After gaining value initially at the start of 2020 and reaching a three-year high in March, the U.S. dollar reacted to increased volatility in currency markets from the coronavirus pandemic as typical of a safe-haven currency. While usually considered a safe-haven currency, the U.S. dollar is not immune to changes in investor perception and confidence. As coronavirus cases continue to climb in the United States during a presidential election year, the U.S. dollar has become more volatile. Given this recent increase in the volatility of the U.S. dollar, I want to visit the relationship between the relative performance of emerging markets and developed markets and the U.S. dollar.
As seen in this week’s chart, the MSCI Emerging Markets (EM) Index and the MSCI World Index (World) ratio and the U.S. Dollar Index appear to have a negatively-correlated relationship. From 1995 to 2000, the U.S. dollar appreciated over 30%, while the MSCI EM Index underperformed the MSCI World Index by over 15% annualized. Then from 2001 to 2010, the U.S. dollar depreciated over 18% while the MSCI EM Index outperformed the MSCI World Index by 14% annualized. Then from 2011 to 2020, the U.S. dollar appreciated over 30%, while the MSCI EM Index underperformed the MSCI World Index by 7% annualized. Overall, from 1995 to 2020, this relationship has a correlation of -0.35.
Another way to look at this is by regressing the five-year relative performance between the MSCI EM and World Indices ratio against the five-year U.S. Dollar Index performance. There is a strong relationship between the relative performance and the U.S. dollar performance. The R-squared for this analysis is 0.78, which reflects a strong relationship between these data series.
One explanation for the negative correlation is that emerging markets tend to issue U.S. dollar- denominated debt because it can borrow more capital at a lower cost. However, when the U.S. dollar appreciates, more local currency is required to service that debt, putting a drag on the economy and increasing the probability of default.
One way to measure a country’s default risk is to look at its credit default swap (CDS) spreads. In essence, a CDS is a contract for bonds with insurance to protect against losses. The wider the spread, the higher the probability of default. Since 2001, the Brazil 10-year CDS has had a positive 0.74 correlation with the U.S. Dollar Index. This means when the U.S. dollar appreciates, the Brazil 10-year CDS spread increases. In early March, when the U.S. dollar reached a three-year high, the Brazil 10-year CDS spread jumped 250 basis points (bps), its highest in two years. During the same period, the South Africa 10-year CDS, which has a positive 0.62 correlation with the U.S. dollar, also jumped to 223 bps.
Another explanation for the negative correlation is that some emerging market countries are producers of commodities and most commodities are priced in U.S. dollars. To put it simply, the stronger the U.S. dollar, the weaker the commodity prices. For example, the price of crude oil is valued globally in U.S. dollars and as the U.S. dollar appreciates, more foreign dollars are needed to purchase crude oil. This would lower the demand for crude oil, causing its price to fall. Because most emerging markets are producers of commodities, the economy would suffer when demand for the commodity drops.
In the first six months of 2020, emerging market governments issued 124 billion in U.S. dollar debt. With the U.S. dollar currently experiencing more volatility than usual, this adds additional currency risk to portfolios with emerging market exposure.
One cannot invest in an emerging market without considering the impact of the U.S. dollar, as there is a strong relationship between emerging market equity and the U.S. dollar. In the last 25 years, the correlation between relative performance of emerging markets and developed markets and the U.S. dollar has been -0.35. The U.S. dollar is just one of many factors affecting the performance of emerging markets, however, it cannot be ignored as it may add additional risk to the portfolio.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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