Niranjan Avasthi of Edelweiss AMC explains 4 reasons why EMs like India benefit from weak Dollar

With the economy sustaining major bruises, this is the right time to invest at low prices and bet on the positive outcomes that inevitably follow a downturn.

The dynamics between the performance of Emerging Market (EM) stocks and the US Dollar is one of the tightest macro relationships that exist in investing. The weekly return correlation between the US Dollar and MSCI Emerging Market Index has consistently been around -0.70 over the last 10 years. This means that when the US Dollar weakens emerging market stocks rally, and vice versa.

Therefore, the MSCI EM Index and the MSCI World Index ratio and the US Dollar Index are negatively-correlated. This negative correlation means that when the US Dollar weakens, the EM index outperforms the World Index. On the other hand, when the US Dollar strengthens the EM index underperforms the World index.

As they say, the proof is always in the pudding. Let us see how these indices have performed in response to movements in the UD Dollar. From 1995 to 2000, the US Dollar appreciated over 30% while the MSCI EM Index underperformed the MSCI World Index by over 15%, annualised.

Then, from 2001 to 2010, the US Dollar depreciated by over 18% while the MSCI EM Index outperformed the MSCI World Index by 14%, annualised.

From 2011 to 2020, the US Dollar appreciated over 30% while the MSCI EM Index underperformed the MSCI World Index by 7%, annualised. Overall, from 1995 to 2020, this relationship has exhibited a correlation of -0.35.

Easing Monetary Policy and Dollar Depreciation

In line with the stance adopted by global central banks to reverse the economic slowdown, the US Federal Reserve has eased its monetary policy significantly.

In its latest policy review, the Fed has maintained policy rates at near-zero levels in the hope of spurring demand to propel the market. An easy monetary policy weakens the dollar and leads to its depreciation.
Since the US dollar is a fiat currency, meaning that it is not backed by gold, it can be created easily, whenever the need arises. In a measure to boost liquidity, the Fed has expanded its balance sheet by creating more money (US dollars).

With supply exceeding demand, the laws of economics dictate that the value of the US Dollar will inevitably fall.

Additionally, investors generally tend to gravitate towards the highest yielding investments. With the Fed cutting rates to near-zero levels, the yields of US Treasury bills or government bonds have mirrored this movement and fallen to historic lows.

With lower rates in the US, investors prefer to transfer their money out of the US, into other countries that offer higher interest rates. The result is a weakening of the dollar versus the currencies of the higher-yielding countries, mainly EMs.

Since the US Fed has expanded its balance sheet at record speed, the US Dollar is likely to go through an extended weak patch. Taking cues from multiple cycles in the past, if the US Dollar continues to weaken, EM stocks may outperform and offer significant returns.

Underlying Opportunities in a Weakening Dollar

A weakening of the US Dollar can benefit EM stocks in multiple ways.

--A weaker dollar allows EM countries more freedom to provide fiscal stimulus without fearing negative implications for their own economies. For example, an EM government will prefer adopting a fiscal easing policy if its currency is rising, mitigating the risk of an inflationary shock.

Considering the Indian scenario, the government will be more comfortable to push forward a fiscal stimulus now that the Indian Rupee is maintaining stability; which we already saw in the recently announced Union Budget. This will overall be good for the EM economy.

--The dollar starts depreciating, investors often flock towards riskier assets for better returns. EMs are a natural choice as they tend to benefit from the weakening dollar and grow faster than Developed Markets (DMs).

--A weaker dollar is usually accompanied by stronger commodity prices which boost growth and have a positive impact on the trade surplus of EMs who are generally commodities exporters.

--A weakening dollar is also good for countries that heavily rely on foreign investments. When the dollar weakens, investors chase high-yielding EM countries, and the money that consequently flows into countries can fund local investments and give an impetus to economic growth.

With the dollar set to remain weak amid efforts to boost the slowing economy, investments are veering towards a sweet spot with the potential to offer significant and sustained returns. The time is ripe for global investors to turn their sights towards EM opportunities by parking a portion of their investment portfolio in well-performing international funds.

(The author is Head - Product & Marketing, Edelweiss Asset Management Limited (EAML)

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