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Solid fundamentals in most countries should limit the damage. The largest markets are not particularly exposed to the risk of a classic balance-of-payments crisis (like the ones occurring today in a handful of smaller markets, including Turkey and Argentina).* Even as emerging markets have increased USD debt, they are less vulnerable today to such crises than they were in the late 1990s, or even as recently as in 2013, when a number of emerging markets last came under pressure.
Periods of USD strength pressure emerging markets in several ways, but the most virulent source of stress is a balance-of-payments crisis. Countries with current account deficits, high levels of USD debt, and low currency reserves are most vulnerable, as they rely on USD inflows, and these inflows rapidly turn to outflows during periods of stress. A stronger dollar makes it difficult for EM borrowers to pay back their USD loans, leading to capital outflows from emerging markets and an even stronger US dollar. Access to US dollars is further eroded if exports to the United States fall, a distinct possibility in the face of escalating trade tariffs. To the degree that EM currencies weaken, inflation pressures would increase through higher import costs. EM central banks could help prevent their currencies from plunging by raising rates, but at the price of slowing the economy and deteriorating the credit quality of borrowers. In other words, the situation puts these countries between a rock and a hard place.
According to the Institute for International Finance, non-financial EM debt (i.e., household, government, and non-financial corporate) totaled $53.1 trillion by the end of first quarter 2018. Roughly 7.6% of this debt is in foreign currency, 76.7% of which is denominated in US dollars. This increase in debt has investors concerned about a widespread balance-of-payments crisis. However, there have been some important changes in emerging markets in recent decades that reduce their vulnerability to USD strength.
First, as globalization has increased, EM corporations that receive increasing USD revenues have increasingly tapped into USD credit markets, as USD revenues provide a natural hedge for those liabilities. However, if those USD revenues are curtailed, as could happen in a trade war, these “natural hedges” would be put at risk.
Second, EM countries have shored up their finances. In particular, FX reserves have grown in relation to GDP (approaching an average ratio of 25%) as EM countries built up defenses after the Asian financial crisis in the late 1990s.
Third, the countries most vulnerable to a rising US dollar—those with high levels of external debt, high current account deficits, and low FX reserves—represent a small percentage of emerging markets in terms of equity market capitalization. Most large countries that have high external debt relative to GDP have adequate FX reserves to at least cover government and financial sector external debt.
Although it is clear that some countries are vulnerable to USD strength, prospects for the dollar are mixed. Even though it is now overvalued by our estimation, the dollar’s strength reflects stronger economic data and tighter monetary policy for the United States versus other countries. History suggests that it may continue to strengthen, particularly amid market stress.
What, conversely, could cause the dollar to weaken and emerging markets to rally? Decelerating US economic growth and/or softer-than-expected inflation could induce the US Federal Reserve to pause tightening. This would likely cause USD strength to fade, and EM assets and currencies could then rally (provided their economic growth held up). Any lessening of trade tensions ahead of the US mid-term elections in November would also spur a rally in global equities, including emerging markets.
As the US dollar strengthened in recent months, EM currencies and assets have fallen—some sharply—but they are still reasonably valued rather than downright cheap, and remain vulnerable to a rising dollar. With EM assets fairly valued, risks and opportunities are roughly balanced over the long term. However, between now and that long-term horizon, there are plenty of hazards. Long-term prospects for non-US equities, including emerging markets, are more appealing than those for pricey US equities; however, US assets may continue rallying for some time before the gravitational pull of relative valuations eventually reasserts itself.
*Argentina is currently classified as a frontier market by MSCI, but is scheduled to move up to their emerging markets index beginning in June 2019.
Celia Dallas is Chief Investment Strategist at Cambridge Associates.
Originally published on July 24, 2018 This report is provided for informational purposes only. The information presented is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Some of the data contained herein or on which the research is based is current public information that CA considers reliable, but CA does not represent it as accurate or complete, and it should not be relied on as such. Nothing contained in this report should be construed as the provision of tax or legal advice. Past performance is not indicative of future performance. Broad-based securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Any information or opinions provided in this report are as of the date of the report, and CA is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified.