There is a widely held belief that emerging markets (EM) are vulnerable to U.S. dollar strength. We're not convinced.
These views are simplistic at best and originate in the 1980s and 90s when US dollar-pegged currencies, and deficits of 10% or more of GDP were common, as was dollar-denominated debt situated on sovereign balance sheets.
Today the picture is a lot less clear. Yes, the body of debt in emerging markets has grown significantly since the Asian crisis. But, it is mainly to be found on private sector corporate balance sheets and predominantly denominated in local currency.
Change has come as local capital markets have developed and regional pools of savings have deepened. On a sovereign level, there are no more dollar pegs to defend and only two to three emerging market countries have significant deficits. Among the most exposed is Turkey, where there is an unusual and persistent use of dollar debt, credit default spreads are high, and the recent recovery in the oil price has hurt the economy (the country is a big oil importer).
It’s often said that when the US dollar strengthens, trade measured in US dollars weakens and trade deficits shrink – but of course the very weakening of EM currencies versus the US dollar makes them more competitive, thus boosting trade again.
For commodities, prices are viewed as inversely correlated to the dollar. So, when the dollar rises, there is a tendency for commodity prices to drop. Essentially, a sharp appreciation in the dollar can overwhelm commodity rallies. In the first instance, however, a stronger dollar has a beneficial impact on energy exporters, such as Russia and Brazil. The majority of oil companies from these countries have a significant portion of their cost base in local currency, while their revenues are in US dollars. On the other side, for the importers like India and Turkey, a degree of relief comes as the commodity price stalls.
Finally, when the US dollar rises in value, investors are expected to prefer U.S. dollar-denominated investments. Fortunately, however, most seasoned investors in emerging markets are not focused on a three-month investment horizon. The benefits of investing in the asset class are mainly to be obtained via longer-term investing, as the growth opportunity takes time to come through.
Low dollar-debt vulnerability
Although there has been a significant degree of diversification into the euro and the Chinese yuan, the dollar remains a key currency in trade and global transactions. However, in terms of its impact on investors, the picture is not clear, mainly due to the significantly improved resilience of emerging markets.
Our preference as seasoned, long-term investors is to look past short-time currency-related volatilities and instead concentrate on high-quality companies that carry low-debt burdens and are set to benefit from the secular growth of these markets over the long term.