Overview
Earlier this year, the dramatic collapse of the US dollar’s interest rate advantage over the rest of the world removed a key support for the currency. And Fidelity’s Multi Asset team continues to hold a negative outlook on the dollar, as the vast scale of debt monetisation in the US will continue to depress interest rates, keeping downward pressure on the currency.
But what does this mean for the rest of the world? This week’s Chart Room looks at how a falling US dollar is generally a boon to EM performance relative to DMs, and vice versa. During periods of low US interest rates, many emerging market governments and corporations may look to take advantage of a weaker dollar to borrow money cheaply and at more favourable exchange rates in order to finance domestic growth initiatives and budgetary needs. Traditionally, these dynamics have helped emerging markets to outperform during periods of relative dollar weakness. Lower DM interest rates can also mean that more capital flows towards EMs in search of higher investment returns.
Besides the dollar weakness and interest rate dynamics, there are other reasons to be relatively bullish on EMs. Equity valuations in EMs have catching up to do. Even after the recent outperformance in November, the MSCI EM index is trading at a 30 per cent discount to the MSCI World index based on 1 year forward price to earnings ratio. And earnings revisions point to a decent recovery in corporate profitability next year.
Furthermore, a recent revival in fund flows into EM assets, where investors have been under-allocated for some time, could provide a catalyst for an upward re-rating in valuations. Lastly, while the roll-out of COVID vaccines is expected to be quicker in developed economies, optimism is being tempered by another wave of new infections, particularly in the US and Europe. Surveys suggest there is much less skepticism over receiving vaccines in emerging versus developed countries, so take up could be higher, which could in turn help their economies return to full capacity sooner.
