Can Emerging Market Equities Work If Commodity Prices Don’t?


April 28, 2016 [Oil, Emerging Markets]
Charles Wilson, PhD

Correlation is not causation when it comes to emerging markets and commodities.


The term "risk assets" has become widely used to describe anything that goes up when the U.S. dollar goes down. Perceptions around the pace of U.S. monetary tightening substantially influence the greenback’s movements. In recent years, risk assets have come to include everything from junk bonds to Chinese steel prices or even Italian banks. In our view, many people have mistakenly confused the correlation between asset prices with causation, especially relative to prices of two asset classes in particular—commodities and emerging market equities. The underlying assumption being that emerging markets are driven by commodity prices. We don’t think that’s really the case on a fundamental level. Most countries in the MSCI Emerging Markets (EM) Index benefit from lower commodity prices in general, especially oil. This makes sense considering that about 90% of the companies in the MSCI EM Index are domiciled in countries that are net importers of energy, as shown in figure 1.

Figure 1: Impact of Lower Oil Prices on Emerging Markets - Net Positive

Source: Bloomberg, as of 12/31/2015

*Free Float Weighted


To understand the relationship between the MSCI EM Index and Brent crude prices over time, we show in figure 2 a correlation between the two since 2000. Last decade both emerging market equity and oil prices saw very good returns, but actually tended to perform at different times as you can see from the very low correlation up until 2008. After 2008, they have become much more correlated, perhaps due to coordinated global monetary stimulus, which has driven correlation among all assets—not just those that are viewed as more risky. The correlation has mistakenly led to the view that emerging markets are driven by commodities, but it seems to us that the recent correlation between commodities and emerging markets have been driven significantly by external factors—largely developed market monetary policy. The correlation has mistakenly led to the view that emerging markets are driven by commodities, but the reality is all assets prices are connected by abundant money supply. Even though U.S. monetary policy was fairly easy last decade, it was not conjoined to the globally coordinated monetary efforts we have seen recently. To be fair, we did see a prolonged period of coordinated global growth last decade that left the world short on supply of certain commodities and led to elevated commodity prices.

In any event, we think higher commodity prices were bad, not good for emerging markets on aggregate. For commodity importing countries, which constitute the majority of emerging markets, higher commodity prices led to broad inflationary pressures, which often eroded the purchasing power of consumers, and in many cases forced governments to utilize their fiscal resources to provide costly subsidies to the poorer segments of the population. It also forced a number of emerging market central banks to run tight monetary policy in an effort to defend their exchange rates and rein in inflation. On the other hand, commodity exporting countries should have benefited from higher commodity prices. However, the reality is that most of these countries utilized the high commodity price windfalls to implement social policies that were often unsustainable. Lower commodity prices should push these countries to adjust, laying the foundation for a more sustainable economic growth model in the future.

If we now remain in a strong but stable dollar environment for several years, that could ultimately be good for emerging markets, as it keeps global demand subdued along with commodity prices and inflation. Goldilocks scenario, perhaps. But very plausible given the fragile state of global growth and its dependence on central bankers for support. That type of environment will certainly help real wage growth and general consumption trends for those markets.

Figure 2: Correlation between Brent crude prices and MSCI EM Index

Source: Bloomberg


At the heart of this debate is the concept that emerging market performance is just a reflection of global risk appetite. As long-term active managers, we fundamentally disagree with that view. Volatile markets often swing a company’s share price around much more than its fundamentals would imply. We think we can take advantage of inefficiencies created by indiscriminate flows into and out of the space during periods of elevated animal spirits or, conversely, risk aversion, selling richly valued stocks when the crowd is buying, and buying them at attractively priced levels when it’s scrambling to sell. Over the long run, beyond apparent market correlations and misperceived linkages, the soundness of a company’s business model and its earnings prospects, alongside the quality of its management, ultimately determine the return on its shares.


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