State of Origin: EM elections, trade and inflation

In the latest episode of the Emerging Markets Equities podcast, Nick Robinson sits down with Bob Gilhooly. Discussing EM and US elections, and how these might affect various EM economies. 

Podcast was recorded on 10th July 2024

Transcript

Nick: Hello everybody, this is Nick Robinson from abrdn and you're listening to the Emerging Markets Equity Podcast, the show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions, from key individuals to evolving trends, all with the goal to identify and profit from opportunities in the region. So 2024 has already been a historic year for elections in democracies. We're just over halfway through the year at the moment, more than a billion people have voted. And there are many more still to go, with half the people on the planet due to vote this year in more than 60 countries. Whilst there is a clear desire for change in many of the outcomes, the change is incurring in different directions. For example Mexico's incumbent government won a surprise supermajority. Whilst India's Modi was forced into a coalition after his party lost its majority for the first time in a decade. So today we're going to talk about issues in emerging economies, particularly with the backdrop of all the elections going on. Joining me today to tackle this is my colleague Bob Gilhooly. Bob has been on the podcast before and is a Senior Emerging Markets Economist based in London. He's been with the firm for about five years, and prior to joining, he was at the Bank of England, where he worked as a Senior Economist covering Asia with a focus on China. So, Bob, welcome back to the podcast. It's great to have you on.

Bob: Thanks, Nick. Great to be back. 

Nick: Great. Well, perhaps, if we start with a, I guess, a top down question on the elections more broadly. What do you think are the learnings that we can take from how elections this year have unfolded? I mean, particularly, I suppose somewhere like India, where we've been hearing for a little while from companies in India that the rural economy was was quite weak and the impact of inflation had been, quite negative on consumer incomes and that's led to this quite large, kind of anti Modi sentiment in rural economies or at least a bit less support for Modi there. Are there other types of learnings that we can take from how things have unfolded broadly? 

Bob: Yeah, I think you're right. I mean, to kind of slightly paraphrase Bill Clinton's famous, strategist, election strategist James Carville, there's a flavor of it’s the economy stupid and I think you're very right to, like, point to this kind of inflationary shock being kind of part of the explanation for some of the the election surprises, around the world, you know, the rural economy in India, I think it was it was harder for people to kind of tap into this notion of, of India's economy powering ahead when their incomes were being squeezed. Modi's biggest losses, or the biggest kind of downside surprise for him was in the kind of regions where the job losses were most acute during the pandemic and then also subsequently have, like a relatively weak recovery. And then I guess we kind of flip it to Mexico. Again, I think inflation does look like it played a role here. You know, the Morena party was one where I think needed push ahead more on infrastructure investment spending in the South of Mexico. They've also kind of promised more, income support across various measures. So I think they were able to kind of capitalise a little bit more positive dimension. But then I guess there's probably also some non-economic factors here. If we compare and contrast India and Mexico, there's a bit of a flavour of, you know, Mexico and Morena party partially probably still able to kind of capture some of the anti-establishment sentiment. In contrast to question, Modi's been in power for, for some time. And that might also, you know, maybe explain a bit why the polls ended up being just so wrong in India.

Nick: Thanks, Bob. And I suppose perhaps if we move on to where the anti-establishment sentiment has been the most strong in the world, and we could talk about the US, perhaps. And, you know, I think this is, you know, the critical election of the year in terms of the world and particularly for emerging market economies. Yeah, how do you see that unfolding and some of the impacts we may see if, as is predicted, we get a Trump victory?

Bob: Yeah. I mean, I guess that the kind of the relative good news is that is that we're at least seeing some signs of the US economy growth dropping down the gear. We're still making some progress on the inflationary backdrop. So, you know, that kind of rates and policy and Federal Reserve backdrop is at least going to move into a slightly more favorable position maybe for emerging markets. Obviously, I think the kind of key dynamics there around those kind of election uncertainties for the US is actually a lot of speculation right now whether Biden is going to step aside. He seems to be indicating that he isn't and if he does that could definitely introduce more uncertainty, about policy under a Democratic presidency that isn't Biden. But I think, you know, really we're talking there about some sort of variation of business as usual. But, you know, Trump is the favourite at the moment. It’s who we marginally expect to take the presidency. And here it is quite a difficult one because the mean certainty is really, you know, what sort of Trump do you actually get, and relatedly, what's the Congressional and Senate split that goes along with that. So, you know, a split Congress could potentially see him pursuing those aspects of the agenda, which are kind of only possible or easier, certainly using executive order. So potentially that amplifies this, the desire to increase tariffs and the time and energy maybe he devotes towards, foreign policy. So that could really ramp up pressure on China and also other major trading partners too. If he is though able to maybe combine trade wars with tax and spending, the market reaction overall might be a bit less, and for us at least from a growth perspective. But all of this risks upward pressure on rates in the dollar, especially since the inflation backdrop is so much less benign when he launched the first barrage of trade actions back in 2016 and 2017. So I think all of this implies, you know, potentially kind of quite nasty crosscurrents for emerging markets. Some might still benefit in the long run if this really amplifies reshoring pressures away from China. Some could still maybe tap into maybe more, stronger US economic growth. But this is really in the context of as also potentially occurring at the same time with higher US rates, dollar strength. So maybe curtailing their ability, further central banks to actually ease policy, which they've been doing kind of cautiously and opportunistically up to now. 

