The US’s abandonment of a border-adjusted tax has removed the single biggest risk facing emerging markets, according to Ashmore’s Jan Dehn (pictured), who said local currency-denominated debt is becoming increasingly attractive. 
The head of research has been very positive on the outlook for emerging market debt for some time and, in an FE Trustnet article published in June, explained why the asset class is set for a five-year recovery.
In another article, however, he pointed out that the biggest risk facing emerging market debt was US president Donald Trump’s proposed 20 per cent border tax and whether he would push it through Congress.
Following a statement from White House officials last Thursday announcing they have set aside plans for border-adjusted tax (BAT), it appears as though this risk has subsided and this is reflected in Dehn’s sentiment.
“The US Congress and the White House last week officially abandoned plans to implement a border adjustment tax,” he said. “This significantly reduces the risk associated with investing in emerging markets local bond markets, in our view.
The head of research explained that BAT – a destination-based tax system – would have forced US and foreign companies producing goods outside of US borders and for consumption within the US to pay a 20 per cent tariff.
He believes this would have pushed the dollar up by 20 per cent which, in turn, would have reduced his expected dollar return on local currency bonds from 50 per cent to 10 per cent from 2017 through to 2021. This therefore would have stemmed capital flows into emerging markets and created a challenging backdrop for its ongoing growth recovery.
“It was our base case that the BAT would not be implemented, but it is still good news that the tax has been abandoned,” Dehn explained. “The joint White House and Congress press release stated that ‘while we have debated the pro-growth benefits of border adjustability, we appreciate that there are many unknowns associated with it and have decided to set this policy aside in order to advance tax reform’.”
Emerging market debt has increased in popularity over the months, with the asset class boasting positive fundamentals and attractive yields at a time when developed market sovereign debt is – in many cases – offering up negative real yields to investors.
Performance of indices over 5yrs
Source: FE Analytics
Manager Ron Temple, who is co-head of multi-asset at Lazard, told FE Trustnet earlier this week that he is particularly bullish on emerging market debt at the moment as its high yields provide some ‘cushioning’ against inflationary headwinds.
“I think emerging market currency-denominated debt looks particularly attractive. The risk factors around emerging markets have come off, they’ve restructured their economies substantially and profit recovery is coming. The emerging market story feels like a pretty good story,” he said.
“Even if inflation goes up to 3 per cent, with emerging market debt you’re still getting a high-enough coupon to get a positive return.”
When it comes to the scrapping of the US border adjustment tax, Dehn said it should also be seen in the context of senator John McCain’s vote against the ‘skinny’ version of the bill to repeal Obamacare, in what the head of researched described as “remarkable revenge against Trump”.
“Like the BAT, the whole point of repealing Obamacare was to free up fiscal room to enable Republicans to significantly cut taxes for corporates,” he reasoned.
“Without BAT and the repeal of Obamacare, it now becomes far more difficult to find room to cut corporate taxes without significantly raising the debt burden, which large sections of the Republican party (the so-called Freedom Caucus) would oppose.
“Hence, the US is now on track for a small tax cut at best. This means less stimulus, less inflationary momentum and therefore a slower pace of Fed hikes.”
In terms of what this means for emerging markets, Dehn pointed out that interest rates and growth of course determine the path of the US dollar. As fewer of Trump’s proposals for fiscal stimulus are pushed through Congress, he said there is likely to be a softer trajectory for the currency than investors may have expected at the start of the year.
Performance of currency vs sterling over 5yrs
Source: FE Analytics
“Investors should not be complacent, however, the head of research warned. “Trump and Congress will be desperate to show results ahead of the next year’s mid-term elections.
“One option now is to gut the Dodd-Frank regulatory regime [which puts the US government in charge of the regulation of Wall Street] in order to encourage much more aggressive inflation of US asset prices.
“This could certainly create a short-term boost to asset prices, but probably at the expense of much larger problems in the longer-term.”
Overall, he expects the dollar to be primarily driven by flows which, in turn, could respond to the relative performance of risk assets in the US versus overseas – including emerging market assets.
“So far, emerging market local bonds are returning nearly ten times as much as US bonds of the same duration, while emerging market stocks are returning twice as much as US stocks,” Dehn continued.
Performance of indices in 2017
Source: FE Analytics
“Going forward we expect emerging market outperformance to become ever greater as the distortion in asset prices in the developed economies and emerging markets caused by quantitative easing gradually unwinds.
“This will make it progressively tougher to sustain overweight positions in dollars and developed markets versus emerging markets, especially local markets.”