The world’s largest investment banks think the U.S. dollar will win if the trade war is not resolved soon.
They believe this for two reasons:
First, the U.S. dollar is a haven.
It is the world’s reserve currency, backed by the largest economy in the world.
This stability attracts worried investors who want a safe place to preserve capital.
Second, emerging-market currencies are vulnerable in times of increased volatility.
Fair enough.
But I’m not convinced the big banks are right.
When the trade war flared up two weeks ago, the U.S. dollar didn’t behave as bank analysts expected.
The dollar fell when investors were most worried. That’s not how safe-haven investments are supposed to act.
To me, that’s a red flag.
It suggests there’s a compelling reason to bet against the U.S. dollar.
Emerging Markets’ Inevitable Rebound
To learn more about why I think the U.S. dollar will weaken if trade war conflicts continue, watch my video below.
Six months ago, I put together a single investment idea I was excited for in 2019: “It’s Time to Invest in Emerging Markets.”
Everything was going so well…
A bet on the iShares MSCI Emerging Markets exchanged-traded fund (ETF) was up as much as 14.5% in April.
Then the trade war flared up and nearly wiped out all its gains.
There may be more downside to come. But a deeper decline will give us all the reason we need to buy back in.
Determined investors still have lots of money to make in this bull market.
And the next phase starts soon…
A Safety Net That Prints Profits
As far as investors are concerned, the Federal Reserve is the global lender of last resort.
The U.S. dollar is the world reserve currency. It funds most of the trades and investments that happen around the world.
And the Fed controls the availability of those dollars.
Back to emerging markets…
Emerging economies need foreign capital — often U.S. dollar loans — to fund economic activity and investment.
That’s why, ever since the 2008 global financial crisis, the world has obsessed over the Fed’s every word and deed.
Not much has changed since then.
So, here’s how I think it’ll go with the Fed this time…
If the trade war creates lasting volatility, investors will rein in risk. They’ll cut back their investments in emerging markets.
Stock markets in emerging economies will feel the pain first. But at some point, it will threaten the real economy.
That’s why investment banks are fans of the dollar. Emerging-market currencies will drop with their underlying economies.
It won’t be pretty for emerging markets.
But…
The world can look to the Fed for reassurance.
Goodbye, Dollar. Hello, Emerging Markets.
Pressure on emerging-market investments can become contagious.
Worry can spread to mature markets.
Emerging market contagion hasn’t derailed developed-market stocks in recent years. But at this stage of the bull market, the Fed can’t let the bubble pop.
The Fed already stopped hiking rates … to ensure it doesn’t squash economic growth and investor sentiment.
Now the world is wondering when the Fed will cut rates.
It won’t happen too soon.
But when the Fed indicates a rate cut is coming, the U.S. dollar will lose.
U.S. interest rates rose tenfold in the last three and a half years.
Compare that to rates flatlined at 0% in Europe, a 250% rise in Canada, a 25% drop in Australia and negative interest rates in Japan. The comparison to interest rates in emerging markets is similar.
Interest rates are the yield an investment provides. A high interest rate makes a currency attractive.
Investors prefer to park their money in higher-yielding currencies … especially if they offer stability.
This is why the U.S. Dollar Index climbed nearly 13% in less than 18 months, a notable move for a currency.
So, when the Fed leans toward a rate cut, the U.S. dollar will start to lose its interest rate advantage.
The dollar will fall and stock markets will climb.
Of course, the dollar doesn’t have to fall. Emerging-market stocks climbed this year even though the dollar climbed too.
But emerging-market stocks will outpace U.S. stocks when a falling dollar gives investors the all-clear to take more risk.
Goodbye, dollar.
Hello, emerging markets.
The iShares MSCI Emerging Markets ETF (NYSE: EEM) is the simplest way to target emerging markets. It provides access to a mix of emerging market stocks, but it’s more weighted to Chinese stocks.
Good investing,
John Ross,
Senior Analyst, Banyan Hill Publishing
P.S. Check out my YouTube channel. Hit the subscribe button to get a notification when I post new content. To watch my most recent video, click here. Do you follow emerging markets? Leave me a comment on what sectors you’d like me to cover, and I’ll be sure to get back to you.