Bearish signals for EMs
A rising US dollar tends to be a headwind for emerging markets, so renewed strength is not encouraging
There aren’t many high-level relationships in investing that seem to work consistently, but the connection between the strength of the dollar and the performance of emerging markets (EMs) is one. When the dollar goes up, EMs tend to struggle; when it is weak, EMs have a much better chance of delivering good returns.
There are two broad explanations for this, the first of which hinges on pretty much what any investor would predict about capital flows. EMs tend to have relatively small, immature capital markets of their own. They are heavily affected by flows from foreign investors. If foreigners are keen to invest, it pushes up the price of shares, or makes it easier for them to borrow at lower rates.
The US is the world’s largest and most liquid capital market and so US investors are major providers of investment in emerging-market assets. When the US dollar rises, it’s usually when US investors are taking their money home. That’s either because it’s a crisis and they are ditching everything to buy the assets that make them feel safest (ie US Treasuries), or because US interest rates have gone up and US assets look more attractive, so they no longer have much interest in looking for higher returns in riskier markets. Investors from other markets may also head into US assets for the same reason, draining further capital.
The less obvious explanation involves global trade. Many EMs are very export dependent. In theory, a stronger dollar relative to their own currencies should help to improve trade, because it makes their exports cheaper for US buyers in dollar terms. However, the US dollar is still the dominant medium of exchange for international transactions: the majority of transactions settle in it and exchanges of other currencies route via it.
Thus a stronger dollar tends to depress global trade growth because financing trade becomes more costly. For an exportdependent economy that means slower growth. And given that many listed companies in these economies are often quite geared to either exports or the economic cycle, that becomes a headwind for earnings.
On a trade-weighted basis, the US dollar has come back from the highs it hit last year, but this month the decline seems to have bottomed out – maybe due to expectations that interest rates would remain higher for longer. EMs had made a decent start to the year, up 4% in local currency terms, but are now looking a little more unsteady. While it’s increasingly dubious to treat all emerging-market economies alike – China, India and Brazil are all very different, to take just three major ones – history suggests that if the US dollar picks up more momentum, it would be a bearish short-term sign for EMs in general.
“The dollar is the dominant medium of exchange for trade”