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January 10, 2020

MRP Adds Long Emerging Market Equities to List of Themes

A confluence of factors has us thinking that the US dollar could weaken this year. That is, of course, if the recent flare up in US-Iran tensions dissipates enough to prevent full-blown military action in the Middle East. The prospect of a weaker dollar creates an interesting opportunity for asset allocators with an eye on emerging markets. Aside from the dollar effect, emerging markets are at a rare inflection point these days, with multiple crosscurrents in their favor.

The U.S. dollar recently experienced its worst monthly performance in 2 years, sliding 2% in December. Moreover, the Bloomberg Dollar Spot index, which tracks the U.S. currency against a basket of its peers, has failed to make new highs since hitting a peak in early 2017. This, after surging about 40% between 2011 and 2017. The buck has weakened just 7% since that 2017 peak, however, we believe conditions are in place for further depreciation over the course of this year due to a confluence of factors.

Return of the Risk-On Trade

Two events that took place in December can be interpreted as bearish for the US dollar. First came news that the US and China had reached a phase-one trade agreement, and plan to roll back some tariffs after the deal is signed on January 15. Then came Prime Minister Boris Johnson’s landslide electoral victory in the UK, which opened up a clearer path forward for Brexit.

Improved visibiltiy on those two items was enough to lower the fear gauge and improve investor sentiment, as confirmed by the powerful rally we witnessed across global equity markets at year-end. When the “risk-on” trade is back on the books, demand for haven currencies like the dollar tends to fall.

Dovish Fed Policy

Barring an inflationary scare, U.S. interest rates are unlikely to rise in 2020, judging by the FOMC minutes from the Fed’s December 2019 meeting. Additionally, the Fed’s pledge to buy $60 billion of Treasury bills a month through the second quarter of 2020 is essentially a form of monetary easing, regardless of what Chairman Powell chooses to call it. Those purchases could bring the Fed’s balance sheet back to record high levels by mid-year. The combined impact of a hold on interest rates and Fed balance sheet expansion should create a drag on the US dollar, everything else being equal.

Falling US "Real Rate" and Shrinking Yield Premium on Treasuries

MRP has argued repeatedly that exchange rates are driven by shifts in inflation-adjusted interest rates, with a lag of several months. As it turns out, “real” U.S. rates have been falling due to the Fed's dovish pivot, three rate cuts, and a bottoming of domestic inflation.

On January 6, the 10-year US Treasury yield was 1.79%, which is 91 basis points below where it was 12 months earlier. In the meantime, U.S. inflation has climbed from 1.6% in January 2019 to 2.1% per the most recent CPI report. Applying that 2.1% inflation rate to a 1.79% yield puts the "real" yield for the 10-year Treasury at -0.31%.

In comparison, the Euro area's inflation rate of 1% and average 10-year yield of 0.37% produces a "real" yield of -0.37%, which is just slightly above its US counterpart.

Also consider the fact that the US Treasury yield advantage over similar-maturity sovereign bonds from other developed markets has shrunk as well. Comparing US and German 10-year government bonds, for instance, shows the Treasury yield advantage narrowing significantly over the past four months, according to this chart from

The decline in real US rates and the shrinking yield premium on US Treasuries together presage a softening of the dollar versus the euro in the months ahead.

Dollar Weakness Makes Emerging Market Assets More Attractive

The prospect of a weaker dollar creates an interesting opportunity for asset allocators with an eye on emerging markets.

When the dollar strengthens, it becomes more expensive for foreign borrowers to service and repay their dollar-denominated debt. This creates a burden on emerging economies as investors begin to sell these assets and the respective currency. To defend their currencies, foreign central banks are forced to raise their own interest rates, making domestic borrowings costlier too, and putting even more strain on the economy.

Conversely, a depreciating dollar brings relief to emerging market economies and makes their assets more attractive to investors. That's the scenario we see unfolding this year.

Rare Emerging Market Inflection Point

Finally, as pointed out by Manraj Sekhon of Franklin Templeton, emerging markets are at a rare inflection point these days, with multiple crosscurrents in their favor. The markets, he says, are just beginning to recognize the vast opportunities that technological disruption and new business models will open up in emerging economies.

The chips are already in place. Brazil stands to benefit from structural economic reforms and a new commodity market boom. India, as one of the largest and fastest-growing markets for digital consumers, can expect a jump in productivity thanks to massive public and private sector investments in digital infrastructure. China, meanwhile, has emerged as the frontrunner in 5G, artificial intelligence, robotics, and electric mobility, all of which will drive the country’s new economy, allowing it to operate more independently from the United States.

Positive transformational changes are also unfolding in smaller emerging market countries, particularly in Asia.


New MRP Theme: Long Emerging Market Equities

Emerging market equities have drastically underperformed the S&P 500 since the March 2009 trough. The +82% gain experienced by the iShares Emerging Markets ETF (EEM) over that 11-year period pales in comparison to the SPDR S&P 500 ETF (SPY)'s advance of +372%. Looking at just the past two years, EM stocks returned -11%, while international developed market equities and US equities posted respective returns of -5% and +17%.

MRP believes emerging markets will have a chance to lead this year, propelled by a downward slide in the US dollar. We are therefore adding Long Emerging Market Equities to our list of active themes.

Emerging Markets vs Developed Markets Ex-US vs S&P 500

2-Year Chart