Loose developed market (DM) monetary policy, rising commodity prices and effective COVID-19 vaccines are converging to drive global capital flows to emerging markets (EMs). In our view, these dynamics are likely to overshadow challenging domestic fundamentals and reboot growth in most economies, supporting local currency assets.

Capital flows to emerging markets typically accelerate following global recessions. Yet we believe the backdrop to 2021, while not without risk, has the potential to be record-setting for several reasons.

A strong synchronized recovery is anticipated. The cyclical rebound from 2020’s stop-start pattern is likely to be vigorous and highly synchronized globally in 2021. Vaccine distribution is set to be concentrated within the first half across advanced economies, and governments have committed to avoid premature fiscal retrenchment. Meanwhile, large negative output gaps (the difference between the actual and potential output) are anchoring low inflation and reinforcing DM central bank commitments to keep financing conditions extremely accommodative, which suggests negative DM real yields will persist beyond 2021.

Global manufacturing is robust. Emerging markets are typically a levered play on global manufacturing growth. Following the initial lockdown, manufacturing growth rebounded strongly and remained resilient during the second and third virus waves. Even if domestic demand remains relatively weak amid the COVID-19 flare-up and moderating fiscal stimulus, many EMs are well placed to benefit from a resilient global manufacturing cycle and the eventual boost from pent-up demand as mobility returns to normal.

Figure 1: U.S. dollar has weakened relative to emerging market currencies during periods of global manufacturing growth

This chart shows the three-month percentage change in the spot U.S. foreign exchange rate for every one percentage point increase in the Global Composite PMI, which is a monthly survey of purchasing managers. The spot exchange rate is shown for each of 28 emerging market countries. The U.S. dollar weakened against 26 of the 28 countries when the Global PMI increased. It was the most sensitive to the Global PMI against the South African Rand, the Mexican Peso, and the Brazilian Real, weakening by more than 50%. The dollar was strongest against the Japanese Yen and the Peruvian Nuevo Sol, gaining roughly 5% -- the only currencies against which the U.S. dollar gained when the PMI increased.

A weaker U.S. dollar reflates EM growth. Dollar depreciation, the counterpart to rising EM capital inflows, increases the price of dollar-denominated EM exports and boosts the ability of EM countries to repay dollar-denominated debt. All else equal, the confluence of strong capital inflows, higher export prices and looser financial conditions should serve to boost EM growth.