The relationship between the US dollar and risk assets is quite an interesting one. The dollar is considered the world’s reserve currency as majority of globally traded commodities are priced in US dollars. During turbulent economic times it is not the South African Rand or the Australian Dollar that investor’s flock to for protection, it is US dollars. Whether or not the dollar is in a bullish or bearish regime generates vast implications across all asset classes. Today, we are going to talk about one relationship in particular, the US dollar and emerging market equities.
Now, what does it mean to be considered an emerging market (EM)? Well, typically EM nations have seen their economic activities evolve from an agricultural focus to a manufacturing and industrial focus. EM countries are not quite as developed as the United States, Germany or Japan but are considered to be “on their way” to becoming a developed nation. Naturally, their economic growth is driven by exports. The two biggest players in EM are China and India. They make up a very big percentage (+30%) of the global labor force and have seen rapid economic growth over the past decade or more.
So, what does the standing of the US dollar have to do with EM? Well, if history is any indication these two assets are very negatively correlated. Below is a regression scatter plot depicting the relative performance of the MSCI Emerging Markets Index to the MSCI World Index and the performance of the US Dollar Index. The R-squared value of nearly 0.70 signals a strong relationship exist between the two data series. In other words, when the US dollar is depreciating (weak) the MSCI Emerging Markets Index is outperforming the MSCI World Index.
Another great way to visualize this relationship is looking at price charts. The below chart depicts the MSCI Emerging Markets Index vs. MSCI World Index (blue line) and the US Dollar Index (green line). To better illustrate the strength of the relationship, I inverted the y-axis on the US Dollar Index. When we see a weak or downward moving US dollar, it is very likely that Emerging Markets are outperforming the rest of the world. The 60-week correlation coefficient between the two price series is -0.66.
A weak or depreciating US Dollar will act as a tailwind for EM focused funds or indices. But why? There are several reasons, but primarily this can be attributed to two things. Firstly, many EM governments issue US dollar denominated debt. When the US dollar appreciates it will cost more local currency to service the outstanding debt. This can dampen economic growth and introduce more stress to their financial system. Secondly, and I would argue more importantly, we have the influence of commodities. I noted earlier that majority of the commodities traded around the world are priced in US dollars. A lot of EM countries are big producers of commodities i.e. Argentina, Kuwait, Chile and Brazil to name a few. A weak US dollar will lead to higher commodity prices. Let us give you an example. If the US dollar is depreciating rapidly and commodity X is priced in US dollars, it will take less EM local currency to purchase commodity X. Because of this, demand will rise for commodity X and the price will increase. Country Y is a big producer of commodity X, therefore their economy will be positively impacted when demand for commodity x increases. To llustrate this relationship, I added the CRM Commodity Index to the below chart. Notice how all three lines maintain the same primary trend direction.
When it comes to evaluating the global landscape of risk assets, these intermarket relationships are an extremely important piece of the puzzle. At the end of Q4 2020, our team at MRA introduced a new position to our model portfolio. A fund that tracks a broad basket of emerging market stocks and gives our clients an area within their portfolio that is set to benefit from a continued decline in the US dollar and a rise in core commodity prices. We believe the risk reward tradeoff from both a technical and value perspective is attractive and will continue to materialize in 2021.
If you have any questions or would like to discuss further - please reach out to us and let us know!
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.