Recent months have seen worrying headlines about Turkey, Argentina, South Africa and other emerging markets. In many cases their currencies have slipped and investors have shunned shares and bonds issued in these and other developing markets. Trade disputes between China, the US and other economic blocs have intensified investors’ anxiety.
Why so much hangs on the strength of the US dollar
One of the major economic themes of 2018 has been the diverging performance of the US relative to the rest of the world. Thanks partly to President Donald Trump’s package of tax cuts, which has spurred robust spending by both consumers and businesses, the US economy is firing on all cylinders. Confidence among small business owners and new job
openings surged to a record high in August, despite worrying news flow about a looming trade war. Larger companies are also powering ahead, with the earnings of S&P 500 companies expected to grow 23% in 2018.
With this as a backdrop, the Federal Reserve (the Fed) continues to raise interest rates – in fact there have now been eight US rate increases since the end of 2015. In contrast, economic performance in the Eurozone, Japan and China has been disappointing this year to date, so we have seen a widening gap in benchmark interest rates between the US and other markets. All of the above has led to one significant outcome: a sharp strengthening of the US dollar.
A strengthening US dollar is usually damaging for emerging markets. It tends to result in investors withdrawing capital from developing regions and it can hurt those countries with dollardenominated debt, as their financing costs rise. Central banks in emerging markets often react to capital outflows and weaker currencies by raising their own interest rates, which can depress domestic activity.
Countries with potential vulnerabilities – such as large current account deficits – suddenly find themselves facing more scrutiny in a strong dollar environment. This has
clearly been the case this year with Turkey and Argentina, where the respective local currencies, the lira and the peso, have slumped more than 40% and 50% so far. These countries suffer their own unique problems, and yet the market’s response was somewhat more indiscriminate and the region as a whole came under intense pressure.
Fears of contagion and the mounting uncertainty of a trade war have helped spread this negativity. Emerging markets will not be spared the negative consequences of an escalating trade war, and indeed the likelihood of a deeper and more protracted trade war between the US and China is behind the decision of Schroders Economics Team to downgrade global growth expectations for two quarters in a row. We now expect emerging market growth of 5% in 2018 (down from 5.1%) and 4.8% in 2019 (down from 5%). China, we anticipate, will remain on course to grow 6.6% in 2018, but drop to 6.2% next year. We had previously predicted growth of 6.4% for 2019.
The reversal of the fortunes of emerging markets will be inextricably linked to the performance of the dollar – and the course of the trade dispute unfolding between China and the US. Although growth will remain positive in 2019, we believe the trend of outstanding US growth will weaken, as the boost from tax cuts fades and higher inflation starts to bite. A deeper, prolonged trade war could prove inflationary and have an effect on US consumer confidence.
US DOLLAR INDEX AND MSCI EM VS MSCI WORLD INDEX
Among corporates, if the extra costs of tariffs cannot be passed on fully to consumers, profit margins will start to narrow and share prices would come under pressure. While President Trump’s actions are notoriously hard to predict, we do know that he cares about his poll ratings – and the US stockmarket. The upcoming US mid-term election in November may result in a split Congress and potentially political deadlock in the US administration. In this scenario, particularly if we see a deteriorating impact on consumers and corporates in 2019, President Trump may soften his hardline stance and the prospect of some form of a deal with China might improve.
The trend of a widening gap in interest rates between the US and the rest of the world may wane in 2019. True, the Fed has pencilled in a total of three rate increases for next year, but we think there is a limit to how high US rates can rise. Given this is the first cycle of rate increases since the financial crisis, the Fed may prefer to pause at the 3% mark – rather than press on with further increases. On the other hand, central banks in Europe and elsewhere may start tightening as early as next year. Although the actual interest rate gap will remain wide, market expectations and the tone from central bankers can at times matter more for the relative strength in currencies.
WHAT THE ECONOMIST’S BIG MAC INDEX TELLS US ABOUT THE DOLLAR’S STRENGTH
How currencies are under/over valued against the US dollar
How does The Economist’s Big Mac index work? A Big Mac costs £3.19 in the UK and $5.51 in the US. The implied exchange rate is 0.58. The difference between this and the
actual exchange rate, 0.75, suggests the pound is 23.2% undervalued.
Source: The Economist
Thirdly, the US dollar is overvalued according to a number of technical measures, leaving it susceptible to a reversal at some point. According to the International Monetary Fund’s External Sector Report in June 2018, the US dollar is overvalued in the range of 8-16%, making it an outlier in terms of G10 currencies.
All of the above point to an end to the current trend of a strengthening dollar, and that might come sooner than we think. If, for example, there is a positive surprise in relation to a cooling of the trade tensions, the dollar could weaken, especially given its current valuation. Whenever it comes, it will prove crucial in bringing relief for much-battered emerging market assets.