Emerging markets: 2021 and beyond

March 30, 2021

11:58 am

This time around the Fed won’t take away the punch bowl but will offer free refills ...
There are many supportive tailwinds for emerging markets as we enter 2021 and beyond. Drs. Cem and Felipe (with quantitative support from Dr. Spies) published a white paper on the outlook for the US dollar. A post-pandemic recovery in global demand coupled with USD weakness will likely provide substantial tailwinds for emerging market (EM) assets through rising capital flows, lower global uncertainty and stronger EM growth.
How much can the US dollar weaken?

Based on our analysis, the dollar may settle at a new long-run level about 12% to 15% weaker than the level at the start of the current episode back in April 2020. This would imply an additional 8% or so decline in DXY from December 2020 levels. It is difficult to predict the pace of the decline but we think that a significant part of it may take place over the next two to four quarters.

This weakness is largely due to the continuation of rising US external imbalances and the normalisation of global risk premia: tariff-related uncertainty, growing concerns of deglobalisation and rising geopolitical risks.

In our view, the US current account deficit will re-widen going forward as fiscal and monetary accommodation will be maintained for the foreseeable future. The dynamics are already in motion with recovery in imports outpacing exports and the current account deficit widening from 1.9% of GDP at end-2019 to 3.4% in Q3 2020 (a 71% increase in actual dollars). The recent pace of deterioration is much faster than that seen during the USD weakening cycle of 2001-2008 and the vaccine rollout may cause further acceleration by fostering faster normalisation of US personal consumption.

Chart 1: Dollar cycles
Chart 2: US current account balance and Broad Nominal Trade Weighted USD Index
Source: Source: RWC Partners, Bloomberg and Haver as at 31 December 2020

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
Effect on emerging markets

A weaker USD strengthens balance sheets in EM, particularly for those with higher external debt ratios, and further eases financial conditions. While a weaker USD (stronger EM foreign exchange) may appear to be negative for EM exports and growth, there is growing evidence that the deepening of global supply chains over the past 20 years (i.e. the increasing import content of EM exports) allows EM exports and imports to expand in tandem. Cheapening imports in local currency helps EM maintain export competitiveness, particularly with growing evidence of more USD invoicing.

We analysed the impact of USD weakness episodes on EM GDP growth, equity indices and capital inflows collectively and individually for 21 emerging market economies (EMEs). We found statistically strong evidence of a weaker USD being associated with stronger GDP growth, higher equity prices and accelerating capital flows using quarterly data for 25 years.

Specifically, we found that a 1% USD weakness may cause the MSCI EM Index to rise by 1.2%, as seen in Chart 4. We also discovered a positive relationship between USD depreciation and percentage increase in flows into EMs.

Percentages information

EM asset and commodity prices change their trajectory when the USD faces substantial weakness. Chart 6 shows that substantial dollar weakness episodes correlate with less uncertainty (decreasing VIX) and higher commodity prices – especially copper.

Consumer discretionary, materials and industrials are the sectors that most accelerate during dollar weakness. These are highly procyclical sectors with high exposure to dollar fluctuations, as shown in Chart 7. In turn, communication services and utilities are sectors that do not outperform. Latin America, parts of Asia such as China and India and some Eastern European countries such as Russia have also performed well.

Chart 3: EM GDP growth and DXY

Chart 3: EM GDP growth and DXY

Chart 4: EM equity returns and dollar appreciation (1994-2021)

Chart 5: EM fund totals and USD

Chart 6: Patterns near dollar weakness (1995-2020)

Chart 7: Sector-level equity patterns near dollar weakness (1995-2020, all indices in USD)

Source: RWC Partners, Bloomberg and Haver as at 31 December 2020

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment

Overall, it is likely that we get a sustained period of dollar weakness over the coming quarters and years. Further expansion of the US current account in addition to receding tariff-related and deglobalisation risks are key drivers of this view. This scenario should be beneficial for EM GDP growth, capital flows and balance sheets, which should likely result in strong equity performance.
‘A weaker USD strengthens balance sheets in EM, particularly for those with higher external debt ratios, and further eases financial conditions’
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