Download Emerging equity markets and commodities: joined at the hip?

Emerging equity markets and commodities:
joined at the hip?
This document is for Professional Clients only and is not for consumer use.
Commodity prices peaked in 2011
and have been under pressure ever
since. This period has also coincided
with the underperformance of global
emerging equity markets versus
their peers in the developed world.
Why is this the case and can we
assume that all emerging economies
are affected in the same manner?
In this paper we set out to explain
why all developing countries and
sectors should not be grouped into
a one-size-fits-all bracket – a sharp
fall in oil prices may have a negative
impact on energy producers
such as Saudi Arabia and Russia,
whereas lower import prices for
oil dependent nations such as
India and Turkey are likely to bring
bonanzas to their local economies.
We will challenge the traditional
notion that depressed commodity
prices are bad news for emerging
markets (EM) generally by arguing
that given the vast depth and
breadth of the developing world,
there will be losers and winners in
such an environment. As active
fund managers, it is our duty to
separate the ‘wheat from the
chaff’ and ensure that our funds
invest where future cash flows
are likely to positively surprise
market expectations.
Economic headwinds
Over the past five years, trading conditions for emerging equity markets have been
tough. Oil prices have dropped sharply from above US$100 a barrel to below US$30,
US interest rates have risen for the first time in a decade, doubts have been expressed
about China’s growth outlook and EM currencies have come under heavy pressure
from a resurgent US dollar. At the beginning of 2011, the energy and materials sectors
accounted for about a third of the MSCI EM Index, a far higher concentration than that
of the S&P500. In the latter, healthcare, technology and consumer-related stocks were
the heavyweight divisions, sectors that have performed relatively better during this
period of historic low interest rates.
Weakening global demand, compounded by oversupply factors, has contributed to a
significant drop in commodity prices since January 2011. While the Thomson Reuters/Core
Commodity CRB Index has nearly halved in value since then – the benchmark measures
a composite of food, metals and energy prices – the relative performance of emerging
equity markets versus those in the Western world has closely tracked it. (See exhibit 1).
Exhibit 1
Close relationship between EM
performance and commodity prices
Materially linked
2011
2012
2013
EM relative performance vs DM
Commodity prices
2014
2015
2016
120
100
80
60
Source: Bloomberg. MSCI EM relative to MSCI World. Thomson Reuters/Core
Commodity CRB Index. Data as at 29 July 2016. 1 January 2011 = 100 .
At first sight it might appear to be the case that a downturn in commodity prices leads
to the underperformance of emerging equity markets. This is a generalisation, however,
because if we dig beneath the surface we find a divergence of performance at both a
sector and country level. The investment universe for EM is wide and diverse, covering
economic powerhouses like China to the smaller economies of Hungary and Peru. A
common thread that unites all emerging countries is secular factors such as favourable
demographics, urbanisation and a growing middle (aka consumer) class. These are the
areas which are likely to provide the most attractive opportunities going forward.
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merging equity markets and
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commodities: joined at the hip?
Benefits of sector diversification
Exhibit 2 shows how certain MSCI EM sectors have performed in relative terms versus
the broader index since 2011. While materials and energy – the sectors most closely
connected to commodities – have underperformed significantly during this time period,
consumer discretionary and technology stocks have fared considerably better.
Exhibit 2
Opportunities outside energy and materials
Sector divergence
2011
2012
2013
2014
Energy
Materials
Consumer Disc
Technology
MSCI EM index
2015
2016
180
160
140
120
100
80
60
Source: Bloomberg. Data as at 29 July 2016. 1 January 2011 = 100. MSCI EM sectors.
Old versus new industries
While the Chinese authorities continue to transition their economy away from heavy
industries towards services, demand for commodities has noticeably cooled. Given that
China is the major market for almost all internationally traded commodities, accounting
for almost half of global demand for industrial metals, energy producers and suppliers
of natural resources have faced considerable headwinds. By contrast, companies that
operate in growth industries such as technology have generally done relatively well in
recent times.
Technology advances have had a significant impact on all of our lives at both a
business and consumer level. The rapid growth of internet usage has provided huge
opportunities for companies able to tap into increasing demand for online services in
areas such as shopping, banking platforms, mobile games and social media. While the
commodity super cycle appears to be now over, the number of internet users in China
has grown massively, rising from about 20 million in 2000, to half a billion in 2011
and to an estimated 700 million plus users today. (Source: Internet Live Stats, 16 May
2016). With a total population of about 1.4 billion, market penetration is just over
50% - still room for expansion given favourable trends in urbanisation. With real wages
and living standards rising, we believe demand for higher-value goods elsewhere in the
consumer space should continue to increase.
