After a very tough 2018, emerging market (EM) equities are off to a good start to the year, up about 13% in U.S. dollar terms. While this is a good showing in absolute terms, in relative terms EM is underperforming developed market (DM) equities by 3 percentage points and the U.S. specifically by almost 5 percentage points.

What is behind this underperformance of EM relative to DM? Often, the answer to that question lies in EM currency performance versus the U.S. dollar – and this time is no different. EM will tend to outperform DM when EM currencies are strengthening versus the U.S. dollar. This relationship between relative performance and the currency makes sense on many different levels. The first is just the direct currency translation effect: EM local returns will be worth more in U.S. dollar terms when EM currencies have strengthened versus the U.S. dollar.

However, this relationship is more than just skin deep. EM currencies will tend to strengthen when global economic growth is improving. Historically, this has been seen during moments when the global manufacturing PMI (Purchasing Managers’ Index) is rising. This suggests EM economic and earnings growth is improving as well – and it encourages flows to move from very defensive U.S. assets to riskier EM assets, pushing up the value of EM currencies. On the flip side, EM currencies have struggled in moments when the PMI has been falling, and thus its equity returns have underperformed versus the U.S. and other developed markets.

At the moment, this is still where we find ourselves today. Since its peak in December 2017, the global manufacturing PMI has fallen 3.8 points from 54.4 to 50.6 in March. During this time, EM currencies weakened by 7%. Encouragingly, the PMI was stable in March relative to the previous month, but for EM currencies to strengthen on a sustained basis, and its equity performance to really take-off, we will need to see the PMI move upwards. There is reason for optimism, given three big changes this year: 1) the Fed pause, allowing other central banks (both in DM and EM) to ease policy and support growth, 2) the pivot in trade talks between China and the U.S., which will hopefully lead to a deal soon, helping depressed business confidence, and 3) the continued positive effects of Chinese economic stimulus on its own economy, as well as on other neighboring Asian ones.

This currency question will be crucial for EM performance the rest of the year. However, in the medium to long-term, these currency waves end up fading from view and EM equity performance is driven by its faster economic and earnings growth. As a result, the currency question is important, but only for tweaks at the margin of what is a structural allocation to EM equities.

EM currencies strengthen vs. U.S. dollar when global growth is improving

EM currencies vs. USD, monthly, average annualized return, Jan. 2000 - Mar. 2019

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Markit, J.P. Morgan Global Economic Research, J.P. Morgan Asset Management. EM currencies is the J.P. Morgan Emerging Market Currency Index. Global Mfg. PMI is the Markit Purchasing Managers’ Index (PMI) for the global manufacturing sector. Data are as of April 26, 2019.