The plunge in the oil price in recent months has given investors a simple but misleading narrative – commodity-consuming developed markets good, commodity-exporting emerging markets bad. As ever with investment stories, there is a grain of truth in this but the reality is more nuanced.
There’s no arguing with the first part of the thesis. Oil under US$80 a barrel is fuelling a positive disinflationary shock that is providing central banks with the cover they need to keep interest rates at rock bottom in the US and UK. In Japan and Europe, it’s providing the ammunition needed to open the liquidity taps even further.
In particular, cheap oil is underpinning the US economic recovery, putting money in the pockets of consumers, cementing the remarkable reversal in the US’ fiscal and trade deficits and keeping profit margins high. That in turn is driving the US dollar higher, dragging hot money back home.
A place in your portfolio
Those conditions argue for a continuation of the US bull market and a place for developed markets in your portfolio. If you favour momentum, you’ll lean towards the US and Japan. Contrarians will argue that Europe is the wild card for next year, with a weak euro compensating for the region’s more sluggish growth.
The second half of the narrative is more complicated. The problem with any observations about emerging markets is that they are too diverse to be lumped together in one category. Notably, there appears to be a divide between Asia and the rest.
The performance of stock markets during the worst of the market volatility in October pointed to this geographical split. The Philippines, Thailand and India all outperformed the US in the first three weeks of October.
The big underperformers were South Africa and Brazil, the common denominator of which is clearly their exposure to slumping commodity markets. The key point about all the Asian emerging markets, with the exception of Malaysia, is that they are all big importers of oil. They are just as big beneficiaries of the oil price slide as the developed markets.
Even before you factor in the impact of the oil price slide of the past few months, the difference in growth between the commodity-exporters and the Asian emerging markets was stark. Brazil, South Africa and Russia have more in common with the low-growth economies of Europe than the still high-octane economies in Asia.
That is because of another key difference between these two groups of economies. The countries with a commodity tailwind are also broadly-speaking the countries that have started to prepare their economies for a shift from export-dependence to domestic-demand-driven models. Since the wake-up call of the currency crises of the late-1990s, the better-run Asian countries have boosted their reserves, avoided the temptation of taking on too much external debt and run trade surpluses.
Next phase of reforms
That means they are now well-placed to move into the next phase of reforms to improve their political institutions and raise productivity. China, Japan and India are engaged in programs of fundamental change. By contrast, much of the emerging world outside Asia sat back during the good times of the export-led commodity boom and did nothing.
The reforms in Asia’s big three are different but the direction of travel is the same. In Japan, the focus is on changing the way companies are run, sweating their assets for the benefit of shareholders. In China, it’s about improving the quality, not the quantity, of growth. That means reducing corruption and increasing the efficiency of the country’s massive state-owned enterprises.
In India, it’s even more basic. The new Modi government, the first single-party majority in 30 years, has a mandate to create the conditions in which businesses can thrive. By cutting red tape and minimising government intervention, growth can accelerate significantly. Within a couple of years India will be growing faster than China.
The collapse in the oil price has done emerging market investors a big favour. It has shone a spotlight on what’s really driving these economies. ‘Commodity-consuming reformers’ is not as snappy as BRICS but it might be a better guide to where to invest your emerging market funds next year.
