(Photo: AP)

Emerging markets look more vulnerable than initially thought as the drumbeat of a global trade war crescendos, according to some of the world’s largest money managers.Goldman Sachs Group Inc. said it’s reducing an overweight position in developing-nation currencies, preferring a more “defensive” stance as China and Europe warned the escalating trade war could trigger a global recession. Citigroup Inc. cautioned that investment flows into emerging-market assets will subside, while Morgan Stanley lowered its recommendation toward the asset class, citing the risk of a stronger U.S. dollar and ballooning trade threats.

Investors are increasingly paying heed as the U.S. digs in. After a flurry of tit-for-tat tariffs, Washington is mulling a new front by potentially ratcheting up scrutiny of Chinese investments, according to people familiar with the plans. Outflows from U.S.-listed emerging market exchange-traded funds that invest across developing nations, as well as those targeting specific countries, hit $3.38 billion last week, the most in more than a year.

The implications are familiar.

“A significant slowdown in trade would materially deteriorate the global growth outlook with repercussions for risky assets,” Elia Lattuga, a cross-asset strategist at UniCredit Bank, said in a note dated June 22. Emerging markets would be “especially exposed,” he said.

(Related: Emerging Markets: More Downside to Come)

While there’s no clear resolution to the fiery trade rhetoric, some money managers are taking a more optimistic medium-term outlook. UBS Global Wealth Management, which reduced its weighting on emerging-market equities to neutral, said trade risks should wane in coming months and help support a double-digit rally in the asset class.

There’s limited downside risk to “already very cheap” developing-nation currencies as any nasty surprises from Donald Trump would only prompt a “temporary and very bitter-sweet sugar high for the greenback,” according to Ashmore Group Plc.

Getting Defensive

Most major developing-nation currencies weakened against the dollar on Monday, while stocks fell to their lowest since August.

The Trump administration’s threat last week to impose levies on another $200 billion of Chinese goods has increased the risk of a trade war and led to a “risk-off” environment in emerging markets, according to Goldman.

“While we have been inclined to discount previous trade rhetoric, we are now taking a more defensive view,” the firm, which oversees more than $1 trillion of assets, said in its fixed-income weekly report on June 22.

Similarly, Credit Agricole is keeping risk-aversion strategies in place, according to analysts led by Valentin Marinov. Emerging-market central banks would eat through their reserves defending their currencies in a trade war, selling Treasuries and contributing to the U.S. yield advantage, they said.

‘Appetite for Destruction’

Monetary policy would be complicated as a flight to safety weakened emerging currencies, pushing up inflation in an environment where growth is “dented by decreased trade volumes,” Isaah Mhlanga, an economist at Rand Merchant Bank, said in an emailed note. That would drive regulators to lift rates to slow price growth, further cutting into economic expansion, he said.

In a report titled “Appetite for Destruction” Commerzbank AG analysts led by Ulrich Leuchtmann warned that it’s tricky to predict where the spat will lead.

“After all, who can estimate the impact of a process that has been unprecedented in trade policy since the middle of the last century?”

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