Financial markets made up their minds on Emerging Markets. It may not be easy to change the perception. However there are good reasons why the current market rout could be over soon. Unless…there are some possible tweets from President Trump, some more sanctions on any country in the Emerging Markets, NAFTA hitting some roadblock….you can name many more. The read is simple: fundamentals are not able to assert themselves and any media or political turmoil could upset a constructive environment.

There are building blocks which will herald any improvement in the emerging markets.

US-Dollar is one of the important indicators. At the current moment it appears that DXY may take a deep breath and reverse some of the gains seen since the beginning of the year.

DXY index weekly

DXY 2018-09-18

Source: Bloomberg

There are numerous reasons why the strength could continue.

  • Interest rate spread between US and Europe as well as Japan
  • US economy performs stronger then Europe or Japan
  • Economic policies are supportive for global flows into the US market

There are obviously other good reasons why US-Dollar should weaken

  • Extreme positioning in US-Dollars
  • Interest rate increases are priced in
  • Europe will slowly follow with rate increases and close the spread
  • Inflation differentials vanished
  • Inflation levels weakened on both sides of the Atlantic

In general it will be the interest rate expectation which will drive the EUR-USD rate in the coming weeks and months

Emerging Markets generally do not like rising US rates and even less rising US-Dollar.

DXY Index vs J.P. Morgan Emerging Market Currency Index (EMCI) Live Spot (invers)

DXY vs JPM 2018-09-18

Source: Bloomberg

Over the period of 5 years the strength in US-Dollar translated into the weakness in the Emerging Markets currencies.

Currently there is a lot of discussions about the economic imbalances burdening Emerging Markets. The debt levels are deemed unsustainable especially in foreign currency mostly US-Dollars. Although unlike 90s the currencies are not pegged to US-Dollar. Nonetheless high debt levels in foreign currencies can lead to defaults and economic hardship mostly via weak exchange rates mechanism. Thus weak currencies are associated with deteriorating financial conditions and falling equity markets in the emerging Markets.

MSCI Emerging Markets

MXEF 2018-09-18

Source: Bloomberg

However shall the rate cycle approach final stages and/or shall the US-Dollar weaken again against major currencies such as Euro or Japanese Yen the chances for Emerging Markets revival are improving. Additionally shall China find a new way of navigating the treacherous waters of trade tariffs and be able to cushion some of the Impact, the gloom can lift.