Emerging markets resilient as oil falls and the dollar rallies
In past cycles, emerging market equities have fallen in sync with oil prices and suffered amid US dollar strength. This time, the winners from cheap oil outnumber the losers, explains Oliver Leyland CFA, Senior Investment Analyst – Latin America, Hermes Emerging Markets.
Going separate ways: Since mid-2014, historically high correlations between the MSCI Emerging Markets Index and both oil prices and the US currency have broken down (see the charts below). Determining whether this divergence is temporary or sustainable could strongly influence decisions by emerging market investors in the near term. The question we have asked, therefore, is: will emerging market equities sell off amid weak oil prices and a strong dollar, as in previous cycles?
It’s different this time: the current oil-price slide is unlike many of those in the past. What markets have experienced over the past year, and which has accelerated since the OPEC meeting in late November 2014, is a supply side shock as chief oil-price setter Saudi Arabia prioritises market share over price. This differs materially from 2008, when collapsing global growth sunk demand. Meanwhile, the drivers of the dollar’s strength are more nuanced, though to some extent caused by the economic weakness of the eurozone and Japan, rather than emerging markets.
No longer a commodity play: emerging markets are also less leveraged to oil prices this time. In 2007, the energy sector accounted for 18% of the MSCI Emerging Markets Index, and this has fallen to 8% today. The exposure of the index to what we define as energy markets – those countries whose equity markets have an exposure of greater than 15% to the energy sector – has fallen from more than 12% in 2008 to less than 7% now. To illustrate the point, in February 2008 Gazprom and Petrobras were the largest two stocks in the index but are now the 19th and 20th largest respectively. As the weighting to energy in the index has contracted, the IT sector has almost doubled from 10% to 19%.
Winners and losers: since 2008, the exposure of the index to oil exporters has diminished. As beneficiaries of cheaper oil, importing countries like China, India, South Korea and Taiwan can be seen as current-account “winners” and now represent 70% of the index, up from 59%. Oil exporters, the current-account “losers”, now represent only 13% of the index, down from 17% in 2008. In economic terms, the combined balance sheet of emerging markets is an overall winner from the fall in oil prices.
Reasons for resilience: given these developments, we believe that the likelihood of emerging markets being broadly hit by a balance of payments shock is lower than when oil has fallen and the dollar surged in past cycles. We do not deny the potential for pockets of stress in mis-managed emerging economies that have become too reliant on energy exports, such as Russia, Venezuela and Nigeria. But all else being equal, emerging market equities have the potential to perform resiliently.
The Hermes Global Emerging Markets Fund outperformed the MSCI Emerging Markets Index by 4.45% and 4.25% in the one- and three-year periods to the end of December 2014 respectively. Its 2.53% exposure to energy stocks contrasts with the benchmark’s 8.03%, resulting in a -5.50% active weight.