Strong Dollar and Emerging Markets

The case for emerging markets is compelling. Economic growth in emerging markets will continue to outrun developed market growth. EM sovereigns are less dependent on USD funding than before, having learnt the lessons in the mid and late 1990s. In credit, emerging market default rates (circa 13% for HY) are well below that of developed markets (circa 20% for HY). Global growth remains in a synchronized growth phase (the notable weakness has surfaced in Europe rather than any emerging market) and trade appears to have rebounded despite recent protectionist posturing by the US.

And yet, the Russian ruble is off 10% from its peak in February, the Argentinian peso is down a fifth (and interest rates are up from 27% to 47%), the Brazilian real has lost over 14%, and the Turkish lira over 15% where rates have crept up from 12.5% to 14%. In each case, the respective current accounts have deteriorated. But the current account is just one factor in driving rates and FX and the sudden deceleration in these EM currencies (and spike in rates) suggests other factors may be at play. Dollar strength and rising US interest rates are more immediate factors.

The impact of a strong dollar are well documented and the reliance on dollar funding has receded since the 1990s, although it has risen again more recently particularly in the private sector. More interesting is that EM central banks mostly operate some form of managed float FX policy which correlates their external asset reserves to their exchange rates drawing down dollar reserves as their currencies weaken. This exacerbates the effect of a strong dollar on the local currency value of their dollar liabilities. Such policies also import US interest rate policy into the domestic money market at a time when the US Fed is the only major central bank raising rates and tightening policy.

So while emerging market fundamentals may be intact for now, they are under pressure from the rising USD and interest rates. We think that there is a good chance that the healthier emerging markets, especially in Asia, will fundamentally weather the tightening cycle. However, the technical picture is less robust and capital will likely flow back to the US on the back of a retrenchment of QE, as well as more attractive dollar yields.

Italy

Just when political risk seemed to be receding, or at least the pricing thereof, in Europe, the impending formation of the Italian government by a coalition of M5S and the League threaten uncertainty as together they support a program of anti-immigration and anti-austerity, both likely to raise conflict with Brussels. The League wants to cut income taxes while M5S is seeking a citizenship income, both adversely impacting the public finances. Italy has already denied seeking debt forbearance but has contemplated the introduction of mini BoTs, which is basically a securitization of tax receipts. Call it what you will, it is debt issuance and an increase in the national debt. Additionally, as a transferable, bearer, security, mini BoTs threaten to undermine the euro by providing a de facto alternative currency. Italian bonds have sold off in the last couple of weeks, the spread between 10 year BTPS and bunds, less than 120 just a month ago are now 164. The ECB’s QE program is expected to end in September, just 4 months from now. Depending on where investors decide to focus their attention, the risk for volatility in Europe has just risen again.