Is the US dollar to blame for EM woes?

Investors who had bought and held EM local currency debt in 2013 would have been unlikely to make any money over the following 11 years. The deprecation of EM currencies would have likely eaten up the interest earned. Similarly, had you invested in EM equities, you would likely have underperformed global equities by 50%, not counting the exchange rate loss.

EM may have some flaws, but fundamentals can hardly explain such underperformance. A more likely culprit in our view is the US dollar cycle. In 2013, the US Federal Reserve (Fed) started tapering its quantitative easing policy. This set off a surge in the dollar which has lasted to this day.

Assessing the EM – US dollar relationship

To illustrate the impact of the dollar on EMs, the chart below identifies six episodes of equal length where the dollar moved significantly – three of dollar strength and three of dollar weakness.

Let’s now consider whether EM performance differs during episodes of dollar strength versus episodes of dollar weakness and if so, by how much. Well, it turns out that the dollar cycle can have a big impact.

The average emerging market economy has historically grown less during periods when the dollar is strong, namely 3.4% versus 5.7% during periods when the dollar is weak. This result and all following results are statistically highly significant.

Exchange rate regimes also matter. Countries with pegged exchange rates have historically tended to be hit twice as hard as countries with floating exchange rates. This points to financial conditions as the main transmission channel. Indeed, EMs have historically experienced credit growth of just 9% when the dollar is strong compared with 16% when the dollar is weak.

Tighter financial conditions can also stymie EM domestic demand. We observe much weaker investment and consumption during episodes of dollar strength. However, a strong dollar also weighs on EM’s external demand. While US growth shows no systematic variation, other advanced economies have historically grown a third slower during episodes of dollar strength.

These slowdowns in activity are reflected in EM asset valuations, in our view.

During phases of dollar strength, EM currencies have historically tended not only to depreciate against the dollar, but also against a broader basket of trading partner currencies – and by more than their higher inflation rates would require. High-yielding currencies are particularly sensitive to the dollar cycle.

On average during the periods under review, the credit spread of EM sovereigns over treasuries tightened by 130bps in years when the dollar was weak but widened by 30bps in years when the dollar was strong.

Finally, EM equities appreciated by 11% in local currency when the dollar was strong, a far cry from the 38% observed during episodes of dollar weakness.

What are the implications for investors?

The Fed is expected to cut interest rates more than other central banks over the next year. This rate cutting cycle starts with the US dollar being in expensive territory in our view. Based on our analysis of the DXY index, since 1970 (inception of the DXY index) the dollar has been more expensive only a third of the time.

We believe this combination of an elevated valuation and potential US rate cuts could provide a headwind to the value of the US dollar. This, in turn, could be good news for emerging markets.

All data sourced from Bloomberg as at August 2024. Past performance is not a guide to the future. Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.