SPEM: The Peak Of The U.S. Dollar Is A Bullish Signal

Overview

The SPDR Portfolio Emerging Markets ETF (NYSEARCA:SPEM) provides exposure to publicly traded companies domiciled in emerging markets.

The fund has an expense ratio of 0.11% per annum (3^rd cheapest among similar ETFs). Vanguard and iShares provide similar exchange-traded funds with cheaper expense ratios.

As of 8^th February 2023, the fund was invested in 3052 different holdings which provides broad and diversified exposure to emerging markets

The fund is managed by State Street and seeks to track the S&P Emerging BMI Index (the “Index”).

Fund performance

The fund has returned 3.91% per annum since its inception in 2007, slightly outperforming its benchmark by 3 basis points.

Overall, the return has been quite poor compared with the S&P 500 average return of 11.88% per annum since 1957. Investors have not been compensated for the higher risk involved with an investment in emerging markets.

The fund’s performance can be seen below:

Portfolio

The fund is heavily weighted towards China and India, which represent nearly 50% of the exposures. The re-opening of China following COVID-19 lockdowns will be a boost for the portfolio. Although, U.S.-China tensions are likely to diminish investor appetite for exposure to China.

On the other hand, U.S.-China tensions have been a positive for India. I recently wrote an article on how India is set to become the world’s third-largest economy.

One key pillar behind this thesis is that companies like Apple (AAPL), Samsung and Google (GOOG) (GOOGL) have been slowly moving their manufacturing operations to India due to U.S.-China tensions and to diversify their supply chains.

The fund’s geographical breakdown can be seen below:

The US Dollar Index has peaked

The US Dollar Index is a leading benchmark for the international value of the US dollar. It is probably the world’s most widely recognized and publicly traded currency index.

As seen in the graph below, the US Dollar Index has peaked, and it is a bullish signal for emerging markets.

I wrote an article back in September 2022 saying that as long as the Federal Reserve keeps tightening monetary policy, there will be downside risk for emerging markets.

However, we are reaching the peak of monetary policy tightening and I believe it is a good time to start investing in emerging markets again.

Although there is still some macroeconomic uncertainty, investors should build exposure now. It is easy to miss a rally in equities as seen in January this year.

Why does a falling U.S. dollar matter for emerging markets?

The international role of the U.S. dollar in emerging markets can not be understated. The U.S. dollar is the world’s most used currency to carry out global trade.

As seen in the graph below, the dollar accounted for 96% of trade invoicing in Americas, 74% in Asia-Pacific and 79% for the rest of the world. The only exception is Europe, where the euro is dominant.

A strong U.S. dollar had been largely inflating the price of imports in emerging markets, causing inflation to increase and central banks to hike interest rates.

Now that the U.S. dollar is falling, this will help alleviate the domestic inflationary pressures affecting emerging markets.

Risks

China’s relation with the U.S. under Xi’s tenure has been very complicated. A planned trip to visit China by US Secretary of State Antony Blinken had to be cancelled after the Pentagon discovered a Chinese spy balloon flying over sensitive missile sites in the western state of Montana.

Taiwan has also been a pain point. The head of the U.S. Navy recently warned that the American military must be prepared for a Chinese invasion of Taiwan before 2024.

President Biden has also vowed to aid Taiwan militarily if such a scenario happens. Taiwan is home to Taiwan Semiconductor Manufacturing co. Ltd (TSM) – the fund’s largest holding and the sole supplier for Apple’s processor chips used in iPhones, iPads, and Mac computers.

The divide between the U.S. and China is getting bigger every day and shows no sign of stopping.

The actualization of this risk is likely to be bearish for the whole market, although emerging market funds are likely to bear the full brunt of it.

Conclusion

Although the risk of conflict is becoming very real, it is a black swan event and may not happen at all.

Ignoring this risk, the peak of the U.S. dollar index is a bullish signal and I believe it is the right time to start slowly building exposure in emerging markets.