Nick: I think one of the learnings from Trump's first campaign was just how literally you could take his pre-election rhetoric and I know at the moment he's been talking about tariffs, particularly related to China. But are there any other things that have been coming out of his, pre or during campaign rhetoric where, you know, there might be other concerns in terms of what he's likely to do?

Bob: Yeah, think for me, probably the biggest concern is actually the trade war morphs from one largely focused on tariffs to one that is much more focused on, on rules of origin. So where the components and where the kind of goods, ultimately from and this kind of potential for increased focus on, you know, does your good just have a bit of Chinese componentry within it. Could be a much more difficult one for corporates to navigate. Could be one where potential for trade diversion or exchange rates to take a bit of the pressure out of tariffs kind of don't really apply to the same degree. So I think that could be quite, quite a nasty combination. And one where, you know, I'm really, really kind of watching out for what, if anything, happens on rules of origin.

Nick: And do you think that would particularly impact somewhere like Mexico, where rules of origin have already been negotiated as part of the USMCA under the first Trump presidency? 

Bob: Yeah, and of course, we've got the the USMCAs coming back up for renegotiation in 2026. So, again, you know, USMCA could be a bit of a kind of stick that the Trump administration uses to beat the Morena administration in Mexico, to try to extract other concessions around migration, kind of other industrial policies. But, I mean, just thus far, it doesn't look like there's a huge amount of Chinese manufacturing is definitively moved to Mexico, I guess I'm also a bit concerned about it not just being a Mexico issue. But, you know, we know that the Chinese manufacturing also operates, in other parts of Asia. So for example, the US doesn't import any cheap Chinese solar panels, but they do import plenty of cheap Asian solar panels that just happen to be owned, largely by Chinese corporates. So exactly how I think you define these things, it's going to be quite difficult. Obviously, the other effect we saw, of course, during the first Trump administration, the first batch of tariffs is quite substantial trade diversion. And that can potentially, you know, rules of origin potentially impacts the degree to which you can divert trade or do a part of the manufacturing process in another country and thereby circumvent, these trade restrictions.

Nick: So do you think there would be any change to the the nearshoring theme within emerging markets under a Trump two? 

Bob: I think probably it's one of actually kind of nearshoring and reshoring being a bit turbocharged. I mean, if you take, as you say, kind of his words very seriously, this is potentially a world in which, you know, corporates are really put under a lot of pressure to move operations, outside of China. Now, whether that is nearshoring in terms of, you know, moving close to the the US market and being able to kind of be protected by the USMCA umbrella or whether it's actually kind of reshoring still within the APAC region, to potentially kind of more friendly or politically aligned economies such as India, or the Philippines is a bit harder to say. Yes, you know, you do cut out some of the costs around travel and shipping by nearshoring. But, you know, APAC still a very deep manufacturing supply chain. I think that advantage might actually see more of a reshoring, or still a significant amount of the reshoring kind of take place within an intra APAC setting.

Nick: Right, okay. And I suppose a lot of this is, you know, related to China and Trump really targeting China at this time in terms of some of those tariffs. I mean, given what we've seen in China this year and, the incremental stimulus that's been applied to the property market, which isn't really coming through at the moment in terms of consumption. How much of a risk, do you think for China, it is at least going forward for the impact of these tariffs on the economy?

Bob: I do think is potentially quite a substantial risk. I probably say the Chinese authorities aren't out of policy levers deal with this. One feature the first trade war was that we saw that actually the Chinese currency depreciated almost in the same magnitude as the kind of rise in average bilateral tariff rates. So I think this time round, again, we could well see, you know, the currency take a bit of the pressure off tariff moves. But I think the the difficulty here is, is one of the scale and the breadth of the tariffs being so high that I think then that could potentially have a much larger impact on multinational firms investment decisions in China that could potentially kind of indicate a kind of longer lasting drag on, you know, Chinese growth. Now, of course, you know, as I said, I don't think Chinese policy makers policy our out of policy levers that can leave but up to now run quite an incremental, cautious policy stance. I think they could ease, quite easily indeed. You know, maybe this is the thing that actually kind of spurs them into a more aggressive easing stance. So, you know, maybe we see actually some firmer measures coming through on the property side to kind of kick start domestic consumption. They've already leaning very heavily, on investment in technology, green investment and 2023, we had this huge roll out of solar wind capacity within China. I think those, you know, all levers that they would reach for more forcefully to try to counter the US trade shock.

