How commodity prices are impacting Emerging Markets
A monthly insight from James Syme and Paul Wimborne (pictured), managers of Pendal’s Global Emerging Markets Opportunities Fund
- There are three broad drivers of the recent commodity boom: a natural demand bounce-back after 2020, US economic stimulus, and Chinese economic stimulus.
- Here we review the prospects for each and discuss our portfolio positioning around the commodity rally.
COMMODITY price moves have been one of the most significant parts of markets pricing in a post-Covid global economic recovery.
As we’ve mentioned before, commodities are a major driver of returns for emerging market (EM) equities as a whole. They’re also a major differentiator of returns among different parts of the asset class.
We feel there are three broad drivers of the recent commodity boom: a natural demand bounce-back after 2020, US economic stimulus and Chinese economic stimulus.
Here we review the prospects for each and discuss our positioning around the commodity rally.
Demand bounce-back
Pent-up demand during lockdowns created a huge demand shock as restrictions and trade interruptions began to ease.
This was particularly noticeable in the housing and construction industries with long lead-times and big price increases on products such as construction lumber, windows and bricks.
One trackable index for this is the US CME lumber future, which rose from US$400/lot at the start of 2020 to more than US$1600/lot in May.
There’s also been a surge in demand for smart, programmable or connected devices, leading to real pressure on the availability of some semiconductor components.
One benchmark, DRAM memory chip, climbed to US$4.60 from US$2.60 in August 2020.
US and Chinese economic stimulus
US and Chinese economic stimulus is the other driver of the commodity boom.
Investors face a complicated world. The biggest economy has broken with 40 years of generally deflationary fiscal and monetary restraint, just as the second-biggest economy has significantly tightened policy.
The Biden administration moved quickly to pass a US$1.9 trillion stimulus package, and is now preparing a US$6 trillion budget that will very substantially increase the rate of investment by the government sector in the US economy.
Meanwhile, as we noted in December, China has moved to end an acceleration in money supply growth and credit growth that began in mid-2020.
Fiscal policy was tightened, which naturally reduces credit growth. We also saw a disappointing Q1 GDP growth rate of 0.6% quarter-on-quarter and a decline in shorter-term bond yields as markets priced in the slowdown.
In this environment it is hard to see where commodity prices might go from their current elevated levels.
Historically a slower China is bad for commodity prices. But this has always been in an environment of tight US fiscal policy.
In terms of where commodities might go — and how to manage exposure in emerging markets — we make the following observations:
1. China’s dominant role in commodity demand
The dominant role of China in terms of global commodity demand and its historical importance to commodity prices should not be dismissed.
When taken alongside the ability of market systems to increase supply in the face of high prices, we would not be surprised to see a meaningful pull-back in commodity prices at some point this year.
2. Not all commodities are the same
It’s important to note that not all commodities are the same. Agricultural products in particular can display a very strong supply response to high prices as farmers’ planting decisions are affected.
In addition some commodities are more exposed to Chinese end demand (steel, coal) and some more to US end demand (particularly oil).
The oil price has risen strongly in the past year. As oil companies struggle to add production capacity — in light of Environmental, Social and Governance (ESG) restraints — we feel there is probably more upside to the oil price than to industrial metals from this point.
3. Correlation between equity and commodity prices
Although the share prices of most commodity-producing companies in emerging markets have risen strongly, there remains a high correlation between those share price moves and moves in the prices of the respective underlying commodity products.
These shares offer exposure to commodity prices, but nothing more.
We have exposure to commodity-producing companies in sectors such as oil/gas, wood pulp, cement and gold. But in every case we have a clearly identified additional catalyst that we expect to come through — as well as the supportive environment for commodity prices.
For example, for Brazilian oil and gas producer Petrobras we believe the market has mispriced when (and even if) domestic product prices deviate from import parity prices. Meanwhile in the first quarter of 2021 the company had free cash flow equal to 10% of its market cap.
At Brazilian pulp and paper company Suzano, we feel the company’s substantial progress in ESG has not been recognised by analysts yet. At Mexican cement maker Cemex we feel the rapidly improving European operating environment is not yet in consensus estimates or priced into the share price. And so on.
4. Opportunities in other sectors
Fourthly, the macro-economic impact of commodity prices creates opportunities in other sectors in certain countries.
Followers of our strategy will be aware of our increased allocation to Brazil and South Africa. Recent economic data and corporate results show robust demand growth there — particularly from South African financials and retailers.
We also note that strong economic recoveries are underway in the UAE (where we have maintained our position) and potentially in Russia (where we are currently underweight).
One of the great attractions of emerging market equities is the global macro exposures the asset class offers. One of the great strengths of a top-down approach is an ability to find preferred opportunities within this view.
The overall environment for cyclical assets remains robust, both for commodities and emerging market equities.
But as always we feel it pays to be selective.
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About Pendal Global Emerging Markets Opportunities Fund
James Syme and Paul Wimborne are senior portfolio managers and co-managers of Pendal’s Global Emerging Markets Opportunities Fund.
The fund aims to add value through a combination of country allocation and individual stock selection.
The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.
The stock selection process focuses on buying quality growth stocks at attractive valuations.
Find out more about Pendal Global Emerging Markets Opportunities Fund here.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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