Turkey’s currency crisis has spooked emerging-market (EM) investors, especially amid growing concern about the strengthening US dollar. We think countries and companies in the developing world are actually much more resilient to a stronger dollar than in the past.
The recovery of EM assets from early 2017 until the beginning of 2018 coincided with a steady weakening of the dollar. It may be more than just coincidence. In fact, many analysts see the greenback´s downturn as a major contributing factor to EM outperformance. Yet the reality is more complex. EM equities fared better in the face of dollar strength from September 2014 to June 2015, and did poorly from then to early 2016—even as the dollar was stable (Display).
Investors Pull Money from EM Funds
But as the dollar has appreciated this year, EM assets have struggled. Dollar-denominated EM bonds have dropped 3.6% this year through May 29, while EM stocks have slipped by 2.1% (in USD terms). Investors have reacted already, pulling money out of EM equity and debt funds over the last month, following four months of strong inflows.
Conventional wisdom suggests that a stronger dollar is a problem for EM borrowers, who are forced to repay debt at a less favorable exchange rate. Many analysts see the dollar´s comeback as an indication of more general liquidity tightening, or a sign that risk appetite is waning, which also adds challenges to EM assets.
Dollar Strength, In Perspective
These are good points—but warrant some perspective.
Despite the dollar’s rebound in recent weeks, it’s still trading about 8% lower against other major currencies than at its peak in early 2017, and remains in line with its five-year average. As a result, we think the exchange-rate pressure on EM borrowers is manageable.
Liquidity pressure may also be overstated. While liquidity may be tightening globally at the margin, investors should bear in mind that this move is starting from very loose levels. And most major central banks are widely expected to keep accommodative policies in place, at least for the remainder of this year.
Does Currency Matter?
Currency moves may not matter as much as they did in the past for EM companies and countries. Many EM companies now generate most of their earnings in their home markets, and carry little dollar debt. That list includes some of the largest index heavyweights, such as Chinese internet companies, which have little fundamental sensitivity to the dollar exchange rate or to interest rates. Companies that are more export dependent actually benefit from the dollar’s appreciation, which improves their competitiveness in the US market.
For countries, the vulnerability of creditworthiness to dollar strength is considerably lower today than it was five years ago. This is because EM countries did their homework in the wake of the 2013 taper tantrum; their external balances are much healthier and are less reliant on external financing. There are exceptions that appear weaker, such as Turkey. So investors must be selective when approaching EM credit in an environment of dollar strength.
Essential To Hedge Exposures
Even if a stronger dollar doesn’t threaten the long-term EM recovery, it’s clear that it can affect the market over shorter periods of time. That’s why it’s especially important to manage currency actively in portfolios today.
Partially hedging an EM portfolio to the US dollar offers several benefits. It allows investors to stay focused on investments with strong fundamentals while dampening volatility and, potentially, to profit from the hedge should the USD strengthen more.
In addition, the cost of hedging is as low as it’s been in more than a decade. That´s largely because rates are rising in the US while remaining low in EM (Display).
Of course, EM assets are affected by changes in risk appetite, which has weakened somewhat this year. Yet there are signs that the heightened volatility which reflected investors’ anxieties has started to wane. For example, the VIX index of US equity market volatility has already subsided to one-third of its peak from early February.
Solid Macro, Earnings Trends
Beyond the currency questions, we believe that underlying economic and earnings growth trends remain strong across most of the EM landscape. This should support continued gains across EM debt and equity markets, in our view.
Emerging market assets are behaving with sensitivity to the USD recently. But we think that active management of currency, stock and bond selection can help investors capture attractive long-term return potential from individual securities while dampening the near-term volatility associated with dollar movements.
About Morgan C. Harting
Morgan C. Harting is the lead Portfolio Manager for all Multi-Asset Income strategies with Alliance Bernstein (AB). He also manages the Emerging Markets Multi-Asset Portfolio and is a member of the portfolio team for the Frontier Emerging Markets Portfolios. Harting joined AB in 2007 as part of the global and emerging-market equities portfolio-management team. Prior to that, he was a sovereign-debt analyst, first at Standard & Poor’s and then at Fitch Ratings, where he was a senior director. Harting holds a BA from Wesleyan University, and both an MA in international relations and an MBA from Yale University, where he was a graduate teaching fellow in international economics. He is a CFA charter holder and a Chartered Alternative Investment Analyst.