Behind the Numbers: What has driven decoupling of commodities and emerging markets?

The composition of emerging market indices reveals stocks less tied to the commodity cycle have been taking a larger share in recent years

Emerging market stock returns have long been linked with commodity prices. More recently, however, investors have begun to note the uncoupling of this formerly tightly correlated relationship.

Here, we explore why this decoupling has occurred and identify what is actually driving emerging markets now, as well as which funds are delivering the best risk adjusted returns.

The most recent divergence between these two markets began in late 2016 as new President-elect Donald Trump’s supposed imminent de-regulation and growth policies drove the dollar’s gains as the MSCI Emerging Market index retracted slightly.

During this period, commentators noted some commodity strength (for example, +10.40 per cent oil and +10.77 per cent copper) despite a falling emerging market index (-5.30 per cent). Energy and mining stocks thrived until the year end, even as commodity performance varied and the emerging market index declined.

The weakening link between the two continued in 2017, with emerging markets delivering a strong +25.4 per cent year-to-date (29 December), while the closest commodities are copper at +18.22 per cent and gold at +3.02 per cent. The tables below provide a feel for fund performance this year compared with last.

Evolving index

So, what has been driving emerging markets? A look at the composition of emerging market indices reveals that stocks less tied to the commodity cycle have been taking a larger share in recent years.

Firstly, from a geographical point of view, there has been a gradual evolution of the MSCI Emerging Markets index. It has shifted from an eight-country shortlist in 1988, with Malaysia having the largest weighting of 33.8 per cent, to 24 countries, with the largest weighting being China at 26 per cent. Figure one shows the extent of change over the last nine years, and these compositions will continue to gradually shift in the future.

China was added in 1996 with Shanghai and Shenzhen listed B shares but its influence has steadily grown. Now Chinese A shares will be included in the index by June. Another winner of MSCI’s recent technical review highlighted Saudi Arabia as a potential candidate, while Argentina remains ostracised to the frontier markets. Greece is another that has oscillated within the emerging index and developed markets.

With the index’s largest weighting being Samsung Electronics, Tencent Holdings Limited, Taiwan Semiconductor Manufacturing and Alibaba Group Holding Limited, it is evident emerging markets are moving up the market value chain and, with the inclusion of more countries, the drivers of the index need no longer only be considered as commodity only.

With a deep pool of talent to draw from and competitive labour rates that aid in exploiting global opportunities and economies of scale, it does not come as a surprise emerging markets are providing strong businesses that feed the global structural appetite for technological change.

Turning our attention to sector weights as detailed in figure two now, the composition has clearly moved away from cyclical energy, materials and industrials, which were at one stage around 39.4 per cent of the index but are currently 19.4 per cent.

What was once a market dictated by commodities has now witnessed a structural shift away from primary sectors and into the more advanced technology sectors. There has also been an uptick in consumer related stocks (combined staples and discretionary 22 per cent from previously 9.9 per cent), while financials are still a large allocation with 23.7 per cent as of July 2017.

China’s influence

The growth in consumer related stocks is further testament to the influence of China’s domestic consumer trends. The large size of China within the index is obviously a factor but so too is the continued improvement to its GDP per capita and the conscious rebalancing away from an export economy to a demand driven one, which will only serve to make this a more dominant sector.

How has this change in drivers to the emerging markets been reflected in fund performance this year? Well, in truth, very impressively, as 40 managers within the Investment Association emerging market sector have outperformed their MSCI Emerging Markets benchmark year-to-date +22.36 per cent.

Figure three looks at one-year rolling RSquared (a measure that represents the percentage of a fund or security’s movements that can be explained by movements in a benchmark index) and reveals fluctuating relationships between commodities and the MSCI Emerging Markets.

Of the agricultural markets tested, coffee has the strongest relationship to the MSCI Emerging Market index. Mining and metals generally have stronger RSquared to the MSCI Emerging Market index, although as you can see, there is a slight down trend. WTI crude oil also has a consistently high RSquared but that too has been coming down.

China and copper have the strongest of relationships of the indices observed. However, of all the variables looked at, it is China that has the increasing RSquared in line with our earlier observations. Interestingly, this does not translate automatically into fund performance.

MI Somerset Emerging Market Small Cap and the Lazard Emerging Markets, which both have the higher rolling RSquared to China, have had a disappointing year (11.74 per cent and 10.62 per cent respectively).

Secular trends

What most managers with a top-down appreciation would have noted is that globally we are witnessing several structural changes that are driving demand and supply dynamics, which in turn will determine which sectors, products and investments will ultimately punch good return figures.

Already well documented trends of ageing populations (higher propensity to save) of developed markets suggest an emphasis to pharmaceutical products, while the emergence of the emerging countries’ middle-class consumers signals a growing market for their tastes (higher reward for concentrating on domestic markets).

With monetary policy proving to be ineffective in stimulating growth, governments are looking at fiscal options which favour infrastructure and, with climate change concerns, green energy could also take off.

The rapid growth of technological companies, the rise of disruptive business models encouraging innovation and the drive to artificial intelligence are all tailwinds for this sector, so it is no surprise that tech companies in China are thriving.

With emerging market countries focusing their capital in these sectors, increasingly the volatile commodity and materials sector is being scaled back. Fund managers have also shunted this area, citing producers as price takers rather than makers.

China and global structural secular trends have replaced commodities as the main drivers of emerging markets and all markets for that matter. Despite China still being one of the main drivers within global markets, emerging markets can still provide diversification for fund investors looking to source different return drivers.

Depending on general risk appetites and access to different managers or instruments, choosing local or hard currency, investors can diversify even further within this asset class.

Robert Wilson is fund analyst at FE

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