Emerging-market investors are contending with an unwelcome surge by the U.S. dollar.
Emerging-market stocks could see the rush of inflows from Wall Street this year turn into a trickle if the U.S.’s economic upward trajectory diverges with a sluggish global economy, a backdrop favorable to the greenback, said Claudio Irigoyen, a strategist at Bank of America Merrill Lynch, in a Monday research note.
Read: Should stock-market investors fear the wrath of King Dollar?
Investors who expected the Federal Reserve’s newfound patience to allow developing markets to draw in fresh money, consolidating the asset class’s double-digit gains in 2019, could face a letdown, analysts said.
“If we continue observing EM growth disappointing, that could have a bigger impact on EM flows, mostly equity flows, than a gradual repricing of the Fed,” said Irigoyen.
“With EM positioning moving towards the crowded side, investors need to see a confirmation in EM growth to continue deploying capital into the complex,” he said.
The iShares MSCI Emerging Markets exchange-traded fund EEM, +0.21% is up more than 12% year-to-date, though it has yet to return to its early 2018 high. Over the same stretch, the S&P 500 SPX, +0.11% has advanced more than 17%, returning to record territory this month as it eclipsed previous highs set in September.
Attracted by cheap valuations and the outlook for reduced monetary tightening by the U.S. central bank, investors plowed $108.9 billion into emerging market equity and bond funds in the first quarter, according to the Institute for International Finance.
The forward 12-month price to earnings ratio, a common valuation gauge, for emerging markets stocks stood at 12.3 times, versus 17 times for U.S. equities, Refinitiv data shows.
But after the U.S ICE Dollar index DXY, +0.02% , a measure of the currency against a basket of six major rivals, climbed above the upper bound of its two-year trading range last week, the upward momentum in emerging markets swiftly lost steam. Since the greenback’s break-out, theMSCI benchmark EM equity index 891800, +0.37% retreated, falling to 2,425.61 on Friday, off 1.6% from a a nine-month high on April 17.
A stronger dollar can weigh on emerging markets as it can raise the cost of servicing dollar-denominated loans.
The greenback's renewed strength has surprised investors who expected a less aggressive U.S. central bank to provide limited upside for the currency. That assumption swiftly unraveled, however, as subdued growth overseas led monetary policy makers outside of the U.S. to take an even more dovish slant than the Fed, said Irigoyen.
Major central banks such as the European Central Bank and the Bank of Japan have pushed out their dates for tapering accommodative monetary policy. And other smaller central banks like the Bank of Canada and the Swedish Riksbank have backpedaled from tightening monetary policy as their economies slow.
The BAML strategist said the widely held assumption in 2019 that the slower global growth would wash onto U.S. shores was fast losing traction. In fact, recent data suggested only the U.S. and China were shrugging off the sluggishness abroad, entrenching the divergence in the U.S.’s growth trajectory with the rest of the world.
U.S. gross domestic product grew at an annual pace of 3.2% in the first-quarter of 2019, while China’s economy rung in a 6.4% growth rate over the same stretch.
In comparison, Capital Economics estimates that growth in emerging economies for the first three months of this year represented the weakest quarter since the mid-2016.
“Today, we have enough evidence that the U.S. and China are leading the cycle despite the U.S. slowdown, but the recovery in the rest of the world is still pending,” said Irigoyen.
He is still confident China's economic recovery will eventually buoy the export-dependent eurozone and lift other emerging market economies. The hope that China would drive EM equities higher have underpinned their sharp run-up since the start of the year.
But he warned if the benefits of China’s stimulus is limited to its own borders and recent turmoil in Argentina and Turkey raise questions about the durability of emerging-market economies, inflows into EM stocks are likely to peter out.
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