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What next for the dollar, the deficits and emerging markets debt?

The apparent results of the US elections are that Congress is divided and, as of the time of writing, the president will be a Democrat.

The “blue wave” that many were anticipating would lead to huge US fiscal deficits and weaken the US dollar has not materialised. However, we believe a structurally growing fiscal deficit, coupled with other historically significant factors, will still lead to a high probability of a weaker US dollar for some time.

Movement in the US dollar has long been seen as a key structural driver for returns on emerging market (EM) assets. Broadly, the data shows there is some correlation between periods of dollar weakness and robust EM returns.

However, history also shows long-term dollar trends are hard to spot as they occur. This is because the greenback can see periods of retracement while the broad trend remains intact. Dollar trends can also potentially be derailed by meaningful shifts in policy or macro dynamics.

Nevertheless, we identify some signs suggesting hope for the emergence of a cycle that is positive for EM assets:

  • The emergence of large and growing twin deficits in the US along with an extended period of abundant dollar liquidity will, we believe, enhance the probability of a weaker dollar trend in the coming quarters and years. Especially in the absence of interest rate differentials between the US and the rest of the world. It is important to note, we believe this move will be a cyclical downturn in the dollar, not a structural decline associated with a change in reserve currency status.
  • There have been two clear periods in the past 20 years of a trending US dollar, and they seem to impact EM debt (EMD) returns in consistent ways, although other factors are always at play.
  • Starting points matter and, if we are entering a multi-year weak dollar regime, EMD returns are unlikely to be as strong as earlier given lower yields both in US dollar and local currency debt. Nevertheless, currency appreciation could easily help to deliver impressive returns for local debt within this framework, and dollar yields would almost certainly do better than most of the rest of global fixed income.

We explore these themes - and more - in greater detail in the PDF below.

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The dollar, the deficits and emerging markets debt 9 pages | 1.093 kb