Distortion in Emerging Markets as U.S. Dollar Trends Upwards

As the dollar starts to strengthen, investors unwind their long-held bets on emerging market stocks, currencies and bonds. The spark in the dollar has left developing countries in confusion and the ripple has spread. Hong Kong’s monetary officials took initiative to prop up their weakening currency while Indonesia raised rates for the first time in four years to arrest a drop in its currency. Currencies like the Turkish lira and Brazilian real are at its low against the U.S. dollar. Not only that, but the MSCI Emerging Markets Index and bond index have underperformed. Looking back at historical data, investors have flocked over emerging-market stocks over those in the developed world mainly due to the microeconomic problems in the developed nations.

However, a strengthening U.S. dollar and rising treasury yield has changed the environment and previous trends on emerging-market stocks. This is because a rising dollar makes it difficult for countries to service debt denominated in the US. currency, while rising yields diminish the attractiveness of foreign assets.

Senior officials around the world say, “The markets are now realizing they have to pay attention to fundamentals and assessing which countries are the most vulnerable. A continued rise in the dollar and U.S. yield will punish comparatively healthy emerging markets alongside more vulnerable ones. The world tends to be a much happier place when the dollar is not going up.”

They are particularly nervous about nations with large current-account deficits and those that rely on foreign investments in finance government spending. Their dependence on the rest of the world for government finances and trade leaves them badly exposed when the dollar rises. On a different note, politicians are also a worry. The Mexican peso has been dogged by concerns over the renegotiation of the North American Free Trade Agreement and a slowly creeping election. It has gotten fairly difficult for new investors to set foot into the market as volatility continues to spread throughout emerging-market assets. More recently, developing countries have largely loosened their currency pegs and built up reserves. Pegs don’t do well in a market that’s volatile because it gets challenged as the market become less stable. On the other hand, the new economic environment has left many emerging economies shielded by robust growth rates.