Weighing the Prospects of Trump’s Trade Agenda

 

November 14, 2016 [us politics, 2016 election, emerging markets, mexico, china]
Charles Roth


Emerging market assets have come under heavy pressure, particularly in Mexico and China, which have also sagged under the specter of rising U.S. trade protectionism. But rather than focus on Trump’s campaign talk, watch his actions.

During the U.S. presidential election campaign, candidate Donald Trump hammered relentlessly at the “very bad” free trade deals Washington has signed or negotiated. He cudgeled two of the U.S.’s top trading partners, Mexico and China, accusing the latter of currency manipulation. In the wake of President-Elect Trump’s victory, the MSCI Mexico Index lost 16%, and the peso tanked nearly as much against the dollar. China’s yuan sank to its lowest level versus the greenback in nearly six years. It’s not just fears of a Trump-driven spike U.S. trade protectionism driving the moves. Trump’s plans for major fiscal spending on physical infrastructure, coupled with tax cuts, have pushed up the U.S. 10-year Treasury yield roughly 30 basis points to around 2.15% by the end of last week and steepened the yield curve amid a rise in inflation expectations. As a result, the odds of U.S. Federal Reserve key rate hikes ahead have risen.

That has implications for all emerging markets (EM), which could see portfolio outflows as rate differentials decline and fears grow that dollar-denominated debts in developing countries become harder to service. The MSCI EM Index, unsurprisingly, shed 3% by Friday, November 11, and EM bonds and currencies more generally also sold off.

The market volatility is no doubt unsettling. But long-term investors should really keep a few things in perspective. First, rhetoric needed to win an election campaign usually changes quickly and dramatically after the campaign is over and the shift toward governing begins. Note Trump’s graciousness in his victory speech, declaring that the U.S. “owes (Hillary Clinton) a major debt of gratitude for her service to our country,” after spending more than a year harshly attacking her record. His comments following a post-election meeting with President Barack Obama, whose counsel Trump said he would seek, were also striking and conciliatory. This isn’t to suggest that Trump won’t follow through on some of his campaign pledges; he just may not do it in the way he has long suggested.

Take China. Officials in Beijing aren’t displeased with Trump’s victory, suggesting they don’t fear his rhetoric given his record as a “deal-maker.” Bloomberg quoted Ruan Zongze, a Chinese official at the research arm of China’s Ministry of Foreign Affairs who had previously served at China’s embassy in Washington, as saying he sees Sino-U.S. relations having “a greater chance of thriving under the Trump presidency.” That’s because Trump “is a businessman, and China likes dealing with businessmen as they are pragmatic and not ideologically bent,” he added. “A businessman is capable of making possible what would otherwise be impossible from the standpoint of a pure politician.” Rather than a 45% tariff on Chinese imports, as Trump had threatened, one sell-side China equity analyst told Thornburg that Beijing would likely accept a 10% tariff on Chinese imports to the U.S., while leaving its currency policy unchanged. It’s a plausible scenario.

China’s trade with the U.S. is no doubt lopsided, as the Middle Kingdom enjoys a significant trade surplus over the U.S. amounting to $365.7 billion in 2015. But even a 10% price increase on that level of imported goods from China would undercut the purchasing power of a significant number of U.S. consumers of those goods, including those who voted for Trump. The president-elect may well understand the economic inefficiency of such trade protectionism: a 45% tariff would simply create that much more inefficiency and loss in U.S. consumer purchasing power of “Made in China” products.

On the currency front, the People’s Bank of China (PBOC) has slowly and steadily depreciated the yuan for some time, guiding it to better reflect the country’s economic fundamentals as it had been overvalued, not undervalued. China’s economic growth has been ebbing for several years now, its trade surplus has declined from $63.25 billion in January to $49.06 billion in October, while the PBOC’s foreign-exchange reserves have eroded significantly, from nearly $4 trillion in mid-2014 to $3.12 trillion at the end of last month. Moreover, the dollar has strengthened sharply since the November 8 election, so the yuan’s decline against it—not to mention that of other global currencies—makes sense. The continued gradual depreciation of the yuan is far preferable to the steeper depreciations that Beijing has at times engineered, which, as in August last year, caused considerable disruption in global currency markets. Trump can arguably find greater currency manipulators among the proponents of negative interest rates and quantitative easing (asset purchase) programs in Europe and Japan.