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merging equity markets and
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commodities: joined at the hip?
Winners and losers
Asian countries are normally recognised to be the big winners from weaker commodity
prices as they tend to be consumers of natural resources. Although their economies
are more exposed to any weakening in global trade flows, they are generally perceived
to be beneficiaries of lower energy bills and cheaper imports. This could boost
discretionary spending in countries such as China, India, South Korea and Taiwan. In
other Asian nations where significant fuel subsidies – the difference between the price
charged to consumers and the ‘true’ price – exist, government savings from lower
subsidies could mean more money for investments in infrastructure, healthcare and
education. The most significant savings are likely to come from places with the highest
fuel subsidies - Indonesia, Thailand and Vietnam. Many emerging European countries
should also enjoy economic benefits from cheaper energy prices, for example Turkey,
Poland and Czech Republic.
By contrast, the big producers of commodities – Brazil and Russia – have suffered from
weaker prices in iron ore, oil and metals. We can also include South Africa in this group
because it is a major exporter of gold, diamonds and platinum even though its top import
is petroleum. Lower revenues also make it more challenging for governments here to
introduce fiscal stimulus packages aimed at boosting flagging economies. However, we
believe that these countries have the necessary tools to boost their resilience to counter
the effect of lower oil and commodity prices, as emphasised in the latest IMF report
(April 2016) on Global Financial Stability. https://www.imf.org/external/pubs/ft/gfsr/
Exhibit 3
Currencies take the strain
% change versus the US$ since 2011
-60
-50
-40
-30
Commodity producers
Commodity consumers
-20
-10
0
Russia
South Africa
Brazil
Turkey
Colombia
Thailand
Taiwan
Philippines
China
South Korea
Source: Bloomberg. Data as at 29 July 2016.
Contrast between commodity producers and consumers
With floating exchange rates being the norm in EMs today (China being the main
exception) exhibit 3 shows how EM currencies have fared against the US dollar. Apart
from the South Korean won, all have depreciated in value against the US dollar since
the beginning of 2011. Some of the declines have been significant – more than 50%
in the cases of the South African rand, the Russian rouble and the Brazilian real. It
is noticeable that currency weakness has been more pronounced for commodity
producers than commodity consumers. The sole exception being Turkey where other
external factors – the country runs a large current account deficit, although this is
narrowing - have weighed on sentiment.
There are two important points to make regarding these large currency gyrations.
Firstly, commodity prices generally have an inverse relationship with the US dollar, for
instance if the US dollar strengthens then commodity prices fall. The opposite happens
as the US dollar moves lower. It is not a perfect correlation but fairly close. Secondly,
currency devaluation improves a country’s competitiveness by making exports cheaper.
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merging equity markets and
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Floating exchange rates
Exhibit 4 shows what impact a weaker exchange rate can have on a commodity when
it is re-priced into another currency. In this example we look at Brent crude oil and
the rouble. Whereas revenues for Russian oil companies are derived in US dollars,
their costs and overheads are invoiced in roubles. With further assistance provided
by a flexible tax system that is less onerous with falling crude oil prices, Russian oil
companies have much lower break-even levels than their peers in the Western world.
Even with oil at US$30 a barrel, Lukoil is still capable of generating free cash flow and
paying dividends, according to our own analysis.
US$
Rouble
Exhibit 4
Weak rouble shields Russian oil companies
Brent crude oil (rebased)
2011
2012
2013
2014
2015
2016
140
120
100
80
60
40
Source: Bloomberg. Data as at 29 July 2016. 1 January 2011 = 100.
Pegged currencies
Many oil-producing countries in the Middle East – Saudi Arabia, Qatar and United Arab
Emirates - have currencies that are pegged to the US dollar. The rationale for fixing an
exchange rate to the US dollar is to stabilise the local economy, making it less volatile in
an uncertain world. The downside risks associated with a pegged rate is that it requires
the country to have large reserves, which can have unwanted economic side-effects
such as higher inflation. The capital outflow pressure is visible in declining FX reserves.
For example, Saudi Arabia lost close to US$120 billion of FX reserves in 2015, 17%
of its total. (Source: JP Morgan March 2016). The risk of devaluation for pegged
currencies in this region increases with lower oil prices.
In recent months, China’s central bank has loosened the yuan’s peg to the US dollar
by letting it track the currencies of its broader trading partners. The composition of
the currency basket includes the US dollar, euro, yen and ten other currencies. China,
too, has recently depleted a significant amount of its foreign exchange reserves in an
attempt to keep the yuan at a relatively stable level.
