Investors rely on a myriad of various indicators to guide their portfolio allocation decisions. But, at least for emerging economies, one of the most useful yet unknown indicators may be hiding in plain sight: the US dollar exchange rate.
In a new study, researchers from Bank for International Settlements analyzed performance trends using the Morgan Stanley Capital International country indices for 50 emerging market economies from 2006 to 2021. Among the numerous seemingly chaotic relationships between various securities, the researchers found a strong correlation that stuck out like a sore thumb: the dollar exchange rate accelerates stock market returns -- and it goes both ways.
The higher local currency stock returns were associated with a weaker dollar and vice-versa -- a stronger dollar relative to the local currency was linked to poor returns or losses for the underlying security in its respective foreign market.
To better capture this intricacy, the researchers introduce the "dollar beta", a new indicator that reflects the sensitivity of stock returns to wings in the broad dollar index (a measure of the value of the United States dollar relative to other world currencies).
When the dollar is strong relative to most currencies, the local currency stock returns tend to suffer, the authors found. Conversely, countries that have a high dollar beta, meaning they're very sensitive to currency exchange volatility, tend to have higher average returns. This makes sense since a high dollar beta is indicative of an unstable or not very predictable local currency exchange, which comes with various risks. Investors who own securities in high dollar beta stock markets, including those who invest in certain indices for emerging markets, are thus compensated for their risk.
The beta dollar isn't just another inflationary or deflationary indicator. If the US dollar, for instance, loses 8% against the Brazilian real over the course of a year, the value of stocks listed in Brazil in the local currency will tend to rise by more than that, so the dollar-denominated return on the investment is a net gain.
"When viewed from the perspective of a global investor who evaluates returns in dollar terms, the dollar-denominated returns tend to be an amplified version of the local currency-denominated returns, in the sense that both the gains and losses in local currency are amplified when converted into returns in dollar terms. Thus, contrary to the hypothesis that exchange rate movements will inject noise that tends to smooth stock returns when converted into other currencies, the dollar exchange rate changes tend to ‘accentuate’ returns when measured in dollar terms," the authors wrote in the journal Oxford Open Economics.
Considering these findings, the researchers highlight the major role central banks play in the equity markets, even though they're not involved directly through the purchase of stocks. Like in the bond market, central banks and financial authorities may want to monitor the size of foreign investment in local stock markets and conduct appropriate stress tests.
In their study, the researchers offer some examples of such foresight. During the initial global market shock of March 2020 caused by the pandemic, South Korea established a stock market stabilization fund that had both private financial institutions and securities industry organizations as participants. In Thailand, the local government set up several stock market stabilization funds between 1987 and 2003.
"The financial channel of exchange rates operates through the risk capacity of market participants and shows up in the response of financial conditions to exchange rate movements," Hyun Song Shin, one of the paper's authors, said in a statement. "Dollar-denominated returns tend to be an amplified version of the local currency-denominated returns; both the gains and losses are magnified when converted into dollars."