Why Emerging Markets Could Be The Winners Of The U.S. Gridlock

Includes: ADRE, PCY
by: RadaEcoWatch

The U.S mid-term elections saw the Democrats winning the majority in the House of Representatives and the Republicans maintaining the majority at Senate;

The Washington gridlock could have the consequence to weaken the U.S. Dollar and to lower government bond yields;

Emerging markets could be the main beneficiaries of this scenario;

However, before investing we need further confirmation that the negative trend in 2018 has come to an end.

The US mid-term elections held on Tuesday 6 November saw the Democrats winning their first majority in the House of Representatives in eight years and Republicans maintaining the majority at Senate. These results were in line with expectations. The incoming gridlock in Washington D.C. could have consequences on both internal and external policies.

On the domestic front, a split Congress will be able to hamper Trump's push for a further round of tax cuts and deregulation, even if there may be some possibilities for compromise on infrastructure spending. However, in our view, this would not be enough to compensate for the missed tax cut had both houses of Congress been controlled by Republicans. On the international front, President Trump could increase its hard line on trade tariffs, which he can impose without Congressional approval.

In our view the impact of the election results on the financial markets could be:

1) Slightly positive for the equity markets in the short term as it removes the uncertainties on the outcome of the elections;

2) Slightly positive for the Bond market – government bond yields could decline – and negative for the US Dollar. Indeed, a further tax cut would have increased inflationary pressures and, as a consequence, the need for the Fed to tighten monetary policy in 2019 (we consider a 25 rate hike on December 19 as a done deal).

We think that Emerging markets could be the main beneficiaries of a weaker Dollar and of lower upward pressures on U.S. Government bond yields. Indeed stronger Dollar and higher US yields are a lethal combination for emerging markets as:

1) A rising Dollar increases the local currency cost of servicing dollar-denominated debt. The increase of U.S. Dollar denominated debt accelerated over the last few years and reached + 16% in March according to BIS data.

BIS data show the strong increase of US Dollar denominated debt in emerging markets

As highlighted by a business insider article, through 2025, emerging market governments and companies face USD2.7 trillion in USD-denominated bonds and loans that will come due and have to be paid off or refinanced. This does not include euro and yen-denominated debt, of which these countries also have a pile.

2) The second reason for a strong dollar posing challenges to EMs is the usual inverse correlation between the dollar and commodity prices.

CRB and Dollar index inverse correlation is weighing on emerging markets

3) A stronger Dollar also has an ambiguous impact on economic growth. While it could stimulate net trade and growth in the short term, in the medium term it could create a debt crisis – as we highlighted before – with a negative impact on investments and on long-term potential growth rate.

What to do now

As we highlight before, a weakening of the Dollar and lower U.S. government bond yields would be positive for emerging markets. In this scenario we would put in our monitor both emerging markets bonds (PCY) and equities (ADRE). However, before investing we would wait for a further confirmation of the inversion of the negative trend that has characterized all 2018. For the first ETF the sign of an inversion would a return above USD26.7 and for the second above USD41.71.

emergin markets bond ETF recovering but still in a downward trend

emerging markets equity ETF recovering but still in a downward trend

Conclusion: the gridlock in Washington over the next 2 years could have the consequence to weaken the U.S.Dollar and to lower government bond yields. This could have a positive impact on emerging markets bonds and equities. However, a further confirmation that the negative trend in 2018 has come to an end is required before investing in these markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.