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When elephants fight, the grass suffers, points out an old African proverb.
The meaning is clear and alarmingly apt for what now appears to be a full-blown trade war evolving between the US and China, as the two powerhouses vie for supremacy in the global economy.
Collateral damage is already evident, and nowhere more so than in emerging markets, which are most vulnerable to the so-called ‘risk off’ sentiment which prompts nervous investors to move their money to perceived ‘safe havens’.
Well before the threats and rhetoric ratcheted up to the level where they are now, the World Bank warned of the impact a trade war would have on the global economy.
“A broad-based increase in tariffs worldwide would have major adverse consequences for global trade and activity,” it said in its latest economic outlook, released in early June.
An escalation of tariffs just up to rates defined as legal by the World Trade Organisation could choke off 9% of global trade flows, similar to the drop seen during the financial crisis in 2008 and 2009, it predicted.
The hardest-hit areas in the event of increased protectionism would be emerging markets and developing economies, with sectors like agriculture and food processing the hardest hit, it added.
Emerging market assets were already under pressure from the US Federal Reserve’s interest rate hiking cycle, which is taking place faster than initially expected this year.
The tightening policy is supporting the dollar, which has appreciated by 5.4% this year on an index benchmarked against a basket of currencies.
Pressure on emerging markets
This puts pressure on emerging market currencies, fanning inflation likely to lead to growth-dampening interest rate hikes in their countries.
Even worse, the dollar strengthening trend raises the cost of the foreign currency denominated debt in developing countries, making less money available for government spending.
Early in June Argentina was forced to take a $50bn loan from the International Monetary Fund – the biggest in the Fund’s history – after its peso crashed to a record low despite interest rates rising to 40%.
Turkey also hiked its interest rates far more than anticipated to support the lira.
But the real trade war bloodbath took place in the second-to-last week of June, with emerging market currencies taking a beating worldwide – including the rand, which weakened to nearly R14 to the dollar from a peak of R11.50 early this year.
Yields for benchmark 10-year government bonds also climbed, extending increases this year from just above 8% to nearly 9%.
Emerging market equities were also hard hit in the same week, and the benchmark MSCI Emerging Market Index saw a staggering $3.7bn of net outflows, taking its capital flight over the last month to $5.39bn.
The MSCI Emerging Markets ETF extended its recent downward spiral, taking its decline over the past month to 6%, and tumbling 10% from its closing high in the first quarter of this year.
Eroding confidence
Although there has been some recovery since then, many analysts see no relief in sight for emerging market assets.
Even if US President Donald Trump’s latest tariff threats towards China – and the European Union – prove to be no more than brinkmanship, damage has been done.
Before the trade rhetoric erupted, China’s growth was already set to slow to 6.5% this year from 6.9% in 2017.
If the slowdown deepens, the country will need less commodities from other emerging markets, and those prices will fall, which will also hit emerging economies in their pockets.
“There is a possibility that things will be defused, but between now and then Trump’s narrative shakes confidence and puts a cloud over prospects.
It’s bad for business, bad for markets and bad for investing,” says Adrian Saville, founder and chief executive of Cannon Asset Managers, which specialises in the management of domestic and global equity portfolios.
Capital Economics, which focuses its research on emerging markets, said in a note on 22 June that the broad sell-off was causing financial conditions to tighten in countries beyond Turkey and Argentina – including Mexico, Brazil, and South Africa.
“If conditions continue to tighten over the coming weeks, the headwinds to growth in these economies will mount,” it said.
Reserve Bank deputy governor Kuben Naidoo said on 19 June at a European Central Bank forum in Portugal that the bank’s monetary policy committee could afford to wait “a few months or even a few quarters” before raising interest rates.
SA is also better shielded than many of its emerging market peers from the rising cost of foreign currency debt, as only about 10% of its borrowing is denominated in other currencies.
Nonetheless, Naidoo also said in the same interview with CNBC International that SA would suffer from the trade war.
“As a small and open economy, we depend on trade for our growth and if there is to be a slowdown in global trade, we will be affected,” he said.
Naidoo pointed out that SA’s exports of steel and motor vehicles would also be affected if tariffs rose on those products, which Trump intends to make happen.
About 20% of South African exports go to China – including half of its mineral exports.
Vulnerable economies
Small, open economies in East Asia, such as Taiwan, Singapore and Malaysia, are most exposed to US tariffs on imports from China due to their role in global supply chains, says William Jackson, a senior economist at Capital Economics in London.
