Emerging markets hate a rising dollar

The relationship between different assets comes and goes. Correlations, to use the jargon, can be unpredictable. However, one that tends to be reliable is the fact that a rising dollar is bad news for emerging markets. The reasons are not complicated. If the value of the US currency is rising, there is less incentive for investors to seek returns overseas. This is particularly the case if the dollar is appreciating on the back of rising US interest rates. When the dollar is strong against other currencies it also becomes more difficult for overseas borrowers to service their debts. With many emerging market countries and companies tending to hold dollar-denominated borrowings, they are vulnerable when the greenback strengthens. As the chart shows, this inverse relationship has been notable this year. Turkey and Argentina have been in the spotlight but the problem is more widespread, with the rupee, rouble and rand all under pressure and equities following currencies lower.

Source: Thomson Reuters Datastream, as at 7.9.18, total returns in local currency. Figures rebased to 100.

Markets don’t always move in lockstep

As globalisation took hold over the past 30 years, we have become used to markets moving in tandem, with the US often taking the lead and others following close behind. It’s sometimes said that when Wall Street sneezes, we all catch a cold. This year has seen a clear breakdown of that synchronicity as the S&P 500 and Nasdaq have powered to new all-time highs while many other markets have gone the other way. As the chart shows, the most dramatic example of this divergence has been between the US and China. In part this reflects the boost to the US economy from Donald Trump’s tax cuts. This in turn has given the US administration the power to weaponise trade policy - trade wars are worse news for America’s trading partners than the US. In the case of China, however, this is not the whole story. Beijing’s attempts to rein in credit were having a damaging impact on shares in Shanghai and Shenzhen well before trade tensions increased in the spring.

Source: Thomson Reuters Datastream, total returns in local currency, figures rebased to 100.

Investors think the Fed will change its tune

The chart here is a simple way of understanding one of investment’s hottest topics right now - the yield curve. When people talk in nervous tones about an ‘inverted yield curve’ they mean that the yield on short bonds (which is closely linked to interest rates) is higher than that on long bonds (which is driven by growth and inflation expectations). This is a worry because it means central banks may be tightening policy too quickly and risking pushing the economy into recession. The line here shows the 10-year yield minus the 2-year equivalent. As is clear, it fell below zero (inverted curve) on a handful of occasions in the past 30 years - all of them were associated with recessions and market downturns. We are still above zero today - but not by much.

Source: Thomson Reuters Datastream, as at 15.8.18. Percentage points difference between US 10yr Treasury Bond Yield and US 2yr Treasury Bond Yield.

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of an investment. Investments in emerging markets can be more volatile than other more developed markets. For full 5 year performance figures please see Market Data.

Acknowledgements
I would like to thank the many knowledgeable and experienced people within the wider Fidelity organisation who have helped me develop the ideas in this Investment Outlook. Although the views expressed here do not represent the shared opinion, or house view, of Fidelity’s investment team, the combined expertise of over 380 investment professionals in 13 countries is a very significant resource on which I have been able to lean. In particular, I would like to thank Gary Monaghan, Investment Director in Hong Kong, Jeremy Osborne, Investment Director in Tokyo, Leigh Himsworth, UK Portfolio Manager, Neil Cable, Head of Real Estate, Curtis Evans, Head of Investment Directing, European Fixed Income, Kasia Kiladis, Investment Director, US, Rebecca McVittie, Investment Director, Emerging Markets, Natalie Briggs, Investment Director, Europe.

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