Emerging markets are a currency trade with equities attached

The index traded at 67.97 this morning, +0.28% on the session. Emerging market equity is discussed as an equity allocation. In practice a large share of what a dollar investor experiences is currency.

The arithmetic nobody enjoys

A local market can rise while the dollar investor loses money, if the currency falls more than the index gains. This is not an edge case. Over multi-year stretches it has been the dominant term in the return.

Which means that stock selection in EM, done well, can be entirely undone by a factor that has nothing to do with the companies chosen. That is worth internalising before doing any of the fundamental work.

What that implies

• The dollar's direction matters more than the earnings outlook, for a dollar-based holder
• Country weights are effectively currency weights, whatever the sector labels suggest
• Local rates policy is a genuine input, because it defends or abandons the currency
• Commodity exposure runs through the currency as well as the index

The consequence is that "EM looks cheap" is usually a statement about the currency having already fallen, not about the equities being mispriced.

Where I stand

Long the index rather than any single country. The currency drag that made the last few years difficult looks to have largely played out, and I would rather take the broad view than pick which specific market benefits.

In emerging markets, being right about the companies and wrong about the dollar is the standard way to lose.

What would change my mind

A sustained dollar advance. That is the scenario in which this view does not work, regardless of what the underlying companies deliver, and it is the reason the view is index level rather than concentrated.