US Dollar’s impact on emerging markets may have just begun

Investors rarely worry about the global economy running out of money. Faith in central banks and liquidity is deeply ingrained. It may even just be cynicism; a belief that central banks will print whatever politicians want. But could the global economy be entering a period where US Dollars are scarce? The Dollar is nearing an eight year high, suggesting something has changed. Yet so far the currency has only recovered a fraction of what it gave up in two decades of devaluation. The new trend could have much further to run.

For many commodities and companies, the Dollar is the only currency that matters. Yet, the end of quantitative easing in the US has changed the rules. The shrinking US current account deficit, as its economy recovers and it also moves to energy self-sufficiency, is sharply reducing the supply of Dollars internationally. Commodity-producing nations ranging from Russia to Australia are seeing their own currencies fall. And, the emerging markets that have fuelled their growth by Dollar borrowing or inflows could be hit.

Investors’ current belief in Dollar strength looks consensual. Indeed the Bank of America Merrill Fund Manager survey this month highlighted this as an investor theme. Institutional money has bought in, and many analysts predict further gains for the currency. Yet it is likely that many investors are still underweight the Dow versus global benchmarks, so strong has been the faith in emerging market growth and European recovery. The persistent strength in the Dollar suggests that many have still underestimated their need for Dollars, and are steadily correcting this. When asset prices move rapidly, there is a bias to expecting some pull-back – the gamblers’ fallacy. Investors tend to underestimate how persistent patterns can be once established, and the potential for ending in panic as the last investors capitulate.

Even though many emerging markets have sound central banks, their businesses have been helped by the ease of borrowing in Dollars. Now, business finance has become more expensive. Companies that have issued Dollar bonds but are not earning Dollars, could find repayment difficult. Dollar weakness was not a problem when emerging economies could maintain competitiveness, reaping productivity gains. But in recent years wages have risen strongly in the emerging economies, encouraging American multi-nationals to bring some of their manufacturing back on-shore. Many Asian currencies now look over-valued, particularly following the collapse in the Yen. Japan’s aggressive move may force a response by others in the region; competitive devaluations across Asia could lie ahead.

Some of the Dollar borrowing risks may even be in the US. The US fracking boom that triggered the oil price collapse has drawn in finance from the high yield and junk bond markets. It is estimated that as much as one-sixth of these markets are exposed to the energy sector, the biggest single industry backing the bonds. Forecasts for growth in fracking production in the US have been pared-back sharply, and existing producers will earn much less. Some failures in these bond markets now seem likely if the oil price stays low.

Trends in reserve currencies tend to be driven by strong long term forces, and investors’ perceptions can be rooted in history. For a long period, US power seemed to be waning, with a weak Dollar boosting many of its emerging economy competitors. US savers helped to provide those Dollars, believing they could find growth and yield in emerging market equities and bonds, respectively. The oil price collapse has delivered a reality-check. Now, the US may even enjoy a geopolitical dividend as some unattractive regimes are starved of their petrodollar lifeblood.

Undoubtedly many investors’ views of the US have been set by a long period of political and currency retrenchment. The anchoring bias – basing beliefs in past experience, is difficult to overcome. Many have based their strategy on this world view; underweighting US and global portfolios or borrowing Dollars. But, the US has emerged in better shape from the financial crisis than most. Investors may need to factor-in more attention to currency in the year ahead.

A version of this article was published as in the Behavioural Finance Series in Citywire on December 15 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice. At the time of writing neither I nor my employer’s clients had interests in any stock mentioned and had no plans to initiate any positions.

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