2016—until the election—had been the year of emerging market dominance. Commodities came roaring back, and not only was it the year of emerging markets (EM), it was also the year of emerging market currencies (with a weak U.S. dollar) and the commodity sectors within emerging markets. Countries such as Brazil, Russia and Peru led, while commodity importers like India and Korea lagged.
Since the election, however, there has been a new regime. The U.S. dollar started strengthening, and emerging markets faced a setback—although commodities have remained robust in the hope that infrastructure spending will support commodities and discussions of oil production cuts have supported oil.
Valuations Make EM Attractive, but What about Currency Risk?
One of the points supporting emerging markets is that anyone building capital market assumptions that incorporate a valuation factor in setting outlook will tend to be over-weight emerging markets. In the WisdomTree High Dividend Index family, for instance, the Emerging Markets High Dividend Index traded at a 50% price-to-earnings (P/E) discount to the High Dividend U.S. Index , one of the widest margins in last nine years. Of course, emerging markets entail higher risk levels, so they should trade at a discount, but I believe investing is about taking risks that you are compensated to take, so emerging markets look attractive to many.
But emerging markets are also critically reliant today on both China’s economy not meaningfully deteriorating and not suffering from too strong of a U.S. dollar. A strong dollar tends to reverberate throughout emerging markets, and that has been the environment over the last five years.
Blending Strong Dollar and Weak Dollar Beneficiaries to Diversify Factor Risk
One idea that could balance this currency risk is to combine a strong dollar beneficiary—a country that sees performance tend to increase on the back of a strong U.S. dollar—with emerging markets that are reliant on a weak U.S. dollar.
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