"Emerging markets are getting crushed: The oil crash raises the risk of a full-blown crisis in the emerging market world."
- CNN Money, February 2016
It's a tale as old as time. Emerging markets stocks "need" higher oil prices. Oil is said to be their lifeblood; without it, they are doomed to a state of perennial crisis.
In markets, investors prefer simple narratives, and lumping all emerging markets into one bucket with one driving factor (crude oil) makes investors feel good. For as long as they can predict which direction crude oil is going, they can predict emerging markets.
There are only two minor problems with this logic:
Going back to 1986, the monthly correlation between emerging markets (MSCI Emerging Market Index) and crude oil is 0.36. In plain English, that means they often move in a similar direction. The key word in that sentence is often, which is far from always.
On a monthly basis, emerging markets and crude oil have moved in the same direction only 60% of the time, which means that 40% of the time they are moving in opposite directions (crude up, EM down or crude down, EM up).
Over the past year, this is precisely what we've seen, with the 1-year correlation dropping to record low of -0.58.
In 2017 thus far, emerging market stocks (EEM) are up over 16%, while crude oil is down 14%.
What gives? This was not "supposed to" happen; emerging markets were "supposed to" be down.
Indeed, but they're up. And as we know from history, this is not the first time this has happened (remember, 40% of the time they are moving in opposite directions).
Why don't they always move together? Good question. Perhaps it's because the Energy sector is not even close to the most important sector in emerging markets. Financials and Technology far outweigh energy exposure in the two most popular emerging market ETFs (EEM and VWO). Additionally, the Consumer Discretionary sector, which is often said to benefit from lower oil prices, is roughly the same size as Energy.
Digging a bit deeper, only one major emerging market country has Energy as its highest-weighted sector: Russia, at just under 50%. Unsurprisingly, Russia (ERUS) is down 7% this year and has a much higher monthly correlation with crude oil of 0.65.
If all emerging markets looked like Russia, the false narrative that emerging markets need higher oil might have some element of truth to it. But alas, they do not. Emerging markets may move with oil more often than not, but that is not the same thing as saying they are dependent on it. Do not confuse correlation with correlation. Just because something moves with something else does not mean something is moving because of something else.
The lesson here: don't invest based on stories, no matter how good they sound. Do the work, evaluate the evidence, and think for yourself.
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