AT THE start of 2023 — after a rough 2021 and 2022 for emerging market equities — we wanted to revisit what we consider to be a key (possibly the key) driver for the asset class: the direction of the US dollar and the capital flows that result from that.
In general, EM economies and the EM equity asset class are dependent on external capital flows.
Economies driven more by domestic demand require capital inflows to finance current account deficits.
Economies with stronger export bases tend to have significant exposure to demand from emerging markets (eg Korean car companies sales in India) and a dependency on foreign financing of corporate investment.
When we talk about capital flows, we mean US dollar capital flows.
Fromer Bank of England governor Mark Carney summarised this well in 2019 (PDF).
Carney noted the dollar was the currency of choice for at least half of international trade invoices. That’s about five times greater than the US share of world goods imports and three times its share of world exports.
“Given the widespread dominance of the dollar in cross-border claims, it is not surprising that developments in the US economy, by affecting the dollar exchange rate, can have large spill-over effects to the rest of the world via asset markets,” Carney said.
“The global financial cycle is a dollar cycle.”
When dollars are sold to realise outbound capital flows, the dollar tends to weaken.
When dollars are repatriated, the dollar tends to strengthen.
So an easy proxy for global dollar liquidity is the dollar exchange rate (or rather all the dollar exchange rates, which can be measured by the broad, trade-weighted US dollar real effective exchange rate).
The US dollar has, since the rise of emerging markets as an asset class, moved in large, multi-year cycles.
As you can see in the graph below, the dollar weakened from 1989 to 1995.
By that point 18 months of US interest rate hikes had started to drive a stronger dollar (as well as a series of devastating economic crises in the emerging world).
This up-cycle lasted until early-2002. By that point interest rate cuts after the dot-com bust started to weaken the dollar.
Despite some volatility around the Great Financial Crisis, the dollar remained in its broad downtrend until mid-2011, when the prospect of an end to the post-GFC quantitative easing started an upward move in the dollar which we may still be in (more on this later).
In 2019 we wrote about the importance of understanding the outsize impact of the US dollar environment on emerging market equity returns.
We wanted, post-Covid and the recent inflation spike, to provide an update to this work.
Starting in 1989 (which is about as far back as we can go, with the caveat that we have had to estimate the dividend component of total return indices for the period 1989-1999), we can see US Fed Funds (which is the global risk-free rate), have averaged 2.9%.
As the graph shows below, equity investors buying developed market equities have enjoyed a return pick-up to an annualised return of 6.7%, to compensate for a volatility in monthly returns of 4.4% (as measured by MSCI World Index).
EM equities investors have enjoyed a further return pick-up to an annualised return of 8.3%, to compensate for a higher volatility in monthly returns of 6.5% (as measured by MSCI EM Index).
What this long period doesn’t capture, is the way that these returns change during strong and weak dollar environments.
Splitting those out shows the long-term average contains two very different groups of returns.
When the dollar is strong, the risk-and-return metrics of developed markets don’t change very much (the weight of the US in the asset class causes the slightest improvement) and there is a corresponding slight worsening in a weak dollar world.
Emerging markets are different.
As the graph below shows, in a weak-dollar environment (measured over 185 months), the average USD annualised return of EM equity is 20.4% with only a small increase in volatility to 6.9%.
Meanwhile, in strong-dollar environments the average annualised USD return is -1.5%.
Essentially, over the last 33 years, all the long-term gains in EM have been made in weak dollar environments.
Looking beyond the data, it’s interesting to consider which types of emerging market do best.
Investors can think of emerging markets on a spectrum from high-savings rate/current account surplus/net saver export economies (Korea, Taiwan, the Gulf States) to low-savings rate/current account deficit/net borrower economies with more dependence on domestic demand (South Africa, India, Turkey, Brazil, Egypt).
As this is a spectrum, some countries have characteristics of both ends, such as Indonesia, Malaysia and Chile.
There are also country-specific conditions that change a country’s characteristics. (For example, Mexico’s large remittances from overseas citizens offsets a tendency to run a current account deficit).
In the above analysis, Latin American markets have tended to perform especially well in weak USD environments.
But it is important to focus more on characteristics than individual markets.
The key characteristics of Latin America in this period have been weak domestic savings and current account deficits, which create an outsized sensitivity to capital flows.
Historically, markets with these features have tended to be weak-dollar winners and strong-dollar losers.
But these are not fixed identities.
Thailand and South Korea ran current-account deficits in the 1990s when they collapsed into crisis with a strong dollar — but both now run large surpluses and are net savers.
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The US dollar has been significantly weaker in recent months, suggesting a peak was reached in October 2022.
To be clear, there have been previous short-term peaks and troughs in the dollar during broad upswings and downswings. (For example in March 2020 during the initial onset of COVID-19, after which the dollar weakened but remained in its uptrend).
But if the dollar has topped out (at a level similar to the top in 2002) — and 2023 and beyond are to be weak-dollar years — investors should bear in mind the highly positive implications for EM equity and for the more capital-sensitive markets within that asset class.
James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.
The fund aims to add value through a combination of country allocation and individual stock selection.
The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.
The stock selection process focuses on buying quality growth stocks at attractive valuations.
Find out more about Pendal Global Emerging Markets Opportunities Fund here
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