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Martyn Hole
- A further rise in commodity prices is a key channel through which the conflict in Russia/Ukraine might affect the rest of EM. If the commodity price increase is sustained, some EM countries may suffer from a deterioration in the terms of trade, weaker growth and a potential negative impact on fiscal and external balances.
- EM equities have historically done better in a higher growth environment, whereas inflation (unless at extreme levels) and fiscal/external balances have been less important
- While higher commodity prices may have a negative impact on some EM countries, it is important not to lose sight of the opportunities EM equities offer. Equities are trading near historical discounts relative to developed markets and the asset class should continue to benefit from a reduction in EM equity risk premium.
Russia’s military aggression against Ukraine, which has become Europe’s largest ground war in generations, has impacted millions of people and triggered a large-scale humanitarian crisis as vulnerable Ukrainians take shelter or flee their homes. The intensification and spread of the conflict is deeply troubling and is having a devastating impact on those people caught in the crisis.
This article focuses on potential market and economic implications of the conflict.
Introduction
A key channel of contagion to EM equity markets outside of Russia is likely to be through commodity prices. Russia is the largest exporter of natural gas and the second-largest exporter of crude oil and petroleum products So far, there has been no disruption to the Russian gas supply (Russia’s exclusion from SWIFT doesn’t include commodities), but the geopolitical developments have propelled oil prices even higher than they were at the start of the year, with Brent oil prices crossing US$100/bbl for the first time since 20141. Both Russia and Ukraine are important food commodity exporters and with Russia and Ukraine accounting for roughly 30% of the world’s wheat exports, wheat prices are at decade-high levels. Russia is also an important exporter of nickel, palladium, and titanium (the aerospace industry sources around a third of its titanium from Russia). In this paper, we look at how the increase in commodity prices might affect the rest of the EM.
Impact of commodity prices within EM countries
If we look at the breakdown of the MSCI EM index, we can see that most of the index is made of countries that import oil, including China, Taiwan, Korea and India.
Many countries in the MSCI EM are net oil importers
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Data as at 28 February 2022 and 31 December 2020 (for net oil importers/exporters). Source: Bloomberg, EIA, IMF WEO, MSCI
The chart below shows the exposure to commodity related sectors in each country’s equity index. Russia has the largest exposure to commodities within the MSCI, followed by Peru (through materials), Brazil and Chile.
Exposure to commodity related sectors in MSCI EM by country
Weights of energy and materials by markets in EM
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Data as at 31 December 2021. Source: UBS. RU = Russia, PE = Peru, BR = Brazil, CL = Chile, SA = South Africa, CO = Colombia, TH = Thailand, HU = Hungary, TR = Turkey, PL = Poland, IN = India, MX = Mexico, EM = emerging markets average, ID = Indonesia, QA = Qatar, KR = Korea, TW = Taiwan, CN = China, CZ = Czech, AE = UAE, KW = Kuwait, PH = Philippines
Macroeconomic impact of higher commodity prices
We have seen that most countries in the MSCI EM IMI are net oil importers, while the exposure to commodities more broadly is more mixed. The next question is how higher commodity prices might impact EM economies. A sustained rise in commodity prices may have a negative impact on the (1) economic growth outlook, (2) inflation and also potentially on (3) external and fiscal balances.
1. Economic growth: Higher commodity prices have an effect on both the demand and supply in an economy. Commodity price increases raise the cost of production, thereby reducing supply, while they can reduce demand through a reduction in wealth of consumers. If we assume that oil prices rise by US$10/bbl, we could see a 0.1-0.6 percentage point decline in GDP growth2, with small, non-oil producing countries such as Singapore, Taiwan, Hong Kong and Thailand, facing the largest drag on growth. The reverse is true for net oil exporters as the value of exports increases, raising the economy’s profits and wages. Because domestic oil prices are generally heavily subsidised in oil producing nations (although this has somewhat been reduced now), a rise in international oil prices will likely have a limited effect on demand or supply within the country.
2. Inflation. The impact on inflation depends on proportion of commodities in the consumer price basket. As an example, food and energy make up over 50% of the CPI basket in India so any increase in commodity prices will have a major impact there. Thailand, the Philippines and Malaysia also have large commodity weights in their CPI baskets3. Another factor is government intervention in fuel prices. Many of the major oil exporters (such as Saudi Arabia, Kuwait) subsidise or regulate fuel prices and so higher commodity prices may not get fully passed onto consumers through CPI.
3. Fiscal balance. For commodity importers, higher commodity prices can lead to a deterioration in fiscal accounts if governments subsidise commodity prices, such as in Korea and Indonesia. For commodity exporters, an increase in commodity prices will help the fiscal balance. Many EM exporters have significantly lower breakeven prices4 for oil than current prices. So, for example, Mexico only needs an oil price of less than $50 to break even, while Saudi Arabia needs an oil price of closer to $805.
