Beware the easy second derivative of high commodity prices

High and rising commodity prices. The natural tendency for investors is to ask what the knock-on impact will be, who benefits, who loses and how best to position our portfolios.

Historically, emerging markets have been the first port of call as commodity prices rebound.

Early signs of a weak dollar and rising commodity prices tend to be beneficial to emerging economies, particularly commodity producers. In these cycles, emerging market currencies appreciate and their domestic economies benefit from the expansion in liquidity and credit with stock returns potentially significantly higher in USD terms.

Investing in emerging markets (EM’s) is highly cyclical. They tend to outperform when global growth is strong, when commodity prices are increasing, and the US dollar is stable or weakening. The dollar tends to oscillate in a cycle that plays out over a decade and a half – an 8 year up-cycle, followed by 8 years of weakness.

The tailwind is greatest for emerging markets when growth prospects look more promising outside of the US (Europe, Asia and EM’s) and valuations in the latter are cheap. This sets the stage for dollar weakness as capital flows towards more attractive prospects outside of the US. The reverse is true when global growth is looking shaky and political uncertainty is high. Then investors flock to the perceived safe haven properties of the US, pushing up the relative value of the US dollar.

Note that as the most closely watched indicator of US dollar strength against other currencies, the US dollar index (DXY) is a US centric trade weighted basket of currencies. That means the dollars performance against the Euro and the Yen is much more important to the DXY, than say the Chilean Peso or the South African Rand. A much better solution is to follow the MSCI EM currency index which tracks the relative performance of EM’s included in the basket versus the US dollar.

How do higher commodity prices affect emerging economies?

The impact of higher commodity prices on the macroeconomic performance of an economy typically depends on whether it is a net exporter or importer of commodities. Economies that are net exporters of commodities tend to benefit from higher prices while those that are net importers of commodities tend to suffer since higher commodity prices makes it more expensive to import the materials and energy required for their economies to function. That’s why it is not a given that one or another emerging market is definitely going to benefit from higher commodity prices. It’s more nuanced than that.

Analysis by the IMF identified more than 300 short-term cycles across 46 commodities, between 1957 and 2011. No surprise that economic activity tends to improve in commodity exporting economies when prices rise, and decline when they fall. According to the IMF, “With few exceptions, indicators of commodity exporters’ domestic economic performance tend to move with commodity price cycles—improving during upswings and deteriorating during downswings. This pattern is observed for each of the four commodity groups. Moreover, the difference in economic performance across downswings and upswings tends to be amplified when cycles last longer and/or when they entail sharper price changes than average.”

The effect is much more pronounced for those economies reliant on exporting energy and metals as opposed to those exporting agricultural commodities. The reason for this is that energy and metal prices tend to account for a higher share of both exports and GDP. Energy and metals are more important for industrialisation and infrastructure building, and so are much more highly correlated with the business cycle than agricultural commodity markets. The impact of higher energy and metal prices can be accentuated if their governments spend royalties on expanding the economy.

The reason for the rise in commodity prices matters. If the commodity price increase is underpinned by demand then the impact on the exporter tends to be even more pronounced, whereas the impact is much less if the price hike is due to a supply shortage. The latter is likely to be short-term and potentially a threat to its own production, whereas the former is more likely to be longer-term and an incentive for them to increase supply.

The S-curve transformation point

$2,000 GDP per capita is typically the transformation point at which economies see their demand for commodities accelerate. China hit the $2,000 mark in 2005 and by then the commodity supercycle was well under way. Indonesia reached this level in 2007 followed by Egypt and the Philippines one year later. Thereafter, very few populous economies moved past that threshold.

As the 2020’s progress India and Bangladesh are expected to move past the $2,000 GDP per capita level. Given the size of their populations this could provide a strong boost to commodity prices. Strong demographic trends are also set to support strong commodity demand growth across these and many other emerging economies.

