what happens to "emerging markets" when overall market goes down diverge
The human relationship between the performance of emerging market stocks and the US dollar is one of the tightest macro relationships that exists in investing. Equally nosotros tin can see in the beginning nautical chart, the relative performance of EM stocks vs the S&P 500 is highly negatively correlated with the level of the dollar. That is, when the dollar goes up, European monetary system underperform Usa big caps and when the dollar goes downwardly they outperform. It'southward like clockwork really. Simply that observation is nil new. Indeed, given the contempo strength of the dollar we've written nigh it twice in the last two weeks here and here. But it'southward likewise a good time to non simply remind readers of the relationship, but also to describe the mechanics of it. That'southward what I'll exercise here, using the Philippines every bit our example written report. I accept no detail bias 1 fashion or the other with the Philippines, it'southward just 1 case of many in the EM world for which dollar forcefulness equals trouble, and vice versa.
The reason EM stocks and economies tend to struggle in the face of dollar strength is largely due to the quantity of Usa dollar denominated debt those countries tend to conduct as a share of total debt. Why would they carry USD denominated debt instead of local currency denominated debt? The answer is lower interest rates and the ability to place larger amounts of debt. Of course, at that place are consequences to issuing debt in a currency a country'southward central depository financial institution cannot print, one of which is that information technology makes the economic system of the issuing land extremely procyclical. That is, economic outcomes are amplified both to the upside and to the downside. This is opposed to many adult market place countries which tend to have congenital in mechanisms in the economy and financial markets that taper cyclicality in both directions.
For instance, in the case of a developed market place state, when growth and inflation are strong and ascent the central banking company may enhance brusque-term rates and the bond market will feel higher longer-term rates. With a lag and all else equal, this will tend wearisome downward the economic system. When growth and inflation are low and slowing, a developed market fundamental banking company may lower brusque rates or take other measures to boost need while longer-term rates volition naturally fall. With a lag and all else equal, this volition provide a cyclical boost to the economy.
However, when a land's debt is denominated in a different currency all that changes. Economic booms cause the currency to strengthen and inflation to fall, which allows the primal bank to lower policy rates. Because rates are falling and the currency is strengthening, involvement and principle payments on foreign currency denominated debt go down, making economic agents feel richer. The government upkeep balance improves, often moving to surplus and bringing the current business relationship with it. Long-term rates fall in sympathy with short rates, which lower default risks and provides further stimulus. Investment increases, wages rise, growth picks up even more and the currency continues to strengthen. Information technology'south a self reinforcing loop of strength begetting forcefulness.
It's ugly when it happens in opposite. Weakness in growth causes the currency to fall, which then causes inflation to rise. College aggrandizement means the central banking concern must tighten policy despite the economic system turning downwardly. The government surplus turns to arrears, and the demand for imported capital causes the current account to turn negative likewise. The ascension brusk rates and a lower currency causes foreign currency denominated debt payments to increment apace. In that location is a cash menses clasp, and especially a shortage of United states dollars with which to make debt payments. Non-performing loans ascent, growth slows more, investment is cut, wages autumn, and the currency weakens fifty-fifty more than. It's a cocky reinforcing loop of weakness bearing weakness. With that, permit's dig into the Philippines instance.
This first chart breaks downward the local currency and strange currency denominate government debt as a percent of the full. Local currency debt accounts for only seven% of full debt issuance in the Philippines. The remainder is largely USD denominated debt.
Here we show the twin deficit as a percent of GDP (correct axis, inverted) overlaid on the Philippine peso per USD exchange charge per unit (left axis). The commutation charge per unit leads past one year. Every bit the currency rises (bluish line going downward), the twin deficits improve materially, equally they did from 2009-2014. When the currency falls the twin deficits deteriorate as USD debt payments go more onerous.
Currency rises and falls bring aggrandizement with it. When the currency strengthens (blue line going down) inflation tends to fall, and vice versa.
The inflationary dynamics cause the primal bank to act. In the case of the Philippines, this meant rate cuts from 2011-2012 as the currency was strengthening and charge per unit hikes in 2018 every bit the currency was falling precipitously. In this case, currency moves led central bank activity by about a yr.
Of form, economic force acquired by the ascension currency pushes down long-term bond rates credit risk abates. The opposite is true when the currency weakens.
When the currency is falling, debt service gets harder. The authorities and companies must come upward with US dollars with which to pay the lenders. The fashion they earn those U.s. dollars is through exports. As the currency falls, a larger and larger portion of the Us dollars the country earns through exports go used in debt repayment. In other words, US dollar liquidity tightens dramatically, which only reinforces the currency weakness. Of course, the reverse is likewise true when the currency is strong.
Non-performing loans are highly correlated to changes in the commutation rate. A ascent local currency ways debt payments are easier to meet and NPLs autumn. A falling currency means debt payments are much more difficult to meet and NPLs rise.
If companies are affluent considering their debt obligations are lower, they are more inclined to invest, and vice versa. Dramatic currency force or weakness feeds right into the real economy through investment.
While unemployment may or may not be afflicted by the currency, real wages (wage growth subsequently aggrandizement) do tend to be highly correlated to the currency, with a lag of 18-24 months. Higher wages plain raise consumption and reinforce the growth while falling wages reinforce the downturn.
The cycle ends when the currency gets to such extreme levels that foreigners add to or subtract from strange direct investment. When the currency is and then low that the futurity ROIC of foreign direct investment is exceedingly high, dollars will outset to menstruation back into the country. This was 2009 and 2016 in the case of the Philippines. Foreign investors were rather tepid from 2010-2013 and then once again in 2018, but may be coming back in. Foreign straight investment flows lead currency moves by 12-24 months.
As readers can see, in that location happen to be logical, almost mechanical, relationships between EM currencies and the economy that reinforce either growth or a slowdown. In the finish, it all comes back to debt, and the propensity of European monetary system to event debt denominated in currency other than the ane they print. The result for investors is a very predictable EM relative performance design that is directly tied to the US dollar.
Source: https://www.knowledgeleaderscapital.com/2019/05/02/emerging-market-stocks-underperform-when-the-us-dollar-strengthens-heres-why/
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