Photographer: Cesar Rodriguez/Bloomberg

Welcome to the Great Unraveling of the Global Convergence Trade

Traders ponder a new era for globalization post-Trump.

What's old is new again.

Market participants seeking a framework in which to play the unexpected election of Donald Trump as U.S. president would do worse than to reach into the archives, all the way back to the early 2000s, when investors sought to profit from the expansion of the European Union. Fueled by a vision of a borderless Europe with a shared currency, strengthened trade and heightened economic growth, hedge funds and other traders laid on bets that would benefit from the region's growing political-economic ties in the form of a "convergence trade."

These trades sought to exploit the diminishing difference between risk premiums demanded by investors to invest in various euro-area countries, with the foremost examples taking place in government debt. The spread between 10-year Italian government bonds and their German equivalents, for instance, reached a low of 10 basis points in 2003, before surging to 5.3 percent in early 2012, during the the height of the continent's crisis. That event cast into sharp and sudden relief the fiscal cracks among euro-area members that had, to some degree, been papered over with financial and political enthusiasm for the EU experiment, helping to fuel housing booms in Spain and profligate official spending in Greece.

Investors that had bet on continued compression in euro spreads found themselves caught out, while others who had long waited for risk premiums to diverge finally saw profits.

converge

Now the election of Trump threatens to take a similar swipe at global markets that have grown used to years of trade liberalization. In the two decades prior to the financial crisis, the dismantling of capital controls, a flurry of free trade deals, and governments' capitulation to demands from multinational companies to cede a degree of national control on economic policy all helped to ignite cross-border trade and capital flows.

These unfettered investment flows helped to reduce sovereign-risk premiums from South Africa to Mexico, while the global trading system buoyed investment and technology transfers to emerging-market nations, feeding hopes that the latter would eventually accede to developed-market status.

Fast-forward to November 2016 and the shock emergence of President-elect Donald Trump — driven, in part, by perceptions of a collapse in the legitimacy of political and economic institutions — could usher in a new dark era for globalization, amid heightened prospects for restrictive trade policies and tighter migration flows, say analysts.

"Trump's protectionist policies may prove another big step back in the gradual unwinding of goods globalization that has defined the past 30 years," Asia analysts at Nomura Holdings Inc. led by Mixo Das, wrote in a report.

The result: a tentative slowdown in the speed at which emerging-market economies converge with their developed peers amid oncoming restrictions on the free movement of goods, services, labor and capital across the developed world, they predict — combined with collapsing support for supranational bodies.

JPGCSOSD Index (J.P. Morgan EMBI 2016-11-09 16-51-35

The slowdown — or unraveling — of economic convergence mirrors a wider breakdown in global politics. "Investors are witnessing an electorate split between extreme right and extreme left. It is global and it is fueled by dissolution of labor markets and stagnating productivity," Macquarie Group Ltd analysts, led by Viktor Shvets, wrote in a research note.

"It is the reverse of 1980s-1990s, when left and right converged on the center-right strategies of globalization and the belief the private sector knows best. Whether left (Sanders, Warren, Corbyn, Clinton) or right (May, Le Pen, Trump) consensus is now the public sector must play a larger role sponsoring growth directly, or by co-opting the private sector, and the pace of globalization must be slowed (or reversed)," the analysts conclude.

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