The troubles in Europe have dominated headlines lately. The situation has gotten so bad that Bank of England surprised everyone last week by expanding its QE program and the European Central Bank has decided to increase its sovereign bond purchases, which is its version of QE. What do these QEs in Europe have to do with the Mexican and Brazilian equity markets? After all, shouldn’t these emerging economies be completely decoupled from that of the developed economy? Well, not quite.
The Impact of QE On Mexican And Brazilian Currencies The muted effect of QE on the European economy and weakening European currencies has a surprising link to Mexican and Brazilian equities. Here, I have used th iShares MSCI Mexico Index ETF (NYSEARCA:EWW) and the iShares MSCI Brazil Index ETF (NYSEARCA:EWZ) as proxies for the Mexican and Brazilian equity markets, respectively. First, QE programs, as demonstrated in Japan and the US, do not boost internal consumption or economic growth. So the Latin American economies won't benefit much from these programs in terms of greater exports or investments. Second, the QE programs in Europe are weakening the Euro and the GBP and strengthening the dollar, but these programs are inadvertently weakening the Mexican Peso and the Brazilian Real even more. You can see from chart 1 the one-year correlation between the dollar and the Peso/Real. Chart 1- (click charts to expand)
While correlation is not causation, the relationship is undeniably strong. There is no point looking past one year because historical data are only accurate when there isn’t a structural break in our data set, but one can argue that the pre-2008 economy landscape is vastly different from that of post-2008. The dramatic economic changes in the past few years have made historical data inaccurate if not misleading. I personally find one year data to be more accurate predicators.
Strengthening Dollar And Declining Mexican/Brazilian Equity Markets
In chart 2, you will see the correlations between the dollar and Mexican (EWW) and Brazilian (EWZ) ETFs. As the dollar has strengthened 7-8% against the Mexican Peso and the Brazilian Real, EWW and EWZ have declined considerably. Even factoring in inflation, markets in both countries have dropped significantly in real terms. The inflaton in Mexico at 3% isn’t nearly as out of control as the inflation in Brazil, but EWW has suffered similar percentage drops.
Conclusion The continuously expanding QEs in Europe will continue to strengthen the dollar and could keep pressuring the Mexican and Brazilian currencies and equity markets. The currency pressures along with a limping if not soon contracting US economy make the downside risks to EWW and EWJ especially elevated.
Disclosure: I am short EWW.