U.S. dollar underpins EM assets

We see the U.S. dollar stabilizing or weakening over the next six to 12 months. Two broad drivers – monetary policy differentials and risk appetite – decide the dollar’s moves, in our view. We see a pause in monetary policy in most developed markets (DM) and some room for additional easing in EMs; easing trade tensions should underpin risk appetite, reducing “safe haven” demand for the dollar. Our currency view underpins our preference for local-currency EM debt and equities.

Global trade tensions weighed on global growth and kept investors on edge in 2019. This coincided with a rally in the dollar to near post-crisis highs, as the chart above shows. The dollar, a perceived safe-haven asset, typically attracts interest when geopolitical risks flare up. With the U.S. and China signing a limited “Phase 1” trade deal and a revised North America trade pact passing the U.S. Congress, we see global trade tensions going sideways in 2020. This should support overall risk sentiment – and reduce flight-to-safety demand for the dollar. As a sign of reduced bullish bets on the dollar, speculators had cut their net long position on the currency to the smallest in 19 months as of Jan. 14, according to Reuters calculations and data from the U.S. Commodity Futures Trading Commission.

Monetary policy (interest rate) differentials are a key driver for currency performance. The dollar was the highest-yielding developed market (DM) currency in early 2019 – on the back of the Federal Reserve’s monetary policy tightening cycle. The Fed has since made a dovish shift and joined other DM central banks in taking a pause in monetary policy actions. This is likely to keep the dollar stable against other DM currencies, in our view. We also see reduced Brexit-related uncertainty as positive for European currencies, including the euro and British pound, removing some upward pressure on the dollar.

We expect global growth to edge higher this year and financial conditions to stay loose. This should provide support for most EM currencies, even as we see some room for EM central banks to further ease their monetary policy in 2020. Subdued market volatility makes “carry” strategies in the foreign exchange market (borrowing in lower-yielding currencies and buying higher-yielding ones) more attractive, adding to the appeal of EM currencies. We see the Chinese yuan stabilizing or slightly appreciating versus the dollar against the backdrop of a positive growth outlook and easing trade tensions. This could help support other EM Asian currencies such as the Indonesian rupiah. From a valuation perspective, currencies including the Russian ruble and Brazilian real appear cheaply valued after sharp selloffs in recent years. Appreciation in EM currencies has historically tended to contribute to positive returns in EM assets overall, our analysis shows. This underpins our preference for EM equities and local-currency debt.