However, whether higher commodity demand translates into further development depends upon the ability to incorporate labour into higher value occupations. The ‘Lewis turning point’ is a pivotal point in a country’s economic development where surplus rural labor is fully absorbed into the manufacturing sector. This typically causes the real wages of agricultural workers and unskilled industrial labour to rise.

In India, the slow uptick in urbanisation relative to other countries is partly due to agricultural policies such as subsidies – accounting for ~4% of GDP – that discourage the movement of people to more productive jobs in the city. In a country where over 40% of the workforce are employed in agriculture (versus 20-25% in China), farm workers represent significant political clout which stymies economic reforms that could also accelerate demand for those commodities related to urbanisation.

The resource curse

Since 2011 though, far from being the rocket fuel for emerging market growth, commodities have been the Achilles’ heal of many emerging economies. The resource curse, also known as “The Dutch Disease”, typically occurs when a commodity boom leads to a country’s deindustrialisation as it can no longer compete against its competitors. But the curse has many other negative consequences.

Many EM’s suffered a long, drawn-out hangover after the punch-bowl was taken away after the commodity super-cycle of the 2000’s peaked. Excessive financial speculation, corruption and complacency among policymakers, a build-up of debts – particularly foreign debts – and overvalued currencies. The high expectations of youth were unable to be met. In many countries this led to disenfranchisement and street protests.

Three of the fabled BRICS (coined by Goldman Sachs) – Brazil, Russia and South Africa – are large, diversified commodity producers and were hit hard by the collapse in commodity revenues. Lower revenues meant that these countries had less means at their disposal to boost their flagging economies. The exchange rate of these economies fell sharply against the US dollar, taking the strain of supporting their economies in the face of lower commodity price earnings. However, a lower exchange rate is a blunt, and not a particularly effective tool to counter the buildup of severe imbalances brought about by the earlier commodity boom.

The breakneck speed at which globalization usurped economies and markets faces a reckoning as its adverse effects (inequality, job losses) have become more politicised. This means that simple market dynamics of a lower US dollar and higher commodity prices may not necessarily equal strong EM equity performance in the future.

The US for one appears to be much less tolerant of the mercantilist currency manipulation practiced by its allies, and zero tolerance for those practiced by its strategic rivals. EM’s with close strategic ties to the U.S. had previously received a free-pass – that is much less likely in the future. EM’s are less likely to be allowed to run large current account surpluses and accumulate foreign reserves, potentially resorting to capital controls to regulate ‘hot-money’ inflows.

Investing in EM’s as a hedge against inflation

Research published by JP Morgan reviewed the relative performance of different asset classes between 1988 and 2020, under low or high inflation periods (so clearly missing out the very high inflation of the 70’s) and whether the inflation rate was rising or falling. The only time that EM equities failed to beat all other asset markets was during periods of ‘low and falling inflation’. Under ‘low and rising inflation’ periods emerging market equities and gold tied in terms strongest performing assets.

Remember though that just because a particular asset has been a suitable hedge against inflation in the past does not mean it will perform as well in the future. In an interview with Jack Schwager in the 1989 book “Market Wizards”, veteran commodity investor Jim Rogers outlines his concerns about gold as an inflation hedge:

“Generals always fight the last war. Portfolio managers always invest in the last bull market. The idea that gold has always been the great store of value is absurd. There have been many times in history when gold has lost purchasing power—sometimes for decades.”

Correlation doesn’t mean causation

It’s worth looking at some of the factors that were going on during the late 1980’s and early 1990’s, especially in those emerging markets most heavily exposed to commodities. Take Chile. The concurrence of the military coup in 1973 and a boom in commodity prices led to a huge stock market rally in the 1970s, with the Santiago stock index rising by 125 times. Then came the collapse in commodity prices and the Latin American debt crisis. Between 1980 and 1984 the stock-market lost 86% of its value. Chile’s copper output gradually expanded during this period, overtaking the United States to become the world’s biggest copper producer with around 1.5 million tonnes of output by the mid-1980’s.