As for Mexico, during the campaign, Trump threatened to impose 35% tariffs on imports from U.S. firms that move U.S. factories to Mexico. It appears that Trump as president would have “termination and withdrawal authority” under section 125 of the 1974 Trade Act governing the U.S.’s free trade agreements with just six months of notice in most cases. That’s the same amount of notice Article 2205 the North American Free Trade Agreement (NAFTA) provides for withdrawal. Trade Act provisions also give the president authority to impose tariffs of up to 50%. But would it be worth upsetting what have long been amicable bilateral relations with Mexico, including since the 1993 signing of NAFTA between the U.S., Mexico and Canada? The U.S.’s $58.4 billion trade deficit with Mexico last year was less than 8% of the U.S.’s total trade gap in 2015.

And as both are World Trade Organization (WTO) members, WTO rules would govern the new bilateral trade relationship. The U.S. would have far more to lose under that regime. “Under WTO rules, average bound tariffs on Mexican machinery and transportation equipment exports to the U.S., which constitute more than 60% of total exports, would move from the current rate of zero to the average bound tariff under WTO of 2.2%,” noted Thornburg’s Pablo Echavarria, citing JPMorgan research. “On the other hand, exports from the U.S. to Mexico would potentially experience a much greater tariff increase under WTO rules. Machinery and transportation equipment, which constitutes 47% of U.S. exports to Mexico, would see tariffs move from zero to somewhere between 2.2% and 33.5%.” Retaliatory tariffs on U.S. exports to Mexico would likely hurt the U.S. more than higher tariffs on Mexican imports would help. Trump economic advisor Stephen Moore has publically argued that NAFTA has done far more good than harm for all three members, and he has doubtless argued as much privately with Trump.

Trump’s pro-growth agenda of tax cuts, deregulation and fiscal stimulus would be undercut by a sharp protectionist turn, given not just the economic inefficiency and higher consumer prices that usually result, but also due to the potential for retaliatory measures by trading partners. Furthermore, he should keep in mind that nearly half the revenues of S&P 500 constituents are sourced from abroad.

“Getting tough” on immigration, legal or illegal, wouldn’t help growth, either. Pew Research Center data show a net migration of Mexicans from the U.S. since the onset of the Global Financial Crisis, with some 140,000 fewer Mexicans in the U.S. in 2014 from the 2009 tally. Lackluster average annual U.S. economic growth of 2.1% since the crisis drove the net outflow of Mexicans, who were unable to find work in the U.S., according to Pew. Former House Speaker Newt Gingrich, a Trump transition team member, has also argued that mass deportations of undocumented Mexicans in the U.S. for years, if not generations, simply isn’t socially, morally or economically viable. The latter point is due to the likely productivity loss and potential wage inflation were millions of workers in low-paying jobs to depart.

To satisfy to some degree his campaign pledges, Trump might simply force an end to “sanctuary cities” in the U.S. via denial of federal funding; step up deportation of felons in the country illegally; and reverse President Obama’s executive orders related to DACA (Deferred Action for Childhood Arrivals), which lifted the threat of deportation of certain classes of illegal immigrants, but implementation of which was already suspended by a federal court anyway. The president-elect on Sunday told 60 Minutes his administration would focus first on deporting those illegal aliens with criminal records and only subsequently make a determination on the “terrific people” here illegally who haven’t broken any other laws. As for the promised wall on the southern border, “there could be some fencing.” Separately, Trump said he’s open to leaving parts of the Affordable Care Act; during the campaign he had repeatedly vowed to repeal it.

If Trump does prove more pragmatic than ideological, as his post-election comments suggest, he’ll focus more on the pro-growth aspects of his agenda and less on the protectionist and restrictionist aspects of it. Faster growth creates jobs and higher wages, which would surely benefit his voters more than trade protectionism and mass deportation programs would. That same economic focus would also justify Friday’s record high in the Dow Jones Industrial Average, which capped its best weekly performance in nearly five years. Stronger U.S. economic and market performance would, in turn, likely spill over into emerging markets, lifting demand for their goods, to the benefit of earnings growth and asset prices in the space.

A pragmatic Trump may make the current volatility in emerging markets a compelling opportunity for longer-term investors.

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