opportunity to assess whether the market under or overreacts to shifting expectations of policy. We can also assess how well it identifies potential winners and losers across the world.

We have months to speculate on what this Trump administration will implement. Some in the market had hoped for a more moderate version of Trump, one who might hire moderates and spend more time on the golf course. The early signs suggest this is wishful thinking.

Summary of Macro Impact

The incoming Trump government has strongly indicated a combination of domestic tax cuts and trade tariffs. The tax cuts will likely come in the form of extending Trump’s expiring tax cuts from his last administration, along with a return of corporate tax rates back down to 15%. This aligns with the minimum level under the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) agreed upon in October 2021.

Tariff expectations vary, but the overwhelming consensus is that China will be singled out for the largest increases—60% was mentioned during the campaign. Across-the-board tariffs have also been discussed, although most economic forecasters are excluding these from their base case scenarios.

During Trump’s last term, China tariffs were often circumvented by rerouting trade through third countries. Vietnam and Mexico were commonly mentioned, with good evidence supporting these claims. The analogy fits well with the trade displacement resulting from Russian sanctions. Trade usually finds a way, although friction and costs are incurred. There is every reason to expect the incoming administration to learn the lessons from the past and directly challenge this rerouting.

The conventional view is that Trump’s policies are inflationary for the U.S., with mixed but net positive effects on growth. Tax cuts and deregulation are growth-positive, while tariffs act as a consumption tax hike, which is growth-negative. In the current environment, both measures are inflationary. This suggests we have to expect the U.S. easing cycle to end earlier and at a higher level of rates. Tougher immigration is another policy focus, which will hurt labour supply. This, too will be inflationary and negative for potential growth.

For EM, the impact is less ambiguous. Tariffs are negative for targeted countries and their trading partners, while a diminished Fed easing cycle will strengthen the USD and increase the cost of capital for EMs.

EMFX Performance review

Let’s begin with our usual exercise of looking at how EM FX nominal effective exchange rates have evolved.

The USD weakness seen after the August US growth scare was felt most strongly in Asian low-yielders. Since September, US data surprises have recovered strongly, and even before the election, the USD had recovered significantly. CNY, THB and MYR have held on to some of their gains, and are still up on the year. I don’t expect that to persist. IDR and INR have faired relatively well, with the highest carry in Asia, Korea has struggled, with the Kospi one of the weakest equity markets globally.

In CEEMEA only the resurgent Rand has flourished. Encouraging disinflation, hopes of reform, and an increased ability to keep the lights on have driven positive feedback loops in rates and FX. It also benefits from being a rare case of an EM high yielder with improving fiscal dynamics. Hungary has been going in the opposite direction. Despite its caution, it seems that the NBH compressed real yields too far and left investors with insufficient risk premium.

LatAm has been a graveyard for EM investors this year. Seemingly, the pervasive pessimism in Brazil over Lula’s desire and ability to address the deteriorating fiscal dynamics knows no end. Polarised politics has delivered a uniformly sceptical set of local investors, and in the absence of inflows into EM, foreigners aren’t there to provide a sufficient counterweight. Mexico has lurched from domestic governance concerns and weakening growth dynamics to fears over Trump tariffs.

Implications for EMFX and the Framework

In my last note, my only solid call was a bullish view on USDCNH—a view that remains intact. However, much of the broader framework is now under significant strain.

Going into the election, markets were already shifting from U.S. growth fears to concerns about "no landing." While the initial stabilisation of growth expectations was positive, the subsequent repricing of rate expectations posed challenges. The inflationary shock now looming significantly raises the risk of a "high-for-longer" U.S. rates environment. This delays the positive feedback loops I anticipated—lower U.S. rates, a softening USD, and capital flowing into EMs. As a result, EMFX is broadly unattractive.

The market provided an opportunity to get long USD on Day 2 after the election. A combination of short-term positioning, wishful thinking about a moderate Trump, and expectations of a China stimulus announcement caused the USD to weaken below election-night levels. This was both an excellent opportunity and a warning for the environment we’re entering. Consensus on the USD is overwhelming, and for good reason. The likely policy changes clearly favour the USD. When consensus is this strong, the challenge becomes judging position size and knowing when to lighten up to buy dips. The noise Trump will generate—on top of macro data—will ensure a bumpy ride, especially as most agree on the direction.

