David Hernandez, CFA
For U.S.-based investors, the movement of the dollar has a direct and indirect impact on emerging market equity returns. The direct impact is straightforward. Purchasing foreign-listed equities requires conversion to the local currency. On top of the change in the price and any dividends of the underlying stock, a weakening U.S. dollar creates a positive currency return, while a strengthening U.S. dollar generates a negative currency return.
The movement of the dollar also has an indirect impact on emerging market returns. This week’s chart looks at the performance of the MSCI EM Local Currency Index and the U.S. Dollar Index (DXY). The local currency index removes any direct currency impact, isolating price performance of the underlying stocks. The DXY measures the U.S. dollar versus a basket of trade partner currencies. Since 2000, the correlation of monthly returns between the local currency index and the dollar index is -0.40, meaning historically they have moved in opposite directions.
There are several reasons why a weak dollar is supportive of emerging market equities. A weaker U.S. dollar is generally positive for overall economic growth and emerging economies typically benefit from strong global growth. Many developing economies are also reliant on dollar-issued debt. A weaker dollar lowers the cost of borrowing, a positive for emerging markets companies and equity markets. The U.S. dollar weakened throughout most of 2020, with the DXY down 10% between February and December. Over that same time frame, emerging markets equities returned 19%. So far in 2021, the dollar is up modestly, with emerging markets pulling back more recently. Looking forward, we expect the historical relationship between the two to persist, positioning emerging market equity investors to benefit should the dollar weaken further.
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