Will the Strong Dollar Continue to Threaten Emerging Markets?

Historically when the US dollar is strong, emerging markets do not perform well - and 2015 has been no exception. Will the dollar index continue its damaging rally next year?

Emma Wall 8 December, 2015 | 11:48AM
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Over the past five years the DXY dollar index has grown around 40% – while emerging markets have struggled to recover to pre-credit crisis levels. Thanks to quantitative easing and record low interest rates the US has dragged itself out of recession – and now, poised on the edge of a rate rise it has a strong currency and the GDP growth to prove it.

History shows that a strong US dollar has not been kind to emerging markets and Asian equities, points out Samir Mehta, senior fund manager at JO Hambro Capital Management, and this cycle is no different.

“Asia is a heterogeneous region with one unifying factor – that when the US dollar is strong it struggles,” said Mehta. “When the dollar is weak, cash floods into emerging markets. Credit is easy to come by and corporates and consumer make bad investment decisions – borrowing to buy retail space, houses and cars. As the dollar strengthens liquidity falls, rates rise and people have less cash to spend which leads to economic slowdown. Businesses which were propped up by cheap debt have to restructure or go bankrupt.”

When the dollar is weak investors want exposure to other currencies. When the dollar is rising, investors sell out of those other currencies to chase the strong greenback.

Graph showing When the US Dollar is Strong, Emerging Markets Falter

Right now, the dollar is strong because US sentiment seems to be positive. Morningstar’s director of economic analysis Robert Johnson gives the US economic growth forecast for 2015 is likely to come in at 2.5%.

“Recent central bank commentary was very dollar supportive and it remains difficult to bet against further strength over the next few months,” said Morningstar UK’s head of investment strategy Andy Brunner. “With the US Fed itching to raise rates, and headline CPI expected to soar in the New Year from zero to at least 1.5%, US treasury yields should head higher taking gilts in their wake.”

What Does this Mean for Emerging Market Investors?

Kenneth Akintewe, senior investment manager at Aberdeen admits that fund flows have certainly been tricky this year, but he says that does not mean there ceases to be good quality companies in the region.

“The Chinese stock market has been volatile, and the powers that be did themselves no favours by attempting to prop up the market and they lost credibility,” Akinkewe admits. “But Chinese corporates are becoming much more efficient, building high speed railways in the US and producing high quality, innovative products – electric cars, mobile phones and even missiles.”

And China may be the dominant market but it is not the only player – smaller economies such as Sri Lanka also offer global players; clothing exporter Brandix for example.

A graph showing a weak US dollar floods emerging markets with cheap credit

These stellar stocks will be standouts however, as the world at large goes through a period of slower growth.

“We are not in a structural bull market,” says Mehta. “We are in a downtrend, a de-growth environment where stock picking is king.”

Is the US Dollar a One Way Bet?

But before you write off all hope for emerging markets, it is worth noting not everyone is bullish on the US dollar. Raymond Kong, director of equity portfolio management for One Asia Investments said that being long on the US dollar, short on the euro or betting on the dollar index (DXY) is overplayed.

“In the US, economic growth is still weak. Third quarter GDP numbers were below expectations. This follows a raft of disappointing economic data including falling consumer confidence last month and last week the latest nonmanufacturing purchasing-managers index shows a sluggish economy,” he said. “Add to that high yield bonds are now headed for the first annual loss since 2006. The declines are worrying because high yield market declines have the reputation of forewarning economic downturns.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Emma Wall  is former Senior International Editor for Morningstar