As part of Frontier Strategy Group’s series on the impact of the US election on emerging markets, this post will focus on the effect on financial markets from the perspective of Latin America. Given the global uncertainty that has already triggered significant volatility in financial markets over the last few years, the US presidential election could present yet another source of instability that could have a direct impact on currency valuations, inflation levels in emerging markets, and domestic interest rates.
Base case: US Dollar strength continues
FSG’s base case scenario for the election is that Hillary Clinton is elected president and Republicans hold on to congressional majority, which, for financial markets, would entail business as usual. The main driver behind currency fluctuations will be US monetary policy, which is expected to continue tightening. An alternative Clinton-win scenario is one coupled with Congressional support for her policy agenda, particularly for a significant increase in public investment that would open opportunities for doing business in the US and help push global commodity prices marginally higher, driving capital and investment to key emerging markets. Regardless of the composition of Congress, a Clinton victory is not likely to have a significant, immediate impact on financial markets, as the US Fed will maintain the same policymaking stance it has had under President Obama.
Given a Clinton victory, the likelihood of a rate hike in December remains unchanged at 70%. Monetary tightening will continue to put pressure on LATAM currencies, with an average expected depreciation of 4.05% for the top 7 markets in LATAM, excluding Venezuela, in 2017.
Uncertainty under Trump drives volatility in the short-term
The most pressing, immediate concern for multinationals is how financial markets will react to the outcome of the election, which depends on the level of uncertainty the result creates. For instance, following the Brexit referendum earlier this year, global financial markets lost over $2 trillion as a result of the heightened uncertainty sparked by this arguably unexpected result, which signifies the most intense period of volatility since the 2008 financial crisis.
It is uncertain how financial markets will react under a Trump victory. Multinationals already know that a Trump victory scenario would compound investor uncertainty across financial markets. But the medium-term impact is highly unpredictable, as financial markets tend to overshoot in the short-term upon the release of unexpected news.
In this regard, FSG’s view is that immediately following a Trump victory, significant volatility will ensue as investors scramble to make sense of the likelihood of the implementation of Trump’s disruptive policy agenda. Assets perceived as safe, such as gold, would probably see value gains as investors retreat to safety, while US monetary tightening would pause amid heightened volatility. A delayed December Fed rate hike could potentially benefit high-yield emerging market vehicles as investors shift their portfolio strategies (such as the Brazilian real). Likewise, not all currencies would behave in the same way, with relatively safer assets that have historically been less impacted by US monetary policy, such as the Peruvian sol and the Colombian peso, attracting the bulk of capital inflows as investors seek carry trade opportunities.
Trump’s uncertainty extends into the long-term
Trump’s victory could have severe long-term repercussions on financial markets. His lack of policy clarity and higher degree of unpredictability compared to Clinton is unsettling to investors, particularly since Trump has made contradictory statements about whether or not he favors low interest rates and a strong dollar. Moreover, he has proposed substantial tax cuts, which would raise US debt levels, while his likely appointment of less-independent US Fed leaders in 2018 would foment worries of unsound monetary and fiscal policy during a Trump presidency.
The US dollar would weaken if Trump’s victory, and the resultant global volatility, prompts the US Fed to delay further interest rate hikes. In essence, such a shift would favor the competitiveness of emerging market currencies until the US begins to implement Trump’s promised fiscal stimulus measures to boost economic growth.
Compared to FSG’s Clinton victory scenario, the average expected depreciation for the top 7 markets in LATAM, excluding Venezuela, would be 8% in 2017.
Summarization of currency effects: The Mexican peso question
While FSG expects all currencies to be moderately affected by the outcome of the election, the Mexican peso stands as the most exposed.
Considering the case of Mexico, the country’s currency has been a firsthand victim to what some are calling the “Trump effect,” borne out by the significant correlation between Mexico’s market volatility and Trump’s polling performance, with the peso falling whenever Trump advances in polls and gaining when he drops. In fact, the Mexican peso has been the most vulnerable to a Trump victory, weakening the most this year among major currencies (after the British pound) on concerns such as Trump’s standing in polls and the potential for higher exposure to protectionist trade and immigration policies being enacted in the US. Hence, under a Trump victory, the Mexican peso is likely to depreciate considerably, at least in the short- to medium-term, to 22.1 by end of 2016 and average 23.5 in 2017, according to FSG projections.
Mexico has a Trump contingency plan
Given the volatility already witnessed during the presidential campaign, policymakers have rightfully expressed nervousness that the election results could exacerbate volatility in financial markets, which could lead to further currency depreciation and increase the risk of higher inflation. While policymakers in Mexico do not foresee a need for aggressive rate hikes under a Clinton victory, the country’s central bank governor has already expressed readiness to step up measures in the event of a Trump victory. In an effort to combat a potential spike in inflation, such measures could include raising interest rates by at least 100 bps and resuming the sale of US dollars in the spot market. The Mexican central bank has already responded to uncertainty this past year by raising interest rates and enacting budget cuts, which was the case in the aftermath of Brexit, when the country hiked rates by 50 bps and slashed its budget by $1.7 billion the day after the vote. For Latin America, the economic uncertainty that particularly surrounds Trump could extend the need for austerity in financially troubled markets, thus increasing pressure in the medium-term.
Actions to take
As multinationals await the results of the US presidential election and consider its immediate aftermath, executives need to be prepared for a victory by either candidate, and the results that each scenario will entail. Although financial market activity is expected to maintain the status quo under a Clinton victory, MNCs need to brace for volatility and focus their efforts on evaluating hedging strategies for all major LATAM currencies when considering a Trump victory. Particularly in the case of Mexico, MNCs will need to be prepared not only for the effects of short-term volatility, but also reevaluate market strategy based on the potential sustained market impact of a Trump victory scenario.