They key upside risks for EM next year are: a) oil prices continuing to decline, but clearly for supply side reasons, b) EM governments and companies pushing forward with macro reform, better cost management and improvements in corporate governance, c) Europe’s credit multiplier reviving, d) the US back end staying low thanks to subdued inflation expectations or early but isolated hikes by the Fed, and e) the texture of US growth becoming more EM friendly.
Of all the upside risks for EM the one that is most intractable is the impact of oil. Clearly lower oil prices imply lower inflation and hence help fixed income. But history would suggest that oil prices and risk assets in EM (equities and FX) are positively correlated; that is, lower oil prices are associated with weakness in EM risk assets. Why would this time be different? Possibly because today the decline in oil prices is not symptomatic exclusively of weaker demand; excess supply plays a role too. Difficult as it is, we think one must attempt to isolate the impact of supply in the current oil price decline. We lay out a model that helps us do this.
The channels through which lower oil prices can help EM are
a) Lower inflation and lower interest rates in EM
b) Monetary policy in the developed world being able to stay looser for longer
c) Stronger global growth
d) Lower transport costs and stronger DM consumers boosting global trade
e) Lower trade and fiscal imbalances in EM commodity consumers.
Much as all of these points appeal to intuition, the reality is that risk assets in EM have historically been positively correlated with oil prices; that is, lower oil prices have been associated with lower stock prices and lower currencies, at least contemporaneously (Figure 1).
Further, not only is the beta of these assets to oil prices positive, the relationship seems tighter during times of declining oil prices rather than in one of higher oil prices (as seen through the higher R-sq). The positive directionality of EM risk assets to oil prices is very likely because for the bulk of their history, oil price variations have largely been symptomatic of global demand, liquidity and dollar movements.
What might be different this time then? Possibly that today the decline in oil prices is being driven to a meaningful extent by supply. But just how strongly EM assets can react to the decline in oil prices depends on the extent to which demand and supply forces respectively are responsible for the move. We would encourage the interested reader to go through the box overleaf, where we detail a simple model that helps us disentangle these influences.
For those who are less interested in the math, let us quickly summarise our conclusion – we think that of the $40/bl decline in oil prices, roughly 30% is due to an exogenous shift in supply. That may be well higher than history, but it still implies that roughly 70% of the decline in oil prices is the driven by the decline in demand or a stronger USD, and is not an unambiguous positive for EM risk assets.
If oil prices are to help EM next year, any further declines in the price of oil must be driven by supply side increases, rather than demand declines or a stronger USD.
The one asset class that doesn’t care whether oil prices are coming down for demand or supply side reasons is duration. That is because, regardless of their driver, lower oil prices typically do lead to lower inflation in EM. Despite weaker currencies, EM inflation is likely to come off by more than DM inflation next year due to the higher weight of energy in EM CPI baskets (Figure 2). Other things being equal, this lower inflation ought to help not just EM duration but also, with a lag, EM equities. We find that there is a decent negative relationship between 6m lagged inflation and returns in EM equities.