Biggest threat to emerging markets: a stronger dollar

Ed Yardeni had a post a month ago (Challenges Facing Emerging Markets) that got me thinking about the relationship between emerging markets, commodity prices, and the dollar. He expanded on this theme in another post today (Emerging Markets Are Cheap for a Reason). He thinks emerging markets are likely to underperform because commodity prices are likely to be flat, and commodity prices are likely to be flat because global growth is likely to remain subdued. I don't disagree with him, but I offer the following charts in an effort to show that the value of the dollar is also an important variable to consider. If, as I suspect, the dollar is more likely to strengthen than weaken in coming years, this would add to the case against investing in emerging markets. By the same logic, if you think the dollar is more likely to weaken, then emerging markets look attractive at current levels.

As the chart above shows, there has been a very strong correlation between the value of emerging market stocks and commodity prices in the past few decades (note that the CRB spot index excludes petroleum). This is a commonsense relationship, since emerging market economies tend to be very resource-driven (e.g., strongly reliant on agricultural and raw materials exports). What's good for commodities is also good for emerging market economies.

As the chart above shows, there has been a fairly strong inverse correlation between the value of the dollar and commodity prices over the past few decades. Since 2002, the dollar has lost about one-third of its value against other major currencies, and commodity prices have more than doubled. Both the dollar and commodity prices have been relatively flat for the past two years.

In the past two decades, the Brazilian stock market has experienced extreme volatility—much more than most other emerging markets—due mainly to the huge gyrations of Brazil's currency. The real lost almost three quarters of its value against the dollar in the early 2000s, then more than doubled from 2003 through 2008. In the past 2-3 years it has lost almost one third of its value. That's another way of saying that the value of the dollar has been a critical variable in determining the value of Brazilian equities. A stronger dollar would thus make it very difficult for the Brazilian economy to advance.

The chart above shows the inflation-adjusted value of the dollar against a large basket of currencies and against a basket of major currencies. Although the dollar has generally appreciated in the past three years, it is still quite weak by historical standards. A significant weakening of the dollar from current levels would take it into uncharted territory, whereas a continued moderate appreciation of the dollar, such as we have seen in recent years, would take it back to more normal levels. For several years I've held the view that the dollar was likely to appreciate, mainly because the U.S. economy was likely to outperform relatively dismal expectations, and I still think that's the case.

Gold prices have tended to track commodity prices reasonably well over the years, as the above chart suggests, although gold has been significantly more volatile. The way I read this chart is that gold prices "overshot" commodity prices following the Great Recession, and are now in the process of coming back down to a more normal relationship—suggesting a gold price of $900 or so in the next few years. Like commodities, gold prices tend to move inversely to the value of the dollar, so a substantial decline in gold prices from currently levels could well coincide with a stronger dollar.