Investing in emerging market stocks and bonds is primarily driven by macro factors, such as liquidity, relative growth, politics and, most importantly, the mighty U.S. dollar. The importance of macro trends is the reason that emerging market investing has traditionally been dominated by short-term oriented hedge funds and Wall Street trading desks. This has been true since the early 1980s when the liberalization of global financial capital flows allowed traders like George Soros to actively engage in EM equity and debt markets. More recently, firms like Ray Dalio’s Bridgewater have made EM a key part of their global diversification strategies.
In global macro, everything is in some sense a dollar trade, so it is imperative that investors have a view on the direction of the dollar. In fact, the dollar’s trend clearly separates the world of financial assets into two camps: Long USD trades — risk tolerant and rate sensitive – which include bonds, growth stocks and other long-duration assets; Short USD trades – risk intolerant – which include value and small cap stocks, EM stocks and bonds and commodities.
Based on recent empirical evidence, investors have developed models to predict the future course of the dollar. Unfortunately, there is not a lot of historical data since the current USD regime is based on a fiat monetary system which has existed only since 1971.
George Soros is said to have come up with a visionary and innovative approach to currency trading in the early 1980s when he proposed that the dollar trend could be determined by the strength of the U.S. economy relative to the global economy. In periods of relative U.S. economic vigor, sometimes referred to as phases of “American Exceptionalism,” the U.S. attracts foreign flows into its capital markets and the dollar appreciates. Under these circumstances, the dollar can remain strong until the cycle exhausts itself because of rising macroeconomic imbalances. In periods of relative global economic vigor, capital flows out of the U.S. into more attractive international assets.
This dollar cycle as suggested by Soros is underpinned by reflexive investor behavior. As the USD appreciates the returns on U.S. assets increase for foreign investors which attracts more investment. When the USD begins a downward trend, then the opposite happens.
The empirical evidence for the Soros model is shown in the graph below. The top segment of the chart shows the evolution of the USD index (DXY) since the 1970s. We can see that there have been three major upswings of the USD over this period, in what appears to be a long-term downtrend. The cycles have lasted about 8-9 years on the uptrend and 8-9 years on the downtrend, for a total of 16-18 years. Given that the current dollar uptrend started in 2011, we would now expect a dollar downtrend to be under way. However, this remains to be confirmed, as currently the effects from the pandemic and extraordinary fiscal and monetary policies adopted around the world may be overwhelming long-term fundamentals.
The bottom segment of the chart shows the performance of the global economy relative to the U.S., with outperformance shown when the blue line is above the bar. One can see that Soros’s insight is largely confirmed by the data: when U.S. growth is relatively strong, the USD tends to appreciate considerably.
The past several years have been extraordinary in the sense that official interventionism in financial markets has reached unprecedented levels. First, we saw exceptional monetary policy adventurism with a novel focus on propping up asset prices in the name of “financial stability.” Second, we saw equally unheard of fiscal adventurism when Donald Trump slashed taxes at the tail end of a business cycle expansion with unemployment at record low levels. Third, the pandemic was met by enormous monetary and fiscal support which boosted the operations and valuations of America’s leading corporations in the tech sector. Fourth, we are now seeing new radical policies from the Fed (average inflation targeting) and the Biden Administration (fiscal expansionism to “Build America Back Better”). Finally, this year we saw the U.S. take the lead in Covid-19 vaccinations which makes it likely that U.S GDP growth will outperform the global economy in 2021. All these factors have contributed to higher U.S. stock prices and a narrative of U.S. exceptionalism, and may have postponed the normal cyclical downtrend of the dollar.
In a recent interview, the investor Stan Druckenmiller made this point when he attributed the recent strength in the USD to foreign inflows into the U.S. tech stocks during the pandemic:
“It just so happened that the FAANG stocks, and many US companies like Zoom were better positioned to deal with COVID than any of our foreign counterparts, so we had a huge inflow into the equity market here. It made up for the change in the bond flow, but once valuations got high, that dissipated, and the dollar peaked out in July.”
Druckenmiller believes that the factors supportive of the dollar have run their course. The rest of the world will soon catch up in vaccinations and by 2022 the global economy will be in full recovery and outpacing the U.S. economy. Moreover, by next year, capital allocators are likely to begin to refocus on the serious structural deficiencies of the U.S. economy: namely, the high and rising debt levels and the gigantic twin deficit (current account plus fiscal deficit.)
The U.S. will come out of the pandemic with historically high debt levels and deficits which are projected to remain at high levels for the foreseeable future. The first chart below shows the progression in U.S. debt levels as reported by the Bank for International Settlements (BIS). The next two charts show the U.S. fiscal and current account deficits and the twin deficit’s relationship with the USD. The twin deficit is projected to widen considerably during the decade as Social Security and Medicare outlays ramp up when the majority of baby-boomers retire. Also, any increase in interest rates from the current levels would worsen the fiscal accounts further.
We can see that the USD did not follow its normal reaction to gapping twin deficits during the pandemic. However, as these deficits persist in the future and the global economy recovers the USD this should change. The expectation that unsustainable twin deficits will persist for the foreseeable future is the primary argument for a weaker USD in coming years.
However, nothing may be so simple in our current macro world of extreme state interventionism and dysfunctional politics driven by populism.
First, for the dollar to fall other currencies must rise, but all the major trading partners of the U.S. appear determined to avoid this from happening Most, like China, have adopted some sort of peg to a basket of currencies to protect their exporters. This means that it would require significant strong-arming from the U.S. to engineer an appreciation of foreign currencies, something that Washington has been reluctant to do.
This raises the scenario predicted by Raoul Pal (Real Vision ) of an orchestrated debasement of global currencies as all major economies seek to print themselves out of their fiscal and competitive dilemmas. The consequences of this would be a massive flight into any scarce real assets (gold, bitcoin, real estate, etc…). Pal argues we are already seeing this play out as most asset classes are trading at record highs.
The Raoul Pal scenario has interesting implications for emerging markets. The EM asset class is almost equally divided into commodity importers and exporters. Most importers of commodities (China, Korea, Taiwan, India) are not likely to tolerate currency appreciation, as long as Washington does not wage war against mercantilist policies. This leaves the commodity exporters to possibly allow their currencies to appreciate. We have seen this happen this year as the South African rand, the Russian rubble and the Brazilian real have appreciated. This process has been abetted by foreign hot money and welcomed by central banks for its deflationary effects. Some other EM countries which have depressed currencies, (Mexico, Turkey) also have much room to allow appreciation and may be the best options for investors to benefit in the coming currency wars.