A 20 per cent US border adjustment tax is the one major risk which could derail the current bull case for emerging markets, according to Ashmore’s Jan Dehn.
The head of research warned that, if President Trump succeeds in pushing his proposed 20 per cent tax through Congress in a bid to bolster the US manufacturing industry, the value of the dollar will rocket relative to local emerging market currencies.
Performance of currencies since start of data (relative to sterling)
Source: FE Analytics
If this happens, he explained that local currency emerging market bonds would be left on the shelf, less money would flow into emerging economies and growth rates would therefore stagnate. 
“The border adjustment tax is a production-based, destination-based tax system. It basically says that everything that gets produced outside of the borders of America – it doesn’t matter if it’s an American company or a foreign company - will incur a 20 per cent tax,” Dehn (pictured) explained.
“But if it’s produced inside the borders of America, it will have no tax at all. Given that America is an importer, that means that all of these goods outside of America with the border adjustment tax will be 20 per cent more expensive.
“When they become 20 per cent more expensive, Americans will buy fewer of them. And when Americans buy fewer of them, fewer dollars will flow out of America and, suddenly out in the real world where people have been used to a certain flow of dollars, there won’t be enough.
“That will of course change the exchange rate and the dollar will go up and up and up until it has risen 20 per cent – exactly in line with the border adjustment tariff.”
In the current investing environment, the head of research predicts that local currency bonds will achieve a 50 per cent return in US dollar terms over the next five years; he said approximately 20 per cent of this recovery is likely to be the result of currency valuations clawing back 20 per cent after falling 45 per cent during the financial crisis. The remaining 30 per cent recovery, according to Dehn, will come from a narrowing gap between emerging market fundamentals and investor sentiment.
However, if the 20 per cent border adjustment tax is implemented, he warned that emerging market currencies will therefore fall by 20 per cent and, instead of making a 50 per cent return over five years, investors will only make 10 per cent – or 2 per cent per year - over this time frame.
“Given that dollar bonds in emerging markets pay a 5.2 per cent yield, I assure you there is not going to be a single soul on planet earth wanting to buy those local currency bonds,” Dehn explained.
“And, if they don’t buy local currency bonds, there will be no money flowing back to emerging markets and, when money doesn’t flow back into emerging markets, financial conditions will not ease, growth rates won’t pick up, default rates won’t go down, and the whole fundamental story goes into overdrive as well.”
As such, he said investors who believe the border tax will be implemented should steer clear of local currency-denominated emerging market bonds. As discussed in an earlier article, however, the head of research is actually very bullish on the outlook for emerging market debt over the long term due to strong fundamentals and attractive valuations.
He also believes it won’t be possible for Trump to roll out the border adjustment tax as it would cause four negative macroeconomic consequences.
“The first consequence is that inflation will go up 2.5 per cent,” Dehn continued. “That is going to push inflation rates in the US from 2 up to 4.5 per cent. That’s actually a faster rate of inflation than the rise in consumer spending, so real spending will start falling – just like we’re seeing in the UK.
“That really poses questions about the outlook for consumer spending which is still driving the US economy and raises recession risk.”
He said this then causes a second problem, as the US Federal Reserve would be forced to hike rates if inflation started rising sharply, which would result in a stock market correction.
“The third problem is it would push up the dollar by another 20 per cent and the dollar is already overvalued,” the head of research explained. “The US economy cannot grow despite negative real interest rates, 30 per cent fiscal stimulus, trillions of dollars of QE [quantitative easing] and lots of investors’ capital which has provided more financing than the US economy has ever had in its entire history.
“There are several reasons for this – high debt levels and low productivity – but one of the reasons is the dollar is overvalued. It is just very difficult to grow when you have an overvalued currency and that’s the problem.
“If you push up the dollar by another 20 per cent because of the border tax, believe me, this is not good for the US economy.”
Performance of currency vs sterling since start of data
Source: FE Analytics
Dehn reasoned that, if Trump faces a recession in his first term, US voters are highly unlikely to re-elect him.
Not only this, he said it would spark a trade war between the US and 232 other countries which will mean Trump focuses on trade problems as opposed to the ‘plight of US taxpayers’.
“[The electorate] will not forgive him for this and he won’t get re-elected, so for those reasons he won’t do the border adjustment tax,” Dehn reasoned. “If you don’t get the border adjustment tax, then you don’t raise $1.2trn from border adjustment tax, and if you don’t raise $1.2trn from the border adjustment tax, you can’t cut taxes by $1.8trn, which was the plan. You can only cut them by $600bn.
“$600bn is a small fiscal stimulus and that means you get small growth rates. If you get small growth rates you get small inflation, if you get small inflation you get small rate hikes, and small growth and small rate hikes is what drives the dollar or, in this case, does not drive the dollar because they’re not enough.
“So essentially, the outlook for the US economy is ‘blah’. If the outlook is ‘blah’, investors are going to look at the returns they getting and they’re not going to be super excited, or they’re going to look at the 50 per cent return they’re going to get in local emerging markets and they will decide this is more attractive. Then money from the whole QE technical trade will slowly wash back. That is my base case.”