The question going forward for Emerging Market investors is this: “What will be the cost of being well diversified globally?” Is EM to be zeroed out, as Blackrock suggests? Since, as we have seen, a significant driver of EM underperformance is a strong dollar, then the most natural source of future EM underperformance may well be an even stronger dollar. Is that possible? Is it plausible? Is it likely?
Strong dollar may continue to wreak havoc in Latin America, but not in Asia
Over the short-term, there are still some plausible scenarios for a strong dollar which would significantly increase the risk factor for EM. Let me outline three of them.
First, when countries get into some trouble, they often go on to get into even more trouble. A cascade effect can be set in motion in which a nation with high dollar debt obligations and falling currency values may well receive downgrades from rating agencies after the sell-off. Downgrades often have negative effects on investor sentiment, which is to say that the probability of a downgrade is not always fully “baked into” the price and the downgrade sets off a second round of sell-offs. In addition, high levels of liability in appreciating currencies can sometimes trigger social unrest via “austerity programs” and rising unemployment. Social unrest is bad for markets and can lead to further sell-offs. Any kind of Latin American crisis is likely to have non-Latin American effects: for example, a stronger dollar and perhaps a stronger yen due to haven effects.
Second, there is the possibility of another factor appearing which would push the dollar up further: Trump has proposed some sort of tax policy which would encourage the repatriation of foreign profits by US-domiciled companies. When the Bush administration pushed through a similar bill in 2004, the dollar appreciated considerably as foreign subsidiaries of US companies clamored to sell their foreign currency units in exchange for dollars which they could bring home to the parent company. This created a temporary surge in demand for dollars and a temporary surge in the price of dollars.
Third, the Fed could engage in hiking rates more aggressively than markets are currently anticipating. Fourth quarter growth is looking fairly strong, and when the Fed meets in early 2017, that growth number will be fresh in its memory. In addition, inflation over the short run (and the market indicators of inflation) are now high enough to give the Fed permission to hike rates in order to show the markets who’s the boss.
Rate hikes can strengthen the dollar directly because hiking interest rates is the mechanism by which the Fed contracts the money supply, making dollars more valuable. In addition, there can be an interest rate arbitrage effect, one that causes investors to buy dollars so that they can buy higher yield US bonds. In general over the past several years, my view has been that the Fed will stay lower longer than most commentators predict. If growth and/or inflation come in higher than expected, then the Fed might tighten more than expected. The dollar would surge in value and EM economies with lots of dollar debt would find those dollars more expensive – and the market would likely punish them.
The problem with that scenario is that a strong dollar tends to lower inflation and lower growth. If this happens, the Fed might slow things down.
Fourth, European political disruption could drive more investors out of the eurozone and into the dollar as a haven. The Italians have just voted “no” to constitutional reform and Matteo Renzi has announced his resignation. This has driven the euro down and the dollar up, at least in the short run. But these things can have contagion effects as other fragile debt-ridden nations are put under the microscope. Furthermore, there is a risk of political contagion (or political cure, depending upon your politics) in which Trump- and Brexit-style electoral outcomes surge across Europe. All of this would tend to strengthen the dollar.
The dollar is somewhat historically overvalued
The dollar went up this much, people say: surely it’s possible that it can go up more. But this does not seem highly likely.
The dollar is not near all-time highs, according to the Trade Weighted Index of ALL Currencies, which includes the Reagan/Volcker dollar bull market of the 1980s; it’s actually about 3% below average:
According to the more limited time horizon for data in the Trade Weighted Dollar Index for Major Currencies, however, the dollar is at a very high valuation:
Thirdly, let’s look at real (that is, price adjusted) exchange rates, over a longer time horizon that includes the weak dollar period of the 1970s. This shows the dollar to be at roughly 6% above its average historic valuation, and at the 4th largest peak in the data set:
It seems that, when viewed against all currencies and against the last several years, the dollar looks like it is in bubble territory. But when viewed in longer terms, including the historic transformation in the early 1980s from a low growth, high inflation economy into a high growth, low inflation economy, the dollar looks to be at a normal to slightly high valuation.
Basically the main difference is between data sets which include the strong Reagan dollar and those which do not.
A Reagan-sized dollar bull market requires better policy than currently expected
This implies that the dollar is only likely to go to much higher values if the actions of the Trump administration turn out to be similar in magnitude to the Reagan Revolution.
So far, the Trump Transformation does not look like it’s on the same scale as the Reagan Revolution. Reagan took tax rates down by much larger increments than Trump is proposing to do. In addition, the world in general has become more competitive. When Reagan cut taxes, he did it in a generally high business tax world, making the US into a gigantic tax haven. Since then, other countries have learned the lesson of Reaganomics, with much of the world cutting taxes repeatedly during the 1990s. If Trump makes all the cuts he intends to make, that would move us to the lower middle range for taxes compared to the rest of the world, whereas Reagan pushed tax rates here close to the bottom of the international range.
In addition, markets are not signaling the kind of US boom which we got under Reagan. The equity yield premium (a measure of the difference in valuation between stocks and bonds) is consistent with the idea that the Trump years will be an improvement over the Obama years (and certainly an improvement in comparison with the anticipated Clinton years) but not a full-flown boom. They seem to imply something more like a return to normal growth rates.
The High Yield risk spread (a metric which compares the valuation of high risk bonds to that of low risk bonds) is sending the same general message of growth hovering around 3%.
Commodity valuations, especially copper, have performed well since the election, but they had plunged last year to levels so low as to suggest that investors had been expecting rough economic times. Their surge since the election takes them up from the bottom levels but not nearly back to the top. This suggests participants are backing off from their dire pessimism towards something like tepid optimism. In other words, Dr. Copper is predicting a recovery, not a boom.
Trump probably wants a weak dollar
Mr Trump, when he was on the campaign trail, spoke passionately about only one public policy issue: trade. He would look down at his notes when he talked about his “own” tax plan, but when he talked about NAFTA and China and “shipping jobs overseas”, there were no downward glances at an outline composed by staff. Mr Trump believes wholeheartedly that US workers have been hurt by trade deficits. Fluctuations upward in the dollar would exacerbate these deficits. A strengthening of an already strong dollar, though it may for the moment be taken as a welcome sign of prestige and of world confidence in a Trump administration, works directly at odds with Mr Trump’s stated policy objectives.
I think the strongest factor to be taken into account is Mr Trump’s protectionist impulses. He doesn’t want a strong dollar. Reagan did want one. As my good friend John Tamny (Political Economy editor of Forbes.com and editor of Real Clear Markets) often says, “Presidents tend to get the dollar they want”.
If Mr Trump gets the dollar which supports the outcome that he wants – lower trade deficits – then he’ll be getting a weaker dollar. And if he gets that weaker dollar, then, over the long run, EM countries exposed to dollar-denominated debt are likely to offer some relief against the head wind of long-term appreciation in the dollar.
This does not imply that it is necessary for the US to intervene in currency markets to bring the dollar down: it may just be a matter of other nations, especially China, intervening to raise their currencies against the dollar – in order to avoid trade sanctions from the US.
The evidence favors a strong dollar in the short run and a weaker dollar in the long run. This means that long term investors would be best served by focusing on what we know from the past in country selection: buying countries with good demographics, and manageable debt levels, which are trending towards greater economic freedom at bargain prices. Basically, for now, that means an overweight to Asia. In the initial strong dollar phase, Asia is much better positioned than Latin America in terms of dollar-denominated debt. It also benefits (less than generally perceived but still to quite a degree) from an overly strong dollar. In the long run, those parts of Asia with high levels of economic freedom have a strong growth edge.