HardAssetsInvestor

Written by Joanne Legomsky  |

August 28, 2008

Commodities And Emerging Markets: Joined At The Hip?

Details

Is the relationship between these two asset classes as straightforward as one might assume?

• The strengthening dollar's effect
• Do commodities drive emerging markets, or vice versa?
• Bubble theory skepticism

 

 

The growing sense that the air is quickly going out of the commodity bubble has only served to dampen the already-waning interest in emerging market stocks.

Indeed, the received wisdom that emerging market equity returns and commodity prices are tightly linked rests on two key assumptions: First, that the explosive growth in emerging market countries is a major driver of commodity prices. Second, that commodity prices are major determinants of emerging market economic growth, and therefore, equity returns.

While there's certainly some intuitive appeal - not to mention, some truth - in this thinking, the relationship between commodities and emerging markets may be less straightforward than is generally assumed, meaning investments in the emerging markets asset class may still be worth considering.

 

Tanking Commodities Prices

The recent feverish retreat in commodity prices reflects both softening demand and the prospect of further weakness ahead, as the economic and credit woes that began in the U.S. a year ago go global.

In the last several weeks, oil has fallen more than 20% from its July peak, gold is off more than 22% and the pullback has spread to industrial metals and agricultural commodities - from copper to soybeans to corn.

At the same time, after a seven-year slide, the U.S. dollar seems to be reversing course, with the more robust greenback putting further downward pressure on commodities priced in dollars. Over the past month, the currency has appreciated some 8% against the euro and the British pound and almost 6% against the yen. Analysts say the move is getting a fillip from those hedge funds and sovereign wealth funds that had bought oil to hedge the declining value of their long dollar positions - and are now unwinding those positions.

Of course, not everyone is bailing out of commodities, and a sustained decline in commodity prices is hardly a given. Goldman Sachs Group Inc. analysts, among others, have declared the oil and crop price plunges a buying opportunity. In their view, commodities are en route to a new higher price equilibrium.

 

Do Commodities Drive Emerging Markets?

If a sustained drop in commodity prices is under way, is it time to issue a DNR order for emerging markets, too?

Indeed, even Boston-based GMO's Jeremy Grantham, prominent among the thinning ranks of emerging market enthusiasts, finally threw in the towel. After declaring in April that emerging markets were ripe for a powerful rally, his firm just lowered its weighting in emerging equities to neutral or slightly below, despite their favorable long-term outlook for both emerging markets and commodities.

Still, some skeptics think a more nuanced view of the relationship between emerging market equity performance and commodity prices is in order.

A study by Vanguard Investment Counseling & Research (IC&R) concluded that the link between commodity prices and emerging market performance was relatively weak. After looking at the correlation between the performance of the GSCI Spot Index and the MSCI Emerging Markets Index from 1988 through 2006, the study found periods of similarities, as well as frequent divergences. Accordingly:

 

• Emerging market price returns and commodity spot returns had little in common from 1988 through 1994.
• Returns then became quite similar from the mid- to late 1990s and again in 2004-2005.
• From 2000 through 2003 and again in 2006, the annual relationship broke down.

 

Since this study, the iShares MSCI Emerging Markets Index declined 9.5% this year through July 1, while the iPath DJ-AIG Commodity ETN shot up 27.09%.