Nick: And looking at China today in terms of the economy and putting aside US election risk, what are you seeing in terms of consumption and signs that perhaps we are seeing some green shoots emerging. 

Bob: Yeah. I mean maybe should first of all just quickly caveat this. I don't actually think the data is going to change what I'm about to say, but just to know what the we're recording this just ahead of the June monthly data dump, where we also get the Q2 GDP release we also got policy announcements coming out pretty soon out the third, third plenum next week. But, you know, a high level, I kind of see, you know, Chinese economy's been doing okay. Not great. It's been, I think, defying the doom mongers call in kind of peak China since by August last year. but, yeah, there's still a lot of headwinds to worry about. You know, house prices continuing to fall, pretty fast pace. There's not really any sign of that turning around thus far. And, you know, as long as house prices are falling, it's tough to be that optimistic about the outlook for consumption, or at least the chances of it really surprising strongly on the upside, the assumption services growth and retail sales, they've all been kind of growing, reasonable pace. And that's despite confidence indices for households, remaining very depressed. So I think for now, the authorities seem to be kind of content to kind of see how some of this past easing around property and also the launch of ultra long government debt issuance plays out rather than kind of reaching very forcefully for new policy levers. Even the EU, you know, slapping tariffs on Chinese EVs doesn't seem to have really made that much difference, if any, to the policy calculus at the moment. So, yeah, it's a difficult one to know. Households are still sitting on a lot of deposits that they built up, because they've not been pushing money into the property sector. So in that sense, household balance sheets that we sort of aggregate, to look to, to bad.

Nick: I suppose if we, if we move on to, another country. I mean, I suppose one of the, you know, cyclical positives on emerging markets and in the last few months has just been this idea that at some point the Fed will look to cut rates and that will allow emerging markets, central banks to start cutting rates as well, and that will stimulate domestic demand. But yeah, there's been a market where that's kind of gone the other way, which is Indonesia, which has also had an election at the beginning of this year. I mean, I suppose what do you make of Indonesia raising rates this year? And do you think there's a risk the other EM may go in that direction? 

Bob: Yeah, it's a good question. Bank of Indonesia of course, is a little bit unusual. Its mandate is actually to maintain, rupiah stability. So in many ways, they do still just act like any other, inflation targeting central bank. But they're clearly, as I said, with this overarching mandate. They are a bit more sensitive to kind of the FX pressure. And I don't think generally speaking, the other there's much read across to kind of other, emerging markets, central banks. So I just kind of absent Federal Reserve reassessing the degree of policy strictness on the US economy, say, by deciding to put rate hikes back on the table, it still seems, I think to me, more likely that what we're talking about is kind of a degree of the pace of rate cuts and the kind of timing being pushed out in EM rather than rate hikes actually becoming more widespread. And, you know, I think part of this, I think it's a very solid reason, is that there's still been very good progress in reducing inflation, across emerging markets. We look on our kind of regional basis. Asia stands out as having headline inflation pretty close to Central bank's targets, Latam and Eastern Europe, you know, bringing headline inflation back to target has proved harder. But you know, it's still well down on where it was this time in 2023 where compared to the peaks hit in 2022. So if we look at a slightly more high frequency measure, both Latam and Eastern Europe are still running around, you know, 3.5% annualised if we if we look at in six month change, and if we look at even more kind of high frequency measures of core inflation across EMs, there's a lot of good news here. These kind of high frequency measures of core are kind of almost back to normal. If we look across like the range. So just one metric will look across the range of say more than 50 emerging markets. The median month over month core inflation rate is actually only 2.3%, in May. So pretty close to kind of what you'd think of the normality targets. Consistent rates, that’s down from a peak of around 11% that we had back in April 2022. So I think there's quite a lot to be confident about in the EM inflation challenge being relatively tamed. Now, that's not to say we're completely out of the woods yet. Services inflation does remain a bit too high in much of Latam and most concerning for me, is probably that it's actually reaccelerating in Eastern Europe. So you know, that is a risk I think for, for maybe where we get into a world of, of EMs hiking rates, if it turns out this kind of signal from service price inflation is really one that central banks are going to have to, react to. 

