Do commodities still matter for emerging market debt or foreign exchange?

Preview

On April 3, the Organization of the Petroleum Exporting Countries (OPEC) surprised the market by announcing a significant increase in planned production of oil. The timing of this announcement coincided with a sharp repricing of global growth expectations, following the US “Liberation Day” tariff announcements a day earlier. In combination, this led to a drop in Brent crude from US$75 to US$60 per barrel. Emerging market (EM) spreads widened sharply over the same period. EMs have long been regarded as an asset class highly sensitive to commodities. Given the prominence of EM commodity-producing countries, we believe it is intuitive to expect both sovereign spreads and emerging markets foreign exchange (EMFX) will likely respond to movements in the prices of their key exports. In certain cases, similar dynamics could be expected for importers. However, as the composition of key EM debt markets changed over time (see Exhibit 1), one wonders if this sensitivity has moderated or even broken down entirely.

In this paper, we explore the primary drivers of commodity prices and assess their continued relevance as drivers of EM debt (EMD) and EMFX. We focus on three commodities: oil, copper and gold, which represent the highest notional trade values (USD) across the EM universe. Our findings show that oil most significantly impacts spreads, though the strength of this relationship varies across countries. Copper and gold’s influence is significantly less clear.

Takeaways for EM debt investors

Our analysis indicates that there is one overriding commodity that still impacts EM debt, namely oil. Crude continues to dominate as a driver of EM spreads, with surprisingly little effect coming from copper or gold, despite the significance of these two commodities within the EM trade landscape. We believe that the structural characteristics of the various commodity sectors influence the extent to which they drive EMD. Major oil-producing countries tend to have a larger share of economic output tied to oil, and a high degree of government involvement, which strengthens the link between oil prices and sovereign credit worthiness.

EM is a heterogenous asset class and so looking at individual countries will continue to be key, in our opinion. Overall, we can conclude that there is a strong relationship between oil prices and credit spreads for oil exporters, while importers are less affected. Furthermore, those countries with a higher share of oil exports as a percentage of GDP, and those with lower credit quality, are most vulnerable to oil price shocks. In general, EMFX returns are not influenced by moves in the underlying commodity prices, though the CLP does have a significant correlation to copper prices.

In conclusion, we believe investors should closely monitor the fundamentals of oil exporting countries as well as their overall portfolio exposure to oil exporting sovereigns, as a downturn in energy prices will likely impact performance of these exposures.