Since June, the US dollar has fallen by over 7 per cent against the euro and pound. For many equity investors, this is a welcome development.
I say so because there has for years been a close negative correlation between the dollar’s trade-weighted index (as measured by the BIS) and emerging market equities. For annual changes since 1994, this correlation coefficient has been minus 0.69. A strong dollar usually sees emerging markets fall – as happened in 1997, 2001, 2008 and 2015. And a weaker dollar sees them do well: this happened in 2000, 2003-04, 2009-10 and 2017-18.
It’s no accident therefore that emerging markets should have done well recently as the dollar has fallen: this is the normal pattern.
You might think such twin moves are the natural result of a loose US monetary policy, which is weakening the dollar and providing liquidity to drive emerging markets higher.
This is part of the story. But not all of it. Even if we control for the level and change in the fed funds rate, there has still been a significant correlation between the dollar and emerging markets.
One reason for this lies in the fact that correlation is not causality. Instead, both emerging markets and the dollar are driven by changes in investors’ appetite for risk. When this increases, investors obviously buy risky assets such as emerging markets. And they sell assets they perceive to be safe (such as US dollars) to buy riskier currencies such as sterling. For this reason, the dollar and emerging markets move in opposite directions.
A weak dollar, however, is also a direct benefit to emerging markets. For governments and companies with dollar-denominated debt, a weaker dollar cuts debt servicing costs and so raises real incomes. And because raw materials are priced in dollars, a weaker dollar reduces their cost in terms of domestic currency and so raises the profit margins of many emerging market firms.
For these reasons, a falling dollar is great for emerging market equities.
While it lasts.
Which doesn’t get us very far. It’s prodigiously difficult to forecast exchange rates, as economists such as Barbara Rossi at Barcelona’s Pompeu Fabra University and Menzie Chinn at the University of Wisconsin have pointed out. Knowing that a weak dollar is good for emerging markets is therefore little use if we cannot predict where the dollar is heading.
We do, though, have some reasons for optimism. One is that the dollar might not be wholly unpredictable. Martin Eichenbaum, Benjamin Johannsen and Sergio Rebelo have shown that, over longer time horizons, nominal exchange rates tend to fall after their inflation-adjusted equivalents have been high. With the dollar’s real rate still close to an 18-year high, this is a reason to suspect it could fall further in coming months.
And there are other reasons to expect emerging markets to rise.
One is simply that futures markets expect the Fed to keep interest rates near zero until well into 2022. Which means that monetary policy will support equities.
Also, emerging markets are relatively cheap. One gauge of this is simply the ratio of MSCI’s emerging market index to its world index. In the past, this ratio has helped to predict returns on emerging markets. It is now half a standard deviation below its post-1994 average, which points to emerging markets doing well.
Thirdly, emerging markets have momentum on their side. This matters. Assets that are driven by sentiment are eve more prone than others to momentum, simply because sentiment spreads from one person to another. We can exploit this fact by using a simple rule proposed by Meb Faber at Cambria Investment Management. He says we should buy when prices are above their ten-month (or 200-day) moving average and sell when they are below it. Such a rule has worked well for emerging markets for the last thirty years: it would have doubled your money relative to a buy-and-hold strategy since 1990. It is now telling us to buy.
We have, then, strong reasons for optimism.
Sadly, however, knowledge of the future can only ever be weak and tentative. There is always the danger of nasty surprises. In particular, if global investors’ appetite for risk were to fall for any reason or none, emerging markets would tumble – which would happen if, say, there is a second wave of the pandemic.
UK investors can, however, partly protect ourselves from this by holding US dollars, gold or gilts – all of which would probably rise if appetite for risk falls.
It makes sense to take a bet on emerging markets. Luckily, though, it is a bet we can partially lay off.