Previously believed to be highly cyclical and heavily dependent on another highly cyclical asset group, commodities, the dynamics between emerging markets, group of seven (G7) markets and commodities have changed.
Cyclicality
There does seem to be a broad connection between the G7 gross domestic product (GDP), Goldman Sachs Commodity Index (GSCI) commodity indices and emerging market equities.
When GDP is accelerating, commodity and emerging market equity prices tend to move up.
However, the relationship is not consistent, with lags in evidence and the scale of moves in commodities and emerging markets varying wildly.
For example, early in the 1980s, commodities continued to bump along the bottom when G7 growth recovered strongly, finally beginning to show year-on-year growth again as growth picked up in the middle of the decade (see chart 1 page 25 Money Management, August 23 2007 edition ).
More recently in 2004, the relationship seems to have disconnected again.
In 2004, as G7 growth decelerated, emerging equities also decelerated, but were still going up 15 per cent year on year. Meanwhile, commodities continued going up.
The effect of this is that since the end of 2003, while annual G7 GDP growth has been reasonable although not exceptional at 2.5 per cent, commodities have gone up 19.7 per cent per year, while emerging markets have rocketed up by 32 per cent per annum.
So, although there is some evidence of cyclicality in emerging equities and commodities, the relationship is vague and does not tell you much about price effects.
The counter argument could be that the recent divergence is just a long lag effect and once the financially-induced surge in commodity prices has unwound, both commodities and emerging equities will drop to be more in line with G7 growth.
To examine this, let’s look at the effect of commodities on emerging market economies.
Emerging economies and commodities
It is undoubtedly true that some economies have benefited greatly from commodity price moves.
The increase in energy prices that began in early 1999 allowed Russia’s President Putin to embark on reforms that re-monetised the economy, paid off debts and eventually led to the current infrastructure and consumer boom.
Russia has spent some of its oil gains wisely, permanently reducing debt, while the rouble has been re-established, leading to de-dollarisation.
It is questionable whether Russia would have recovered from the 1998 crisis without the energy price increases. If oil prices dropped now, Russia would be a long way from suffering an immediate financial or economic crisis.
Not all emerging economies have benefited from rising commodity prices.
Many estimates of the effect of increasing commodity prices on emerging economies are available, including those in chart 2 (page 25 Money Management, August 23 2007 edition ).
Chart 2 (page 25 Money Management, August 23 2007 edition ) ( shows Russia would now be positively affected by a jump in oil prices while many emerging economies including Thailand, Malaysia, China and India would suffer from rising oil prices.
A similar picture could be obtained from looking at other commodities such as metals and agricultural crops.
Brazil, while largely insulated from oil price movements, is a large exporter of soya and iron, among others.
While Brazil’s recent strong economic and market performance is often assumed to be heavily based on commodity strength, the reality is a little different.
Not only has Brazil seen major improvements in the export of commodity-based products, but the export of manufactured goods has improved too.
Charts 3a and 3b (page 25 Money Management, August 23 2007 edition) show Brazilian exports in both commodity and manufactured sectors in price terms and volume (that is, using a constant price).
Rising input costs do not appear to have damaged Brazil’s export opportunities of manufactured goods, which account for close to 60 per cent of total exports.
Primary goods account for only 25 per cent of Brazil’s exports.
Brazil’s rising export prices and volumes hint at the causality involved: high global trade.
Commodity prices are being driven up by strong final demand.
However, as can be seen from chart 1, final demand in the G7 is not that strong, highlighting the decoupling between US and G7 growth and emerging market growth.
Looking at global oil demand (see table 1, page 24 Money Management, August 23 2007 edition), it is clear that the US still dominates, however a clear trend is evident.
In absolute terms, China has added over 5,000 million barrels of demand since 1980 versus 3,500 million for the US. As China is an increasingly large part of the global economy, these trends are accelerating rapidly.
The picture is even more dramatic for metals demand (see table 2, page 24 Money Management, August 23 2007 edition ).
China is now the dominant single country in metals demand, and the US has dropped in importance.
Overall, the developed world is now a minority player.
While a year ago the argument would have been made that China was simply buying commodities to produce for the rest of the world, the recent US slowdown has overturned this argument.
Chinese demand for commodities has not slowed and commodity prices have remained strong.
In conclusion, the assumed relationship between commodities and emerging markets was probably never quite right, and has now been disproved.
In years gone by, commodity prices were expected to respond to G7 growth with emerging markets trailing on behind.
Whether or not this was ever quite right in the past, it is certainly not now.
Commodity prices are now driven up by strong global demand and that demand is increasingly coming from emerging markets. Commodity prices will cool when global demand cools, and not before.
If the world continues this way for the next few years, then commodity markets should be looking nervously at emerging markets for signs of weakness, not the other way around.
Nick Field is portfolio manager, emerging markets at Schroder Investment Management Australia .
