Weakening dollar offers emerging market equities boost amid post-lockdown trade surge, predicts Man Group

Emerging Markets

As the global economy slowly emerges from the coronavirus lockdown, conditions could be set for a weaker US dollar, in turn strengthening emerging market equities, according to new research by analysts at Man Group.

A research note by the London-headquartered, publicly listed global hedge fund group suggested that as the global economy gradually emerges from lockdown, trade flows will likely accelerate – which historically has coincided with a weaker dollar as US consumers buy goods from around the world.

Hedge funds that trade emerging market assets posted gains of 4.55 per cent last month, according to HFRI’s Emerging Markets Index. But EM hedge funds remain down 11 per cent since the start of 2020 as the coronavirus crisis squeezed returns.

Spooked investors have traditionally sought refuge in the US dollar in times of crisis, and the currency has trended upwards throughout this year’s Covid-19 pandemic.

But Man Group’s note pointed to a recent Bank of America-Merrill Lynch survey that found that more than a third (40 per cent) of investors now believe the US dollar is overvalued.

Meanwhile, the interest rate pick-up for the US dollar has disappeared.

“With the Federal Reserve having slashed interest rates in the past three months, it doesn’t pay to be long the US dollar,” Man analysts said in their ‘View From The Floor’ market commentary this week.

“If - and it remains an if – we do see a weaker US dollar, this could result in a material loosening of financial conditions in emerging markets, which could benefit equities.”

Man analysts believe EM equities appear “favourable” when measured on certain metrics, such as FX implied volatility and cross-asset volatility risk.

Emerging markets’ FX implied volatility recently reached some 12 per cent.

“Historically, our analysis shows that buying EM equities when EM FX implied vol hit 12 per cent pays off, with a hit rate of 97 per cent and an average 1-year gain of 32 per cent.”

Man also examined the points at which the Citi EM risk index, which tracks cross-asset volatility by various measures expressed in a standardised form, hits a “trigger level” of 0.5 on the MSCI EM Index.

“Historically, buying EM equities when the Citi EM risk index has hit 0.5 has paid off well, with a hit rate of 100 per cent and an average 1-year gain of 62 per cent.”

Earlier this month, Man sounded a cautious note n emerging markets risk amid growing EM government debt and deteriorating finances, coupled with tightening travel restrictions as a result of the coronavirus pandemic.

Brazil, a key emerging market economy, has seen Covid-19 cases soar recently, with the World Health Organization warning this week that Latin America risks becoming the new epicentre of the ongoing crisis.