Emerging markets: At the mercy of the mighty dollar

By Linda Eedes, investment executive at Foord Asset Management

Nearly every major currency has lost ground against the dollar this year. Even the so-called hard currencies have cracked under pressure. In July, the euro breached parity with the dollar for the first time in 20 years, while, in September, the British pound reached an all-time low perilously close to dollar parity. The rand is in good company at least.

What’s behind this dollar strength? The answer is rate hikes and risk aversion. With the US economy in relatively good shape, the US Federal Reserve has raised interest rates faster than any other advanced economy to combat inflation. Investors have also sought out the dollar’s safe-haven appeal amidst rising geopolitical tension and market turmoil. The combination of increasingly attractive yields and perceived safety has caused an irresistible pull toward the mighty dollar.

The rand’s recent slump is less about the rand and more about what is finding favour with the world’s investors: the US dollar.

Dollar strength is negative for emerging economies for two main reasons. Firstly, most commodities are priced in dollars, so vital imports become more expensive — countries can inadvertently import inflation along with their wheat and fuel. Secondly, many emerging market governments borrow in dollars, so their borrowing costs increase when the dollar strengthens — crowding out other government spending.

South Africa has also suffered the knock-on effect of rising food and energy costs. However, its position as one of the world’s largest exporters of commodities, such as platinum group metals, has helped to offset imported inflation. Fortunately for us, South Africa’s debt is mostly rand-denominated.

While the Fed is fighting inflation, emerging market central banks must fight the twin perils of inflation and dollar strength. They can only do this by also rapidly raising interest rates, even if this tips their economies into recession before the US. The SA Reserve Bank has therefore had no option but to follow the Fed’s lead in aggressively hiking the local repo rate.

Countries such as South Africa, with structurally higher inflation and interest rates, should experience steady currency depreciation over time. This in turn fuels inflationary pressures, which we must manage if we are to meet our primary investment objective of achieving meaningful inflation-beating returns for our investors over time.

For portfolios that permit offshore investment, investing abroad achieves the dual outcomes of currency hedging and better diversification from the wide global opportunity set outside of South Africa. Nevertheless, it is worthwhile noting that more than half of the revenues generated by companies listed on the JSE Limited are earned in foreign currencies. This provides a useful hedge against rand weakness for investors in portfolios focused only on the SA market.

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