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June 20, 2016 | Global Equity
Collapse of the Commodity Complex

Portfolio Manager

Todd McClone, CFA, partner, is a portfolio manager for William Blair’s emerging markets strategies. Before joining the firm in 2000, he was a senior research analyst specializing in international equity for Strong Capital Management. Previously, he was a corporate finance research analyst with Piper Jaffray, where he worked with the corporate banking financials team on a variety of transactions, including initial public offerings, mergers and acquisitions, and subordinated debt offerings. He also issued fairness opinions and conducted private company valuations. Todd received a B.B.A. and B.A. from the University of Wisconsin–Madison.

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The collapse in commodity prices over the past years is one concern driving underperformance and outflows in emerging markets.

The decline in commodity prices is a supply and demand issue, in my view. Certainly, decelerating economic growth in China, the largest buyer for most commodities, is part of the problem the commodity complex has been facing. But another problem is excess supply. Mining projects conceived and initiated at the highs of China’s economic growth boom, which drove seemingly endless demand, are now coming online at a time when demand is declining and the market is oversaturated. Falling demand and rising supply have led to falling prices, with iron ore, copper, and coal experiencing significant downfalls.

Falling demand and rising supply have led to falling commodity prices.

The fall in oil prices is primarily a supply issue, in our view, as shale has durably changed the dynamics of the energy market. U.S. oil production has almost doubled over the past five years as shown in the chart below. As shale has disrupted the equilibrium in the oil market and the Organization of the Petroleum Exporting Countries (OPEC) can no longer control the price of oil by slashing production, producers are now focusing on defending their market share at the expense of pricing. Increased production from Saudi Arabia, Russia, and Iraq—in addition to Iran oil coming into the market—is resulting in an oversupplied oil market, thus pressuring oil prices.

But does the end of the commodity boom spell doom for emerging markets? I don’t think so.

First of all, it’s interesting to observe that the impact of commodity sectors on emerging market equities is vastly diminished. As a result of the sharp decline in commodity prices, the energy and materials sector weights in the MSCI Emerging Markets Index are now only 13%, down from 38% at the peak of the commodity boom and almost on par with the MSCI All Country Word Index.

Furthermore, if we differentiate the MSCI Emerging Markets Index by countries that are winners and losers as a result of weaker commodity prices, we find that countries that account for 70% of the index are net beneficiaries of falling commodity prices. So, despite the conventional wisdom that falling commodity prices are negative for emerging markets, the reality is that there are far more emerging markets that are beneficiaries of weaker commodity prices than those that are not.

Countries that account for 70% of the index are net beneficiaries of falling commodity prices.

Lastly, in my view, the general perception that emerging markets and commodities are highly correlated suffers from an anchoring bias. The correlation between commodity prices and emerging market equity prices significantly increased from 2005 to 2013, driven by acceleration in Chinese demand for commodities amid China’s investment boom, which benefited commodity-producing countries in emerging markets and drove a general optimism regarding the asset class. It was a sort of rising tide that lifts all boats, driving correlations higher.

Of course, the collapse of the commodity complex another time isn’t the only concern depressing investor sentiment about emerging markets. I’ve already discussed three other situations—disappointing economic growth in emerging market countries, the potential impact of U.S. interest-rate hikes and a stronger U.S. dollar, and fears of a hard landing and currency devaluation in China. And there’s also some good news, which I’ll discuss later.

Portfolio Manager

Todd McClone, CFA, partner, is a portfolio manager for William Blair’s emerging markets strategies. Before joining the firm in 2000, he was a senior research analyst specializing in international equity for Strong Capital Management. Previously, he was a corporate finance research analyst with Piper Jaffray, where he worked with the corporate banking financials team on a variety of transactions, including initial public offerings, mergers and acquisitions, and subordinated debt offerings. He also issued fairness opinions and conducted private company valuations. Todd received a B.B.A. and B.A. from the University of Wisconsin–Madison.

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