Should we rethink what a strong dollar means for emerging markets?

When the US dollar strengthens, investors usually assume that emerging market equities will struggle, and vice versa.

So why does this happen? Firstly, a lot of emerging market economies are saddled with dollar-denominated debt so, if the currency strengthens, their loans become more expensive to pay back. Another reason is that, during times of caution or uncertainty, investors will turn to the US dollar for comfort and instead shun supposedly higher-risk investments such as emerging markets.

Does this mean investors should give up on emerging markets?

In our view, no. I recently came across some interesting research from Aberdeen Standard, which houses Elite Rated funds such as Aberdeen Emerging Markets Bond and Aberdeen Latin American Equity. It showed that, over the last six periods of rising US Treasury yields, emerging markets outperformed in four.

Co-chief investment officer Andrew Lister told me: “We think the perceived wisdom that a strong dollar and rising rates in the US naturally translate to weak performance for emerging market assets is a gross oversimplification, and yet it seems firmly embedded in the current investment narrative,” he said.

He explained that, because interest rates have been so low for so long, what happens now is that investors get nervous whenever there is talk of a rate rise, so they sell out of equities and flock to ‘safe haven’; assets. But, when interest rates do actually rise, they are often not as extreme as the market has already anticipated. And so, investors breathe a sigh of relief and return some of their money to the stock market. This is called a ‘relief rally’; and tends to happen in both equity markets and currencies*.

I also spoke to the emerging markets team at M&G, who pointed out that the relationship between the US dollar and emerging markets is incredibly complex.

“Currencies are driven by a multitude of factors as indeed are emerging market economies,” they said. “There are also more than 20 countries in the MSCI Emerging Markets index, each of which has different drivers economically and very, very different market compositions. What is clearly evident however is that over the past few years those countries running current account deficits have been hit the hardest as it means they hold more dollar-denominated debt.

“In a world of higher US interest rates and more investors wanting to hold US dollar assets, this can be challenging. On the other hand, most emerging market deficits have narrowed over recent years, making those economies and their currencies somewhat less exposed to a rising US dollar.

Dr Ian Mortimer, who co-manages the Elite Rated Guinness Global Equity Income fund alongside Matthew Page, agrees that healthier balance sheets in many emerging market countries have made equity markets more resilient to a rising US dollar.

“The adage that a strong dollar is bad for emerging market assets is no longer as straight forward as it maybe once was. Emerging markets are dominated by Asia today and, in Asia, we have seen successful central bank changes which mean many countries have less dollar-denominated debt,” he explained.

“What we have seen recently, however, is investors moving out of emerging market equities. Following the financial crisis, many investors bought emerging market assets because the yields were higher than in developed markets. But now that interest rates in the US are rising, the yield difference has become slightly less compelling. This is in conjunction with increased trade war tensions, which is making investors nervous.”

Ian is positive on emerging markets though, as he believes the regions will benefit from better-than-expected growth – many countries, unlike in the developed world, are in the early stages of their current economic cycle.

Here at FundCalibre, we think the key is to pick the truly active managers, who can navigate any potential risks and tap into some of the high-growth and income-paying opportunities that emerging markets have to offer.

*Source: Aberdeen Standard. As of 27 July 2018.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.