This is the fourth installment of our mini-series on the US elections. Our first article noted the market risk from a disputed US election; our second article reviewed the domestic policy risks and their implications for asset allocation; and the third identified equity sectors most exposed to a change in government. This article seeks to highlight how changes in US foreign policy could be market relevant for the coming year.
Foreign Policy as Market Driver
Historically, US foreign policy mattered little to investment decisions. During the Cold War, it was largely confined to decisions to grant improved market access to emerging markets (EM), at the time a very marginal investment niche. In the post-1989 era of hyper-globalization, US foreign policy affected financial markets mainly via geopolitical risks and commodity prices, though even that relevance declined with lower oil intensity among industrialized economies.
This changed after the Global Financial Crisis, which laid bare the hollowing out of the middle class in established democracies, partially as a result of the global trading system. In addition, the internationalization of monetary policy meant central bank decision making processes began to intersect with foreign economic policy, both in formal settings (e.g., G-20) as well as ad hoc. Hence the term ‘currency wars’, which entered the international affairs lexicon in 2010. But it was not until 2016 that global exchange rate policies as well as trade relations became sensitive to the US political cycle, as evidenced by subsequent trade tensions.
For the 2020 election, we see four foreign policy areas relevant to investors, each for different reasons:
Effect of US-Chinese Rivalry on Capital Flows
First, the obvious: China. The secular trend of decoupling the globe’s two largest economies will continue unabated as US-China relations have bipartisan consensus in viewing it as adversarial. The tone and approach could change, but not the overall direction. While trade was the most glaring dispute at the outset and was then followed by technological dissociation, US-Chinese rivalry will now increasingly affect capital flows.
The reverse is likely to take place as well with soft incentives and hard rules deterring US institutional investors from providing capital to Chinese enterprises. While there are some individual firms that may struggle with these new obstacles, this should not affect the underlying valuations of the US or Chinese equity markets overall. Similarly, Chinese bonds could continue to offer the same relative portfolio appeal for developed market investors, notably low correlation and higher yields.
Exchange Rate Stability a Rare Source of Good News for EM
We believe the primary adjustment would occur via the exchange rate instead of stock or bond valuations. Figure 1 shows the USD/CNY exchange rate as well as the yuan’s real effective exchange rate (REER) since Donald Trump took office in January 2017. It illustrates that the bilateral currency pair can deviate from broader foreign exchange (FX) dynamics as well as experience episodes of sudden repricing.
In our view, the main differentiator of a Biden Administration is that FX volatility would be lower and less politically driven. In this context, the second aspect would be the spillover effect on other EM economies. A depreciating US dollar is supportive as is a stable, if not appreciating yuan.