Over the next 10 years the stock-market would rally 33.5 times, finally topping out during the summer of 1995. Law’s introduced in 1982 reformed rights for private companies with the country adopting free market policies that would attract foreign investment. Copper extracted from the country’s mines doubled to 3 million tonnes by the mid-1990’s as new deposits were discovered and brought online. Copper prices rebounding from the early 1990’s recession also helped. Despite the extreme volatility during this 22 year period, the Chilean stock market provided dollarized annualized returns of 39.6%.

Market based reforms were happening elsewhere in emerging markets, propelling GDP growth and the equity performance of many emerging economies. This was supported by foreign investment. The launch of emerging market equity indices (such as the MSCI Emerging Markets index) in the mid-1980s helped propel portfolio capital into Latin America and other emerging markets.

It’s worth noting therefore that the strong EM out-performance performance during periods of high inflation or low but increasing inflation was the result of a happy accident. Those reforms were, to some extent a one-off. Compare this to the returns over the following 25 years. Even with the assistance of the early 20th Century commodity bull market annualized returns were a measly 1.9%.

Strong economic performance does not necessarily = strong equity market performance

The stock-market is not the economy, and vice versa. Something that many investors easily forget. Each emerging market economy is different. No single EM is alike. One way to see this is to look at the composition of the equity indices that make up the EM equity indices that typically channel investor funds. Energy and commodity related equities account for 14% of the value of the MSCI EM index in 2020, according to calculations by Renaissance Capital. A surprisingly low proportion given how dependent EM economic growth is to commodities. Technology companies accounted for 37%.

The proportion of commodity related equities varied sharply across the constituents of the index. In Peru and Russia, resource equities accounted for between 50 and 70% respectively, between 20% and 40% in India, Brazil and Chile, and as less than 10% in most other EM economies included within the index.

Remember then that you should not lump all emerging markets together and assume that a rebound in commodity prices will be solace to the fortunes of their equity markets. A revival in commodity prices could give a boost to many emerging economies. A diversified commodity exporter like Brazil will benefit from the general rise in commodity prices. Rising demand for green power will benefit in particular leading platinum exporters like South Africa and Russia, and copper producers like Chile and Peru. As the market for hydrogen fuel grows, demand is expected to rise particularly fast for “green” hydrogen, produced with renewable energy rather than fossil fuels. Because it is already a major source of wind and solar power, Chile is also expected to emerge as the low-cost producer of green hydrogen. Not all emerging economies rely on the export of commodities. That being said they are affected by the US dollar, and so should commodity prices move significantly higher that is likely to be mirrored to some extent by a depreciation in the dollar. Commodity importing nations could suffer, e.g. India is a large net importer of crude oil.

Challenge to find intrinsic value

Simply because it has possible to discover and profit from value in emerging markets during previous periods of strong commodity prices does not mean the same will be the case this time.

Jean Van de Walle has been investing in emerging markets since the early 1990’s, working for Citibank, Alliance Bernstein, the Abu Dhabi Investment Authority (ADIA), and most recently manging a family office called Sycamore Capital. Jean is the Adjunct Professor of Emerging Finance at the NYU Stern Business School where he teaches a class on investing in emerging markets.

Van de Walle believes that the game of finding intrinsic value in EMs has become significantly harder over the past two decades. Every major investment institution pours over the same small selection of large companies. This means that the odds are firmly stacked against investors finding an undervalued resource stocks in emerging markets:

“The Brazilian market has totally changed. I would say today that it is one of the most sophisticated and ‘over-studied’ markets. The amount of human resources studying the Brazilian market in proportion to the size of the market must be one of the largest in the world. There’s a whole generation of the best minds – engineering, mathematics – who have all gone into the financial market. And they all do more or less the same thing: they look at the 20 investable companies in the market. That’s a huge amount of ‘brain power’ relative to the amount of assets. That’s why I think that discovering opportunities of intrinsic value in Brazil today – given that there are 50, 100 mangers with very capable people doing this – is an extremely difficult task. Quite different from how it was 30 years ago.”

