With the U.S. dollar losing steam, investors are seeing new life in some emerging market equities. A strong dollar resulting from the Federal Reserve’s rate hiking campaign that began in March 2022 dealt emerging markets a heavy blow by worsening inflation, lifting their debt burdens and raising the specter of capital outflows. But the dollar has recently begun to show signs of weakening, with the U.S. Dollar Index, which measures the greenback against a basket of six major currencies, losing nearly 6% over the past 12 months. The dollar index dipped below the 100 level on July 14, marking its lowest level since mid-April 2022. The dollar index was last trading around 101. .DXY 1Y mountain Dollar under pressure Emerging market equities are likely to outperform their developed market peers, UBS wrote in a Wednesday note, with the dollar’s slowdown providing a tailwind that will also allow emerging market central banks to begin to ease their own rates. “I think you would be remiss not to mention [that] if you’re thinking about a weaker dollar persisting, there is a lift for U.S. investors investing outside of the U.S.,” said Shannon Saccocia, chief investment officer at Neuberger Berman Private Wealth. Emerging markets that have “significant imports in commodities” stand to benefit from a weakening dollar, according to CFRA head of ETF Research Aniket Ullal. Most commodities are denominated in dollars, so a weaker dollar results in lower input costs, especially energy. Ulllal pointed to India, which is a “significant net importer” of oil, as an example. Conversely, export-oriented countries such as Vietnam benefit less from dollar weakness, which makes their exports less competitive, said Ullal. Dollar-denominated debt Availability of capital aimed at emerging markets improves in a weaker dollar environment, reducing the risk that nations and companies will come under strain. Emerging markets sell debt in dollars; as a result, if the dollar depreciates against a home currency, it is easier for corporates to make their outstanding debt payments in dollars. “But also, the general funding environment just eases up, and lenders and suppliers of capital are just a little bit looser with funds when the dollar is weaker in emerging markets,” said BMO Wealth Management chief investment officer Yung-Yu Ma. “So there’s just a dynamic where the overall access to capital funding improves when there’s a weaker dollar in emerging markets, and vice versa. When there’s a strong dollar, [that all] tends to contract,” Ma added. ESG play Emerging market equities are currently trading at a significant valuation gap, according to UBS. The Swiss bank found that the MSCI Emerging Markets index is trading near a 36% discount to the S & P 500. Strategist Xingchen Yu picked Latin America, South and Southeast Asia, and Central and Eastern Europe as regions that will have “an increasingly favorable environment” for EM stocks. Investors eyeing emerging markets should also weigh environmental, social and governance factors, Yu added. He noted that the MSCI EM ESG Leaders index has underperformed the broader EM benchmark due to regulatory shocks and a shift to growth stocks from value names over the past year — making valuations attractive for investors. “In recent years, selecting companies based on their ESG characteristics has supported performance and mitigated risks, and this is a trend we expect to continue,” said Yu. The simplest way to gain exposure in emerging markets is through ETFs. The three largest are: Vanguard FTSE Emerging Markets ETF , iShares Core MSCI Emerging Markets ETF and iShares MSCI Emerging Markets ETF . Core MSCI is higher by 9.6% in 2023, iShares MSCI Emerging Markets is up 8.2% and Vanguard FTSE Emerging Markets has gained 7.4%. EEM YTD mountain EEM in 2023 —CNBC’s Michael Bloom and Sarah Min contributed to this report.
