Who will benefit from the weak dollar
Could a weakening dollar benefit emerging markets over the next decade? The analysis of Natalya Zeman, Investment Director of Capital Group
Historically, the dollar and emerging market equities have always had an inverse correlation: during periods of dollar appreciation, emerging market equities lost ground to developed markets and vice versa. With the dollar depreciating sharply in recent months, many have started to think that the greenback's long bullish decade may finally come to an end. The question, then, is whether this environment can incentivize a new wave of outperformance for emerging market equities.
WILL THE WEAK DOLLAR ALLOW EMERGING MARKETS TO OUTPERFORM?
The dollar remains the dominant currency of international trade: about half are denominated in dollars and international payments are mostly made in dollars. When the dollar is solid, companies operating in multi-currency economies use it to quote and settle transactions. This drives up the cost of imports, which can hurt margins for emerging market companies. A solid dollar is also associated with a "flight to safety" tendency. Investors have typically fled to the currency in times of uncertainty – such as in 2022 when Russia invaded Ukraine – due to its liquidity, reserve status, track record of economic and political stability, transparency and the rule of law.
Looking ahead, however, there are signs of a possible cyclical weakening of the dollar and this outlook generally favors emerging market equities. Structurally, after 15 years of US economic and currency leadership, the region's relative attractiveness relative to emerging markets may decline. Once again this supports the argument in favor of a diversification of investment portfolios away from the US, towards international and emerging markets. History indicates that the Fed's reduction of key rates should coincide with a weakening of the dollar. Higher relative rates in the US lead to an attractive carry for investors. As this gap begins to close, relative returns lose their attractiveness. Historically, the strength of the dollar tends to weaken when Fed rates are falling, and vice versa.
Emerging markets have outpaced US markets during and after recessions. Since the first investments in emerging markets in the late 1980s, the US has experienced six technical recessions, which tended to occur during or after the end of a cycle of rate cuts. The dollar has generally strengthened during recessions – times when investors seek safety. Finally, the data shows that the relative attractiveness of the US relative to emerging markets is declining. The US trade deficit continues to widen, financed by external debt. The US trade deficit increased by 112% at the end of 2022, financed by borrowing from other countries. The US debt-to-GDP ratio increased from 57.2% in 2002 to 129% in 2022, and nearly half of all US external debt stems from just five countries: Japan, China, the United Kingdom, Belgium and Luxembourg.
DIVERGENT PERSPECTIVES
The prospects for economic growth are divergent. The growth forecasts of the International Monetary Fund (IMF) for emerging markets are equal to +3.9% for 2023 and 4.2% for 2024. They are, however, significantly lower for developed markets: 1.3% for 2023 and 1.4% for 2024. Economic cycles also seem to diverge: the US is at the end of its cycle and continues to fight inflation, emerging economies are recovering. The likelihood of a policy-induced recession in the US has also increased due to the crisis in the region's banking sector.
Emerging markets are also becoming less sensitive to the dollar cycle. Increased local financing and more mature capital markets reduce the debt risk and risk of capital flight historically associated with a rising dollar. As local currency bond markets developed, foreign investors began to participate directly in these markets, as did sophisticated long-term investors in local emerging markets such as banks, insurers and pension funds. Local currency debt markets have therefore rallied sharply over the past decade and capital markets have matured to include more sophisticated instruments, for example as a hedge against currency and inflation risks. This trend is expected to continue for equity and local currency debt markets, with further development of emerging market capital markets.
In recent years, many emerging markets have focused on diversifying their economies – promoting domestic consumption, investing in infrastructure and education, and encouraging the development of high-tech and service sectors. China and India, for example, now the world's two most populous countries, have large and growing domestic consumer markets, accounting for about a quarter of global consumer spending. However, it is important to note that a substantial change in the dollar's status as a world reserve currency would take quite a long time. According to IMF data, the dollar accounted for 58% of all central bank reserves during the fourth quarter of 2022, the euro just over 20% and the renminbi just 2.7%. As always, the risks to this prospect of a weakening dollar and a potential solid period for emerging markets are worth considering.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/dollaro-debole-mercati-emergenti/ on Tue, 15 Aug 2023 05:36:32 +0000.