Weak US Dollar and High Deficits: Tailwinds for Emerging Markets?

• History shows that whenever the US dollar has weakened, emerging markets have been able to benefit.
• Debt burden as a warning signal: In many developed markets, government budget financing is becoming more important than price stability.
• Many emerging markets currently appear to be more disciplined borrowers and are gaining investor confidence.

On paper, emerging and developing countries — emerging markets, or EM — have long appeared to be promising investment regions. Their economies grow faster than those of developed markets, their populations are younger and their debt levels are often lower. In addition, interest-rate levels are higher and equity markets are moderately valued. Nevertheless, EM equities have significantly lagged behind over the past fifteen years. A turning point now appears to be emerging: by the end of October this year, the MSCI Emerging Markets Index had gained around 33 percent, while the MSCI World Index, which comprises developed markets, rose by only 20 percent. Two factors are likely to have contributed significantly to the improved investment environment: a substantially weaker US dollar and growing fiscal dominance in developed markets.
 

When the Dollar Weakens, Emerging Markets Breathe a Sigh of Relief

The development of emerging markets has always been closely linked to the dollar. When the US currency strengthens, EM assets come under pressure; when the dollar loses value, they become more attractive. This inverse relationship is well documented historically. When the dollar appreciated strongly in the mid-2010s as a result of monetary tightening by the Federal Reserve, EM equities lagged far behind developed markets. In phases of dollar weakness, such as in the early 2000s, they generated significant excess returns.

The mechanisms behind this are multifaceted. A weaker dollar prompts global investors to look for returns outside the US. As a result, capital flows into emerging markets, improving liquidity and refinancing conditions there. For countries with high levels of dollar-denominated debt, repayment costs in local currency also decline, creating fiscal leeway. Export-oriented economies benefit twice over: because commodities are often priced in US dollars, a weaker greenback increases the purchasing power of buyers outside the dollar area — demand picks up, while commodity prices and export revenues rise. At the same time, import prices may fall, easing inflationary pressure and allowing central banks in emerging markets to pursue a less restrictive monetary policy.
 

Fiscal dominance as a new risk in developed markets

Yet the weak dollar explains only part of the dynamic. Equally important is what is happening on the other side of the global financial system: in developed markets themselves. There, a phase of fiscal dominance is increasingly taking shape. In the US, the UK and parts of the eurozone, government debt is so high that central banks can no longer align their monetary policy solely with inflation and economic activity, but must increasingly take account of the sustainability of public finances. Rising financing costs are putting governments under pressure and forcing monetary policymakers to provide relief through lower interest rates — at the expense of their credibility in fighting inflation. The political wrangling over rate cuts, most recently visible in President Trump’s public calls on the Federal Reserve, illustrates just how much priorities have shifted. For investors, this is a warning signal: when government budget financing becomes more important than price stability, capital markets can be thrown off balance.

Ironically, it is precisely the emerging markets — once associated with fiscal instability — that are emerging stronger from this development. After years of tough adjustment and restrictive monetary policy, they now largely have solid balance sheets. While the major developed markets are suffering under a growing fiscal burden, many emerging markets present themselves as more disciplined borrowers — and are thereby gaining renewed investor confidence.
 

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For capital market investors

Historically, a weaker US dollar has always supported emerging markets — and there are many reasons to believe that this pattern will continue. With the US Federal Reserve expected to cut interest rates, the dollar is likely to weaken further. At the same time, many emerging markets stand on a solid fiscal foundation. This could cause global capital flows to continue shifting in their favour. Lower refinancing costs, rising commodity demand and the high debt burden of developed markets are making investments in emerging markets attractive again after more than a decade of relative weakness. However, risks remain: political uncertainty, country-specific problems or external shocks could slow the development at any time. Yet the overall tone is different than in the past: if the dollar continues to weaken and fiscal dominance takes hold in the major economies, emerging markets could benefit not only in the short term, but also step out of the shadow of developed markets over the long run.