Dollar May Drag Down Emerging Markets

Countless Moving Parts

One factor that makes investing such a difficult task is the almost infinite number of inputs impacting the value of any asset. For example, emerging market stocks could be negatively impacted by economic divergences between the United States and Europe. How can that be?

1. Strength in the U.S economy may cause the Federal Reserve to raise interest rates in 2015.
2. Higher rates in the U.S. make the U.S. dollar more attractive relative to the euro.
3. Emerging market stocks tend to be negatively correlated to the U.S. dollar, meaning when the dollar strengthens, emerging markets tend to experience a currency headwind.

Fed May Raise Rates In 2015

Although economic data has been mixed recently, the trend has been improving over the last year. FromReuters:

Better U.S. economic data has boosted the view the Fed may be closer to raising rates, and the dollar’s gains have come at the same time as rising Treasury yields. Still continuing slack in the labor market is also viewed as keeping the Fed on hold for several more quarters. “People are more confident that the Fed is reaching its objectives,” Chandler said. He added, however, that “while the economy is healing, it’s not healthy.”

ECB vs. Fed

While the Fed is expected to rein in monetary policy in the coming months, the European Central Bank (ECB) has indicated a bias towards increasing their stimulative efforts. The diverging paths between the central banks are having an impact on the currency markets. From Reuters:

The dollar hit a 14-month peak against the euro on Tuesday, on optimism the U.S. economy is growing in line with expectations that the Federal Reserve may begin raising interest rates next year.

Investment Implications – The Weight Of The Evidence

On Tuesday, the S&P 500 closed inside the support band shown in the chart below (1984 to 1991). Therefore, it is too early to get overly concerned about recent weakness in equities. The blue trendline in the chart below has acted as support on numerous occasions (see green arrows). The S&P 500 bounced near the blue trendline Tuesday (see orange arrow), meaning buyers stepped in at a logical level.