How to identify emerging markets benefitting from a weaker US dollar

A softer US dollar is setting up a turning point for emerging markets – but not all countries will benefit equally. Pendal’s Global Emerging Markets Opportunities team explains

• Dollar weakness supports EM relative returns
• Deficit countries do best
• Find out about Pendal Global Emerging Markets Opportunities fund

A WEAKER US dollar is creating a supportive backdrop for emerging-market equities, says Pendal’s Global Emerging Markets Opportunities (GEMO) team.

The US Dollar Index – which measures the USD against other major currencies – is down about 10 per cent so far this year

Emerging market returns have historically been strongest when the US dollar is weak, because servicing US-dollar debt becomes cheaper; domestic purchasing power in EMs improves; and cheaper imports help keep inflation under control, creating room for rate cuts.

The prospect of a lower US dollar over coming years suggests EM equities are potentially at an inflection point, creating conditions for a multi-year outperformance of their developed market peers, argues the GEMO team.

“We see the classic conditions in place for an extended period of EM outperformance helped by potential US dollar weakness,” the team has told Pendal investors.

US dollar under pressure

Pressure from policy shifts could place continued downward pressure on the US dollar.

The US Federal Reserve is signalling further rate cuts, while the Trump administration has shown a preference for a weaker dollar through public statements and by raising currency concerns in tariff negotiations.

At the same time, investors are questioning the Fed’s commitment to its inflation target and weighing the risk of greater policy volatility – a loss of confidence that is adding to downward pressure on the dollar.

How dollar weakness boosts EM

Pendal’s GEMO team believes the level of the US dollar affects the performance of businesses in emerging markets in several important ways.

A weaker dollar improves balance sheets and creditworthiness at EM companies by making it cheaper to service US dollar debt.

EM consumers benefit because they can buy more imported goods, which get cheaper as local currencies strengthen. This puts a dampener on prices across EM economies, containing inflation and opening opportunities for rate cuts.

Similarly, because commodities are often priced in US dollars, a weaker dollar means they become cheaper in other currencies, lifting demand and prices. Many EM economies are commodity exporters.

And lower US interest rates leave investors searching globally for higher returns, adding capital flows to EM equities and bonds.

“A weaker US dollar environment has historically been better for emerging market equities,” says the team.

Some EMs are better placed than others

Still, while EM performance lifts as the US dollar weakens, the effect is uneven and investors should be discriminating in stock selection, says the GEMO team.

The Pendal team strongly believes in a top-down, country-level approach to emerging markets investing.

Economies with a current account deficit – common in Latin America and South-East Asia – benefit most from cheaper borrowing, lower imported inflation and stronger consumer demand.

But big exporters that run a surplus such as Taiwan and Korea can face headwinds as their products become more expensive in US-dollar terms.

“EMs differ from each other in fundamental ways,” says the team.

“That means that any given macro environment is going to suit some EMs and perhaps be a headwind for others.

Find out about

Pendal Global Emerging Markets Opportunities Fund

Read more

“This is grounded in the observation that emerging markets go right or wrong at the country level.

“Country factors – such as the current account deficit/surplus dynamic – dominate EM returns in a way that they do not in developed markets.”

How Pendal is positioned

The Pendal GEMO portfolio reflects this selectivity, holding just nine of the 24 MSCI EM countries.

Overweights include Brazil, Indonesia, Mexico and South Africa – economies with current account deficits, inflation under control, scope for rate cuts and attractive valuations.

Taiwan and Korea are underweight in the fund, with the team citing earnings pressure in semiconductors, autos and steel from tariffs.

In China, GEMO favours selective exposure to domestic-demand names and Hong Kong listings, avoiding tariff-exposed sectors.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here