Fran Rodilosso, Head of Fixed Income ETF Portfolio Management, CFA
January 10, 2019
Rising rates and a stronger dollar drove much of the narrative in the market last year, but for 2019 the prospect of these themes continuing is less clear. Although there are valid reasons to expect more of the same, we believe there are several drivers that may lead this trend to pause or even reverse. In the event that U.S. dollar strength slips, we believe this could lead to opportunities in emerging markets local currency bonds.
EMFX Weakness in 2018
Source: J.P. Morgan and Bloomberg as of 12/31/2018. EM Debt FX Return represents the foreign currency return of the J.P. Morgan GBI-EM Global Core Index. DXY represents the U.S. Dollar Index.
Arguments for a Weaker Dollar
In an environment with less external pressure, we believe many emerging markets currencies could rally. First, a slowdown and perhaps end of the Federal Reserve’s (Fed's) rate hiking cycle seems likely in the coming year. Although the Fed “dot plot”1 still forecasts two hikes next year, market expectations now reflect no further hikes and even a possible rate cut late next year. With changing expectations, U.S. market interest rates have gone lower, providing downside pressure on the U.S. dollar and upside pressure on emerging markets currencies (EMFX).
Second, a fair amount of risk premium is built into emerging markets local rates and EMFX, which looks excessive, in our view, compared to fundamentals such as the growth differential with the U.S., creating a fertile ground for emerging markets rallies. For example, when comparing the current level of the dollar versus global currencies in relation to the differential between U.S. and global interest rates, the valuation gap that favored long U.S. dollar positions has more than reversed following 2018’s dollar appreciation. In other words, although fundamentals in emerging markets generally remain sound, attractive valuations may provide the bigger catalyst for EMFX strength in the near term.
Third, with gridlock in Washington and no clear conviction from either party to rein in government spending or pursue entitlement reforms, government debt is expected to continue to grow quickly. With lower tax revenues, ongoing fiscal deterioration will likely, at some point, have a negative impact on the dollar.
Other factors to consider include the possibility of stronger growth outside of the U.S. China’s stimulus measures in 2018 may kick in this year and provide a broader boost to the global economy, with emerging markets as a primary beneficiary. Further, a widening U.S. current account deficit and decreased demand by foreign investors for U.S. bonds due to higher currency hedging costs may reduce dollar demand. Finally, in our view the dollar’s net speculative positioning looks elevated, creating ample room for the move down if the aforementioned factors materialize.
The planned reduction of the Fed’s balance sheet is a heavy-weight factor that should provide support for the dollar in the next two years. The broad dollar cycle has had an inverse relationship with global liquidity. If the Fed shrinks its assets relative to the rest of the world, this should push the dollar higher over this time horizon.
In addition, if global ex-U.S. (or “rest-of-world”) growth continues to lag the U.S., it is difficult to foresee sustained dollar weakness. Further, additional hikes by the Fed beyond the market’s now tempered expectations would likely be supportive of the dollar in 2019.
What Does This Mean for Emerging Markets Investors?
For emerging markets investors, a pause or reversal in U.S. dollar strength favors emerging markets local currency bonds. A weaker dollar also reduces the cost of hard currency funding for emerging markets issuers, providing support to hard currency assets as well. Importantly, local currencies are already at historically low valuations against the U.S. dollar, and any of the factors mentioned above could provide a catalyst for currency appreciation next year.
IMPORTANT DEFINITIONS AND DISCLOSURES
1The dot plot shows where each member of the Federal Open Market Committee (FOMC) thinks the fed funds rate should be at the end of the year for the next few years.
J.P. Morgan GBI-EM Global Core Index: tracks local currency denominated EM government debt. The index weighting methodology limits the weight of countries with larger debt stocks, with a maximum of 10% and a minimum of 3%.
U.S. Dollar Index: tracks the value of the United States dollar relative to a basket of developed market trading partners’ currencies.
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