In a year marked by geopolitical turbulence, volatile trade relations, and shifting interest rate expectations, one undercurrent has quietly reshaped global financial dynamics: the weakening of the US dollar. This depreciation is not a footnote — it is a pivotal force breathing new life into emerging market (EM) assets. As investors adapt to a landscape defined by looser US monetary policy, widening fiscal imbalances, and recalibrated global alliances, the dollar’s decline warrants scrutiny — not just for what it reflects, but for the strategic possibilities and risks it unveils.
Firstly, let’s reflect on what is behind the US dollar slide.
- Political and Geopolitical Risk: Uncertainty around US trade policy and renewed geopolitical tensions have undermined the perceived safety of dollar assets. Escalating tariffs, fracturing supply chains, and questions about America’s commitment to multilateralism have created fragility in the dollar’s role as a global reserve currency.
- Structural Fiscal Headwinds: A burgeoning fiscal deficit—now exceeding 7% of GDP—and mounting national debt (above USD 35 trillion) have raised concerns about long-term fiscal sustainability. For global investors, especially foreign holders of Treasurys, the erosion in confidence adds a risk premium to the dollar, prompting a search for alternatives and reducing demand for dollars.
- Federal Reserve Pivot and Interest Rate Expectations: With inflation moderating faster than expected last year, and growth showing signs of fatigue, the Fed paused its tightening cycle and hinted at potential rate cuts. This compresses yield differentials versus EM currencies, weakening capital demand for USD-denominated assets. This year however, there seems to be a subtle shift from the Fed as they monitor possible tariff induced inflation. Fed chair, Jerome Powell, is of course under pressure from President Trump to reduce rates, who has shown a clear wish for a weaker dollar.
- De-Dollarization Momentum: Several emerging markets have accelerated efforts to transact in local currencies, particularly in energy and commodity trade. BRICS nations are exploring alternatives to dollar settlements, and global central banks are diversifying reserve allocations. These structural shifts chip away at the dollar’s long-term hegemony.
Historically, emerging market equities, local currency debt, and commodities have demonstrated a strong inverse correlation with the US dollar. When the greenback weakens, financial conditions in EM economies typically ease. Countries with dollar-denominated debt benefit from reduced servicing burdens, enhancing fiscal flexibility and strengthening investor sentiment.
Simultaneously, a softer dollar boosts global demand for dollar-priced commodities — many of which are exported by EM nations — improving trade balances and accelerating domestic growth. This environment creates fertile ground for capital inflows, as lower perceived risk, attractive nominal and real yields, and renewed growth expectations entice global investors back into EM assets.
For EM equities, dollar depreciation often translates into stronger earnings potential for domestic facing companies when the lower cost of imported inputs supports margins. The resulting terms of trade improvement can drive profitability and upward earnings revisions, setting the stage for valuation rerating.
Finally, a weakening dollar broadens the policy latitude for EM central banks. As imported inflation subsides and FX pass-through diminishes, monetary authorities gain space to pause rate hikes — or even pivot to easing — thereby bolstering domestic demand and improving the real interest rate landscape.
The chart below highlights this inverse correlation over the last twenty years, with the relationship proving valid once again so far this year during the environment of US dollar weakness.
Year to date, the Brazilian real has appreciated 11%, the Taiwanese dollar 12%, the Mexican peso 10% and the South Korean won 9% to name but a few. One must remember however for how long the US dollar strengthened, and hence, our Mondrian calculated purchasing power parity currency analysis suggests that many EM currencies still trade at significantly undervalued levels. Looking at the charts below, we show the South Korean won, Indian rupee, and Taiwanese dollar still trading two standard deviations below fair value.
These 3 markets as an example, account for almost 50% of MSCI EM. With widespread currency undervaluation of this magnitude, the EM asset class could see further significant support ahead if the US dollar continues to weaken.
Not all countries should be expected to gain equally from this effect. Countries with robust macroeconomic fundamentals, such as current account surpluses, credible central banks, low inflation, and political stability; are better positioned to benefit from dollar depreciation. Conversely, structurally fragile economies, e.g. those with high dollarized debt, weak fiscal anchors, or populist policy regimes, may struggle to attract durable inflows, despite favourable external conditions.
At Mondrian we treat currencies conservatively and don’t make any investments purely on currency undervaluation; it’s just one part of the top-down analysis that complements our search for attractively valued low risk investments with a superior skew of outcomes.
Having a greater level of assurance on currency protection is of course helpful, not just for our own confidence in absolute returns, but in guiding asset allocators too, as can be witnessed from the inverse correlation discussed.
Conclusion
A weakening US dollar historically creates a fertile backdrop for emerging market assets, driven by enhanced capital flows, commodity tailwinds, and improved debt dynamics. However, country differentiation, external shocks, and shifting global liquidity conditions necessitate a nuanced approach. For value investors like Mondrian with a laser sharp focus on risk, a disciplined EM strategy that blends macro and FX insights with fundamental long-term bottom-up investing is key to unlocking value in a depreciating dollar environment.
Disclosures
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