4. Current account balance. Commodity exporters should see an improvement in current account balances through better terms of trade. The chart below shows the net commodity exposure by country as a percentage of GDP. Russia, Chile, Malaysia, South Africa and Brazil are the largest beneficiaries of higher commodity prices, although they vary in the type of commodity that they are exposed to.
Net oil/gas, food and ores/metals trade balances by country, % GDP
Trade balance in 2019 (% of GDP)
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Data as at 31 December 2019. Source: UBS
The chart below shows the impact of a US$10 increase in the price of oil on consumer price inflation and current account balances for the largest constituents of the MSCI EM IMI. As can be seen, the impact on China, Taiwan and Indonesia are all fairly minimal. Thailand looks the most exposed to a rise in oil prices, both in terms of inflation and external balances.
The impact of higher oil prices on inflation and external balances vary
Impact of a US$10 increase in the price of Brent Crude oil inflation and current account balances
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Data as at 31 January 2022. Source: HSBC. Saudi Arabi improvement in CA balance is 2.1% of GDP. No data for inflation. CPI = consumer price inflation. CA = current account balance
The mix of upside risks to inflation and downside risks to growth may lead to a re-evaluation of monetary policy, to become either more hawkish or dovish, depending on the central bank, but also how long lasting the impact is. In general, oil price shocks associated with geopolitical turmoil have been perceived to pose a greater threat to growth than inflation, but central banks could go either way. There are clear regional differences across EMs – Asia has yet to raise interest rates as inflation has remained benign, CEMEA has delivered hikes though real rates are still negative (both ex post and ex ante) and Latin America has already front loaded the rate-hiking cycle.
Impact of higher commodity prices on EM equities
The final lens through which to look at the impact of the conflict on EM equities is how the rise in commodity prices impacts EM equity returns.
High commodity prices have generally been associated with strong EM equity returns in the past. This is likely to have been because commodity exporters traditionally had a higher weighting in the index6, which has now changed due to changing economic drivers – economies shifting from manufacturing to consumption. High commodity prices could also be associated with higher EM returns if the rise in prices was driven by stronger global demand as the broader global economic growth would have supported equity returns.
Supply-driven spikes in commodity prices, as we are currently experiencing, are generally negative for EM commodity importers through changes in terms of trade, weaker growth, and a potential deterioration in fiscal and external balances. However, fiscal and external balances only really impact EM equity markets if financing of either deficit becomes a major problem. Most EM countries are in relatively decent shape at the moment and so a small deterioration in fiscal/external accounts is unlikely to have a major impact on EM returns.
EM equity returns in high/low growth and high/low inflation scenarios
Average monthly MSCI EM IMI returns during the past 33 years
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Data as at 28 February 2022. Source: Bloomberg
It’s a different case for growth and inflation. We used US PMI to proxy global growth and separated periods into higher/lower growth and higher/lower US CPI (year-on-year inflation accelerating/decelerating on a monthly basis). The chart above shows that EM equities have risen the most in periods of higher growth and that the level of inflation is less important. However, periods of particularly high inflation, as seen in the 1970s, caused economic and capital destruction and low equity returns. Note that EM equity returns are positive in all four periods, highlighting the benefit of staying invested throughout different economic cycles.
In terms of sector impact, energy and materials should naturally be the largest beneficiaries from higher commodity prices, while real estate would probably lose the most as the sector uses a lot of commodities as inputs. Manufacturers and industrial companies may also suffer if they struggle to pass higher costs onto consumers.
Conclusion
If the commodity price increase is sustained, some EM countries may suffer from a deterioration in the terms of trade, weaker growth and a potential negative impact on fiscal and external balances. Growth seems to be the driving factor for EM equities so the impact on growth will be important to watch. In terms of regions, EM Asia is the most negatively affected by the rise in commodity prices and Latin America and CEEMEA more positively. Colombia, Saudi Arabia and Brazil should benefit the most. In terms of sectors, energy and materials are the largest beneficiaries, while real estate would probably lose the most.
While higher commodity prices may have a negative impact on some EM countries, it is important not to lose sight of the longer-term opportunities EM equities offer. EM accounts for almost 60% of global growth, which should continue to rise given their younger population and urbanisation. Meanwhile, inflation and government debt levels are manageable and corporate governance is improving. In terms of valuations, equities are trading near historical discounts relative to developed markets and the asset class should continue to benefit from a reduction in EM equity risk premium.
1. Source: Bloomberg. As at 28 February 2022.
2. Source: Barclays Research as at 25 February 2022
3. Source for country CPI weights: national statistic agencies.
4. the price which would balance the budget
5. Source: Barclays Research as at 25 February 2022
6. MSCI EM IMI
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