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The dollar has been appreciating steadily since July, after investors began to price in the prospect of US rate rises next year, dragging down emerging markets (EM) currencies.
The early stages of the move saw most pressure piled on lower-yielding EM, with the higher yielding – and higher risk – currencies outperforming. Nevertheless, both current-account surplus nations, such as Malaysia and South Korea, and those with deficits, such as Brazil and South Africa, have fallen.
Despite the obvious diversity of EMs – including their FX reserves, health of trading partners, balance-of-payments positions and monetary cycles – most FX and credit analysts are bearish that EM as a basket can outperform in a strengthening dollar environment.
The prospect of a weakening EM currency and strengthening dollar – even against the yen and euro – will complicate post-crisis carry-trade strategies for real-money portfolio managers, an investor base that is traditionally dollar-based.
“A strong dollar tends to suck liquidity out of emerging markets and is often associated with rising risk aversion,” says UBS.
At the same time, because EM performance is typically measured in dollars, a rising dollar leads to negative translation effects for those economies, with lower commodity prices and weaker dollar-adjusted earnings.
Further falls
There is room for further falls, say analysts. “We still believe real-money investors have been comfortable with USD longs versus EM FX, but the defensive positioning has not happened in a broader measure,” says Luis Costa, an EM strategist at Citi. “USD-EM longs have been concentrated on low yielders with a high density of foreign fixed-income positions, such as MXN and PLN.”
UBS predicts “these dollar moves should be accompanied by further weakness of most EM currencies”, with end-2015 forecasts for the Bric currencies of RMB6.35, BRL2.55, INR65 and RUB39.9.
Among the more exposed currencies are the Turkish lira and South African rand, with these currencies at least risking a repeat of the chaos of 2013.
“Turkey and South Africa are on the front line with their excessively high level of inflation, accommodative monetary policies and, above all, large current-account deficits,” says HSBC in a research report. “In other words, the so-called fragile-currencies theme is making a return.”
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Most analysts, however, expect EM adjustment will be relatively orderly, avoiding a repeat of the volatility that ensued when the Fed first talked about its plan to end QE.
“The taper tantrum was about rising US yields and increasing volatility,” says Daragh Maher, currency strategist at HSBC. “If we saw a similar rise in yields and volatility now, then EM FX would surely have a very difficult time. But we expect US yields to stay at around about the same level. So while we do expect weakness for EM FX, we don’t expect it to be destabilizing.”
What’s more, among the currencies to have recorded only modest losses against the dollar are the IDR and INR, both fragile-five candidates.
“Improvements in economic and political fundamentals in India since then might argue for greater resilience to the prospect of higher US policy rates,” says Maher. “However, it is likely that the comparative stability in the US Treasury market this time has helped prevent too much trauma for the IDR and INR, and emerging market FX in general.”
Based on 10-year correlations, UBS says EMEA-based EMs have the lowest correlation with the dollar, due to the presence of low beta, often low liquidity, markets such as Poland, Czech Republic and Egypt, and markets with large surpluses such as the UAE and Qatar. At the other end of the spectrum, LatAm economies have the highest correlation to the dollar at -0.81.
“Below-average correlations exist for Korea, Mexico, Poland, Taiwan, UAE, Qatar and Philippines,” says UBS.
Reluctance
The outlook will differ depending on the role of commodities within the economy. Chinese import growth is contracting and the People’s Bank of China has proved itself reluctant to ease policy too much, so the smart money is on further commodity falls.
“On the whole, it is accepted there is an inverse correlation between the dollar and commodities, which may not be true in any single moment but often holds up over time,” says Maher. “If this relationship continues, we may therefore see a strengthening dollar hit commodities producers harder than consumers.”
What’s more, the fall of the euro against the dollar also presents buying opportunities.
“We believe that the PLN and in a lesser extent the HUF should record moderate appreciation against the EUR in 2015,” says HSBC. “Substantive ECB easing and its consequences on the euro and in capital flows dynamics should be supportive, particularly given their favourable macro-mix.
“Low inflation and a rather robust economic growth will provide a solid base to the currencies. More importantly, Poland and Hungary will continue to enjoy a supportive external position, remaining net creditors to the world.”
EM investors might switch cash to foreign-currency-denominated debt, predicts Citi’s Costa, as “FX in EM is forced towards weaker levels [and] the valuation between local and external debt tends to decouple.”
Equity investors are faced with equally bleak prospects. Since the end of 1998, in four periods of dollar rises, EM equities have lost an average of 22%. In the three periods of sustained dollar declines – which have tended to take longer to play out – the average gain in EM equities has been 116%. Investors allocating assets by sector are advised to avoid materials which have a high correlation with the US dollar, while energy, industrials, IT and healthcare are all more defensive, with lower correlations.
There are reasons to believe the dollar will continue strengthening for some time yet. So far, the dollar has appreciated by around 5% against a trade-weighted index. In historic dollar rallies – excluding the two most extreme examples, between 1980 and 1985, and 1995 and 2001 – the dollar has strengthened by around 20%, on average.
HSBC reckons the dollar will be the strongest-performing currency not only of 2014 but of 2015 as well. Meanwhile, an energy-independent US should support the dollar by reducing the US external deficit, says UBS, while “the real effective value of the US dollar, according to our economists, is close to a 40-year low and around 10 percentage points below its recent average”.
However, history might not be the most relevant guide to what will happen this time around, suggests HSBC’s Maher. “In the past, exchange-rate manipulation has been determined by authorities looking to reduce imports and increase exports to improve their own balance of payments, improving their trade balance at the expense of others,” says Maher.
“This time it’s all about stealing inflation, which is a very different motivation. It means we won’t see the US current-account deficit becoming a reason for the US to pursue a weaker dollar. This time it will be a question of whether the US can create enough inflation to offset dollar strengthening.”