Emerging markets are set to experience further turbulence over the coming months, in large part because of the escalating trade war between the US and China. What are the likely next steps and how can investors mitigate the effects?
It has been a bumpy ride for emerging market debt investors over the past 12 months - and if events in May are anything to go by, we could be in for a volatile second quarter.
For some investors, the events of the past six months are likely to feel like a ‘one step forward, two steps back' scenario. After a pronounced sell-off in 2018, emerging market debt bounced back during the first quarter of 2019, as risk appetite returned and the US and China agreed to halt new trade tariffs. Local currency emerging market debt delivered an average return of 6.6% during the first quarter and 4.2% in sterling terms, according to data from JP Morgan Asset Management.
However, just as the asset class started to turn a corner, trade tensions between the US and China picked up once again. This culminated in US president Donald Trump's administration raising tariffs on $200 billion of Chinese goods from 10% to 25% on 10 May. China then retaliated by increasing tariffs on $60 billion of US goods, coming into effect on 1 June.
These events provided a blow to risk assets, causing global markets and emerging market currencies to sell off as investors flocked to perceived safe havens such as US government bonds.
In light of the ongoing trade tensions, investors may be tempted by attractive valuations in the emerging market debt space. However, it is important to consider the potential risks and unknowns.
Understanding the risks
Anthony Willis, a multi-manager at BMO Global Asset Management, says it is not yet clear if the recent escalation in trade tensions indicate that talks have been unsuccessful or represent a tactical play from president Trump.
"We do still think it is in the interests of both sides to reach a trade deal. But if it is not to be, the Chinese authorities will likely take further steps to cushion the impact of persistent and high tariffs on their exports to the US," he says.
Willis points out that China has the potential to take action outside of tariffs and may look to frustrate the operations and growth of US companies doing business in China. The government could also depreciate the currency, which would create ripples across global markets.
