3. How supportive will a weaker US dollar be for emerging market equities?
The correlation of the US dollar index to EM equities tends to be quite solid. A decline in the value of the US dollar has historically provided a tailwind for EM equities and other riskier asset classes. We believe this remain the case going forward; however, the tailwind in not likely to be strong for three key reasons. First, as Figure 2b shows, rates in EM are currently at or very close to their lowest levels in history. In the wake of all past crises, interest rates in EM were higher and more attractive to both fixed income and speculative capital flows. In other words, FX “carry” was attractive. This is not the case now.
Also, large fiscal stimulus packages increased fiscal deficits and, ultimately, debt levels. In some cases, this debt is being monetized. This, too, will exert pressure on some EM currencies, preventing them from strengthening.
And last, the correlation between US dollar weakness and EM equities was, in part, due to the commodity and materials component of EM – a part that has decreased not only in size in the EM index, but also in relevance to the expected economic recovery. In the past, infrastructure spending played a big part in economic recovery, especially in China. Infrastructure spending in China and other countries is now less commodity- and materials-sensitive and more technology-driven (think 5G, cloud).