The general economic narrative currently is that plunging oil prices signal lower expected global growth. This sentiment results in weaker emerging market (EM) currencies and further equity market sell-offs, which have been compounded by concern around Covid-19.
Although the US economic growth story remains stubbornly stable, the concern is whether growth in the rest of the world will drag down the US during 2020, as monetary policy and further rate cuts seem to have lost their market-supporting magic.
The literature is quite conclusive that unexpected negative oil price shocks result in weaker EM currencies.
Since the Covid-19 sell-off on February 20 and the recent oil price collapse, we have seen this play out, with the Mexican peso depreciating by 16%, the Brazilian real by 9%, the Indian rupee by 3.5%, the Russian rouble by 17% and the rand by 10%. While the Bric nations (Brazil, Russia, India and China) have experienced the brunt of the EM currency weakness, other EM currencies have not sold off as significantly, such as the Turkish lira that has depreciated by only 3.5% and the South Korean won by 2.5%.
Two reasons to upweight EM equities
The knock-on effect of weaker EM currencies is that global EM investors are losing both through their equity exposure to EMs and the currency translation. For example, US investors in the MSCI-SA Index would have lost about 22% since February 20 on the equity portion alone, but because the currency weakened as well, the total loss is about 29%.
However, while EM equity investors and portfolio managers in South Africa are worried that the weaker currency and weaker global developed equity markets will trigger a bigger sell-off in EM, we don’t believe that this will happen.
Oil price shocks negatively impact EM currencies, but not EM equities
There are two economic rationales for stable relative EM equity returns for the rest of 2020. Firstly, EMs generally have higher growth than developed markets and the sell-off in global EMs is primarily driven by concerns for weaker growth from developed markets.
According to the latest OECD report (March 2020), in response to the impact of Covid-19, their GDP projections for 2020 are for G20 advanced economies growth to slow to 1.3% (recovering to 1.6% in 2021) and G20 emerging economies to slow to 3.8% (rebounding to 4.9% in 2021).
This is a very positive catalyst for EM equities, once currency volatility subsides.
Secondly, we can only find evidence that oil price shocks impact EM currencies (and not EM equities) over the medium term. Since 2000, negative oil price shocks are at best coincidentally correlated with EM equity returns. Once the oil price shock is over, there is no further EM equity weakness, despite short-term continued weak or negative EM currency effects. Oil price shocks have therefore been good buying opportunities for EM equities.
The graph below analyses the question of what MSCI emerging market equity returns delivered relative to developed equity markets (ie. excess returns) since 2000 subsequent to every 20% (or greater) decline in the Brent crude oil price.
Relative returns of MSCI EM equities to MSCI DM equities 125 days after oil price shocks (pa%)
The surprising result is that 125 days after 20% declines in the oil price, MSCI EM equities deliver average annualised returns of around 18% above developed market returns (as represented by MSCI World).
This means that EM equities perform exceptionally well relative to developed markets shortly after a steep decline in oil prices.
Global investors should therefore seriously consider upweighting EM equity exposure over the medium term, especially via an unhedged USD conversion to benefit from any EM currency recovery after an oil price shock.
Don’t be confused by EM yield spreads
Another big concern for global EM investors is the widening spread in EM bond yields relative to developed market bond yields. Most EM investors believe this signals higher EM sovereign risk and potential contagion. However, we caution investors to look at the source of these widening spreads.
As the chart below shows, EM bond yield spreads have dramatically widened since the Covid-19 sell-off in February and the recent collapse in oil prices. EM bonds, on average, now trade at nearly 500 basis points higher than developed market bonds.
This increase is not only due to a short-term spike in higher EM yields. It is, more importantly, due primarily to a plunge in developed market yields.
EM yield spread above developed market bond yields (EMBI spread)
Developed market yields are collapsing (European 10-year yields are now at negative 0.8%), because of concerns of rapidly slowing growth in Japan, Europe and even the US, as well as concerns for the likelihood of further monetary intervention (interest rate cuts).
The weakness in EM currencies due to the oil price shock and the reluctance of their central banks to lower rates (which would further weaken their currencies) is telling us that EM yields are actually much more attractive now than they have been in a long time.
Once EM currency volatility subsides, the wider bond yield spreads that are not as a result of EM sovereign risk – developed market (DM) yields are actually falling, driving the EMBI spreads higher – is providing us with a very useful entry point to upweight EM equity allocations.
In summary, our view is that EM currencies are indeed negatively affected by oil price shocks in the short term, but that EM equities often benefit from this over the medium term as EM currency weakness makes EM markets cheaper.
Coupled to this, higher relative bond yields that are not due to higher EM sovereign risk will result in medium-term currency stability (due to the more advantageous carry-trade effect). This creates an important tactical opportunity for global and offshore SA investors to increase their allocation to emerging equity markets once currency volatility normalises.
Roland Rousseau is equity and quantitative strategist at RMB Equity Strategy and Structuring.