Breaking Down the Presumed Correlation Between Commodities and Emerging Markets


July 20, 2017 [emerging Markets, performance, commodities]
Charles Roth

The divergence this year in the performance of the emerging markets stock index and commodities prices reflects improved earnings quality and valuations of developing country stocks, not to mention big changes at the top of the index.

Among the lingering misconceptions about emerging markets is that they are proxy plays on commodities, prices of which presumably drive returns in developing country stocks. Historical correlation, though, should never be confused with causation.

The performance of emerging markets and commodities this year makes the point starkly. From the beginning of the year to July 20, Brent crude is down around 12%, and the S&P GSCI, a broad-based commodities index, is off nearly 9%. Meanwhile, developing country stocks are having a banner year so far, with the MSCI Emerging Markets Index climbing 23%. Is this an aberration that will sooner or later revert to mean, falling back in line with stumbling commodities prices?

Probably not. As Thornburg’s Charlie Wilson noted recently, cyclical tailwinds have combined with structural drivers, which we discussed last week in Emerging Views. The cyclical tailwinds, particularly the earnings outlook and associated valuations, are significant. Forecast EM index earnings per share at the end of June stood at $79 in 2017 and $88 in 2018, both of which are still well below the peak of $111 in expected EPS set six years ago, even though they’re also nicely off the recent February 2016 trough.


Figure 1 | MSCI EM EPS Has Room to Grow

Source: Bloomberg, as of 6/28/2017.


Interestingly, “the composition of earnings from the prior peak has substantially changed and has improved in terms of quality,” Wilson notes. In mid-2011, energy and materials comprised slightly less than 30% of the index, more than double their 13.8% weighting today, he points out. Conversely, information technology has climbed to 26% of the index currently, versus 12% back then.


Figure 2 | Change in MSCI EM Index Leadership since 2011

Source: MSCI, Bloomberg.


Three of the top five index components in 2011 were “national champion” natural resources companies focused largely on export markets, replaced today by mega-cap internet and e-commerce companies. “The transition in the top five index weights since 2011 reflects the change in the overall index. Gazprom, Petrobras, and Vale have been replaced by Tencent, Alibaba, and Naspers,” Wilson points out. “The leadership within emerging markets has become companies with more of a domestic orientation and less driven by global trade and commodity prices.” Even as earnings quality and potential upside of top index constituents have improved, their price-to-earnings ratios, as Figure 1 also shows, are hardly demanding relative to the index’s own history and to those of developed country indices, particularly versus the S&P 500 Index.


Figure 3 | EM Remains at a Discount to the S&P Index

Source: Bloomberg. (Blended 12 Months)


To be sure, volatility in emerging markets hasn’t gone away, particularly in those reliant on energy and commodities exports. In the second quarter, the dollar-denominated MSCI Russia Index dropped nearly 10%, while the MSCI Brazil Index swooned almost 7%. Yet their pain didn’t overwhelm the gains in the MSCI China Index or MSCI India Index, which were up 11% and almost 3%, respectively, in the period. The latter two are part of the roughly 80% of EM market capitalization countries that are net oil importers.

Of course, the broad EM stock index isn’t immune to steep draw downs and rebounds, either, often driven by intense currency market swings.


Figure 4 | The Importance of Downside Protection in Emerging Markets (as of 12/31/2016)

Source: Morningstar


Investors can partially mitigate such swings by focusing on select companies that exhibit resilient earnings growth, low financial leverage and steady free cash flow generation. Such firms can both protect on the downside and participate on the upside. They may not be first out of the gate in a recovery cycle, but by compounding off a higher base over the long run, they should ultimately return more and with less volatility. This, in fact, has been evident over the last 18 months, when deep value resource plays were the first to rebound off the early 2016 lows, only to be overtaken by lower leverage, higher return on equity segments this year.


Figure 5 | Low Quality Leads to 2016, Leadership Change in 2017

Source: Bloomberg, Thornburg Investment Management.

Past performance does not guarantee future results.


This isn’t to say there aren’t attractive natural resource plays in emerging markets. But the lower quality, more indebted, state-affiliated energy and commodities “enterprises” don’t hold as much sway over the broad index as they used to, which should continue to reduce the EM index’s erstwhile high correlation with commodities markets and reflect steadier earnings growth ahead. It’s not your father’s emerging markets index anymore.

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