Emerging markets – finding returns when the US dollar is strong

Set against a difficult economic backdrop, some emerging markets have still been able to achieve solid returns in both equity and fixed income markets. The challenge for investors is to find the markets that offer attractive investment opportunities, while understanding how they will be affected by the key economic and financial trends driving markets – such as currency movements and the outlook for commodity prices.

How investors can do this was the subject of a webinar at HSBC’s 2022 Global Emerging Markets Forum, with a panel where senior analysts and strategists explored the need-to-know investment themes in emerging markets.

The single theme that connects all global markets, developed and emerging, is the powerful upward trend in the US dollar. The US Dollar Index gained 13% in the first eight months of 2022¹, and moves in the greenback are important in emerging markets, as they affect everything from the total returns that investors receive to the stability in domestic financial systems.

There are three factors that explain the US dollar’s strength. For a start, global growth is weak, creating an environment that is favourable to the US currency. Secondly, the US Federal Reserve has a hawkish stance that has exceeded market expectations. Finally, there is a broad tightening of monetary conditions across the world.

Taken together, these developments create headwinds for emerging currencies, and over the coming quarters investors will be looking for currencies that can keep their value in a prolonged period of US dollar strength.

When it comes to market returns and the flow of capital, the strength of the US dollar is the second most important factor, behind the overall health of the global economy, according to econometric models conducted by Murat Ulgen, Global Head of Emerging Markets Research, HSBC.

“So when you have a global growth environment that is weak or weakening, combined with a strong dollar, you will see significant outflows out of fixed income,” he said, highlighting that USD60 billion had left bond funds so far this year.

But the recent outflows will unlikely turn into a rout on the scale of the Taper Tantrum in 2013 – a period of market turmoil that sparked global investors to pull money out of the so-called “Fragile Five”, including Brazil, India, Indonesia, South Africa, and Türkiye.

Mr. Ulgen highlighted a number of reasons to believe that some emerging markets are in a much stronger position than in the past. In the current stretch of market volatility, many central banks in emerging markets have already hiked rates aggressively. They have healthier external balance sheets, which is advantageous when liquidity is being withdrawn, and better current account balances, reducing their funding requirements.

Emerging market equities have performed as expected, with the MSCI Emerging Markets Index (USD) down 17.5% in the first eight months of the year², as the strong dollar impedes performance. But underlying the movement in the index are surprising movements in individual markets, with traditional defensive markets in Asia underperforming, while cyclical commodity plays have offered good returns during the market downturn.

“Who would have thought at the beginning of the year that countries like Brazil and Chile would have led emerging market performance in this kind of environment?” asked John Lomax, Head of Global Emerging Market Equity Strategy, HSBC, who attributed the success of resource-rich countries to the interplay between commodity prices, local monetary policy, and factors related to structural growth.

But when looking at emerging market returns, it is impossible to ignore the foreign exchange component. In fixed income, this is especially important as the US dollar appreciates against currencies all over the world.

With the US dollar likely to remain strong in the foreseeable future, there will be headwinds for many emerging markets. But healthy balance sheets and current account balances, along with pre-emptive moves by central banks, makes it unlikely that we will see economic or financial crises occur. Investors that take a selective approach to the emerging markets universe will still be able to find opportunities in an asset class that remains the long-term driver of global growth.