Trade war risk fades, for now

We see a reduced near-term risk of trade wars, as President Donald Trump’s White House appears to have softened its stance toward both the North American Free Trade Agreement (NAFTA) and China. This could benefit emerging markets (EMs).

Emerging market equities and the Mexican peso, 2016-2017 Some of the EM assets being dumped as part of the “Trump trade” have made a comeback. The Mexican peso — poster child for that trade — has made a round trip, returning to levels seen before the election. EM equities’ performance against developed market peers has been on the mend, as shown on the chart above.

Second thoughts on free trade

Trump‘s victory sent tremors across EMs as the risk of trade wars spooked investors. But the threat looks to have receded, especially after the Treasury Department did not name China a currency manipulator in its first foreign exchange policy review under the Trump administration.

There are other signs that the initial hostility is dissipating. The administration’s recent letter to Congress on renegotiating NAFTA pointed to a mild stance. Also, Trump’s April meetings with Chinese President Xi Jinping appear constructive, buying both sides time to address a large bilateral trade imbalance. In a show of cooperation, China has proactively offered some trade concessions.

We do see longer-term risks as the U.S. is likely to revisit some trade policies from the 1980s and pivot toward a transactional approach to trade. Geopolitical uncertainties are another concern.

But in the short term, a lower chance of trade wars is good news for EMs that are benefiting from global reflation and solid domestic demand. Trump’s recent comments that the U.S. dollar is “too strong” and signs of a preference for a low-interest rate policy are also supportive. We see a declining EM risk premium as the market focuses on fundamentals, underpinning our overweight in EM equities. EM Asia equities stand out as a potential major beneficiary, in our view.