The U.S. dollar just hit a 14-year high against the Euro. So, as the world's reserve currency, dollar strength will have implications for investments around the globe, particularly for emerging markets.
Here's what you need to know.
What the Media Missed
A stronger dollar has caused a mainstream media freakout that's been largely misdirected. The focus has been on the impact to the U.S. The story goes that corporate profits particularly in the manufacturing sector could take a hit and this weakness may spill over into the broader economy.
(**Note: In theory, a stronger curency does make purchasing U.S. exports less attractive to foreigners whose currency and buying power weakens versus the dollar. But U.S. exports aren't the primary driver of our economy, consumption is. We've outlined before, in more detail, why we think the media's attention is misguided, here and here.)
Establishment media is missing the more important implication of the dollar, Emerging Markets. In the fourth quarter-to-date, the U.S. dollar index is up almost +8%. Emerging Markets (EEM), meanwhile, have taken it on the chin, -5.9% over that same period.
The U.S. Dollar/Emerging Market relationship is fairly simple to understand. The problem is two-fold. Most Emerging Markets are commodity exporters. Since commodities are priced in dollars, prices typically take a hit when the dollar strengthens. Also, developing countries account for one-third of the $9.7 trillion dollar debt held outside the U.S. as of the end of 2015. As the dollar strengthens against these developing country currencies, it becomes harder to service that debt which is priced in dollars.
Here's a brief recap of Emerging Market crises
As you can see in the Chart of the Day below, a decade of Emerging Market crises are typically preceded by a decade of easy money from the U.S. federal government which seeks to perpetuate a weaker dollar for one reason or another.
The developing crisis typically follows these stages:
- Flooding the world with dollars sends cash-flush investors in search of opportunities abroad.
- Developing economies pig out on the money pouring in.
- New debt is then issued but becomes increasingly difficult to pay back as the cycle turns and dollar heads higher.
Below is a timeline of the U.S. Dollar index with Analysis...
Click image to enlarge.
1960 – 1979
The Federal Reserve and U.S. government tag team to weaken the U.S. Dollar through abandoning the Gold Standard and Fed easy money policies. Latin America goes on dollar-denominated debt binge.
1982 – 1989
- Mexico Default (1982)
- Latin American Debt Crisis (and IMF imposed austerity, 1982 – 1989)
1980 – 1989
The Plaza Accord (1985): The governments of France, Germany, U.S., U.K. and Japan agree to manipulate foreign exchange markets by depreciating the U.S. dollar relative to the Yen and Deutsche mark. The U.S.’s resulting easy money policies caused money to flow into emerging markets.
1990 – 1999
- Mexico’s Tequila Crisis (1994)
- Contagion in Argentina and Brazil (1994 – 1995)
- Asian Financial Crisis (1997 – 1998)
- Russian Default (1998)
- Brazil Currency Crisis and devaluation (1999)
- Turkish Financial Crisis (2001)
- Argentina Debt Default (2001 – 2002)
- Uruguay Banking Crisis (2002)
2000 – 2009
A secular growth slowdown and two recessions in the U.S. (Dot Com bust and the Great Recession) cause Presidents Bush and Obama and Fed chairmen Alan Greenspan and Ben Bernanke to implement a variety of fiscal and monetary easing policies. The U.S. Dollar hits all-time lows in April 2011.
Money flows into Emerging Markets once again, in search of higher growth and higher interest rates. At the same time, the invention of ETFs greatly reduces barriers to investing in Emerging Markets. Chinese demand for raw materials quintuples bolstering these commodity export-driven economies.
2010 – Present
- India and Indonesia Currency Crises (2013)
- China Mini Banking Crisis (2013)
- Argentine Currency Crisis (2014)
- Russian Currency Crisis (2014)
- Turkey and Brazil Currency Crises (2015)
- Mexican Currency Crisis (2016)
Why This Matters Today
The post-financial crisis trend of dollar weakness is clearly over. The dollar has been strengthening for the better part of three years now. The Federal Reserve is tightening monetary policy, which will cause further dollar strength. Simply put, expect further carnage in Emerging Markets as this trend sets off a deleveraging of the $9.7 trillion in dollar-denominated debt held outside the U.S.
