Things aren’t going as expected for the dollar. President Donald Trump’s ambitions to lower taxes and rebuild infrastructure, coupled with the Federal Reserve’s plan to raise interest rates, were supposed to strengthen it.
Instead, as Bloomberg News reported on Monday, the Bloomberg Dollar Spot Index -- which tracks the dollar’s movements against 10 leading currencies -- has slid below its 200-day moving average and given back most of its post-election gains. The index was up 5.7 percent from election day to Dec. 31; it’s down 4.1 percent this year through Monday.
It’s sensible to wonder whether the dollar’s recent slide is a sign that post-election euphoria is fading, but by one measure a decline was overdue before Election Day. That should be welcome news to at least one group of investors: the daring U.S. shareholders in emerging-market stocks.
U.S. investors have always been skittish about emerging markets. According to research provided by Goldman Sachs, emerging markets accounted for 47 percent of global GDP as of December 2016. They also made up 10.8 percent of global equity market capitalization. And yet, just 3.6 percent of the average U.S. investor’s stock portfolio is allocated to emerging markets.
One reason is that many investors are spooked by emerging-market currencies. Unlike emerging-market bonds, which are denominated in dollars, the stocks are denominated in local currency. When the dollar strengthens relative to emerging-market currencies, U.S. investors lose money on the conversion.
That risk is more than some investors are willing to bear. It doesn’t help that currency crises pop up in emerging markets occasionally. It also didn’t help that emerging-market currencies badly lagged the dollar for more than a decade in the late 1980s and 1990s, just as stock markets in developing countries first opened to U.S. investors.
For example, the price return for the MSCI Emerging Markets Index was 119 percentage points lower in dollars than in local currency during its first year in 1988. From 1988 to 1999, the index’s average one-year price return was 52 percentage points lower in dollars. It wasn’t until 2000 that U.S. investors enjoyed a boost from a declining dollar.
Nearly two decades later, it looks as if investors’ fear of emerging-market currencies is overblown. For one thing, it turns out that currency fluctuations have added little risk to emerging-market stocks. The annual standard deviation of the MSCI Emerging Markets Index has been just 1.2 percentage points higher in dollars than in local currency from 1988 through February. In fact, currency fluctuation contributed more risk to developed-market stocks than emerging ones. The standard deviation of the MSCI EAFE Index has been 2.2 percentage points higher in dollars than in local currency over the same period. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)
Also, currency fluctuation in emerging markets has been much more muted since 2000. The average annual five-year return for the MSCI Emerging Markets Index was 43 percentage points lower in dollars than in local currency from 1992 to 1999. Since then, the average difference has shrunk to just 1.9 percentage points.
But there’s something even more notable about the difference between those five-year dollar and local currency returns since 2000: They’ve shown a strong tendency to mean revert. In other words, a period of gains for the dollar relative to emerging-market currencies has been followed by losses, and vice versa.
That makes intuitive sense. As developing economies become larger and more stable, their currencies become more stable, too, and less susceptible to meltdowns. When that happens, the return from the dollar relative to those foreign currencies should approach zero over time, which is what has happened over the last two decades.
The annual price return for the MSCI Emerging Markets Index has been 4.6 percentage points lower in dollars than in local currency over the most recent five years through February. That’s well above the average gap of 1.9 percentage points since 2000, which implies that the dollar should weaken rather than strengthen in the years ahead. That should be more good news for emerging-market investors.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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