The decline of alpha in the EM value space can be seen in the disappearance of funds focused on value. Instead, investment funds are focusing on growth sectors, particularly technology. This has implications for investors wishing to gain exposure to a particular commodity dependent country through an ETF or something similar.

Choose emerging market commodity producing nations carefully

Emerging economies are not all about commodities, so you need to pick wisely. In the same way that a commodity investor should consider various risk factors when investing in a specific commodity based company, economies dependent on commodity exports also have their own set of risk factors.

One person at the forefront of investing in emerging markets was Ruchir Sharma. Formerly the head of emerging market at investment bank Morgan Stanley for 25 years, Ruchir is also the author of Breakout Nations, The Rise and Fall of Nations, and The 10 Rules of Successful Nations. In 2021 he left Morgan Stanley to focus on investment and writing opportunities.

His experience includes traveling to several countries to look for investment opportunities, gather data for research and meet different stakeholders. He typically spends one week every month in a different country, meeting with leading politicians and top CEOs. As Sharma himself states, “Reading Excel spreadsheets in the office can’t tell you for example, whether a political regime gets the connection between good economics and good politics.”

Sharma created a pioneering framework based on his travels, that can be used by any investor to identify markets most likely to under and over-perform in coming years. This framework was outlined in the third of his books, The 10 Rules of Successful Nations. To identify breakout nations it is key to travel with an eye toward understanding which economic and political forces are in play at the moment, and whether they point to growth, and at what speed, bearing in mind that they are in constant flux. The 10 forces that Sharma watches out for include:

1) Population- Successful nations fight demographic decline

According to Sharma the impact of demographic trends on the performance of an economy are significant, “If more workers are entering the labor force, they boost the economy’s potential to grow, while fewer will diminish that potential. And unlike any other major force in economics, population growth is a function of just a few factors – fertility, longevity, and immigration.” It is the working age population that is especially important. According to Sharma, a 1 percent decline in the growth rate of this age cohort shaves 1 percentage point off economic growth.

Successful countries are taking aggressive steps to combat working age population declines. Tactics used include encouraging immigrants, women and retirees to enter, or return to the workforce. Baby bonuses are another tactic used, but for obvious reasons the economy has to wait a while before these new recruits become ‘productive’ parts of the workforce, and may even stymie the growth of the working age population if there is inadequate or expensive childcare preventing parents from remaining in the workforce.

However, simply ensuring that the working age population continues to grow is never a sufficient condition for rapid economic growth. According to Sharma these demographic tailwinds are only powerful if “political leaders create the environment necessary to attract investment and generate jobs.”

2) Politics- Successful nations rally behind a reformer

Crises tend to result in a nation that is desperate for reform, and ready to back a serious reformer. It is here that nations often throw their political weight behind someone, maybe an outsider to political office with a broad base of support and that is ready to part with the old and introduce new and improved policies. For commodity orientated EM’s this point of desperation often occurs when the commodity boom has gone bust, government finances are under pressure and society has had enough.

The reverse often happens when times are good, when high commodity prices and induced an economic boom . Here the populace and the political establishment often become lazy and complacent to the underlying issues affecting the nation. In periods such as these aging, stale leaders from the establishment often gain office with little in the way of new ideas and being technocrats lacking the wide support needed to introduce sweeping reforms.

Investors need to understand the risks of abrupt policy changes, both internally and externally. For example, the election of a populist government might result in the nationalisation of resource investments, or at the very least a commitment to renegotiate the terms of the agreement with the commodity company. Meanwhile, changes in the country’s relationship with its neighbours could result in wider political pressures. For example, a case in point are the sanctions placed on Iran by the US due to the formers nuclear activities. A sudden and radical change can completely undermine an EM investors valuation framework.

3) Inequality- Successful nations produce good billionaires

According to Sharm, inequality can undermine growth in at least three ways: by discouraging mass consumption, by rewarding corruption and fueling resentment against wealth creation. The backlash may bring a populist leader to power, one that who “delivers radical redistribution in a way that burns down the economy.”

