The Impact of US Tariff Risks on Emerging Markets: An In-Depth Analysis

Introduction

Understanding the complexities of emerging markets (EM) becomes even more challenging when considering potential US tariff risks. The US election coming up has put the spotlight on tariff policies, which will have a big impact on EM currencies and stocks. This blog aims to give a full breakdown of how these risks might play out in different EM areas giving useful insights to investors.

Understanding the Tariff Risks

The US can shape global trade patterns through its tariff policies. As the US election draws near various combinations of fiscal and trade policies could affect the Dollar and EM currencies. Tariffs are noteworthy because they can change currency values, trade balances, and market feelings. For instance, if the US were to impose a 10% tariff hike across all sectors, it could lead to significant shifts in global trade flows and cause various EM currencies to depreciate against the Dollar. This type of broad tariff increase would likely reduce the competitiveness of exports from EM countries, impacting their trade balances and economic growth.

Currency Sensitivities to Tariffs

Emerging market currencies with high beta, such as the Korean Won (KRW), Colombian Peso (COP), and Indonesian Rupiah (IDR), tend to react sharply to episodes of declining tariffs. Historically, these currencies have strengthened significantly when trade barriers are eased, benefiting from increased global trade flows and improved risk sentiment.

According to the latest data, the KRW, COP, and IDR posted the largest gains, each appreciating over 1.5% against the USD during tariff relaxation periods. Other high-beta currencies, including the Malaysian Ringgit (MYR), South African Rand (ZAR), and Chinese Yuan (CNY), also showed notable gains, reflecting their trade-dependent nature.

Conversely, Central and Eastern European (CEE) currencies, such as the Czech Koruna (CZK) and Polish Zloty (PLN), exhibited more moderate appreciation, suggesting lower sensitivity to trade-related events. Meanwhile, the Hungarian Forint (HUF) was the only currency to weaken, indicating idiosyncratic risks or economic challenges unique to the region.

This data reinforces that Asian and Latin American currencies tend to benefit the most from lower tariffs, while CEE currencies remain relatively stable, and select emerging market currencies, such as the HUF, may even underperform in such scenarios.

Fundamental Exposures to US Tariffs

Emerging market (EM) equities with high revenue exposure to the US are particularly vulnerable to tariff risks. The MSCI EM index reveals that North Asia (Taiwan, Korea) and Latin America (Mexico, Brazil) have the highest goods revenue exposure to the US, ranging from 10% to 24%. Notably, Taiwan leads with 24% exposure, followed by Korea and Mexico at 16% each, making them more susceptible to potential trade restrictions.

For instance, Taiwan Semiconductor Manufacturing Company (TSMC) derives a significant portion of its revenue from the US, heightening its risk exposure. Similarly, Mexico’s strong reliance on US trade for goods places it at greater risk of tariff-related disruptions.

Conversely, India, Thailand, and Kuwait maintain a more balanced trade profile, with higher services exports contributing to US revenue rather than goods. India’s US revenue exposure is primarily service-based (4%), driven by IT and financial services, while its goods exposure remains low (2%).

Meanwhile, CEE-3 countries (Poland, Hungary, and the Czech Republic) and China have minimal direct exposure to US revenue, benefiting from wider trade diversification. This suggests that regions with lower US reliance, particularly in services, may be better insulated from tariff volatility compared to manufacturing-heavy economies like Taiwan, Korea, and Mexico.

Equity Market Reactions

Tariff-related reactions have varied across different EM equities. Last year, tariff announcements had a significant impact on South African, Brazilian, and Chilean equities. These markets experienced the highest levels of volatility and decline in response to tariff changes, particularly affecting their growth rates and exchange rates against the USD and CNH.

For example, during the major tariff increases in 2019, South African equities declined by an average of 6%. However, Indian and CEE-3 equities (Poland, Hungary, and the Czech Republic) were more insulated from the US tariff impact. These markets showed less volatility in response to US trade policies, making them a safer choice for investors looking to minimize risk. To illustrate, the Indian stock market maintained its growth rate, with only a 2% decline during the same period.

Potential Scenarios Based on Election Outcomes

The potential results of the US election on international trade policies are:

Scenario 1: More Tariffs: The case with the highest tariffs on every product warrants a   depreciation of EM high-beta currencies and big plunges of companies having high US revenues in EM. For example, a 10% tariff increase would cause the MSCI EM index to dip by 5%.

Scenario 2: The Status Quo: In case the current tariffs are kept, the market will calm down and there will be short-term volatile adjustments. Currencies like MXN and ZAR may find it a bit difficult to keep up with the Hong Kong dollar, while equities might have minor movements.

Scenario 3: Fewer Tariffs: EM currencies and equities would benefit from a reduction in tariffs. For example, if the US reduces total tariffs by about 5%, demanding markets like North Asia and Latin America could see 3-5% economic growth. Consequently, equities in these regions would likely rise similarly.

Limitations and Counterarguments

While this makes for a robust framework of analysis, several limitations exist:

• Market sentiment: The unpredictable shifts in investor sentiment result in deviations from historical trends.
• Geopolitical Factors: Other geopolitical events in the Middle East or Europe may have some bearing on EM Markets, whatever it may be, independent of U.S. Tariffs.
• Policy Changes: Any sudden policy change by the EM governments in response to the US's new tariffs can cause deviation from the expected outcomes.

Key Takeaways for Investors

1. High-Beta Currencies Monitoring: On top of that, close attention must be placed on high-beta currencies like MXN and ZAR, which are more sensitive to the tariff risks. The background seems to underperform against such an environment of increased tariff risks for these particular currencies.
2. Assess revenue exposures: Look at EM equities with a large portion of US export revenues. Those that are potentially most impacted from tariff-driven disruptions are companies in Korea, Taiwan, Mexico, and Brazil. Their performance is going to give early signals about the more general market trend.
3. Regional Diversification: Diversify into regions more immune to US tariffs, like India and the CEE-3, and add more stability from changes in US trade policy.
4. Bracing for Volatility: With the elections expected to be held closer, there is likely to be increased volatility within EM markets, especially with any potential adjustments in US trade policies. Of course, it will be quite a plus if investors are knowledgeable about political moves, given the ability of such political moves to predict changes in the market.

Conclusion

It requires a strategic approach to navigate the risks that can emerge from US tariffs, particularly for emerging market investors. Equipping the investor with knowledge of currency sensitivity and true fundamental revenue exposure enables them to plan on reducing risk but at the same time on exploiting any opportunity. Stay ahead of shifting global trade dynamics; the US election remains months away.

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