Low but stable oil price is good for emerging markets

The oil price has been volatile lately, dropping 29% during the first two weeks of the year only to rally 55% during the past two months, after having dropped sharply since mid 2014.

The recent rally has been supportive for emerging and frontier market equities but there is reason to believe crude price will stabilise at a historically low level, possibly around current levels, and one may wonder how that will impact these markets going forward as we are basically back at where we started the year.


Source: MacroBond  Note: MSCI total return USD indices for EM/FM

Low oil price is generally assumed to be bad for emerging markets. The reason is primarily related to sentiment as a falling price for crude tends to be associated with reduced risk appetite. Indeed, the emerging market stock market index shows a relatively close correlation with oil price over the past 15 years.

But that is not necessarily unique to emerging and frontier markets – and not based on fundamentals. First of all, equity markets in general often move in line with the oil price although developed markets are less volatile and tend to smooth out the peaks (like in 1H 2008) and troughs (like in 2H2015). In any case, all markets have held up better than the oil price recently, perhaps as a result of the fact that the current oil price weakness is primarily due to oversupply than sluggish demand.


Source: MacroBond  Note: MSCI total return USD indices for DM/EM/FM

A more essential point is that the close correlation between emerging market equities and the oil price is not based on fundamentals. A vast majority of emerging markets are actually net importers of crude and thus benefit from lower oil prices. Only 8 out of the 23 markets in the MSCI EM index, representing less than 20% of the total weight, are net oil importers and energy overall only makes up 7% of the index. The situation in frontier markets is slightly different as only 5.5 of 23 markets are net oil exporters (Vietnam is a net crude exporter but net oil product importer and thus counted as a half), but these markets represent more than 45% of the index. A number of extended frontier markets, most notably Saudi Arabia and Iran, are major oil exporters. But the weight of energy in the frontier index is nevertheless below 10%.

The old EM/FM consumption theme should thus be more relevant than ever in a low oil price environment. Retailers – be it food, clothes, electronics or e-commerce – airlines, auto producers, home developers and other consumption oriented sectors should prosper as disposable income should grow in this low oil price environment. It is even possible to get exposure at a deep discount now, especially in oil-dependent markets.

Moreover, the oil price adjustment has helped to correct some macro economic imbalances in the emerging world. First of all, it has been instrumental in pushing inflation towards an all-time low and many forecasters believe inflation will continue to fall. While deflation might be a real threat in the developed world, an average inflation rate below 5% is very healthy for the emerging world. This is especially true as growth is expected to re-accelerate.


Source: IMF  Note: EM/FM are all countries except DMs

Second, lower oil prices also help to correct the current account imbalance within the emerging universe. The current account balance spread between oil exporters and importers tend to surge to 7-8 percentage points of GDP during oil price surges. This does not only create an uneven playing field but is also distortive. This imbalance has, however, been wiped out during the past few years, possibly overshooting, but is expected to level out over the coming five years.


Source: IMF  Note: EM countries according to MSCI index

Finally, although low oil prices are primarily positive for importers, it is not necessarily all bad for exporters. Low oil prices tend to force these countries to implement reforms that are difficult (and deemed unnecessary) during periods of high prices. Reforming the exchange rate mechanism towards a floating system like Russia did in 2014 is a good example. Consolidating budget expenditures is another example that is evident on a country by country basis as well as in general terms.  But there are obviously negative examples as well. The refusal of Nigeria, another oil exporter, to devalue its currency is futile and counter-productive.


Source: IMF   Note: EM countries according to MSCI index

Low oil prices are also making it easier for importers to implement long overdue reforms. The (partial) removal of costly and distortive energy subsidies in places like India and Indonesia are welcome and might not have happened if oil prices stayed high.

These fundamental factors are unlikely to drive equity markets during the short term, especially as long as crude prices continue to be very volatile, but should help to drive interest back to emerging markets once the oil price stabilises. At the end of the day, it is arguably the volatility of the oil price rather than the actual level that drives sentiment. Put differently, it is the prospect of lower prices rather than low prices that is problematic for emerging markets.


Marcus Svedberg is chief economist at East Capital

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