Sharma’s approach is to identify those nations where billionaires are taking a large and growing share of the wealth, and in particular the industry that they are active in. For example, industries such as commodities are more typically associated with corruption in emerging economies than other industries. The Forbes billionaire list is updated regularly and enables investors to track the changing fortunes of billionaires across the globe. It and others like it are much more timely and accurate than official data provided by individual countries.

4) State power- Successful nations have right sized governments

Conventional economic theory for much of the past 40-50 years is that smaller government is better for a country’s economic growth and investment prospects. However, some governments are too weak to provide the basic infrastructure and institutions necessary to support economic growth, e.g. roads and the rule of law. On the contrary, high government spending can result in the misallocation of capital and other resources, resulting in economic growth stagnating.

According to Sharma, the basic rule of thumb to look for is “when government spending is much higher (or lower) as a share of the economy than in other nations at the same income level.” Successful nations therefore have the right-sized government (as a proportion of total GDP) for their stage of development.

Another factor that Sharma follows with interest is the size of second cities. Over-sized capital cities often indicate excessive power in the hands of the political elite, which may then worsen inequality and hamper the productive potential of labour and businesses far from the centre.

5) Geography- Successful nations make most of their locations

Sharma watches out for countries that successfully building trade ties to the world, and spreading the wealth to their own provinces. Location is vitally important if a country wants to thrive as an export power. For example, the south east Asian nations of Malaysia, Thailand and Vietnam among others are very close to the Strait of Malacca, enabling goods to be transported east and north to China, Japan and North America, and west to major markets in North West Europe.

The most closed economies – those where international trade is less than 40% of GDP – fall into two groups. The first group have large internal markets such as China and Indonesia. The second group tend to be commodity orientated economies and include Nigeria and Iran.

Brazil is an example of a country with a large internal market, and a significant part of the economy devoted to commodities. Despite it’s many advantages it has resisted opening up to foreign trade for decades. According to Sharma, Brazil has the lowest trade/GDP percentage (~20%) of any country, apart from outliers such as North Korea.

6) Investments- Successful nations invest heavily and frequently

Investment typically accounts for 20-25 percent of spending in an economy. Yet is by far the most important indicator of change in an economy’s fortunes. No investment equals no money for consumers or governments to spend – not without borrowing it of course.

Sharma analysed the postwar performance of 56 highly successful economies, in which GDP was growing by at least 6 percent for a decade or more. Emerging countries tend to be in a strong position when investment is high (~25-33 percent of GDP), and rising. Investment’s share of GDP in developed economies is typically nearer 20% because the infrastructure is already built.

Not all investment is a good investment. When money is funneled into building out the economy’s manufacturing base good things tend to follow. When money spent on feeding the commodities or real estate sector trouble is often lying in its wake.

7) Inflation- Successful nations control the real inflation threats

Although there are the odd economic outliers that have high consumer price inflation, today these are typically rare, even in emerging markets. That being said Sharma suggests that it is still worth being wary of those economies where inflation is in the double or triple digits.

It is often those countries that have invested too little in basic infrastructure that are most at risk of consumer inflationary pressures. A textbook example is Brazil. As commodity prices rise early in the cycle, economic growth begins to gather steam. However, because of the lack of infrastructure spending, consumer prices rise at a much earlier stage in the economic cycle than other countries, one in which “growth tends to sputter out before it really gets going.”

High inflation destabilises an economy because it induces uncertainty on the part of businesses and consumers and political discontent among the electorate. The latter either meaning that reforms are delayed, or the country disintegrates before a new leader establishes themselves.

However, the real threat to emerging market economies, and the investors who funnel their money into them is where central banks fail to take account of financial inflation, e.g. high and overvalued equity markets. The most successful economies are those that have a dual mandate, mindful of consumer inflationary pressures and financial market booms.

