Falling commodity prices are a natural red flag for emerging market (EM) investors. But 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 EM local fixed income markets.
Without doubt, lower commodity prices are a negative terms-of-trade shock to large parts of the EM complex, representing a hit to both current and fiscal accounts. From their first-quarter peaks, iron ore and Brent crude prices are down 37% and 16%, respectively.
The impact of lower commodity prices must be viewed in a broader context – notably, their effect on developed economy growth and central bank policies, the dollar, and the extent of any pre-existing EM imbalances.
Not a typical commodity price decline
The recent decline in commodity prices does little to change our constructive view on EM local markets for several reasons:
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 undervaluations of 2015-2016, bond market resilience to potential currency weakness on a broader commodity price rout becomes a more important investment consideration.
These arguments are not to suggest that weaker commodity prices are immaterial, but simply that the current episode represents a positive supply shock to the global economy, which should serve to reinforce the extremely favorable financing climate for emerging markets. In the absence of significant external imbalances, EM currencies should continue to appreciate, reinforcing a convergence of real interest rates toward those of the developed economies.
Watching for real red flags
So what would change our benign view of the recent commodity price decline? 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.
Even then, evidence of weakening exchange rate pass-through to EM inflation expectations marks a break from the past. For all but a handful of emerging markets, monetary policies should be less constrained by currency depreciations stemming from weaker global growth expectations and negative terms-of-trade shocks.
Gene Frieda is a global strategist based in PIMCO’s London office.
For more on this topic, please read "A Constructive Case for Emerging Markets."