A global commodities boom has largely driven economic expansion in emerging markets over the past decade. Now, with energy prices sharply weaker and non-agricultural commodities generally under challenge, are emerging markets (EM) vulnerable? In our view, some clearly are – specifically those focused on commodity production.
However, a large portion of EM economies are geared to exporting manufactured goods, and they stand to benefit from lower energy costs. Among EM debt sectors, we believe the most effective access to the manufacturing economies is through local currency bond markets.
The weakness of commodity exporters versus manufacturers has been evident in growth and trade balance data over the past year. For example, among the so-called Fragile Five markets, Brazil, Indonesia and South Africa have been sluggish, while Turkey and India have experienced recovery.
Wider gap between manufacturing and commodity exporters
This pattern has been mirrored in current exchange rate trends, which in our view are likely to continue in the near future. Demand from China (the central driver of commodity pricing over the past 15 years) will likely expand at a slower pace, while the supply of energy is increasing in large part due to U.S. shale production, potentially capping commodity valuations and limiting currency recovery for commodity producers.
Real effective exchange rates: Manufacturing and commodity exporters
On the positive side, we believe that economic growth and the trade balances of EM manufacturing exporters should continue to benefit from lower oil prices, both by reducing their costs and by limiting global inflation in general, which should help real wages and consumption globally—and translate into more demand for manufactured goods.
“Winners” are found largely in emerging Asia and Europe, including both current account surplus countries like Korea and Hungary, and deficit countries like Poland, India and Turkey. Such markets generally have stronger trade links with the accelerating U.S. economy and the still-stable eurozone, which is likely to benefit from further monetary easing and the normalization of the credit markets after the European Central Bank’s recent quality reviews of financial institutions. We would put Mexico on the list of beneficiaries but the weak oil price may cause some delays to energy investments there.
Manufacturing exports as % of country’s total exports
Countries which have relatively high exposure to commodity exports are Colombia, South Africa, Brazil and Indonesia. It’s worth noting that this group may actually benefit from a sustained fall in oil prices, which would bolster Asian growth and increase demand for their products and services. Those countries with heightened political risk, such as Venezuela, Mongolia, Ecuador and Russia, could also be vulnerable.
Investment implications
While emerging markets have a reputation as a commodity play, manufacturers account for an increasingly large segment of the EMD universe. In our sample of the “mainstream” EM countries, manufacturing exports (excluding China) represent $2.5 billion versus $1.3 billion for metal and energy exports.
In addition, manufacturing exporters tend to offer greater economic diversity, and the 14 countries in our sample whose manufacturing exports exceed 50% of total exports are spread out across regions.
What is an effective way to gain exposure to the EM manufacturing sector?
In our view, local currency debt is well positioned to benefit from improving inflation and current account trends of manufacturing exporters, compared to hard currency debt.
Additionally, it is less exposed to commodity exporters as manufacturers make up 55% of local currency J.P. Morgan GBI-EM Index, while they represent only 35% of the hard currency sovereign index. Moreover, the GBI-EM Index tends to include countries with relatively strong fiscal/monetary policy and the developed financial systems needed to support local bond issuance, which also explains the dominance of manufacturing-oriented economies in this index.
More broadly, lower commodity prices are likely to benefit some countries and hurt others, suggesting the importance of a relative value approach in selecting exposures. However, as long as the economic recovery in developed markets remains consistent, lower oil prices should benefit global growth and, by extension, growth in emerging markets. This in turn should bolster the fundamentals supporting the emerging markets debt asset class.
