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Oil has slipped into its first bear market since August after West Texas Intermediate crude slumped to almost $43 a barrel overnight, more than 20% below its recent peak in February. Iron ore, coal and copper haven’t been faring well either.
While falling commodity prices tend to be a red flag for emerging market investors, PIMCO’s global strategist Gene Frieda argues this time is different. He notes there are good reasons to believe the current confluence of lower commodity prices, declining inflation expectations and a softer dollar will reinforce rather than undermine the rally in emerging local fixed income markets.
Frieda offered four key reasons why the recent decline in commodity prices hasn’t altered his upbeat view on emerging markets:
Weaker commodity prices are not emblematic of softening external demand. Instead, declining oil and iron ore prices look to be an isolated function of classic supply overhangs. Falling energy prices should reinforce the recovery in domestic demand across developed economies through higher real income growth, thus boosting demand for EM exports.
The reversal in energy prices saps upward pressure on global inflation seen in the past year. The lack of inflation pressure enables developed economy central banks to normalize monetary policy gradually, while offering scope for many EM central banks to maintain accommodative conditions.
For EM commodity exporters, softer commodity prices and a weaker dollar offset each other from a broad balance-of-payments perspective. What commodity exporters lose on the export side, they gain on the capital flow side due to relatively high (and, as energy prices fall, rising) real interest rates. Currencies of EM commodity producers have thus been less correlated with weaker commodity prices due to a positive offset from looser external financing conditions.
For all but a handful of EM economies, local interest rates have become much less sensitive to currency depreciation that normally accompanies lower commodity prices. This reflects improving central bank inflation-fighting credibility and a general lack of external imbalances, among other factors. As EM currencies appreciate from the extreme under valuations of 2015-2016, bond market resilience to potential currency weakness on a broader commodity price rout becomes a more important investment consideration.
So what would prompt Frieda to change his view?
Weaker global growth would be more problematic than stronger global growth. Benign underlying inflation conditions give central banks the luxury of normalizing rates slowly. But rock-bottom interest rates in the G3 (the U.S., Europe and Japan) leave central banks with less scope to lean against negative growth shocks.
Closely related would be negative growth developments in China. If a weakening credit impulse were to lead to significantly softer Chinese growth in late 2017/early 2018, this would likely act as a double whammy for EM, via lower commodity prices, weaker demand and renewed fears of central bank impotence at the zero lower bound. Fortunately, most evidence points to a gradual, rather than a sharp, slowdown in Chinese growth.