by David Rees, Senior Emerging Markets Economist
As US election results slowly fed through last week, a relief rally in emerging market (EM) assets was underway. But how long will it last, given that Biden’s victory was anticipated? Especially as the markets’ anticipation of a “blue wave”, with the Democrats taking control of the Senate, has so far not come to pass. What’s more, Biden is unlikely to unwind all of the outgoing Trump administration’s protectionist policies – particularly with regards to China – which have become popular on both sides of the aisle in Washington.
If anything, a more methodical and multi-lateral approach may ultimately be more successful in decoupling the US from its reliance on supply chains in China. But at the very least, an end to social media diplomacy and a return to more traditional and predictable policymaking ought to allow investors to step more confidently into EM.
EM markets rallied on news of Biden’s victory
EM assets reacted positively to news that the Democratic Party candidate, Joe Biden, had won the presidential election race; equities, bonds and currencies all registered strong gains. The election result was closer than opinion polls and betting markets had expected. But while the Senate race disappointed, ultimately the election of Biden was anticipated, which ought to limit the extent of the initial market rally. However, memories of the outgoing President Trump’s surprise victory in the 2016 election are still fresh for investors. There is clearly relief that there will be an end to his erratic and strongly protectionist policymaking, particularly towards China, which has been a constant cloud hanging over markets in recent years.
That’s not to say that Biden will be a soft touch. We do not yet have much detail on how the incoming administration will approach the trade war with China, or trade policy in general. However, measures aimed at curbing China’s development have become popular on both side of the aisle in Washington. This suggests that it is unlikely that Biden will reverse all of the Trump administration’s policies, if at all. But it does seem likely that Biden will take a more considered, multi-lateral approach to the issue that will probably include more dialogue with Beijing.
Ultimately, a more methodical approach to trade may be more successful in decoupling the US from its heavy reliance on supply chains in China. As we will explore in a forthcoming piece, this would still have an impact on the long-term performance of EM economies and assets. For now, the end of social media diplomacy and a return to more traditional and predictable policymaking may be welcomed. This should give investors the confidence to step more meaningfully into EM assets.
EM valuations look attractive
There certainly appear to be opportunities in EM as the global economy moves into a cyclical recovery. For example, as the chart below shows, there is a wide current gap in the price/12 month forward earnings ratios of the MSCI Emerging Markets and World index of developed market equities. Similar sized valuation gaps have historically been the precursor to a period of significant outperformance over a two-year time horizon. This is based on monthly valuation gap data and the subsequent relative performance of the MSCI Emerging Markets and the MSCI World over the next two years, using data going back to 2003.
Those valuations may become even more compelling if the EM economic recovery continues. For example, growth in China’s M1 money supply, deflated by inflation, tends to be a good leading indicator of the business cycle there. Given China’s importance to global supply chains, “real M1” has also become a fairly reliable leading indicator of the earnings component of the MSCI Emerging Markets index – both on a trailing and forward-looking basis.
As the next chart illustrates, if that historical correlation holds firm in the months ahead, analysts’ expectations for earnings are likely to be further revised-up and this would usually be supportive for the performance of EM equities. A large stimulus package in the US after Biden takes office would only add to a more positive outlook for earnings. This now looks less probable though, unless the Democratic Party is able to win two run-off Senatorial elections in Georgia in January. The Republicans need one additional seat to control the Senate. But if the Democrats win both, Senate would be divided equally, a scenario which would permit the vice-president the casting vote.
More generally, long-term policies such the Fed’s shift towards Average Inflation Targeting have the potential to drive a sustained period of capital flows to EM in the future. The upshot is that while strong post-election rally might not last long, Biden’s victory may finally usher in a period of EM outperformance.