Structural shift in commodities demand reshapes EM fortunes

In August 2015, I contributed an article to beyondbrics titled “Redefining EM: Matrix offers new perspective on definition”. In it, I set out a 2×2 bloc matrix which helped explain much of the behaviour and relative performance of currency, stock and bond markets in emerging markets.

It focused on two national economic characteristics: whether a country tended to run a current account surplus or deficit and whether it primarily exported commodities or manufactured goods.

In explaining that matrix, I maintained that asset prices were affected by the waxing and waning of two moons, each of which controlled its own tide, a tide that ebbed and flowed across the matrix. (For the 2017 matrix see below).

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The first mainly American moon controlled the tide of US dollar liquidity that flowed across from the US dollar-long eastern half to the US dollar-short western half of the matrix.

In 2017, this tide is intact; a materially weaker US currency (the dollar Index is down more than 9 per cent year to date) has helped trigger a tsunami of investment capital from developed markets into emerging markets.

This has increasingly been made up of passive ETFs, which are estimated to have contributed 40 per cent of 2017’s record-breaking flows. The result? This liquidity-driven tide is now high and emerging market fixed income and equity markets have recorded strong performances in 2017, in US dollars up 8 per cent and 19 per cent respectively.

In 2015, a second mainly Chinese moon controlled the tide of commodity prices that flowed from the commodity-short southern half to the commodity-long northern half of the matrix. But this commodity tide has recently bifurcated: the energy one is currently ebbing, the industrial mineral one is flowing.

The energy-heavy CRB Index is down 11 per cent year to date reflecting price declines for oil, coal and gas. Invariably, this has weighed on the asset performances of the oil-rich north-east bloc of the 2×2 matrix: commodity exporting plus current account surplus running. But beneath the CRB average, a more interesting story is developing: copper, cobalt, lead, zinc and lithium are all up between 15 per cent and 35 per cent in 2017. This favours especially the current account deficit running, mineral exporters of the north-west bloc which has, as a result, outperformed the north-east.

What is going on? The Chinese moon has been partially eclipsed by fundamental changes now playing out in the supply demand dynamics of the energy complex. The positive effect of China’s still fast growing demand for energy has been blunted by new supplies from both shale and renewables. The underperformance of the north-east bloc thus reflects the changing character of the oil market and indeed the broader energy market.

Part of this is due to the highly publicised shale revolution in the US continuing to bring on new oil and gas supplies and so capping oil’s price upside. Libya, Iran and Iraq are also producing more oil; Venezuela and Mexico less.

Another part is due to the under-reported but growing influence of renewables in the overall energy mix, concentrated as they are on the critically important marginal source of new electricity supply. In new electricity generation in 2016, solar added 73GW, wind 55GW, coal 52GW and gas 37GW. Only in the US has shale gas offered serious competition in the race to grow electricity production, production which if powered by the sun or wind is not just more environmentally friendly but increasingly just cheaper.

And with the rapid improvements now taking place in battery technologies, renewables are taking a growing share of the growth in energy demand in the auto transport sector, previously the near exclusive preserve of oil. Unless there are oil supply interruptions, this trend could limit future upside for the oil price. In terms of the EM matrix, this means that the previously sheltered north-east bloc will probably not be where almost all the oil exporters will congregate in future. Without the cover of a current account surplus, some will be found in the more exposed, more cyclical corner of the matrix: the north-west bloc.

Collectively, renewables accounted for 60 per cent of all new energy capacity installation in 2016. In this respect, oil’s status as the king of the commodity complex is not as assured as it once was: “peak oil” risks becoming “peak demand”. Equally, as a recent headline in the Financial Times put it: “The lights are dimming on King Coal’s hold over energy markets”. The age of carbon is entering its twilight years. Can one yet ask whether lithium-rich Chile and Bolivia will be the Saudi Arabias of the renewable age?

Here then is the equity matrix reloaded as of August 2017, covering those countries in the MSCI Emerging Market Index. Bloc membership has proved remarkably durable, barely changing since 2015: Poland and the Philippines have moved from the south-east to the south-west as small current account surpluses have become near negligible deficits.

Had oil producers Venezuela, Saudi Arabia, Angola, Algeria, Iraq and Kazakhstan been index members, they would have migrated from the north-east to the north-west as their current account surpluses turned to deficits. Indeed, only Russia and the UAE have been permanent members of the “oil bloc” since August 2015: even Qatar (as did Kuwait) briefly dipped into deficit territory in 2016. (Fellow Opec member Nigeria only recently regained current account surplus status after allowing the naira to devalue from N150 to the US dollar to N350.)

The average US dollar equity performance by bloc for the year to mid-August 2017 has been as follows: NW: +15 per cent; NE: +1 per cent; SE: +21 per cent; and SW +20 per cent. The EM story for 2017 can therefore be summarised accordingly. Liquidity flows have pushed the equities of the manufactured goods exporting nations up on average 20 per cent. By contrast, for commodity exporters, equities of the mineral exporters have on average gained 15 per cent whereas the oil exporters are broadly flat: for the latter, the tide of liquidity has not been strong enough to offset weaker oil prices.

Looking ahead, the question to ask must be whether any of the rising tidal flows could reverse, from flowing in to ebbing out. If they do, the period of outperformance of emerging markets will draw to a close.

If the recent period of weakening for the US dollar were to come to an end and thus see a slowing or even reversal of the tide of capital flows to emerging markets — possibly precipitated by a sell-off on Wall Street and a flight of capital worldwide to the safety of US Treasuries and so by definition the US dollar — the resulting tantrum would in particular negatively impact on those countries running current account deficits in the western half of the matrix. the so-called Fragile Five — Turkey, Brazil, India, South Africa and Indonesia — are all in this zone. Weakness in the latter zone’s currencies would be likely and this would flow through into their stock and local currency bond markets.

Alternatively, or even in combination with liquidity outflows, if industrial commodity demand emanating from China — domestically driven by its gently-being-squeezed housing market, internationally from underwriting its One Belt, One Road initiative — were to back off, countries exporting industrial commodities in the north-west bloc may be exposed to a downturn in their asset prices. As these countries are perceived as having “commodity currencies”, both their currencies and so their stock and local currency bond markets would suffer.

That said, some of today’s strong mineral demand may be secular in nature, driven by the dawn of the age of renewables, and so not as China-sensitive as previously. But then, given that much of the renewable energy revolution is being driven by Chinese solar panel, wind turbine and lithium-ion battery manufacturers, it could be said that China is now intent on holding back the energy tide by harnessing new technologies at home rather than importing the feedstock required to run old ones from abroad.

Michael Power is strategist at Investec Asset Management.

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