Chile would also be hard hit as it produces the copper used in China’s electric sector.
South Korea, Chile and Taiwan are most vulnerable, with nearly 30% of their exports going to China last year, according to IMF data. Russia will also be affected, with China taking ten percent of its exports.
According to Capital Economics, emerging market export growth had begun to slow even before the latest fears of a trade war between the US and China escalated.
In volume terms, it fell to an 18-month low in April, expanding by around 2% compared with the same month last year, and down from an average of 5% over the course of last year.
Higher oil prices are another big negative for the economies of emerging markets that are not exporters of the commodity.
Despite an agreement by the Organization of the Petroleum Exporting Countries (Opec) to raise output, the modest increase in supply would not be enough to address an ongoing political and economic crisis in Venezuela, Oxford Economics said in a research note on 22 June.
Although the price of the benchmark Brent crude has dipped since then, it still expects prices to average $80 a barrel in the second half of this year and $77 a barrel in 2019.
So far this year the price of Brent crude has hovered at above $70 a barrel – well up from a trough of $27 in January 2016.
Rising risks
Trade uncertainty is now perceived to be the biggest risk for global companies, with 35% polled in the latest CNBC Global CFO Council quarterly survey saying they believe that US trade policy is the biggest external risk their company faces.
This compares with a ratio of 27% in the first quarter of this year and just 11.6% in the fourth quarter of last year.
Perhaps unsurprisingly, two-thirds of the poll’s respondents, both in North America and those in the Asia Pacific region, expected the issue to have a negative impact on their firms.
These trends do not bode well for the global economy. Some analysts believe that falling confidence and supply chain disruptions stemming from a trade war would not only slow economic growth, but amplify the trade shock enough to trigger a global recession.
“The good news is that we are still many steps away from a full-blown trade war,” Michelle Meyer, an economist at Bank of America Merrill Lynch, said in a recent research note. “The bad news is that the tail risks are rising, and our work and the literature suggest a major global trade confrontation would likely push the US and the rest of the world to the brink of a recession.”
Both China and the EU weighed in with similar warnings in Beijing on 25 June, with Chinese vice premier Liu He saying that he and European Commission vice president Jyrki Katainen had agreed to “oppose trade unilateralism and protectionism” as “these actions may bring recession and turbulence to the global economy”.
On the face of things, China looks like it will come off far worse in a global trade war as its exports to the US reached $430bn last year – about a fifth of China’s gross domestic product – while the Asian giant only imported about $130bn of goods from the US.
But China could retaliate in other ways – by devaluing its currency, targeting US companies operating in China, or even dumping some of the $1.18tr in US Treasuries it owns.
In another salvo, the Trump administration has said it will also restrict Chinese investment in US companies and start-ups in strategically important tech sectors like aerospace, artificial intelligence, and robotics.
The value of Chinese foreign direct investment in the US has already plummeted by more than 90% to $1.8bn in the first half of this year compared with the same period in 2017.
Economists say that if its dispute with the US remains a tariff battle alone, China could lose up to one percentage point of GDP growth, but if the hostilities escalate, the fallout would be much more severe.
The upside: EM yields for the taking
So how should investors position themselves for the volatile global economic outlook? Econometrix Treasury Management’s MD George Glynos thinks that the pessimism generated by global trade war concerns are overdone, particularly where emerging markets are concerned.
“I’m not of the view that things are just one way from here. There’s been a tremendous amount of readjustment in emerging markets and at these levels one might be tempted to nibble back in (to EM bonds and currencies). We are advising clients that now is the time to expose their portfolios to yields they can’t get anywhere else,” he said.
Cannon Asset Managers’ Adrian Saville is also circumspect. The best approach would be to take an industry rather than a country approach, avoiding open and highly traded industries like steel, heavy manufacturing and tourism, he said.
“We are advising that you pay very careful attention to this risk, and it is always important to separate risk from overreaction,” he said.
Goldman Sachs recommends that in the US, investors put their money into companies with large domestic sales exposure rather than more foreign-facing firms, as these would benefit from a global trade conflict.
Chris Potgieter, head of Old Mutual Wealth Private Client Securities, has said that this is a good time to invest in agricultural producers who can substitute production from either the US or China.
This article originally appeared in the 7 July edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
