Emerging Markets: currencies & commodities into 2017
As top-down investors we must be sensitive not only to country-level top-down developments but also to exposure to global top-down drivers. One of the most important of these for emerging market equities is movements in the US dollar. As the world’s key trading currency, the dollar is the funding denomination for many portfolio investments. This means a stronger dollar is often linked to lower levels of risk tolerance in global markets as investors withdraw from international investments, including in emerging markets. A stronger dollar is also often linked to weaker commodity prices, as much of the end demand is from non-US consumers.
One of our concerns about recent performance in emerging markets is a disconnect in these long-established relationships. The US dollar (as measured against the DXY basket of global currencies) has had a strong rise since the low of late April. In the seven months since, the DXY index has risen 9.6%, with a particularly sharp 4.6% move since the US election result on 8 November.
Emerging markets, however, have not reacted as expected. The MSCI EM price index is up 2.7% in US dollar terms, with the MSCI Brazil Index (+14.7%) and MSCI Russia Index (+6.8%) amongst the strongest performers. There are a number of ways to demonstrate the historical relationship between these two markets and the dollar, but an easy way is to consider market behaviour during the second half of 2014 (when DXY rose 13.2%): the MSCI Emerging Markets Index fell 9.0%, with the MSCI Brazil Index down 23.5% and the MSCI Russia Index down 45.2%.
Similarly, at a sector level, the last seven months have seen outperformance from both the materials (+6.0%) and energy (+4.1%) sectors, whereas the second half of 2014 saw price returns of -20.9% and -31.6% respectively. Again, the pattern can be seen in underlying commodities, with strong gains recently in copper (+14.7% to US¢266/lb) and iron ore (+62.2% to US$87/t). The oil price has also picked up, with Brent crude reaching US$54/bbl.
As well as looking irrational compared to macro drivers, these commodity price levels look stretched at a fundamental level. Most industrial metals remain in a broad state of oversupply and the major mining companies have been continuing to roll out global-scale projects at low cash costs of production. BHP Billiton and Vale continue to work on huge projects with Free on Board (FOB) Shipping costs of around US$20/t, while copper remains in surplus and cash costs are around US¢ 100/lb at big projects like Escondida (BHP) and Los Pelambres (Antofagasta). The substantial decline in oil prices in recent years has been driven by fracking and shale hydrocarbons with low production costs. This production capacity continues to overhang the market.
We are concerned that Chinese monetary easing has driven an aggressive re-pricing of commodities that does not reflect that supply/demand balance in end markets. We expect Chinese policy-makers to ease back on stimulus in the next few months, now that growth has recovered and Chinese inflation is rising, which is likely to be a problem for this commodity/risk rally.
How inflationary pressures will develop in the US in 2017 is unclear at this stage, but it is definitely clear that the labour market is tight and that the incoming Republican administration has a highly stimulative policy agenda. There is a significant chance that 2017 will see further strength in the US dollar alongside a reduction in Chinese stimulus, and we would be concerned about both commodities and commodity-related emerging markets in such a scenario.