The recent weakening of the U.S. dollar has raised hopes that international stocks, including those of emerging markets, may be ready for a period of superior performance compared to those of the United States. This is because, in the past, foreign stocks have enjoyed strong results during periods of dollar weakness. The dollar cycle has tended to last about a decade and a half, with some eight years of dollar strength followed by some eight years of dollar weakness. The dollar has been strong relative to foreign currencies since 2012, so perhaps the recent weakness of the greenback may indicate the cycle is now turning.
The strength of the dollar tends to be associated with periods of U.S. “exceptionalism:” times when the U.S. is growing more and creating more wealth than the rest of the world and, consequently, attracting more capital to its shores. The U.S. is also often seen as the primary safe haven for capital, given its deep capital markets, rule of law and friendly attitude to foreign capital inflows. During times of global political or financial stress this “safe-haven” status of the U.S. is especially important. This has certainly been the case for the past eight years which have seen negative interest rates in Europe and Japan and massive capital flight from many emerging markets, including China and Latin America.
The U.S. safe haven status diminishes in importance when the prospects for economic growth and returns on capital appear to be relatively better in foreign markets. This may be the case today given the complicated circumstances of U.S. in terms of politics and the economy in the wake of the disastrous management of the Covid-19 pandemic. The U.S. is now committed to negative real interest rates for the foreseeable future and is likely to turn to financial repression to face growing debt and social liabilities. Ten-year Treasury bills now yield 0.5%, which points to a combination of low growth and deflation for the foreseeable future. Moreover, high U.S stock prices also point to very low forward returns.
On the other hand, growth prospects now look relatively more attractive in Europe, Asia and emerging markets, and the valuation differential between U.S. and foreign stocks are near record highs. This has set the stage for the current weak performance of the U.S. dollar. As shown in the chart below, The U.S Dollar Index (DXY) has fallen sharply, by about 10% since its March high and is now trading well below its 200-day moving average.
However, it is important to note that the DXY, though the most watched indicator of the USD, is weighed heavily to the Euro and the Japanese Yen. To get an idea of the trends for emerging markets we have to look at the MSCI emerging markets currency ratio which shows the weighed relative performance for all of the countries included in the MSCI EM index. The following chart, from Yardeni Research shows this ratio. We can see here that there has been so far only a slight uptick in this ratio, not enough to indicate a trend.
Furthermore, the previous chart obfuscates the continued poor performance of the majority of EM currencies. Aside from China and a few other Asian currencies, all the major EM currencies continue to lose value. We can see this in the chart below. Not surprisingly, the worse performing currencies belong to those countries that have poorly controlled the pandemic and suffer from financial and political instability.
In conclusion, it is still early to bring out the champagne. Though the USD is weakening relative to the Euro and the Yen, and especially gold, emerging markets are not yet participating because fundamentals are in many cases still deteriorating.