Like any trader, I tend to spend a lot of time working through little thought experiments. Here’s one that I’ve been looking at, lately. The chart below outlines the relationship between the dollar index (black candles), the MSCI Emerging Market Index (Red line, in US dollar returns) and the S&P 500 index (blue line), going back to 1990.
The reason I’ve gone back to 1990 with the chart is to display the shift in intermarket relationships. In essence, the early 1990s saw a powerful combination of a rally in US equities, compounded further by a rising dollar (relative to other currencies). While that was great for US stocks, it limited the appeal for Emerging Market equities which didn’t generate any real returns in US dollar terms (in part due to the East Asian currency crisis).
The bursting of the NASDAQ bubble, and 9/11 led to a sea change in US monetary policy. Strong dollar policies were largely abandoned; consumption was encouraged and the ensuing current account deficits went hand in hand with a cheaper dollar. This was a great environment for Emerging markets, which benefited both from rising demand for their goods, and (in many cases) rising currencies (relative to the dollar).
The graph below, which compares the US current account with the dollar index, is by no means a timing tool or indeed a complete explanation. A single factor model of current account surpluses/deficits does not explain currency movements. But, over long periods, the relationship plays out as you would expect.
This is the context within which, the dollar is vitally important to any asset allocation choice. Over short periods, intermarket relationships shift significantly (relative strength charts are a good way of studying shorter-term intermarket movements). But, over the long run, market moves and economic trends do interact. You could make the claim that markets (usually) discount data before it arrives, so the dollar index would be expected to lead, rather than lag current account data. But, this is a fluid process, and a historical narrative always sounds more compelling than making assertions about the future.
We can however make a few loose observations. A strong dollar plays a somewhat destructive role for emerging market equities. Till quite recently, the “risk trade” was fairly well defined. A strong dollar was a “risk off” trade – bad for all equities, good for bonds. More recently, the “risk on”, “risk off” paradigm has shown signs of shifting. We’ve seen the S&P rally alongside a stronger dollar, but Emerging Markets have under-performed. This could very well be transitory. There is nothing conclusive to suggest that we’re in a secular dollar bull market.
I’ll leave you with one of the charts that have grabbed my attention. This is simply a zoomed in version of the question mark area of the earlier chart comparing the S&P (in blue), the MSCI EM index (in Red) and the dollar index (candles). The structure of these relationships suggests that any significant signs of dollar weakness could make emerging markets very attractive. Signs of negative divergence on the RSI add a bit of zing to that potential trade. But, remember, divergence isn’t a substitute for price action. The point of analysis such as this, is to build a context to navigate multiple scenarios – not to lock yourself into any one view.