Historically, commodity prices and emerging market assets have been closely correlated. This was true in the secular commodity bull market of the 2000s and has continued to be the case in the subsequent commodity market bust beginning in 2011. While the latter was unfolding amid the broader bull market, emerging market assets had always appeared to be more geared to the downside during sharp market corrections. Indeed, they have generally proven to be serial underperformers.
However, in the early part of 2016 this trend appeared to reverse. Markets plunged amid fears that the People’s Bank of China might devalue the renminbi again and in the wake of the US Federal Reserve’s modest rise in the Federal Funds Rate. Despite these ructions, key commodities, emerging market currencies, equities and xed-income securities weathered this particular storm far better than was the case in previous set-backs. More often than not, market price behaviour is more eloquent about true investor positioning than surveys and fund- flow reports. Consequently, market price behaviour, an assessment of investor sentiment and ows, forms one of the key elements of our core investment decision-making framework, Compelling ForcesTM, along with ‘fundamentals’ and ‘valuation’.
Correlation characteristics appeared to be changing in a stressed market environment, suggesting that the prices of metals and emerging market assets could be beginning a process of relative stabilisation or had actually reached their cyclical low points. Oil prices, however, suffered a further plunge at the beginning of this year, demonstrating an unusually high correlation with growth assets and in particular equity markets. However, oil has a unique dynamic due to the in uence of the cartel known as Organisation of the Petroleum Exporting Countries (OPEC). OPEC had kept prices abnormally high by constraining supply, which ultimately attracted investment in new technology and new entrants, effectively ending the cartel. With Opec no longer managing supply, the market price played this role and the oil market played catch-up with other global commodity markets.
The key change to fundamentals has been capacity cuts and supply constraint. Many market participants, as they often are, were simply ‘behind the curve’ because negative market momentum had taken over. But as the spectacular performance of gold mining stocks in the rst quarter of the year illustrated so well, when the sellers have sold, it only takes a modest amount of buying to have a dramatic impact on the price. To the end of June, gold mining stocks, as measured by the Euromoney Gold Miner Index, were up an eye-watering 100%.
We took relative commodity-price and emerging market currency resilience in the face of equity and credit market weakness as a signal to start the process of rebuilding exposure to commodity-related and emerging market assets in general. We have resisted the siren call of simplistic relative valuation metrics for a number of years. It is worth remembering the advice of one experienced emerging market observer: “never buy the equities until the respective currencies have put in their lows”.
Resource stocks specifically, but emerging market assets more generally, tend to be highly cyclical and in our view, should be treated as opportunistic rather than a core exposure in a multi-asset context. In this era of constrained growth and returns, we can’t afford to ignore emerging markets and related exposures, which represent a large and growing opportunity set and more normal risk premia. But as investors, we should accept their inherent cyclicality and act accordingly.
Philip Saunders is co-Head of Multi Asset Growth at Investec.
