As most of the investor community is aware by now, one the most distinguishable consequences of Donald Trump’s presidential election has certainly been the sell-off in emerging markets.
Under the view that a U.S. government spending splurge may accelerate domestic growth and inflation, funds all across the world have started reducing their positions in local currency EM bonds, which suffered their biggest losses last week since 2008.
Currency markets all across the developing world have shown a tremendous correction as well, with the Mexican peso plunging 12% to a record, while the Brazilian real and South Africa’s rand have lost more than 7.8% each.
And this rout is likely to deepen. If acted upon, Trump’s protectionist overtures would certainly slow exports from and reduce investments to developing economies. For now, these markets have not found a bottom. If we take iShares MSCI Emerging Markets ETF (NYSEARCA:EEM), the correction during the last five trading days has been impressive:
In addition, central banks in the U.S., Europe and Japan are either ready to raise borrowing costs or stop easing further, which should drag Treasuries’ yields up and put further pressure on emerging markets. Funds that were looking for better performance outside the developed world would certainly rebalance their portfolios, weighting more risk-free positive yields, at least until they get a better picture of what Trump’s key policy action will be.
Any more hints that imply a slant toward isolationism, an aggressive supply-side infrastructure plan and a cooling relationship with Mexico should reinforce the trends we have witnessed for the past five trading days.
As described, in the aftermath of Trump’s win, risk premiums for emerging markets have done nothing but increase. And with most variables conspiring to drive a back-up in global fixed-income yields, the effect on Argentina’s sovereign yield curve is inevitable.
But the effect has been stronger on the country’s longer-maturity bonds. In the case of Argentina’s 2046 bond, the correction taking place these past few days has been significant. It would not be surprising to see this bond trading below USD105, which would mean yields surpassing 7.2%.
However, despite the drop in bond prices, Argentina still remains among the best carry trades available.
As explained in this article, the disinflation taking place in the country, which guarantees positive real interest rates in local currency, has resulted in millions of USD entering Argentina in the form of carry trades. These have been quite profitable ventures.
But things could change quickly, as these carry trades can be unwinded in no time. And FX plays a critical role here.
The exchange rate
Despite the fact that the USDARS reaction to the US election has been quite stable when compared to most LatAm currencies, these past few days have shown some more volatility.
As the peso devalues, it erases the profitability of the carry trades, especially when these trades are attached to instruments like LEBACs, whose yields continue to decrease as part of the central bank’s main disinflation strategy.
Though some trends still give some support to the Argentine peso. The country still enjoys USD inflows, a product of its tax amnesty law, and yields remain attractive when compared to the rest of LatAm, which still attracts foreign capital looking for EM exposure.
However, seasonality plays against the country. Fourth quarters have statistically proven to be tough for the peso as the inflows of hard currency – a product of its crop sales – diminish, while holiday vacations and imports demand higher amounts of dollars.
For now, caution and selectivity should prevail regarding LatAm and Argentine assets in particular.
Nonetheless, the trades that took place this past week are all based on interpretations of what Trump would or would not do. When investors and funds take positions regarding these ideas, the market moves with great volatility and valuations end up differing substantially from reality. Exaggerations to one side or another are completely plausible, and this is where opportunities arise. Stay tuned.
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Adrian Limoli is a research analyst and investment advisor.