Emerging Market Stocks At 2-Year Highs... What's Next? - emerging markets cartoon 12.19.2016

Are you buying Emerging Markets (EEM) near two-year highs? We suggest you don't. As U.S. economic growth heats up, the Federal Reserve raises interest rates and the U.S. dollar strengthens as a result, emerging markets could take a hit. 

The U.S. Dollar/Emerging Market relationship is fairly simple to understand. The problem is two-fold:

  1. Most Emerging Markets are commodity exporters. Since commodities are priced in dollars, prices typically take a hit when the dollar strengthens. 
  2. Also, developing countries account for one-third of the $10 trillion in dollar denominated debt held outside the U.S. as of September 2016. As the dollar strengthens against these developing country currencies, it becomes harder to service that debt which is priced in dollars.

"Obviously a lot of the outperformance of Emerging Market assets in the year-to-date (e.g. MSCI EM Index +11.8% vs. S&P 500 +4.9%) has to do with the fact that the U.S. Dollar and U.S. rates (10-year Treasury yield) are down -1.4% and -12 basis points, respectively, over that same time frame," writes Hedgeye Senior Macro analyst Darius Dale in today's Early Look.

What's Next for Emerging Markets?

Don't expect this Emerging Market outperformance to continue. Our research suggests the U.S. dollar has plenty of room to run from here. Why? The U.S. economy is accelerating:

  1. Corporate Profits ramped to +9.3% year-over-year. Recall this TREND of profits #accelerating comes after 5 consecutive quarters of negative year-over-year profit growth.
  2. Year-over-year Retail Sales hit the highest level since March 2012.
  3. Durable Goods +5% year-over-year growth; Ex-Aircraft & Defense +3.4% year-over-year growth
  4. Capex +2.7% year-over-year growth in February (up year-over-year for 3 months in a row, after a 2-year long #recession)
  5. US Home Prices (Case/Shiller) +0.9% month-over-month and +5.7% year-over-year = 3 year high 

Meanwhile, as we highlighted in our Quarterly Macro Themes, our GIP (Growth, Inflation, Policy) Model is forecasting a negative inflection in European and Japanese growth here in the second quarter that should trend for at least the next 3-6 months.

As such, we expect monetary and fiscal policy divergence to gather steam in favor of the U.S. dollar which, as the chart below shows, could rise materially. Using the pervasive bull run in the dollar from 1998 to 2001 as a corollary for the current setup implies 20% to 25% upside for the U.S. dollar versus the euro and yen. That level of dollar strength would be a significant headwind for Emerging Markets.

Emerging Market Stocks At 2-Year Highs... What's Next? - strong dollar room to run


We're not calling for an Emerging Market crises like the ones listed below but it is worth reflecting on the relationship between U.S. dollar strength and emerging market weakness. 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. Sound familiar?

A developing Emerging Market crisis typically follows these stages:

  1. Flooding the world with dollars sends cash-flush investors in search of opportunities abroad.
  2. Developing economies pig out on the money pouring in. 
  3. 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 of Emerging Market booms and busts...

Emerging Market Stocks At 2-Year Highs... What's Next? - StrongDollar vs.  WeakDollar Cycles EM Crises

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)


The post-financial crisis trend of dollar weakness is clearly over. The dollar has been strengthening for the better part of three years now. Meanwhile, the Federal Reserve is tightening monetary policy, which will cause further dollar strength.

Be nimble. The strengthening U.S. dollar won't hit all emerging market countries universally. As Hedgeye Senior Macro analyst Darius Dale writes today, "Generally speaking, the larger of the Emerging Market Economies are less at risk from global dollar tightening."

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Editor's Note: We can't give you the specific countries we like and don't like. (For that subscribe and check out today's Early Look, in fact, we're running a special deal right now.) But below is today's Chart of the Day from the Early Look which should provide some context on the countries that are heating up economically (and those that aren't).

Emerging Market Stocks At 2-Year Highs... What's Next? - 4.11.17 Chart of the Day