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July 25, 2017 | GSAM Connect

EM and the Commodity Conundrum

Behavioural science has long highlighted the risk of anchoring, where investors rely too heavily on the first piece of information they receive, allowing it to subconsciously influence their future assessments. Many market participants had their first exposure to emerging markets (EM) in the mid to late 2000s, when commodities were the dominant part of EM indices and in the midst of a hyper bull-market. Despite meaningful structural changes over the past ten years, we believe subconscious biases still exist, and the notion that commodities are the critical force for EM has not yet fully dissipated.

The fact that commodities have become a less significant driver of the asset class is apparent in our view when observing correlations. From late 2008 to late 2012—when commodities represented over a third of the universe—the 12-month weekly return correlation between EM equities and energy/metal spot prices was consistently around 0.651. In other words, EM equities and commodities moved relatively close together. Since then, however, the relationship has begun to unwind, with the interrelationship far less obvious—year-to-date, the correlation has barely broken above 0.251. Even in 2016, when commodity prices rallied over 60%, correlations were nowhere close to post-crisis highs.

Ten years ago, almost half of the EM universe was represented by commodity-dependent countries with sizeable commodity export surpluses. Today, that number is less than one-third . Similarly, having peaked in 2008 at close to 40% of the EM universe3, the energy and materials sectors now make up less than 14%. While some of that decline is undoubtedly due to the challenging commodity price environment and subsequent underperformance in 2014 and 2015, it is also a result of newer sectors emerging. As wealth and consumption have increased and evolved in Emerging Markets, so has the sector composition. The technology and consumer sectors are now the dominant long-term drivers of the asset class, with a combined weight of 44% in the MSCI EM Index2. This substantiates our empirical findings that earnings are the primary driver of equity markets over the long run. With consumer and technology companies becoming dominant within EM, income growth and spending supported by the rising EM consumer have started to have a greater bearing on the asset class than commodity prices.

12-month rolling weekly return correlation for EM equities and Energy/Metal spot prices*


Source: Datastream, as of July 20, 2017. Past performance does not guarantee future results, which may vary. Past correlations are not indicative of future correlations, which may vary.

This is not to say that significant commodity market inflection points will not continue to drive EM—we believe they will. But it will likely be a short-term phenomenon in our view, with other structural factors driving EM's long-term performance. Hopefully, as we go forward into the future, these forces will be sufficiently powerful and evident to erode investors' previous biases.  

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