Emerging markets experienced a dreadful start of the year. Measured in local currency, emerging stocks lagged their developed counterparts by more than 10%. Many country-specific reasons can be put forward for this underperformance. Korea suffers from the massive devaluation of the Japanese yen, with Japan being its biggest competitor. Inflation expectations in China are creeping up and the shadow banking sector poses risk to growth. Political and fiscal uncertainty in India remains high and Russia needs strong energy prices to keep growth going. On top of that is seems very likely that some of Russia’s billionaires had money in excess of 100K in Cypriot banks.
But there is another factor that investors should keep in mind when investing in emerging markets. And that factor is the US dollar. The graph below shows the relationship between the trade weighted dollar and the relative performance of the MSCI Emerging Market Index to the MSCI World Index. It shows a clear correlation between the two variables, which is pretty stable over time, although there are only two big moves since 1994. When the dollar weakens (the right X-axis is inverted) emerging markets tend to outperform and vice versa.
There are many possible reasons for why this is the case. First, because of the outstanding emerging debt in US dollars. A more expensive dollar means more difficulties in paying the debt back. Second, countries with big current account deficits (basically more imports than exports) are also vulnerable because they have to realize a steady stream of foreign capital inflows. This becomes harder with a currency that is depreciating against the dollar, which in turn could lead to a disorderly unwinding of portfolio flows into emerging markets. A third possible reason is that the dollar remains the only real reserve currency. A stronger dollar is often accompanied by higher uncertainty or volatility, which is bad news for emerging markets. More recently a weaker dollar has also been a measure of (global) liquidity. A stronger dollar indicates less liquidity, provided by central banks like the Fed, which can result in reversal in emerging market flows.
The graph shown above depicts the negative relationship between the trade weighted dollar and the relative performance of emerging markets. Independent of the reason for this relationship, taking the dollar into account (will it rise of fall?) when deciding to invest in emerging market s or not, is probably a sound thing to do. This does not mean that other factors are irrelevant of course. Earnings, valuations, relative momentum all contribute to the decision making process. The trade weighted dollar is just one to add to your list.