By Joanne Legomsky
The growing sense that the air is quickly going out of the commodity bubble has only served to dampen the already-waning interest in emerging market stocks.
Indeed, the received wisdom that emerging market equity returns and commodity prices are tightly linked rests on two key assumptions: First, that the explosive growth in emerging market countries is a major driver of commodity prices. Second, that commodity prices are major determinants of emerging market economic growth, and therefore, equity returns.
While there's certainly some intuitive appeal - not to mention, some truth - in this thinking, the relationship between commodities and emerging markets may be less straightforward than is generally assumed, meaning investments in the emerging markets asset class may still be worth considering.
Tanking Commodities Prices
The recent feverish retreat in commodity prices reflects both softening demand and the prospect of further weakness ahead, as the economic and credit woes that began in the U.S. a year ago go global.
In the last several weeks, oil has fallen more than 20% from its July peak, gold is off more than 22% and the pullback has spread to industrial metals and agricultural commodities - from copper to soybeans to corn.
At the same time, after a seven-year slide, the U.S. dollar seems to be reversing course, with the more robust greenback putting further downward pressure on commodities priced in dollars. Over the past month, the currency has appreciated some 8% against the euro and the British pound and almost 6% against the yen. Analysts say the move is getting a fillip from those hedge funds and sovereign wealth funds that had bought oil to hedge the declining value of their long dollar positions - and are now unwinding those positions.
Of course, not everyone is bailing out of commodities, and a sustained decline in commodity prices is hardly a given. Goldman Sachs Group Inc. analysts, among others, have declared the oil and crop price plunges a buying opportunity. In their view, commodities are en route to a new higher price equilibrium.
Do Commodities Drive Emerging Markets?
If a sustained drop in commodity prices is under way, is it time to issue a DNR order for emerging markets, too?
Indeed, even Boston-based GMO's Jeremy Grantham, prominent among the thinning ranks of emerging market enthusiasts, finally threw in the towel. After declaring in April that emerging markets were ripe for a powerful rally, his firm just lowered its weighting in emerging equities to neutral or slightly below, despite their favorable long-term outlook for both emerging markets and commodities.
Still, some skeptics think a more nuanced view of the relationship between emerging market equity performance and commodity prices is in order.
A study by Vanguard Investment Counseling & Research [IC&R] concluded that the link between commodity prices and emerging market performance was relatively weak. After looking at the correlation between the performance of the GSCI Spot Index and the MSCI Emerging Markets Index from 1988 through 2006, the study found periods of similarities, as well as frequent divergences. Accordingly:
- Emerging market price returns and commodity spot returns had little in common from 1988 through 1994.
- Returns then became quite similar from the mid- to late 1990s and again in 2004-2005.
- From 2000 through 2003 and again in 2006, the annual relationship broke down.
Since this study, the iShares MSCI Emerging Markets Index declined 9.5% this year through July 1, while the iPath DJ-AIG Commodity ETN (NYSEARCA:DJP) shot up 27.09%.
According to IC&R, the strong relationship from 1994 through 1999 may have been more coincidental than causal. And they cited some good reasons why emerging markets and commodities might not move in synch over short and longer periods.
For one, both the Emerging Market index and GSCI are very diverse. And regions and countries differ in their usage and production of various commodities. So, for example, while energy is the largest component of the GSCI, energy is not highly correlated across emerging regions. In addition, noncommodity influences, like the Russian default, affect developing countries differently.
Do Emerging Markets Drive Commodity Prices?
The notion that emerging market countries are a major driver of commodity prices also appears to come with caveats. For example, despite recent concern that strong demand from emerging markets would continue unabated despite higher commodity prices - fueling inflation - economists observed that, in fact, rising commodity prices have had an equal, if not greater impact on developing-country demand.
Paul Justice, an analyst with Morningstar's ETF analysis unit, said investors who subscribe to the notion of a commodity bubble might want to avoid those with a hard assets focus. Countries like Russia, Venezuela and much of the Middle East are heavily dependent on the oil and gas industries. Similarly, many African or Latin American countries are reliant both on industrial metals, such as copper and aluminum, or precious metals - gold, silver or platinum.
Justice contrasted the dynamics of those markets with those of India and China, which benefit from abundant, knowledgeable labor forces.
However, Morningstar itself doesn't buy into the commodity bubble thesis. "Our take is that the recent pullback in commodities is temporary, reflecting cyclical weakness in the U.S. Longer term, there are powerful demand forces," Justice said.
Currently, he thinks the Brazil stock market looks undervalued. He noted that the iShares MSCI Brazil Index (NYSEARCA:EWZ) has fallen almost 15%, in lockstep with other emerging markets, even though Brazil's economic growth remains brisk. Its 6.5% inflation rate is among the lowest in emerging countries, and a major new oil field was discovered off the coast last November. In recognition of Brazil's relative strength, Standard & Poor's boosted the country's credit rating in April.
Another way to obtain targeted exposure in both emerging and non-U.S. developed markets is through one of the 10 new SPDR International ETFs from State Street Global Advisors, which began trading on the American Stock Exchange July 22. Commodity bears who want to keep a toe in emerging markets might consider defensive global sector ETFs, such as International Health Care Sector (NYSEARCA:IRY) or International Consumer Staples Sector (NYSEARCA:IPS).
For those bold emerging market contrarians who remain attracted to Russia, there are several options, including the Market Vector Russia ETF (NYSEARCA:RSX).