Emerging Markets: The Fundamental Divergence

While the US dollar appreciation and sharp drop in commodity prices since mid-2014 have been the reasons for our negative stance on emerging market producers throughout the past year, the second round of commodity price decline experienced during the past quarter, alongside Chinese cyclical weakness, has brought about a more generalized negative sentiment on all emerging economies, regardless of their fundamentals.

In a nutshell

• The fundamental divide between consumer and commodity producing countries is still in place – favor Asia.
• India looks particularly well positioned, both structurally and from a cyclical perspective.
• Brazil’s woes are not just oil-related, and point to a lengthy recession.

The recent contagion should not mask the wide divergences that remain between emerging countries. We hold to our view that caution and selectivity are warranted. Indeed, while Latin American countries and Russia continue to suffer from their dependence to commodity prices, as demonstrated by collapsing currencies and contracting industrial production growth, emerging Asia is faring much better, with industrial production still growing at a healthy pace. In other terms, despite the increased fragility of the emerging world at large, the divide between consumer and commodity producing countries remains. So long, of course, that we are correct in assuming a Chinese stabilisation – within its secular downtrend.

For now, many thus maintain our long-held preference for Asian countries. As a whole, the region still boasts solid fundamentals with an expected 2015 current account surplus of 2% (International Monetary Fund (IMF) data) and controlled inflation levels (except in Indonesia) allowing for pro-growth monetary policies. India’s long-term story also remains extremely positive, as long as supply-side reforms do not disappoint, with a fast growing and young middle class. Cyclically, as a net importer, India is a major beneficiary of the fall in commodity prices, which has also helped control historically high inflation levels, allowing the central bank to adopt an expansionary monetary policy.

On the other side of the spectrum, many remain negative on Russia, South Africa and most Latin American countries. Russia’s dependence on oil has brought about a vicious circle of falling currency, high inflation, tight monetary policy and contracting growth. Although, even though oil broke below $40, most expect oil prices to rebound to our long-held USD 50-70 range, this should not prove enough for Russia to break out of the vicious spiral anytime soon. With a large external deficit, high inflation and falling currency, South Africa remains vulnerable to capital outflows. Finally, within Latin America, indeed emerging economies as a whole, Brazil is our biggest concern. The issues there seem to have intensified rather than stabilized over the past few months. A broader collapse of Brazil, which represents some 3% of world GDP (roughly the size of France or Italy), would be particularly worrisome, not only for the region but also for already fragile global growth.

How concerned should we be about Brazil?

Like Russia, Brazil is trapped in a vicious spiral of collapsing currency, skyrocketing inflation, tight monetary policy and deepening recession. The oil price drop did exacerbate Brazil’s woes, but it is not their underlying cause. The country’s fundamentals had already been eroding for some 10 years, as evidenced by a deteriorating current account and lax fiscal policy – even as commodity prices were booming.

Most see three major risks for Brazil. The first is political: Dilma Rousseff’s growing unpopularity means that she has no capital to drive fiscal reforms. An impeachment could in theory allow for a more credible leader to take the reins, but it would also lead to a period of high uncertainty. The second risk stems from China: Brazil would be severely hurt by a hard landing of its main trading partner. The third risk is fiscal: while sovereign default is unlikely in our view given the low level of US dollar-denominated debt, private debt is also growing fast.

All told, many expect Brazil to remain in recession for some time and its currency to stay weak, which will eventually become a support. In terms of our global economic scenario, assuming that China, the US dollar and commodity prices do stabilize, Brazilian issues should not have a systemic impact.

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Lower oil prices: good news or bad?

The past months have been marked by weaker oil prices, with the WTI breaking below $44/barrel, and now sitting below a record 5-year low. With the lack of agreement among OPEC members to cut output, and subdued demand in a low potential growth environment, investors should probably factor in durably lower oil prices than they have been used to over the past 3 years. Is this good news or bad news?

Let’s consider the largest consumer in the world: the US economy. Although lower oil prices have historically been generally positive, not all periods of falling oil prices have led to an accelerating economy. Indeed, while lower prices coming from rising supply with resilient demand are good, declining demand is worrying. So, which is it today? Despite a small seasonal down-tick in world demand in October, rising supply has clearly been the prevailing factor driving prices down over the past few months. As long as this is the case, lower oil prices are positive for energy consumers. As to the U.S. industrial sectors exposed to capital equipment, a slowdown may be on the way since oil companies will inevitably reduce capital expenditures.

What about the rest of the world? Who are the winners, who are the losers? Net oil exporters will obviously suffer, while net oil importers will benefit.Not surprisingly, the Middle East will be the largest loser, although the region is immunized by its large fiscal surpluses. The situation in Russia is far more problematic, and the collapse in oil prices will certainly accelerate the country’s fall into recession. That said, the majority of the world economies are net oil importers/consumers and will therefore benefit from the slump in oil prices. As such, a further step towards discerning the prime winners is to look at the share of energy in their consumer price indices: the larger, the better. Turkey should also welcome lower oil prices as a means to reduce its large current account deficit and to better control inflationary pressures. Finally, Eastern Europe (Poland, Hungary, Czech Republic) as well as some core European countries (Spain, Germany) will get a nice boost from cheaper oil.

So, all considered, lower oil prices are a net positive for the global World economy. What opportunities on the investment side? Lower energy prices support consumers’ purchasing power. In the US, periods of negative oil returns have historically been associated with periods of out-performance of the MSCI Consumer Discretionary and Staples equity indices over the MSCI US equity index. An exposure to the US Consumer therefore appears to be a direct way to benefit from lower oil prices in USD.