Why is a Strong US Dollar Bad for Emerging Markets?

Why does a strong US dollar and a rising Federal Reserve bank rate often mean bad news for emerging market returns? And what does that mean for today's outlook?

Emma Wall 2 May, 2017 | 9:40AM
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Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm joined today by Salman Ahmed, Chief Investment Strategist for Lombard Odier to talk about emerging markets.

Hello Salman.

Salman Ahmed: Hi, good afternoon.

Wall: So, we often hear that a strong dollar and indeed a higher Fed rate are both bad for emerging markets. But I don’t think a lot of investors understand why, why are they bad?

Ahmed: Well, let's start with the dollar. I think the dollar's negative influence on emerging markets comes through two channels. The first one is a negative influence on commodities and you have a lot of commodity exporters in emerging markets. So that’s the negativity coming through. The second one is the external debt profiles of emerging markets. There is a balance sheet effect which happens when dollar goes up because the external liabilities go up as well, i.e. from the point of view of emerging market countries. So that’s where the negativity from dollar to emerging markets comes through.

In terms of Fed rates or interest rates in the U.S. actually the arguments are a bit more nuanced, it depends on what is causing the increase in the rates. So, in 2013 for example taper tantrum it was increase in real rates. It was seen as negative for growth and that was negative for emerging markets. But if the rates are going up because of growth than it can be positive for these developing nations.

Wall: Well, that’s the background. Now we're looking at the present situation in the U.S. the dollar is very strong, so strong in fact that new President even hinted it was too strong and rates are rising at a slower pace than we were expecting, but they are rising. What does that therefore mean for emerging market forecast.

Ahmed: So, I think if you look at historical data it tells you that it should be negative for emerging market assets, but it hasn’t been. And that is because the fundamental improvement in emerging markets over the last couple of years. When this confluence of factors came back in 2013, fundamentals of lot of these countries were very vulnerable and over the last three, four years what we have seen is these countries have improved especially current account balances. And that is now manifesting itself into a lower sensitivity to these factors than in the past.

Wall: How important is the U.S. still when it comes to looking at emerging markets. I know it used to be said that if the U.S. sneeze the rest of the world caught a cold. But indeed, emerging markets are becoming much more self-reliant and un-reliant on their neighboring countries, aren’t they?

Ahmed: Precisely I think this has been a key shift over the last I would say five to seven years. That emerging market dynamics are becoming way more heterogenous. And as you referred there is a clear-cut trend in fact after Trump administration coming through. Trend towards what we call globalization 2.0, whereby regional dynamics and for example China trading with its neighbors, i.e. connecting Eastern India to Western India. It is globalization in itself as well. Those dynamics are manifesting itself in stronger domestic demand and that is one precise factor which I think is very different from the last 10 to 12 years.

Wall: So, protectionism may actually end up being worse for the U.S. than it is indeed for emerging markets.

Ahmed: I think in some cases it will be and in fact over the last few weeks we have seen the definition of protectionism being challenged. In fact, I was at the IMF meeting recently and IMF individuals are saying protectionism is a very ambiguous term.

So, you can see that this is the kind of thinking which is coming through whereby we have to be very clear about what kind of protectionism we are talking about. The good thing is that at the top level, China, U.S. trade war looks unlikely and that is positive thing for emerging markets.

Wall: Well, you did touch on early, you said that emerging markets are increasingly heterogenous, does that mean that you shouldn’t expect all emerging markets to be positive.

Ahmed: I think this is a world of winners and losers and survivors. So that means this heterogeneity we have to think about very, very carefully what is the chain of factors and what will be response of these countries and what other reforms in different countries are taking place. So, they are for example the vulnerable ones I would characterize as South Africa, there is political noise there, Turkey to a certain extent, although some uncertainty is coming down after the referendum results. While I really like India, I think it's a very strong fundamental profile. I still like Russia a lot, because it is one of those countries which screens very, very strongly on fundamental basis.

Wall: Salman, thank you very much.

Ahmed: Thank you.

Wall: This is Emma Wall from Morningstar. Thank you for watching. 

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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Emma Wall  is former Senior International Editor for Morningstar