If you’re not a currency trader or haven’t traveled abroad in the last year, you may not know that the U.S. dollar has dropped to its lowest level against other currencies in 15 months. And the decline of the world financial system’s linchpin currency is only quickening as the U.S. Fed nears the end of its rate-hiking cycle. In this environment, a wide range of assets stand to profit, not least of which is the AI-infused U.S. technology sector. However, no space stands more ready to benefit from this environment than emerging markets.
EMERGING MARKETS ON THE RISE
Historically, emerging market (EM) equities have displayed an inverse relationship to the dollar, primarily because EM companies, just like their home countries, have funded growth with dollar-denominated debt. A cheaper U.S. dollar shrinks balance sheets and reduces net interest expenses, resulting in a combination that often leads to upward earnings revisions. And, while the dollar is already down more than 10% from its 20-year high in 2022, it’s reasonable to think the Fed’s recent rate-hike pause signals even further weakness. The U.S. central bank’s behavior, in other words, could be a catalyst for EM outperformance.
So, too, will be the behavior of other central banks. European central banks are close to a year behind the Fed in the rate hike process, and still not sure when their rates will stabilize. Meanwhile in Japan, rising wages and prices continue to put pressure on the Bank of Japan to relax efforts to keep their yield curve low. These shifts in the balance of monetary policy will result in more flows out of the US into foreign bonds, weakening dollar demand.
THERE WILL BE WINNERS…
Despite their interesting prospects and historically moderate (maybe even cheap) valuations, emerging market equities have lagged developed markets all year—by more than two percentage points if you compare the MSCI Emerging Markets Index to the MSCI World Index. In our view, the expected increase in EM profitability will warrant a narrowing of that valuation discount.
Several EM countries are already showing signs of pricing improvement. By region, Latin America is the clear winner, led by Mexico and Brazil, both benefitting from the post-Covid reshoring trend, where firms look to source products like clothes and computer chips closer to home and away from manufacturing powerhouses like China. The Mexican peso and the Brazilian real have both profited from reshoring. Brazil has been helped by a stronger currency and the increased likelihood of policy rate cuts as the country’s inflation moderates.
In southeast Asia, Indonesia and the Philippines have been standout performers year to date. Both nations have benefited from policy reforms and appear to be on track for economic expansion as inflation decelerates. The Bank of Indonesia, in fact, may be the first central bank in Asia to cut rates, even ahead of the U.S. Fed.
THERE MIGHT BE LOSERS…
Meanwhile, China (yes, the world’s second-largest economy is an emerging market) continues to be a source of disappointment. The country’s post-reopening recovery has been slower and more uneven than expected, and choices made by the Chinese Communist Party -- the so-called three Ds -- have impeded its continued economic progress:
- Demographics – The one-child policy has resulted in a population shift with too few children to replace the adult population as it ages.
- Debt – China’s private sector, real estate in particular, is heavily levered, with private debt nearly 300% of GDP.
- Deflation – A post-pandemic supply glut is pushing consumer and producer prices down rapidly.
All of this starkly contrasts the market’s expectations for a Chinese economic revival post-Covid. The onus now is on the country’s policymakers to re-establish confidence. At this hour, China’s prospects are questionable.
THERE WILL SURELY BE OPPORTUNITY
EM equities have lagged their developed market peers for four out of the past five years, and we believe they are poised to catch up to their developed market peers. Beyond just reverting to the mean, however, EM economies are in place to actually produce higher economic growth than advanced markets.
Since these growth projections are hardly uniform around the world, avoiding the losers will be as important as finding the winners. As performance across emerging markets diverges, active management will be vital.
Derek Izuel, CFA is Chief Investment Officer and portfolio manager at Shelton Capital Management.
Investing in Emerging Markets may not be for everyone. The information contained in this document is given on a general basis without obligation and on the understanding that any person acting upon or in reliance on it, does so entirely at his or her own risk. Any projections or other forward-looking statements regarding future events or performance of countries, markets or companies are not necessarily indicative of, and may differ from, actual events or results. This information is intended to highlight issues and not to be comprehensive or to provide advice.
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