For commodity exporters with floating exchange rates, for example Russia, the price
movement has been significant. The advantage of having an underperforming currency
whose value is determined by market forces is that it helps to adjust the current
account (typically from deficits) towards sustainable levels. While we are seeing an
improvement in the current account deficits for Turkey and Brazil, there has been
deterioration in the current account balances for South Africa and Colombia. This
suggests that some countries still have more rebalancing to do.
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Exports and GDP
If we classify exports from EM into two simple categories; (1) commodities and (2)
manufactured goods, there has been a divergence in performance between the two
since 2011. While the former has struggled somewhat, manufacturing exports have
held up far better. A clear example is the manufacturing sector in Mexico which,
supported by competitive labour costs and a recovering US economy, continues to
press ahead. We believe that other manufacturing countries such as China, Philippines,
South Korea and Taiwan also have good long-term prospects.
Exports are a key component of a country’s output. Given the weakness of commodity
prices, the real GDP growth rate of commodity producers has suffered with some
economies in recession, for example Brazil and Russia. By contrast, the manufacturing
economies of Mexico and the East Asian countries listed above, national output
continues to expand at a healthy rate, although there are signs now that growth
momentum is slowing down.
Structural changes and reform
During the years of high oil prices, many energy-dependent emerging countries took
steps to reduce their reliance on the expensive commodity. The search for alternative
sources of energy gas gained momentum, particularly in renewables such as solar and
wind. The adoption of renewable energy programmes is growing twice as fast in EM
than in the developed world. China is now the world leader in terms of installed wind
and solar capacity and Brazil held its first solar-only energy auction in October 2014
(Source: The Guardian February 2016). Solar energy is cheaper than coal in India with
more than one million households here using distributed renewable energy systems to
provide them with basic electricity (Source: Renewable Energy World, February 2016).
Unfortunately, not all commodity producing countries fixed the roof while the sun
was shining during the boom years of 2003-2010 when economic growth was strong
and stable. While some governments implemented structural reforms back then,
others did not do enough. With public finances under increasing pressure, the room
for manoeuvre today is more limited. However, we are seeing encouraging signs of
progress with reforms in Mexico opening up the domestic energy sector to the private
sector for the first time in years. Reform in India is heading in the right direction,
albeit at a slower pace than first envisaged following the election of a more market
friendly government. Even in Russia, we are seeing some positive developments as the
government attempts to modernise the economy, expand its privatisation programme
and promote Moscow as a financial centre in an attempt to shift the economy away
from a dependence on the energy sector.
Business friendly
If these reforms are to be successful it would help if they were implemented in a
business friendly environment. All economies need some form of business regulation
but if the rules and processes are too complex it may deter investment and the startup of new enterprises in areas of growth. With too much red tape and bureaucracy, a
company will open up a new production facility elsewhere. Encouragingly, we believe
emerging countries are going in the right direction in making their economies a more
attractive place to invest and do business in, a view supported by the findings of the
latest World Bank ‘Doing Business’ survey. http://www.doingbusiness.org/rankings
Out of a global index of 189 countries, the 2016 report showed three Latin American
countries – Mexico, Chile and Peru – in the top 50, and there are several emerging Asian
nations now in the top 20.
Furthermore, we believe many emerging countries have made significant progress
in addressing concerns over corrupt government practices as well as implementing
structural and institutional reforms aimed at increasing productivity growth.
Conclusion
We believe the EM investment universe is more than just a commodity play. As active
fund managers we seek to exploit market opportunities through long-term exposure
to strong and healthy companies through our highly selective, bottom-up investment
process. As part of a balanced portfolio, where stock selection is fundamental, we
believe the long-term investment case for EM remains attractive.
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merging equity markets and
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commodities: joined at the hip?
Important information
This document is for Professional Clients only and is not for consumer use.
The value of investments and any income will fluctuate (this may partly be the result of
exchange-rate fluctuations) and investors may not get back the full amount invested.
Where Dean Newman, Head of Emerging Markets Equity Team at Invesco Perpetual,
has expressed opinions, they are based on current market conditions and are subject to
change without notice. These opinions may differ from those of other Invesco Perpetual
professionals.
Invesco Perpetual is a business name of Invesco Asset Management Limited
Perpetual Park, Perpetual Park Drive, Henley on Thames, Oxfordshire RG9 1HH, UK
Authorised and regulated by the Financial Conduct Authority
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