The Dollar leads Emerging Markets equities: The veteran's mantra
- Stable US$ reduces fundamental FX rate and fund translation risks in EM equities and fund inflow trends mirror US$ moves
- EM equity index performance is very correlated with US$ over the last 3 years, but much less so on 5-20 year time frames
- Country mix changes in EM might explain this. China's dominance in EM index and rise of locals might weaken the US$ link
The mantra that I have heard in emerging markets is that any pitch for funds from asset allocators gets off the ground much more easily when everyone in the room (I guess, these days, I should say "on the call") agrees that the outlook for the US$ is stable and, ideally, weak.
In contrast, a strengthening US$ forces EM equity fund managers to walk up a down escalator: the FX rates in the countries where their favourite companies operate face downward pressure (unbearably so for countries with external account vulnerabilities and low policy credibility), the risk is compounded if those companies rely on imported inputs where changes in costs cannot easily and promptly be passed on without destroying demand, and, to cap it all, there is an additional whammy from the translation of local currency public equity positions into a US$-denominated fund.
At times it can feel that the thousands of lines of spreadsheet modelling produced by an EM portfolio team, built on hundreds of hours of meetings with management, utilising all their collective financial analytical, linguistic and forensic skills to determine the portfolio are trumped by the outlook for one variable: the US$ (which, ironically, most EM teams do not tend to forecast).
Correlation of US$ and Emerging Markets
A chart of net inflows into EM equity funds and the US$ (or, more precisely, the inverse of the US$), over the last ten years, suggests that both trend in the same direction.
When looking at the US$ (inverse) and the MSCI EM index over the last 20 years, it also appears that both trend in a similar fashion. However, the correlation of the US$ and the EM index is much greater in recent, shorter time periods (6 months to 3 years) than over longer ones (5 to 20 years).
This lower correlation over longer time periods may be a result of the significant changes to the country composition of the MSCI EM index. Not only is the MSCI EM time series ever changing but, as with most equity indices, the weight of successful investment stories grows over time ("survivor bias").
Challenges to the US$ and Emerging Markets mantra
As long as the world regards the US$ as a safe haven in times of global crisis (ie the US$ remains the dominant reserve currency) then it is safe to say that until the crisis passes (whether Covid-19, an oil supply scare, a geopolitical flash point, or all them at the same time as we have seen in 2020) then it is unlikely that local currency EM equities can outperform developed markets and global equity benchmarks (both of which are dominated by US equities).
Outside of these crisis periods, we offer the following reasons why the mantra on the US$ and EM might be more challenged in future.
- China – The weight of China in global GDP and in the EM equity index is approximately 20% and 40%, respectively.
- As China becomes a bigger driver of trade and cross-border investment the fate of countries in EM could become proportionately more linked, in terms of fundamental drivers, to the Renminbi (although the US$ translation link, in terms of how equity funds report their returns, would persist).
- Separately, if there is significant restriction on US institutional capital flows to China, as result of US foreign policy changes, then the EM index could move significantly for reasons completely independent of the US$.
- Domestic versus foreign investor pool- The domestic investor pool, which is usually much more sensitive to total returns in local currency, rather than US$ terms, compared to the international one, may come to dominate (in terms of share of traded value on equity markets) as:
- Emerging countries grow more wealthy;
- Channels for illicit high net worth capital flight are tightened;
- Domestic pension management becomes more institutionalised;
- Foreign investors ignore more and more of the "smaller" countries in EM (the big-3, China, Taiwan and Korea, already account for over 60% of MSCI EM); and
- Local interest rates (bank deposit and government bond yields) fall.
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