President Biden is a danger for investors in emerging market equities.
I say so for a simple reason. He’s planning on a massive loosening of fiscal policy: Democrats hope to get a $1.9 trillion stimulus package (equivalent to almost 9 per cent of GDP) through Congress by next month.
This could raise interest rates simply because people will spend at least some of the $1,400 cheques they get as part of the package – which could raise inflation.
Just how much it’ll do so is a matter of debate among the grand old men of economics: former Treasury Secretary Larry Summers and Olivier Blanchard at the Peterson Institute for International Economics say it will, but Nobel laureate Paul Krugman is less sure. For our purposes, though, what matters is the market’s opinion. If it expects interest rates to rise the dollar could well rise in anticipation of a higher income from it.
This of course is textbook economics. The standard Mundell-Fleming model tells us that fiscal expansions raise exchange rates.
Hence the threat to emerging markets. A stronger dollar is bad for these in two ways. First, a high level of its trade-weighted index leads to falls in MSCI’s emerging markets index, controlling for other things (which I’ll come to). Secondly, year-on-year rises in the dollar are associated with year-on-year falls in emerging markets.
My chart shows that these effects are powerful. It shows that the US dollar, along with just four other factors, has explained over three-quarters of the substantial variance in annual returns on emerging markets since 1995.
And the dollar’s impact is big. On average since 1995 a 10 per cent annual rise in the dollar’s trade-weighted index (controlling for other things) has been associated with 30 percentage points lower annual returns on emerging markets.
One reason for this is that a stronger dollar makes raw materials (most of which are priced in dollars) expensive in terms of domestic currency. That doesn’t just raise companies’ costs and hence squeeze profit margins. It also squeezes households’ purchasing power by raising food prices. That means weaker economies and perhaps even political instability.
Also, many emerging market governments and companies have debts denominated in US dollars. A stronger dollar makes it harder to pay interest and principal on these debts. At best this squeezes incomes and economic activity. At worst it can trigger financial crises.
If you’re holding a lot of emerging market funds, therefore, a Biden-boosted dollar is a danger for you. And because they are so highly correlated with emerging markets, mining stocks are also under threat from this direction.
There is, though, a complication here: how would the stimulus affect global investors’ appetite for risk?
The danger is that the prospect of higher rates could trigger a reversal of the “reach for yield” that has boosted equities not just since March but for years before then. Yes, interest rates aren’t going to rise soon. But if investors fear that others will fear a reversal of the reach for yield, US equities could fall well before rates rise. And falling share prices in the developed world would drag down emerging markets.
But the opposite could also happen. A stronger US economy could increase appetite for risk, to the benefit of emerging markets. Rises in US bond yields (a sign of increased appetite for risk) are usually associated with good returns on emerging markets.
Personally, I wouldn’t want to bet strongly upon which of these mechanisms will be more powerful.
What we can be more sure of is that emerging market investors have two comforts now.
One is that the dollar is, for now at least, quite weak: it’s near a three-year low against the euro and a four-year low against the yen. On its own, this is a support for emerging market equities.
The other is that these markets are relatively cheap. The ratio of MSCI’s index of them to its world index is half a standard deviation below its post-1994 average. In the past, this has led to decent annual returns.
Emerging market investors should not therefore throw in the towel yet. You should be aware, though, that a rising dollar is a potential problem for you.