8) Currency-Successful nations feel cheap

Sharma suggests that investors in emerging markets should regularly take the pulse on the price of goods. For example, The Economist magazine frequently publishes a Big Mac index that seeks to compare the price of a standard product (in this case a McDonald’s Big Mac, but it could be equally be an iPhone) across different countries.

The upshot is that if a country ‘feels’ cheap it is more likely to be a good place to invest. It not then it may have already become infected with some of the other aforementioned ailments afflicting poor performing EM’s. Politicians may think that a strong currency is a sign of a strong economy – admonishing speculators and the like who might do it harm – but in reality the opposite is true. If the currency is too strong then exports may no longer be competitive in international markets.

Sharma also makes a point of tracking the foreign exchange rates charged by black-market money changers and the travel habits of local businessmen (for example, whether they are moving money home or offshore). Both of these indicators can be an early warning sign of a country suffering under its currency regime.

The higher the foreign exchange reserves the more a country is able to weather economic storms that might impact its currency. Although the currencies of all emerging economies may suffer a sharp sell-off in the event of a crisis, a healthy FX reserve will be in a better position to manage the market. FX reserves are especially important if a commodity producing nation has fixed its exchange rate against the US dollar (or a basket of other currencies) as it enables them to hold the link. If they have inadequate reserves then they will face pressure from investors. Other commodity producing nations with a floating exchange rate will allow their currency to drop, providing a boost to their export competitiveness.

9) Debt- Successful nations avoid debt mania and phobia

Analysis by the Bank for International Settlements (BIS), the IMF and financial authorities discovered that investors should watch out for economies in which private sector credit has been growing significantly faster than economic growth for a period of five years or more.

Although attention naturally focuses on the narrative of previous EM crisis (short term, foreign debt), the best leading indicator of a slowdown or an impending financial crisis is a surge in private sector credit.

In his book Sharma shares the results of research he carried out looking at the 30 most severe credit binges all the way back to 1960. In all 30 cases private credit grew over a five year period by at least 40 percentage points as a share of GDP. In all cases economic growth suffered a slowdown when private debt hit this threshold, which on average led to GDP growth halving over the subsequent five years. Sixty percent of cases suffered a financial crisis.

10) Hype- Successful nations rise outside the spotlight

As with many trends in economics and financial markets once a trend gets a devoted media following it’s probably time to take some chips off the table. The same can be said for EM hype. The flip side of this phenomenon, according to Sharma, is that the next EM darling often emerge from the shadows. As Sharma says, economists tend to project recent trend rate performance of EM economies in small increments yet miss the big structural shifts occurring beneath. Too rigid a belief in linear progression gets us into trouble, especially when it comes to commodity dependent EMs near the peak in the cycle. It also stops us seeing the opportunities present, often in obscure places at the bottom of the market.

Overall, Sharma believes that EM economies are no different from other markets, in the sense that asset valuations often overshoot fair value when the future appears nothing but rosy. These boom conditions create the conditions for the inevitable bust that must follow. Sharma believes that popular understanding of EM economies lags well behind the reality. This creates a risk for armchair investors unwilling or unable to keep track of the conditions on the ground, “by the time a regime’s rules have been decoded by experts and hashed over in the media, it is likely already in decline.” That’s why its important to “learn the macroeconomic numbers, then go to the country and kick its tyres, get a feel for the “story”.”

Smarter to stick with a diversified mining exposure instead

Given the various pitfalls involved with investing in EM’s, combined with the persistent correlation between EM high levels of economic growth, a weaker dollar and stronger commodity prices it may make sense for investors to simply buy a basket of diversified mining companies instead.

If you do decide to buy EM equities on the basis of commodity performance, should you simply buy and hold? The short answer is no. Buying commodities (or the equity of companies involved with their extraction) is not a set it and forget it investment, and neither should EM investing. Knowing when the bullish narrative is about to run its course, and its time to cash out of a bull market (whether that be in commodities or EM’s), is the key to success in these markets.

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