Global Dollar Strength and Its Implications for Emerging Markets: Currency Risk and Equity Valuation Adjustments

The U.S. dollar's performance in 2025 has been a defining force in global financial markets, with the WSJ Dollar Index (DXY) reflecting both volatility and structural shifts. As of September 28, 2025, the index closed at 94.75, a 0.28% drop from the previous day-a sharp reversal from its 0.29% gain on September 17, which marked its largest one-day rise since early September, according to Morningstar data. This fluctuation underscores the dollar's sensitivity to macroeconomic signals, including Federal Reserve policy, trade dynamics, and global risk appetite. For emerging markets (EMs), the dollar's strength-or weakness-has profound implications for currency risk, capital flows, and equity valuations.

The Dollar's Dual Role: Safe Haven and Headwind

The U.S. dollar remains the world's primary reserve currency and a safe-haven asset. When global uncertainty rises-such as during trade tensions or geopolitical shocks-capital flows into the dollar, tightening financial conditions in EMs. For instance, the dollar's resilience in 2025, despite slower U.S. growth and rising deficits, has been driven by its role as a hedge against uncertainty, according to a J.P. Morgan outlook. Conversely, a weaker dollar, as seen in the first half of 2025, when the DXY fell 10.7%-its worst performance in over 50 years-has historically boosted EM equities and currencies by easing financial conditions and reducing debt servicing costs for dollar-denominated borrowers, according to a Mondrian analysis.

However, the current environment is nuanced. While the dollar has weakened year-to-date, its recent rebound in late September suggests that investors remain wary of global risks, including U.S.-China tensions and the Fed's cautious approach to rate cuts, as noted in an EY outlook. This duality-where the dollar acts as both a headwind and a refuge-creates a volatile backdrop for EMs.

Currency Risk and Capital Flows: Winners and Losers

Emerging markets with strong macroeconomic fundamentals-such as current account surpluses, credible central banks, and political stability-are better positioned to benefit from dollar depreciation. For example, India, which is forecast to grow at 6.6% in 2025, has attracted capital inflows due to its robust manufacturing sector and fiscal discipline, in line with a William Blair outlook. In contrast, countries like Brazil and South Africa, grappling with fiscal constraints and currency volatility, face tighter financial conditions when the dollar strengthens, according to EY.

A strong dollar exacerbates currency mismatches for EM firms. Many corporations in Brazil and South Africa hold dollar liabilities while generating revenue in local currencies. When the dollar appreciates, their debt servicing costs rise, eroding profitability and creditworthiness, as shown in a ScienceDirect study. Conversely, a weaker dollar allows these firms to delever, improving margins and attracting foreign investors. This dynamic is evident in equity valuations: Indian equities, for instance, have outperformed peers in 2025, supported by structural tailwinds and a more favorable debt profile, according to a UBS note.

Equity Valuation Adjustments: The Fed's Tightrope

The Federal Reserve's policy trajectory has been a critical determinant of EM equity valuations. While rate cuts typically weaken the dollar and support EMs, the Fed's 2025 decisions have been tempered by concerns over a potential "soft landing" and global growth slowdowns. As of September 2025, the Fed's cautious approach has limited the dollar's decline, capping EM outperformance, according to a Cambridge Associates analysis.

Moreover, EM central banks have responded to global inflationary pressures by raising rates aggressively, which has constrained money supply growth and dampened earnings expectations. For example, Brazil's central bank has maintained high interest rates to curb inflation, slowing economic momentum and weighing on equity valuations, according to EY. In contrast, countries like Mexico and India, which have balanced rate hikes with structural reforms, have seen more resilient equity markets, per UBS.

The Path Forward: Navigating Uncertainty

The dollar's trajectory in late 2025 will hinge on three factors:
1. Fed Policy: A slower pace of rate cuts or a pivot to tighter policy could reignite dollar strength, tightening EM financial conditions.
2. Trade Dynamics: Escalating trade tensions, particularly between the U.S. and China, could drive safe-haven demand for the dollar, overshadowing EM growth prospects.
3. Global Risk Appetite: A shift toward risk-on sentiment-driven by improved growth outlooks or geopolitical de-escalation-could weaken the dollar and boost EM capital flows.

For investors, the key lies in balancing macroeconomic insights with bottom-up analysis. While a weaker dollar historically favors EMs, the current environment demands scrutiny of individual markets' fiscal health, trade balances, and policy credibility. As a Mondrian analysis notes, "A disciplined EM strategy must integrate macroeconomic trends with granular company-level fundamentals."

Conclusion

The U.S. dollar's strength in 2025 has created a complex landscape for emerging markets. While a weaker dollar offers tailwinds for equities and currencies, structural challenges-including fiscal imbalances and trade tensions-remain significant headwinds. Investors must navigate this duality by prioritizing EMs with robust macroeconomic foundations and avoiding those vulnerable to currency mismatches. As the Fed's policy path and global trade dynamics evolve, the dollar's role as both a refuge and a risk will continue to shape the fortunes of emerging markets in the months ahead.