Why emerging-market bulls are cheering a weaker U.S. dollar



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The U.S. dollar’s summer slide is widely seen as a boon for stocks, including emerging market equities.

The correlation between a falling dollar and gains for emerging market equities is relatively tight, said Nick Nizoliek, co-chief investment officer and head of international and global strategies at Calamos Investments, in an interview.

Read: Here’s what the U.S. dollar’s fall means for the stock market

In his Wealth of Common Sense blog, Ben Carlson, director of institutional asset management at Ritholtz Wealth Management, offered this breakdown of how different assets, including emerging markets, respond in years when the dollar falls:

Between 1974 and 2019, he found that in years when the dollar rose, foreign stocks on average returned 2%, while emerging markets gained 2.7% versus a 10.8% return for the S&P 500
SPX,
+1.02%.
But in years when the dollar fell, foreign stocks rose 18.6% and emerging market stocks returned 22.5% versus a 12.8% rise for the S&P 500.

See: The U.S. dollar is struggling. That should give a shot in the arm to global growth, Goldman Sachs says

Why the outperformance? Perhaps the most cited reason is a simple one: For U.S. based investors, the value of foreign currency-denominated holdings rises as the dollar weakens.

But there’s more to it, Nizoliek said. For one, a weaker dollar allows emerging market countries more freedom to provide fiscal stimulus without fearing negative implications for their own economies. For instance, an emerging market government might feel more comfortable with fiscal easing if it’s currency is rising, dampening the potential for an inflationary shock.

The ICE U.S. Dollar Index
DXY,
+0.04%,
a measure of the currency against a basket of six major rivals, fell 4% in July for its biggest monthly decline in nearly a decade. It’s down 0.5% so far in August and is off around 3.6% in the year to date.

The S&P 500 index, meanwhile, has roared back from a plunge that saw it drop nearly 34% from a record close on Feb. 19 to its March 23 pandemic low, a swoon that was accompanied by financial market turmoil that included a global scramble for dollars that sent the dollar soaring. The S&P 500 returned to record territory last week and has continued to push to new highs, leaving it up 7.7% for the year to date.

The outperformance this year has yet to come. The MSCI Emerging Market Exchange Traded Fund
EEM,
+0.26%,
which tracks a popular emerging market index and had also dropped around 34% from its February high to its March low, is back in positive territory for the year, up around 1.1%.

Nizoliek argued, however, that market volatility in 2020 underscores the “inefficiency” of focusing on emerging market benchmarks. The firm’s Evolving World Growth Fund
CNWIX,
+0.66%
is up more than 30% in the year to date. Five of the top 10 names in the fund as of June 30, including MercadoLibre
MELI,
-0.65%,
an Argentine-based, U.S.-listed online marketplace, and Sea Ltd.
SE,
+3.16%,
a Singapore-based digital services company, weren’t part of the benchmark index.

The dollar isn’t the only factor cited by emerging market bulls. They also look for China and other Asian economies, in particular, to continue to lead the bounce back from pandemic-induced shutdowns.

While aggregate gross domestic product in emerging markets is forecast to bounce back quickly over the next 18 months, advanced economies are expected to be slower to recover, likely taking two or more years to get back to 2019 levels, wrote analysts at William Blair — a factor that might in turn help keep the dollar under wraps.

Nizoliek said downside risks to the outlook, meanwhile, are the usual suspects — a significant return of the COVID-19 pandemic in emerging markets or a policy misstep by the Fed or others that sends rates up sharply. The latter seems particularly unlikely given the Fed’s signals that it’s ready to do more in terms of easing to shore up the economy if needed, he said.

The bigger worry, he argued, is not adequately capturing the potential upside if things go right.

“In this environment, many stocks that haven’t participated in the last decade will be new leaders…and making sure you have procedures to identify those stocks and get them in portfolios is critical,” he said.



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