Dollar Strength Is More Than Priced Into Emerging Market Equities

| About: iShares MSCI (EEM)
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The recent dollar strength has sparked fears for the debt-servicing ability of developing countries.

While certainly material, these concerns appear to be now fully priced into emerging economy equities.

Being fully priced in, the risk-reward trade-off errs on the side of an EM trend reversal.

As of late, I've been seeing a lot of coverage regarding the headwinds that the recent pronounced dollar strength presents to the prospects of emerging market economies. For example, even here on Seeking Alpha, a recent article by Nicholas Mushaike noted that:

"...emerging markets pose a huge default risk because of a stronger dollar...this increased leverage by emerging markets will cause currency devaluation to spin out of control as the dollar continues to strengthen, implying that the already indebted countries will have to pay more money in interest payments because their currencies are now very low relative to the dollar."

First of all, I'm not a staunch believer in the debt-burdened emerging economy theory, as while the average EM debt-to-GDP ratio has certainly been trending upwards, the relative significance of these increases has been, well, rather insignificant. Taking the top 10 EM countries according to allocation in the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM):

In a similar vein, I've observed numerous analyses around the web plotting the trend in the dollar against various proxies for broad exposure to emerging market equities. The usual analysis entails something similar to the following:

I've even seen such an analysis done by a rather widely respected global macro analyst, and I've been left frustrated on multiple levels. First of all, in my opinion, the above analysis is in violation of basic logic. The dollar is (or at least has been for the last ~25 years), a mean-reverting series. The relationship above is thus dependent on the assumption that either emerging market equities must move perpetually sideways (albeit with volatility) or that the dollar must perpetually decline for the index to achieve long-term growth. Secondly, I place little faith in first-order comparisons of nominal price trends, and I was thus motivated to dig a little deeper to reveal the true relative significance of the contemporary dollar-EM divergence.

Let me be clear that I do agree that trends in the dollar effect prospects for emerging markets. Accordingly, I began to hypothesize that it is perhaps the relative moves in the dollar that can foretell the true trends in emerging markets. To that end, I began by taking the relative change in the dollar index from its long-term average and applying this difference to a 50-day moving average for the ETF. This created what I have dubbed the "Adjusted TWD" (TWD being the trade weighted dollar). While I wasn't completely satisfied with the results, I felt that they certainly represented progress:

Next, I decided to transform the variables in order to perform a relative-value analysis of this adjusted trade weighted dollar and the ETF:

Smoothing this series to delineate a trend creates a promising indicator for the relative outlook of the ETF:

So, is a strong dollar a concern for emerging markets? Absolutely; that is just basic economics. When a developing country is forced to borrow in a hard currency (or through a very convoluted structure, is effectively borrowing in a hard currency), any significant depreciation against that currency presents real concerns. It is also important not to view the above factors in a vacuum, as slowing global growth expectations are also very much at play here. But markets are based on forward expectations, and it is important to analyze and understand which expectations are currently priced into the market. It appears that the recent strength in the dollar is more than priced into emerging market equities, and the historical relationship would actually predict a strong reversal in the recent weakness in the relevant proxies.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.