The U.S. dollar's nosedive is fueling a rally in emerging-market assets.
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Since the start of this year, the dollar has fallen more than 8% against a basket of currencies, according to the Federal Reserve.
That is good for emerging markets because their dollar denominated debts become cheaper to service, roll over and pay back. Research also shows that international lenders are more willing to lend whenever the U.S. currency falls. Meanwhile, developing-market economies are in good shape, adding to the positive view of these markets.
The value of emerging-market equities and bonds has surged. The MSCI Emerging Markets stock index has returned more than 30% this year, compared with 15% for the developed-market MSCI World Index and 13% for the MSCI USA.
Net flows into emerging-market equity funds have increased this year by 0.5% of the total assets they manage, according to fund tracker EPFR Global. That compares with a 2% fall in the money going into richer nations.
That outperformance could be set to continue as the dollar stays weak. Strategists say stubbornly-low inflation will ensure the Fed's easy-money policies stay in place for longer, putting pressure on the currency.
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"A weaker dollar eases global financial conditions," said Jack McIntyre, portfolio manager at Brandywine Global, because many companies in emerging nations borrow in dollars, "so if the dollar is strong, this means they have to pay back their debt in a higher currency."
A net 47% of investors are positioned to gain if developing-nation stocks go up--a seven-year high--while bets against the dollar have multiplied, according to a survey of fund managers published Tuesday by Bank of America Merrill Lynch.
The outlook for emerging economies has brightened compared with last year, as a recovery in commodity prices helps Brazil, Argentina and Russia climb out of recession. Meanwhile, the expansion of giants such as China and India is set to remain robust--a relief for many investors, who for years had feared a sudden slowdown in Chinese growth.
Peter Elston, chief investment officer at Seneca Investment Managers, believes the U.S. economy is due to slow by 2020, so he's now selling stocks in the U.S. and buying them in emerging markets.
"In some of our funds, we can't reduce U.S. stocks any further because we are already at zero," Mr. Elston said.
But much of the current bet on emerging-markets is down to the declining greenback, rather than just robust economics.
Since the start of the year, emerging-market bonds issued in local currencies have returned 17%, compared with 10% for bonds in so-called "hard currencies" such as dollars or euros, according to indexes published by J.P. Morgan Chase & Co.
Over the past year, Claudia Calich, who runs the Emerging Markets Bond Fund at M&G Investments, a GBP281 billion ($373 billion) asset manager, has doubled the share of her allocations devoted to local-currency debt to almost 40%, including assets in Mexican pesos and Egyptian pounds.
Since the late 1990s, emerging-market equities have usually outperformed when the dollar declined and struggled when the greenback rallied.
This is in contrast with large-cap developed-market indexes, which usually move in lockstep with the dollar, since the multinational firms they track get most of their revenues in foreign currencies.
Emerging countries are different, analysts say, because their dependence on dollar credit is greater and a strengthening greenback makes it more costly to roll over loans. That offsets any gains from higher overseas income.
It isn't just that borrowing gets more expensive. International lenders--who also rely on dollar funding--can often close their wallets whenever the value of the U.S. currency goes up, according to research by the Basel-based Bank for International Settlements, and that can hit emerging-markets the hardest.
Signs of stress can be gauged by the so-called cross-currency basis swap spread, which measures the gap between money-market and derivative-market rates when borrowing in dollars. When the dollar started rallying in 2014, it grew wider. As the U.S. currency sold off this year, that gap narrowed.
According to research by consultancy Oxford Economics, this "cross-border liquidity channel" linked to the dollar is crucial for developed markets, especially Latin America.
Foreign borrowers are also benefiting from low dollar lending rates. Yields on 10-year Treasurys are now below 2.2%, from 2.5% at the beginning of the year.
For emerging markets, the situation is radically different from last year, when the prospect of higher fiscal spending in the U.S. boosted the dollar and Treasury yields. That led to a fear of an emerging-market selloff, like in 2015, when the MSCI Emerging Markets index dropped 17% on concerns over the Chinese economy and the end of stimulative monetary policy.
"We believe the dollar will remain broadly stable towards year-end because of the cautiousness of the Federal Reserve," said M
organe Delledonne, a strategist at ETF Securities.
"We see a continuation of the appetite for risk in emerging-markets," she added.
Write to Jon Sindreu at firstname.lastname@example.org
Corrections & Amplifications
This story was corrected at 11:54 a.m. ET because it incorrectly said a weakening, instead of a strengthening, greenback makes it more costly for them to pay back debt.
A strengthening greenback makes it more costly for emerging-market countries to roll over loans. "Dollar's Fall from Grace Fuels Emerging-Markets Boom," published at 10:57 a.m. ET, incorrectly said a weakening greenback makes it more costly for them to pay back debt.
(END) Dow Jones Newswires
September 13, 2017 12:05 ET (16:05 GMT)