Nick: Okay, and is there anything that's particularly driving that in Eastern Europe, any economies where, kind of services inflation is, is a particular concern. And what would be behind that? 

Bob: I mean, it's reasonably widespread, less so in Poland. But we see a bit in Hungary. We see in Czech. Latvia as well, where we've kind of had this, this reacceleration, on the services side, it's difficult to pin it down exactly. You know, some analysts and commentators kind of point to a lagged effect operating through, food and energy prices and maybe that is just a temporary one off driver and then things will come back and normalise. But it also looks like, you know, kind of wage, wage dynamics are potentially driving that could also be still ongoing recovery of tourism flows. Still a bit of, I guess, a kind of hangover from the supply shock of the pandemic, overall. But yes, it's a tricky one, I think, to to point to, I think super concrete to be honest on on that one. So it's more in my kind of to watch bucket rather than, I've got a great explanation for what's going on here and how it's going to develop. 

Nick: Yeah. Thanks, Bob. I guess we touched on India earlier, and I suppose, you know, this is, India has been a country we've talked about a lot on the podcast before, and we've talked a lot about how the dynamic within the Indian economy is shifting a bit towards investments away from consumption with the investment that's been going on in grid infrastructure and property market and the like. Yeah, I wonder, you know, given a lot of the rural economy is weaker. I wonder if for the election outcome shifts that kind of dynamic at all between investment and consumption and what the government is likely to try and achieve going forward?

Bob: Yeah, I think probably will put a little bit more emphasis back on, as you say, that kind of infrastructure side of things. I mean, this was kind of already part of government policy. So to some extent, I still view the Indian election result as one of broad continuity of policy or maybe, continuity of policy direction, but I think, with Modi kind of falling short on the, you know, the very lofty election expectations, I do think this probably will mean fiscal policy is probably a little bit looser than it would have been otherwise, you know, in part to keep your coalition partners happy. Some of that will, you know, spill through into infrastructure and other forms of social spending and social security, which I think will go, both probably towards a bit more investment, but also kind of some degree of helping to prop up some of these incomes that have taken a hit through the through the pandemic and the recent kind of inflationary surge, that we've had globally. I think, you know, for us, you know, India's still the one major emerging market where we're kind of pointing to upside economic risks, one downside of Modi kind of falling short of getting this very strong majority probably means that it's probably lowered the chances a bit of some of the more challenging reforms, such as agricultural reforms, land reforms. And, you know, for us, those are still what we see as key to really unlocking much stronger, rates of growth. So getting that sectoral reallocation of moving people, you know, outside of low productivity, low wage agricultural jobs into the higher productivity manufacturing services sector is still very much key for our view on how, you know, India could move more convincingly to a world of kind of exceptionally high growth, you know, maybe emulating some of China's very rapid convergence, that it had through, you know, the 2000, and late 90s, too.

Nick: Thanks, Bob. So, watching the progress of those reforms in India will be key. And I suppose the other country where perhaps reforms are being talked about in a less positive sense at the moment is Mexico and be interested to get your view on some of the proposed Mexican reforms. And, a sense of how negative they could be for the country.

Bob: I think, you know, there's this kind of two main, main reasons for some adverse market reaction to this kind of surprisingly strong, win by Claudia Sheinbaum. You know, first of all, it's just that the new policy mix seems a little bit less restrained fiscally. So some of her kind of key headline policies include minimum wage rises above inflation, introducing a pension for women aged 60 to 64, universal scholarships for children, reforming some of the government institutions, such as the Institute of Social Security, Social Services. So that probably empowers some state workers a little bit more. Probably going to end up with slightly stronger benefit package also going to be put in place. So all of that is kind of like at the margins. Yes. You know, the Mexican economy is still doing well, but maybe fiscal policy is a bit looser, than it would have been at the result. And then the second main reason for this kind of negative reaction, is the Morena supermajority in the lower house and close proximity to where the upper house means only a very small number of senators need to be brought onside, for the government to be in a position to make constitutional amendments. So this move to change the election of members of the judiciary to one of popular vote, and that isn't, you know, it's not anti-democratic, per se, but I think where markets worry is that this potentially removes like a check and balance from the system. So the judges who are voted in for, you know, the concern here is the perception that they might often more side with the government. Similarly could affect companies ability to get a fair hearing on disputes with the regulators, or with the government more generally.

Nick: Certainly something we're keeping an eye on, on the team at the moment in terms of our our Mexican outlook. And that feels like a pretty good place to, draw the podcast to a close. So thanks very much, Bob. Appreciate you coming on today. 

Bob: Thanks. Great to be back. 

Nick: And thanks to everyone who took the time today to listen in. If you enjoyed it, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for our next episode and tune in.