[This article appears in our August 2018 issue of ETF Report.]
The emerging market (EM) story is facing strains. After a stunning rally in 2017 that took the MSCI Emerging Markets Index up by 37.3%, stocks of developing countries have struggled so far this year. The index briefly hit a decade-high in January before steadily dripping lower to last trade with a year-to-date loss of 6.7%.
ETFs tied to emerging markets, like the $46 billion iShares Core MSCI Emerging Markets ETF (IEMG) and the $59 billion Vanguard FTSE Emerging Markets ETF (VWO), have followed suit to the downside, raising sharp divides in the analyst community about whether this is a buying opportunity or the start of a more severe downturn in the asset class.
On one side, you have analysts like those at UBS, who see "solid rally potential" in emerging market equities, while on the other, you have analysts like those at Morgan Stanley who expect an "outright bear market" for EM.
Rising Dollar Sinks EM
No matter which side of the debate they land on, analysts tend to agree on one thing―a rising dollar is negative for emerging market equities. Since the start of 2018, the U.S. Dollar Index has climbed nearly 3% to last trade near a one-year high.
A climbing dollar hurts returns for U.S. investors who invest in emerging market stocks, which are typically denominated in emerging market currencies.
"When the dollar is rising, it tends to bring money back towards the U.S." as "investors take off the risk trade," said Geoff Dennis, head of global emerging markets strategy at UBS. EM traditionally does very poorly during times of a rising dollar, as investors "pick away at the weaker stories within emerging markets," he added.
In addition to hurting investors' returns, a stronger dollar: makes it more difficult for emerging market countries to finance their dollar-denominated debts; reduces foreign investment in emerging markets, hurting economic growth; and tends to weigh on EM foreign currency reserves as central banks draw them down to stabilize their domestic currencies.
The dollar's pull on emerging markets is so powerful that even bullish analysts such as UBS' Dennis concede that, were the greenback to rally further, the outlook for the asset class would be severely challenged.