(The views expressed here are those of the author, the founder and CEO of Emmer Capital Partners Ltd)

The maxim “buy the rumor, sell the news” characterized currency markets in the months following Donald Trump’s first presidential election victory in 2016, as the original ‘Trump trade’ was unwound.

If the current version of this trade plays out similarly, the initial beneficiaries will likely be emerging markets that are ‘short’ the dollar, either via U.S. dollar borrowings or a large current account deficit. But EM investors should remember how widely the dollar swung the first time around as they consider how to position themselves for Trump 2.0.

Since the third week of September, the U.S. dollar has strengthened 4.0% against a basket of EM currencies, the S&P 500 Index has risen by 8.0%, and the U.S. 10-year Treasury yield has jumped by around 60 basis points (bps). This so-called ‘Trump trade’ reflects expectations of lower taxes, strong growth, more national debt, higher inflation and a slower pace for Federal Reserve rate cuts.

These market moves closely parallel the shifts seen in the months surrounding the 2016 election. From around the third week of October 2016 until the second week of January 2017, the U.S. dollar appreciated by 6.5% against the EM currency basket, the U.S. 10-year Treasury yield spiked 100 bps, and the S&P 500 rose by almost 9.0%.

This trade was largely driven by hopes of growth-boosting tax reductions and infrastructure spending. However, optimism about the growth outlook faded soon after Trump was inaugurated, dragging down the dollar.

Ultimately, Trump trade 1.0 lasted only around three months. The dollar and Treasury yields reached their 2017 peaks just before Trump’s inauguration in January. Over the following six months, the greenback depreciated almost 8.0% and the 10-year yield dropped 55 bps.

LOOKING FORWARD

Fast forward to 2024-25, and the main difference this time around is that the second Trump administration will enter office with a Republican super-majority, likely enabling smoother implementation of its proposed agenda, including corporate tax cuts, mass deportations and a vast swathe of import tariffs.

But does that mean the dollar will continue appreciating? Not necessarily.

It’s true that U.S. import tariffs usually lead to depreciation of the target country's currency against the dollar so that the price of imports remains relatively unchanged in dollar terms. In the present episode, however, the tariffs have been well telegraphed. Thus, many of the target countries' currencies have already depreciated significantly, most notably the Chinese yuan.

Moreover, the Federal Reserve’s rate reduction path is likely to continue, albeit more slowly than many experts thought a few months ago, and this easing is apt to curtail dollar strength. It’s notable that the yield on the U.S. 10-year Treasury slid around 25 bps last week from its post-election high.

Finally, the dollar already appears to be overvalued. The U.S.’s Real Effective Exchange Rate is at a 10-year high, according to CEIC, a global economic data provider. This indicates that U.S. exports are as expensive as they’ve been in a decade.

In short, the fundamental cards seem stacked against an already overvalued dollar.

SHORT SQUEEZE

If the Trump trade does turn and the dollar depreciates, this could be good news for the many emerging economies that are ‘short’ the greenback, meaning they have significant dollar-denominated debt, large current account deficits or a combination of the two.

EM countries collectively hold $10 trillion in external debt, most of it denominated in U.S. dollars. This total has almost doubled over the past decade, aided by the near-zero interest rates in the U.S. over much of that period.

While external debt is Asia has mostly plateaued in recent years (Malaysia is a notable exception), foreign liabilities have continued to rise as a proportion of GDP in the Americas, Europe, the Middle East and Africa. This is particularly notable in Eastern Europe and Latin America, where foreign debt ranges between 50% and 125% of GDP.

Among currency depreciation victims, Hungary, Chile, Poland and Czech Republic figure prominently. They are also, unsurprisingly, among the top external debtors.

Countries that have both high levels of external debt and large current account deficits, meaning their imports greatly exceed their exports, include Chile, Turkey, Egypt and Colombia, and, to a lesser extent, South Africa, Philippines and Peru.

This large ‘short’ position is clearly a vulnerability when the dollar is strengthening, but when the greenback depreciates, these countries see their imports get cheaper and the value of their external debt declines in local-currency terms.

UNINTENDED CONSEQUENCES

EM countries that have suffered the most due to dollar strengthening in recent months are thus poised to gain the most if the Trump trade reverses as it did during the president-elect’s first trip to the Oval Office.

But the story isn’t quite that simple.

While the dollar did weaken early in Trump’s first term, it then took another turn and started appreciating after the implementation of tax cuts in December 2017 and the imposition of large import tariffs in early 2018.

EM currencies responded in kind. From April to October 2018, the Hungarian forint depreciated by 12.7%, while the Polish zloty and Chilean peso fell by 11.5% and 14.4%, respectively. Among the exporters to the U.S. hit by tariffs, the Chinese yuan and Mexican peso depreciated by 10.8% and 11.4%, respectively.

So even if Trump Trade 2.0 turns, EM investors shouldn’t get too comfortable because another sharp turn could be just around the corner.

The views expressed here are those of the author, the founder and CEO of Emmer Capital Partners Ltd. and the former Head of Asia-Pacific Equity Research at BNP Paribas Securities.

(Writing by Manishi Raychaudhuri. Editing by Anna Szymanski and Mark Potter)