Dollar Strength, EM Stresses = Ongoing U.S. Equity Risk

Today, a discussion about to what extent dollar strength, that leads to EM stresses, will infect U.S. bourses.

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Our EM team has been warning for some time that sharply higher foreign-currency debt levels among emerging market (EM) companies and banks will pose a formidable challenge to EM. Indeed, we have written about the risks associated with the end of the “dollar carry trade” (i.e. EM companies’ and banks’ borrowing in U.S. dollars).

With the dollar still rising, concerns about the impact of EM weakness on the U.S. and other developed markets are mounting. Could EM vulnerability to a rising dollar trigger a global financial accident? “Crises” are inherently difficult to time – it is impossible to know when investor behavior/psychology will turn. There are two points that make us leery about EM risks as they relate to U.S. (and other developed markets). First, EM is far more important in terms of its global GDP weighting than in previous decades, implying that when EM catches a cold, the rest of the world will more than just sneeze. Second, with policy options in developed economies nearly exhausted, the tool to deals with a crisis are more limited than, for example the 1990s.

At a minimum, slower demand from emerging markets and dollar strength risk creating earnings disappointments for globally-exposed sectors in developed market bourses. Indeed, the rise in the dollar and poor EM demand have been key reasons why we have advocated a domestic vs. global approach within the U.S. stock universe. A cautious approach is still warranted.

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