My personal preference is to own USD against CNH and other low-yielding Asian EMs. Here you have the carry on your side as you target both a strong USD and headwinds for the EM economies closest to the most probable and largest set of trade tariffs.

Elsewhere I think you can divide EMs into losers and non-losers from the red wave. The non-losers will be the countries not heavily involved in affected manufacturing supply chains and not likely to catch the ire of the Don. LatAm FX ex-Mexico contains many of the non-losers. Sadly, as discussed in prior notes, it contains some of the most worrisome fiscal stories.

The Turkish Lira remains unaffected, as do some other controlled exchange rates where the FX is a policy tool to facilitate disinflation. That process is far from complete in Turkey, so as long as they remain committed to the fight one can enjoy the carry on offer. When rates are at 50%, TRY shouldn’t flinch at a 1% swing in US terminal rates.

My favoured approach here would be to park the desire to own high real-rate currencies until such time as they get eye-wateringly cheap, or if there are reasonable expectations of positive fiscal developments. We will remain in a bear market for EM flows for the foreseeable future, and that means more opportunistic trading and less static longs. I will be watching the backup in USDZAR for a potential entry point - this is the best story in high-yield EMFX right now. As the most favoured high yielder, there’s potential for an overshoot.

Mexico is a wildcard in the Trump story - here I can see the negatives resulting from a clampdown on its role in the China supply chain, but I can also see the potential for a deal. Trump loves a deal, and maybe Mexico can help him make a success of his immigration policy in exchange for some leeway on the trade front. There's every chance that MXN can return as an EM darling in 2025.

The USD

The USD entered this Trump episode more expensive than it did his previous term—over 10% higher in REER terms. This naturally raises concerns about overvaluation, but I find these concerns unconvincing at this stage. To me, valuation serves as a guide to the potential magnitude and speed of currency moves rather than their direction. I like to target cheap or expensive currencies but rarely engage unless there is a catalyst. Overvaluation can persist well beyond my investment horizon.

If the forces acting on the USD remain supportive, appreciation is likely—though the magnitude may be tempered by its elevated valuation.

One can also argue that the extent of overvaluation is overstated. Productivity differentials are a well-accepted factor in currency valuation, and the U.S. has seen significant productivity outperformance in recent years. This should mitigate the REER-based overvaluation concern, providing further justification for staying constructive on the USD.

The U.S. remains ‘exceptional’ in multiple respects. Its shale revolution has ensured energy independence, while Silicon Valley has created globally dominant businesses that continue to flourish. The performance of the S&P500 has outstripped nearly all assets globally, and continues to attract capital to the U.S. These structural advantages combine with the USD’s position as both a safe-haven and a relatively high-yielding currency. The combination of these factors makes the USD uniquely appealing in the current macro environment, against the deteriorating appeal of most other currencies - damaged by the threat of tariffs.

Consensus trades are dangerous, and require careful management - but so early into a structural shift, this one looks compelling.

Signing off…

Thank you for your time and attention. Please feel free to reach out with any feedback. As mentioned earlier, these notes will be infrequent but I look forward to checking in periodically.

As always, if you’re trading, be disciplined and be lucky.

Stephen

Disclaimer

The contents of this note, including any analysis, opinions, and commentary, are purely for informational purposes and reflect solely the personal views of the author, Stephen Elgie, at the time of writing. They should not be construed as investment advice nor as an inducement, recommendation or solicitation to engage in any form of currency trading or other investment activities.

All information, data, and material presented in this note are believed to be accurate and reliable, yet they are not to be taken as a guarantee of future performance. The views expressed herein are subject to change without notice.

Readers are urged to exercise their own judgment and due diligence before making any investment decisions. The author and his employer, Argo Capital Management Limited accept no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this material.

This note is not intended for distribution to or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.