STRONG DOLLAR WARNING FOR EMERGING MARKETS

 

As the dollar strengthens, what investing opportunities are to be had in emerging markets?

Eric Anderson, managing partner, Milltrust International

Emerging markets (EMs) have not always suffered in times of a relatively strong dollar. In fact, up to the end of August, EMs have done well this year. Some of our winners have come from EM-based companies exporting in US dollars. These businesses make their revenues in the US currency and pay their costs in local currencies, which is increasingly positive in times of a rising dollar. Manufacturing-intensive exporting countries such as Mexico have benefited the most, with the improving US economy and the lower cost of raw materials driving up revenue in the sector.

A stronger US dollar and the expected rise in US interest rates have also reduced the source of cheap financing available to EM governments. However, this in turn has forced them to address their structural problems in order to raise long-term economic activity. A lot of EM countries have voted this year, which has lifted structural reform to the top of the agenda. Clearing up infrastructure bottlenecks, removing supply-side constraints and opening up markets to competition and foreign investment, among other reforms, should provide investors with a myriad of opportunities to make a profitable investment. India, Indonesia and Mexico should provide some interesting opportunities here.

On the other hand, a rising US dollar could trigger a sharp reversal of capital flows. Some countries will be more vulnerable than others in this situation, particularly those relying more on foreign currency borrowing to sustain their economies. Countries whose current account deficits are financed primarily by foreign direct investments ? as opposed to portfolio flows ? should, in theory, be more resilient to capital outflows. However, most commentators and investors tend to focus more on the size of the deficit rather than how it is being financed.

Countries with tighter monetary conditions will also find it difficult to manoeuvre should there be a capital flight. At the same time, investors should be wary of countries with a low foreign exchange reserve to short-term external debt ratio, a key metric to gauge its ability to meet foreign payments.

Brazil looks to be one of the more vulnerable countries with high inflation, tight monetary conditions and a current account deficit. The ongoing presidential election looks uncertain, with negative sentiment surrounding the incumbent Dilma Rousseff. What is clear is that reform is desperately needed to stimulate the economy and restore the country to an accelerating growth trajectory. Despite Rousseff?s market-unfriendly interventionist policies, she has implemented some necessary reforms this year, dealing with diesel, electricity and gasoline prices as well as reducing exchange rate intervention and the role of public banks. The country also continues to be supported by a strong demographic tailwind, low unemployment and positive consumer confidence indicators, which should still provide some strong investment opportunities in the country for the medium-to-long term.

We have already seen an EM sell-off in September, and there will likely be more volatility in the months ahead as the US normalises its monetary policy. However, the markets will not penalise all EM countries equally. You can expect those that have taken the necessary fiscal, monetary and structural reforms to be rewarded even in a rising US dollar environment.