Falling Commodities, Emerging Markets And Your Portfolio

How Falling Commodities Impact Emerging Markets And What You Can Do About It

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Commodities have been in free-fall since mid-2014, with only a few exceptions in the agricultural space. Crude oil prices have been cut in half, natural gas prices are off by a third, and sugar is down over 40% - even gold and silver prices haven’t escaped the bear cycle.

These dynamics have taken a toll on many emerging markets that rely on commodity exports to fuel their economic growth. In aggregate, the iShares MSCI Emerging Markets Index ETF (NYSE ARCA: EEM) has fallen more than 15% between August of 2014 and August of 2015.

Countries with greater exposure to hard-hit commodities – like crude oil – have seen even greater declines, such as the iShares MSCI Brazil Index ETF’s (NYSE ARCA: EWZ) 40%+ decline.

In this article, we’ll take a look at how falling commodity prices have taken a bite out of emerging market returns and how investors can adjust their portfolios.

Price Movements

Commodities have moved lower almost across the board, led by crude oil’s tremendous drop and lagged by commodities like wheat that fell just 6.5% lower.

There are many different reasons for the drop in commodity prices. First, the U.S. dollar has gained ground against most international currencies in anticipation of a Federal Reserve rate hike, which has put downward pressure on dollar-priced commodities. The corollary is emerging market currencies have weakened versus the U.S. dollar, which means they are receiving less real value for the commodities they sell to the global markets.

The second-factor influencing commodity prices is China’s economic slowdown. As the single largest consumer of industrial metals and other manufacturing inputs, the country’s economic slowdown over the past couple of years has reduced demand. China’s GDP growth rate has swiftly fallen from 14.5% in 2008 to 7.35% in 2014, while the country’s equity market has experienced significant turbulence and its housing market has started to slow.

Looking at Exposures

Most emerging market economies are driven by exports to developed markets. For instance, China’s exports accounted for 22.6% of its GDP in 2014 compared to just 13.5% in the U.S., which is driven largely by domestic consumer spending. Some emerging markets export commodities used as manufacturing inputs, while others export finished products that are sold on the international market – and commodity prices only really affect the former.

There are several countries with high exposure to commodities:

  • BrazilBrazil is a leading exporter of a number of different commodities, ranging from crude oil from its new offshore oil plays to coffee grown inland.
  • PeruPeru is a leading exporter of copper, gold, and other precious and industrial metals to countries like China that produce finished goods.
  • ChileChile is a leading exporter of copper, which is the largest sector as a percentage of its GDP, primarily to countries like China.

Portfolio Protection

International investors holding emerging market equities and bonds can take a number of different actions to protect their portfolio from declines.

The best option is to diversify away from commodity-heavy countries like Brazil and Chile and move into more diverse emerging markets.

In fact, the iShares MSCI Emerging Markets ETF (NYSE ARCA: EEM) may be a good option, since its only major commodity exposure is in Russia’s Gazprom – a leading player in the natural gas space. Individual countries operating on the manufacturing side rather than the commodity side may also be worth considering.

A second option would be to hedge against the decline in these equities by purchasing put options to limit downside or by selling call options to generate extra income to offset any declines. These strategies entail retaining the exposure to the emerging market equities and bonds but could pay off if commodities begin to turnaround moving into 2016.

Key Takeaway Points

  • Commodity prices have moved sharply lower due to the higher U.S. dollar and lesser demand from China’s economy.
  • Brazil, Chile, and Peru have the greatest exposure to commodity prices, while producers are less exposure to the downside.
  • Investors can protect their portfolios by diversifying away from economies with commodity exposure or by using options.